What is the difference between inflation and price level?

In economics, inflation is a rise in the general level of prices of goods and services
in an economy over a period of time. When the price level rises, each unit of
currency buys fewer goods and services; consequently, inflation is also an erosion in
the purchasing power of money a loss of real value in the internal medium of
exchange and unit of account in the economy.
Inflation is best defined as a sustained increase in the general price level leading
to a fall in the purchasing power or value of money.

What are the measures of inflation?

Commonly used measures of inflation
Examples of common measures of inflation include:

consumer price indices (CPIs) which measure the price of a selection of

goods purchased by a "typical consumer".

Cost-of-living indices (COLI) which often adjust fixed incomes and

contractual incomes based on measures of goods and services price changes

list index summary analysis (LISA) which measures the change in volume of
peoples' voices.

producer price indices (PPIs) which measure the price received by a

producer. This differs from the CPI in that price subsidization, profits, and
taxes may cause the amount received by the producer to differ from what
the consumer paid. There is also typically a delay between an increase in the
PPI and any resulting increase in the CPI. Producer price inflation measures
the pressure being put on producers by the costs of their raw materials.
This could be "passed on" as consumer inflation, or it could be absorbed by
profits, or offset by increasing productivity.

wholesale price indices, which measure the change in price of a selection of

goods at wholesale, prior to retail mark ups and sales taxes. These are very
similar to the Producer Price Indexes.

commodity price indices, which measure the change in price of a selection of

commodities. In the present commodity price indexes are weighted by the
relative importance of the components to the "all in" cost of an employee.

GDP Deflators measures price increases in all assets rather than some
particular subset. The term "deflator" in this case means the percentage to
reduce current prices to get the equivalent price in a previous period. The
US Commerce Department publishes a deflator series for the US economy.

What are the effects of inflation?

Inflation can have positive and negative effects on an economy. Negative effects
of inflation include a decrease in the real value of money and other monetary items
over time; uncertainty about future inflation may discourage investment and saving,
and high inflation may lead to shortages of goods if consumers begin hoarding out
of concern that prices will increase in the future. Positive effects include a
mitigation of economic recessions, and debt relief by reducing the real level of
debt.
Economists generally agree that high rates of inflation and hyperinflation are
caused by an excessive growth of the money supply. Views on which factors
determine low to moderate rates of inflation are more varied. Low or moderate
inflation may be attributed to fluctuations in real demand for goods and services,
or changes in available supplies such as during scarcities, as well as to growth in the
money supply. However, the consensus view is that a long sustained period of
inflation is caused by money supply growing faster than the rate of economic
growth.
If inflation is high in an economy there are three main problems it can cause:

1. People on a fixed income (e.g. pensioners, students) will be worse off in real
terms due to higher prices and equal income as before; this will lead to a
reduction in the purchasing power of their income.
2. Rising inflation can encourage trade unions to demand higher wages. This can
cause a wage spiral. Also if strikes occur in an important industry which has
a comparative advantage the nation may see a decrease in productivity and
suffer.
3. If inflation is relatively higher in one country, exports will become more
expensive for other countries to purchase, this will create a deficit on the
current account.
Effects of inflation:
1. General effects of inflation
2. Negative effects of inflation
3. Positive effects of inflation
These effects are summarized below:
1. General effects of inflation
An increase in the general level of prices implies a decrease in the purchasing
power of the currency. That is, when the general level of prices rises, each
monetary unit buys fewer goods and services. The effect of inflation is not
distributed evenly in the economy, and as a consequence there are hidden costs
to some and benefits to others from this decrease in the purchasing power of
money. For example, with inflation lenders or depositors who are paid a fixed
rate of interest on loans or deposits will lose purchasing power from their
interest earnings, while their borrowers benefit. Individuals or institutions with
cash assets will experience a decline in the purchasing power of their holdings.
Increases in payments to workers and pensioners often lag behind inflation,
especially for those with fixed payments. Increases in the price level (inflation)

erodes the real value of money (the functional currency) and other items with
an underlying monetary nature (e.g. loans and bonds). However, inflation has no
effect on the real value of non-monetary items, (e.g. goods and commodities,
gold, real estate)
2. Negative effects of inflation
High or unpredictable inflation rates are regarded as harmful to an overall
economy. They add inefficiencies in the market, and make it difficult for
companies to budget or plan long-term. Inflation can act as a drag on
productivity as companies are forced to shift resources away from products
and services in order to focus on profit and losses from currency inflation.
Uncertainty about the future purchasing power of money discourages
investment and saving. And inflation can impose hidden tax increases, as
inflated earnings push taxpayers into higher income tax rates.
With high inflation, purchasing power is redistributed from those on fixed
incomes such as pensioners towards those with variable incomes whose earnings
may better keep pace with the inflation. This redistribution of purchasing
power will also occur between international trading partners. Where fixed
exchange rates are imposed, rising inflation in one economy will cause its
exports to become more expensive and affect the balance of trade. There can
also be negative impacts to trade from an increased instability in currency
exchange prices caused by unpredictable inflation.
High inflation can cause the following negative effects:
Cost-push inflation Rising inflation can prompt employees to demand higher
wages, to keep up with consumer prices. Rising wages in turn can help fuel
inflation. In the case of collective bargaining, wages will be set as a factor of
price expectations, which will be higher when inflation has an upward trend.
This can cause a wage spiral. In a sense, inflation begets further inflationary
expectations.

Hoarding People buy consumer durables as stores of wealth in the absence of

viable alternatives as a means of getting rid of excess cash before it is
devalued, creating shortages of the hoarded objects.
Hyperinflation If inflation gets totally out of control (in the upward direction),
it can grossly interfere with the normal workings of the economy, hurting its
ability to supply.
Allocative efficiency A change in the supply or demand for a good will normally
cause its price to change, signalling to buyers and sellers that they should reallocate resources in response to the new market conditions. But when prices
are constantly changing due to inflation, genuine price signals get lost in the
noise, so agents are slow to respond to them. The result is a loss of allocative
efficiency.
Shoe leather cost High inflation increases the opportunity cost of holding cash
balances and can induce people to hold a greater portion of their assets in
interest paying accounts. However, since cash is still needed in order to carry
out transactions this means that more "trips to the bank" are necessary in
order to make withdrawals, proverbially wearing out the "shoe leather" with
each trip.
Menu costs With high inflation, firms must change their prices often in order
to keep up with economy wide changes. But often changing prices is itself a
costly activity whether explicitly, as with the need to print new menus, or
implicitly.
Business cycles According to the Austrian Business Cycle Theory, inflation sets
off the business cycle. Austrian economists hold this to be the most damaging
effect of inflation. According to Austrian theory, artificially low interest rates
and the associated increase in the money supply lead to reckless, speculative
borrowing, resulting in clusters of malinvestments, which eventually have to be
liquidated as they become unsustainable.
3. Positive effects of inflation
Inflation can cause following positive effects:

Labor-market adjustments Keynesians believe that nominal wages are slow to

adjust downwards. This can lead to prolonged disequilibrium and high
unemployment in the labor market. Since inflation would lower the real wage if
nominal wages are kept constant, Keynesians argue that some inflation is good
for the economy, as it would allow labor markets to reach equilibrium faster.
Debt relief Debtors who have debts with a fixed nominal rate of interest will
see a reduction in the "real" interest rate as the inflation rate rises. The real
interest on a loan is the nominal rate minus the inflation rate.[dubious discuss]
(R=n-i) For example if you take a loan where the stated interest rate is 6% and
the inflation rate is at 3%, the real interest rate that you are paying for the
loan is 3%. It would also hold true that if you had a loan at a fixed interest rate
of 6% and the inflation rate jumped to 20% you would have a real interest rate
of -14%. Banks and other lenders adjust for this inflation risk either by
including an inflation premium in the costs of lending the money by creating a
higher initial stated interest rate or by setting the interest at a variable rate.
Room to maneuver The primary tools for controlling the money supply are the
ability to set the discount rate, the rate at which banks can borrow from the
central bank, and open market operations which are the central bank's
interventions into the bonds market with the aim of affecting the nominal
interest rate. If an economy finds itself in a recession with already low, or even
zero, nominal interest rates, then the bank cannot cut these rates further
(since negative nominal interest rates are impossible) in order to stimulate the
economy - this situation is known as a liquidity trap. A moderate level of
inflation tends to ensure that nominal interest rates stay sufficiently above
zero so that if the need arises the bank can cut the nominal interest rate.
Tobin effect The Nobel prize winning economist James Tobin at one point had
argued that a moderate level of inflation can increase investment in an economy
leading to faster growth or at least higher steady state level of income. This is
due to the fact that inflation lowers the return on monetary assets relative to
real assets, such as physical capital. To avoid inflation, investors would switch
from holding their assets as money (or a similar, susceptible to inflation, form)
to investing in real capital projects.

How inflation will effect the employer & employee?

Inflation

_______

real wage (w)

How inflation will effect borrowers and debtors?

Real interest rate(r)______ i = r +

so r = i

Effects of inflation on other variables:

Impact on other variables
Uncompensated inflation reduces incomes, thus consumption and savings.
Through a Keynesian multiplier, income and consumption will cumulatively fall
further.
If inflation is mainy demand-pulled, it vanishes the increases in nominal
effective demand and it frustrates consumption expectations.
By contrast, if inflation is mainly due to efforts of increasing margins and
profits, it is possible a rise in consumption in high-income groups.
Investment should be discouraged by uncertainty about future engendered by
inflation and its wide fluctuation.
Still, to the extent that benefits of inflation are mainly reaped by domestic
firms, the real interest rate for investment fall inversely with mounting
inflation. Thus, a low or moderate inflation may help investments, at least to the
extent they are actually influenced by real interest rates and until a central
bank intervention.
In fact, central banks can try to control inflation through a sharp increase in
real interest rates, more than proportionally reflected in nominal interest
rates.
This move usually provokes a fall in investment and a revaluation of currency.
The first effect brakes domestic demand, the second the foreign one.

Summarizing some of these arguments, higher inflation leads to higher nominal

interest rates. In a first phase, the latter may not keep pace with inflation,
thus real interest rates may fall. But afterwards, if the central bank does not
accomodate inflation, the real interest rates are kept much higher than before.
Still, too many elements are intertwinned, so that these relationships should be
treated with great caution.
In absence of central bank reaction, it is for example common that inflation
tends to provoke currency devaluation, opening a vicious circle.
This is certainly the case with hyperinflation. In fact, in this case, central
banks often choose to fix a certain exchange rate target as a nominal anchor
in the battle against inflation: with fixed exchange rates, inflation makes
import cheaper in comparison to domestic products, so that domestic firms face
more intense competition, which should brake inflation.
Until the fall in inflation does not takes place, domestic goods become more
expensive in a international comparison, typically with a fall in exports and a rise
of imports, heavily deteriorationg the trade balance.
At the same time, if indexed, local wages and incomes will improve their
international purchasing power, thanks to fixed nominal exchange rate.
On financial markets of fixed-interest bonds, an increase of inflation will
reduce the burden of debt and interest payments.In the case of large public
debt, inflation is an important relief for the State (also through larger tax
revenues and lower personnel costs), menacing to engender a political tolerance
toward inflation.
___________________________________________________________

Types of inflation:
A transversal classification distiguish inflations, basing on their broadlydefined origins:
1. domestic demand;
>Demand pull inflation
>Domestic inflation
2. domestic costs, as wages;
>Cost push inflation
>Tax based cost push inflation
3. external sources,
>Imported inflation
as oil price increases or currency relative devaluation.
Types of Inflation
There are four main types of inflation. The various types of inflation are
briefed below.
Wage Inflation: Wage inflation is also called as demand-pull or excess demand
inflation. This type of inflation occurs when total demand for goods and
services in an economy exceeds the supply of the same. When the supply is less,
the prices of these goods and services would rise, leading to a situation called
as demand-pull inflation. This type of inflation affects the market economy
adversely during the wartime.
Cost-push Inflation: As the name suggests, if there is increase in the cost of

production of goods and services, there is likely to be a forceful increase in the

prices of finished goods and services. For instance, a rise in the wages of
laborers would raise the unit costs of production and this would lead to rise in
prices for the related end product. This type of inflation may or may not occur
in conjunction with demand-pull inflation.
Pricing Power Inflation: Pricing power inflation is more often called as
administered price inflation. This type of inflation occurs when the business
houses and industries decide to increase the price of their respective goods and
services to increase their profit margins. A point noteworthy is pricing power
inflation does not occur at the time of financial crises and economic depression,
or when there is a downturn in the economy. This type of inflation is also called
as oligopolistic inflation because oligopolies have the power of pricing their
goods and services.
Sectoral Inflation: This is the fourth major type of inflation. The sectoral
inflation takes place when there is an increase in the price of the goods and
services produced by a certain sector of industries. For instance, an increase in
the cost of crude oil would directly affect all the other sectors, which are
directly related to the oil industry. Thus, the ever-increasing price of fuel has
become an important issue related to the economy all over the world. Take the
example of aviation industry. When the price of oil increases, the ticket fares
would also go up. This would lead to a widespread inflation throughout the
economy, even though it had originated in one basic sector. If this situation
occurs when there is a recession in the economy, there would be layoffs and it
would adversely affect the work force and the economy in turn.
Other Types of Inflation
Fiscal Inflation: Fiscal Inflation occurs when there is excess government
spending. This occurs when there is a deficit budget. For instance, Fiscal
inflation originated in the US in 1960s at the time President Lydon Baines
Johnson. America is also facing fiscal type of inflation under the presidentship

of George W. Bush due to excess spending in the defense sector.

Hyperinflation: Hyperinflation is also known as runaway inflation or galloping
inflation. This type of inflation occurs during or soon after a war. This can
usually lead to the complete breakdown of a countrys monetary system.
However, this type of inflation is short-lived. In 1923, in Germany, inflation
rate touched approximately 322 percent per month with October being the
month of highest inflation.

The main causes of inflation

Inflation can come from several sources: Some come direct from the domestic
economy, for example the decisions of the major utility companies providing
electricity or gas or water on their prices for the year ahead, or the pricing
strategies of the leading food retailers based on the strength of demand and
competitive pressure in their markets. A rise in government VAT would also be a
cause of increased domestic inflation because it increases a firms production
costs.
Inflation can also come from external sources, for example an unexpected rise
in the price of crude oil or other imported commodities, foodstuffs and
beverages. Fluctuations in the exchange rate can also affect inflation for
example a fall in the value of sterling might cause higher import prices which
feeds through directly into the consumer price index.
We make a simple distinction between demand pull and cost push inflation.
Demand-pull inflation
Demand-pull inflation is likely when there is full employment of resources and
aggregate demand is increasing at a time when SRAS is inelastic. This is shown

in the next diagram:

In the diagram above we see a large outward shift in AD. This takes the
equilibrium level of national output beyond full-capacity national income (Yfc)
creating a positive output gap. This would then put upward pressure on wage
and raw material costs leading the SRAS curve to shift inward and causing
real output and incomes to contract back towards Yfc (the long run equilibrium
for the economy) but now with a higher general price level (i.e. there has been
some inflation).
The main causes of demand-pull inflation
Demand pull inflation is largely the result of the level of AD being allowed to
grow too fast compared to what the supply-side capacity can meet. The result is
excess demand for goods and services and pressure on businesses to raise
prices in order to increase their profit margins.
Possible causes of demand-pull inflation include:
1. A depreciation of the exchange rate which increases the price of imports
and reduces the foreign price of UK exports. If consumers buy fewer

imports, while exports grow, AD in will rise and there may be a multiplier
effect on the level of demand and output
2. Higher demand from a fiscal stimulus e.g. via a reduction in direct or
indirect taxation or higher government spending. If direct taxes are
reduced, consumers will have more disposable income causing demand to rise.
Higher government spending and increased government borrowing feeds
through directly into extra demand in the circular flow
3. Monetary stimulus to the economy: A fall in interest rates may stimulate
too much demand for example in raising demand for loans or in causing a
sharp rise in house price inflation
4. Faster economic growth in other countries providing a boost to UK
exports overseas. Export sales provide an extra flow of income and spending
into the UK circular flow so what is happening to the economic cycles of
other countries definitely affects the UK
Cost-push inflation
Cost-push inflation occurs when firms respond to rising costs, by increasing
prices to protect their profit margins. There are many reasons why costs might
rise:
1. Component costs: e.g. an increase in the prices of raw materials and other
components used in the production processes of different industries. This
might be because of a rise in world commodity prices such as oil, copper and
agricultural products used in food processing
2. Rising labour costs - caused by wage increases, which are greater than
improvements in productivity. Wage costs often rise when unemployment is
low (skilled workers become scarce and this can drive pay levels higher) and
also when people expect higher inflation so they bid for higher pay claims in
order to protect their real incomes. Expectations of inflation are important
in shaping what actually happens to inflation!

3. Higher indirect taxes imposed by the government for example a rise in

the specific duty on alcohol and cigarettes, an increase in fuel duties or a
rise in the standard rate of Value Added Tax. Depending on the price
elasticity of demand and supply for their products, suppliers may choose to
pass on the burden of the tax onto consumers
Cost-push inflation can be illustrated by an inward shift of the short run
aggregate supply curve. The fall in SRAS causes a contraction of national
output together with a rise in the level of prices.

Which government policies are most effective in reducing inflation?

Most governments now give a high priority to keeping control of inflation. It has
become one of the dominant objectives of macroeconomic policy.
Inflation can be reduced by policies that (i) slow down the growth of AD or (ii)
boost the rate of growth of aggregate supply (AS). The main anti-inflation
controls available to a government are:
1. Fiscal Policy: If the government believes that AD is too high, it may reduce
its own spending on public and merit goods or welfare payments. Or it can
choose to raise direct taxes, leading to a reduction in disposable income.
Normally when the government wants to tighten fiscal policy to control

inflation, it will seek to cut spending or raise tax revenues so that

government borrowing (the budget deficit) is reduced. This helps to take
money out of the circular flow of income and spending
2. Monetary Policy:A tightening of monetary policy involves higher interest
rates to reduce consumer and investment spending. Monetary policy is now in
the hand of the Bank of England it decides on interest rates each month.
3. Supply side economic policies: Supply side policies include those that seek
to increase productivity, competition and innovation all of which can
maintain lower prices.
The most appropriate way to control inflation in the short term is for the
British government and the Bank of England to keep control of aggregate
demand to a level consistent with our productive capacity. The consensus among
economists is that AD is probably better controlled through the use of
monetary policy rather than an over-reliance on using fiscal policy as an
instrument of demand-management. But in the long run, it is the growth of a
countrys supply-side productive potential that gives an economy the flexibility
to grow without suffering from acceleration in cost and price inflation.