The Causes and effects of inflation

In the previous post, we looked at what inflation is and how they calculate it. In today's post, we are going to, as always, look at inflation with a practical example called The Brick Wall Theory example.

Don't know what that is? Read about it here.

If you don't want to read about what inflation is and just want to see an example that is also fine. I will tell you in short what inflation is to make sure that you will be able to understand the example.

Inflation is the process of a sustained, significant rise in the general price level over a period of time. Basically, inflation is the process where money loses its value over time. Your groceries might cost you $50 today, but in ten years time, the same amount of groceries is going to cost you $65.

This post isn't going to explain all the things we already covered here with an example, rather we are going to look at the causes of inflation and then we are going to look at what the effects on the brick wall company and my neighbour is. The causes of inflation can't directly be traced to the brick wall company and my neighbour as inflation is something that happens on a large scale in the economy. The effects, however, have a direct impact on the brick wall company and my neighbour.

Causes of inflation

Inflation has two main causes. These two causes are demand-pull inflation and cost-push inflation. We can now go and look at each of these causes in more depth and explain it with the brick wall theory.

Demand-Pull Inflation

Demand-pull inflation occurs when an economy's total demand rises higher than its total available output capacity. In short, this means that there are too much money and too little things. 

If we look at this in a way that we can analyse it with the brick wall theory, we have to scale it down and only look at the wall building industry. When more people want to build walls, the demand for the wall building company's product will rise. The company will start to struggle to keep up with all the orders so over time they will have to increase their prices in order to be able to keep up with production.

Supply and demand for inflation

The graph above illustrates the supply and demand for brick walls. The demand curve shifted to the right because more people could afford to build walls. The supply couldn't keep up which led to the price rising from P1 to P2

Essentially this is happening all over the economy. There is more money available to buy things and the producers can't produce fast enough. Prices then rise and inflation occurs.

Now you might be asking, "why is their more money available?" Well, that is exactly why we are looking at the causes of inflation.

Total spending in the economy can be written as:

E=C+I+G+(X-M)

• E=total spending
• C= consumer spending
• I= Investment spending
• G= Government spending
• X= exports (money flowing in)
• M= imports (money flowing out)

When total spending in the economy rises higher than the total production in the economy, prices will rise and demand-pull inflation will occur. The prices of the products are being "pulled" higher by the increasing demand. 

To understand how the total spending can rise we can look at leakages and injections.

Consumer spending can rise in several ways. People can decide to save less and spend more, governments can decrease taxes which will, in turn, enable people to spend more, people import less which means that they have more money to spend in the economy and when people get access to more credit they will be able to spend more. When investment spending and government spending increase a ripple effect can move through the economy which will lead to even more spending and create inflation. Basically, when the injections in the economy rise or the leakages shrink people will have more money to spend which will lead to inflation.

In the brick wall example, the government lowers taxes which enables more people to build walls. This increase in demand led to the price to rise. What this means is that my neighbour would have had to pay fewer let's say, two years ago, than he would have had to pay today.

Cost-push Inflation

Cost-push inflation occurs when the prices of goods and services rise because the prices of the underlying factors of production rise.

• A rise in wages and salaries. (labour)
• A rise in the cost of key resources. (land)
• A rise in the price of foreign exchange (when the products get imported).
• A rise in the business' profit margins. (entrepreneurship)
• A rise in the government's machine operating costs. (capital)
• A decline in labour productivity.
• Natural disasters.

When the brick wall company has to pay more for their factors of production, they will have to increase the prices of their products. For example, when their workers strike for higher wages the company will have to ask more for their products because of the higher cost of production.

Supply and demand for cost-push inflation

As you can see, when the strike happened, the wall building company had to raise their prices which led to inflation.

Effects of inflation

Inflation affects a lot of things in the economy. It would be impossible to look at all the things that inflation would have an effect on. Instead, we are only going to look at the brick wall theory example to explain the effects of inflation.

Inflation has the most notable effect on the following things:

• Debtors and creditors.
• People receiving wages and salaries.
• Investors and savers.
• Taxpayers.
• Businesses.
• Governments.

Let's say that our neighbour made use of a service where the wall building company makes it possible for people to pay the cost of the wall over a period of five years (yes that is a long time but it is essential for the example to work). This service will make my neighbour the debtor and the wall-building company the creditor. Let us also say that the interest rates payable is a smaller percentage amount than the average inflation over the five years. What this will mean is that my neighbour would essentially be paying the money back in a time where it is less valuable than it was when the wall got built. My neighbour benefits from this as it is in real terms cheaper for him to build the wall. The wall building company, on the other hand, is losing out because they are receiving less money in real terms than they would have if it weren't for inflation.

People like my neighbour and the people working for the wall building company receive salaries form their employers. The salary they earn would by them fewer things over a certain period of time because of inflation. This can in turn also leads to more inflation as people tend to get salary raises to compensate for the inflation which then means there is again more money available that then creates inflation. 

Investors and savers are scared away by inflation. One way that inflation gets combatted is by higher interest rates. This is bad for investors, especially foreign investors because the high interest makes it expensive to invest in a country. This is bad for the wall building company as investors will not invest that easily into the company because of the high-interest rates. Savers also don't like inflation because it eats away the value of the saved money. This means that my neighbour would be scared to save his money because he is scared that the inflation will take away its value. 

Inflation leads to higher salaries and wages which in turn means that governments can ask for higher tax incomes. This is bad as taxpayers will always have to pay more and more as inflation grows. My neighbour is going to have to always pay more taxes even though he got a raise at his job.

Inflation causes production costs to rise which means that businesses have to raise their prices or lower their profit margins. This makes it extremely difficult for companies to compete, especially against foreign companies. The wall building company feels this as they are making fewer profits from their business because of inflation.

Governments also buy goods and services in order to provide it to the people in the country. Inflation means that they too have to pay more for the goods and services because the prices increase. Essentially my neighbour, the consumer, feels this as well because he will have to pay more for the government services.

How do they prevent inflation?

Yes as you guessed it, there are ways that they try and prevent or lower the effects of inflation. Again there are a lot of arguments about the best way is to fight inflation. The two most popular arguments are, like in a lot of places in the economy, between the monetarists and the Keynesian views.

The monetarists believe that inflation sprouts out of the increase in money and that it should be combatted with policies aimed to reduce the money in the economy. This focusses a lot on demand-pull inflation and wants to lower the amount of money available to spend. There is this thing called the monetary policy which consists of the following:

• Controlling the repo rate. By raising the repo rate (the rate at which central banks lend money to commercial banks) the central bank is, in turn, making it more expensive for consumers to get credit and buy fewer things slowing down the effects of inflation.
• Central banks can also opt to raise the cash reserves of the commercial banks (the amount of money which banks has to have stored at the central bank as a reserve) this means that the banks will have less money to lend to consumers, lowering the amount of money available in the economy.

The amount of money can also be manipulated by other means called the fiscal policy. This policy isn't controlled by the central bank of a country but rather the government itself. The fiscal policy consist of the following:

• Raising taxes will lead to less available money in the economy for consumers to spend.
• Governments can lower their spending which will make the ripple effect throughout the economy smaller which will then lead to less inflation.

The Keneysians argument is more focussed at the cost-push side of inflation and says that inflation should be fought in the long term by using policies which helps companies to become more productive and competitive which will then keep prices low.

In the future, we will look at a lot of things in the economy which has a monetary and Keynesian argument. To be notified when I post new things, subscribe with your email in the box at the right to get updates about posts right in your inbox. Also, you can follow me on Pinterest by clicking on the Pinterest button in order to get updated when I make new pins.