Causes of Inflation and Deflation

WITH THE AID OF DIAGRAMS, ILLUSTRATE THE CAUSES OF INFLATION AND DEFLATION, AND BY COMPARING THEIR ECONOMIC EFFECTS CONSIDER HOW BOTH CAN AFFECT THE CORPORATE SECTOR.

The essay will describe causes of inflation and deflation and explain how they can affect the corporate sector.

1. INTRODUCTION

DEFINITION OF INFLATION AND DEFLATION

Inflation is a process in which the price level is rising and money is losing value. (Parkin, Powell, Matthews p654)

Inflation tends to rise when at the current price level, demand for goods and services in the economy are greater than economy's ability to produce goods and services.

The graph below shows continuously growing inflation, occurred by a rising price level.

If the price level is rising, the inflation rate is positive. If the price level rises at a faster rate, the inflation rate increases.

Inflation is measured with a price index.

The two main measures of inflation are: the Retail Price Index (RPI) and Consumer Price Index (CPI).They measure an average of the prices paid by costumer for a fixed basked of goods and services included such items as food, heating, housing goods, bus fares and petrol.

One of the several variations on inflation is hyperinflation. When it occurs, the value of money becomes worthless. Although it is extremely rare it may lead to the breakdown of a nation's monetary system. One of the most famous happened in Germany between 1921 and 1923 and Turkey in 1999 when inflation reached 70%.

Deflation is very unusual although some countries such as Japan and China have experienced price deflation in their economies in recent years.

Falling prices can arise from too much supply or too little demand. There are four causes for deflation.

Decreasing Money Supply

Increasing Supply of Goods

Decreasing Demand for Goods

Increasing Demand for Money

AS line is representation of aggregate supply, in relation to price level and GNP. When supply of goods increases, AS moves downwards to AS' and there is productivity growth. Point A where AS meets AD (aggregate demand) moves in this instance to B, creating deflation. This situation is bad for companies, therefore bad for profits as businesses can not raise prices and the real debt rises.

AD is the line for aggregate demand. As the demand for money increases, AD moves downwards to AD'. This represents a monetary stimulus that leads to lower interest rates, point B moves to C, where the new AS' and AD' meet. Inflation comes to force, which is better for companies their profits and pricing power and the real debt falls.

2. CAUSES OF INFLATION

There are different schools of explaining causes of inflation as it can be caused by different things at different times. Inflation often follows a war, when government has to spent large sums on military equipment and has not raised enough taxes to pay for it.

*Monetary inflation - quantity theory

By Monetarism, inflation is an effect of the supply of money being larger than the demand for money.

(http://en.wikipedia.org/wiki/Inflation)

The Monetarist explanation of inflation operates through the Fisher equation where:

M.V = P.T

M = Money Supply

V = Velocity of Circulation

P = Price level

T = Transactions or Output

As Monetarists assume that V and T are fixed, there is a direct relationship between the growth of the money supply and inflation.

Individuals can also spend their excess money balances directly on goods and services. This has a direct impact on inflation by raising aggregate demand. The more inelastic is aggregate supply in the economy, the greater the impact on inflation. If both happen together the inflation is even worse. If the inflation is caused by an increase in demand, then it is known as demand-pull inflation. If the inflation is caused by a change in aggregate supply, then it is known as cost-push inflation.

It is also important to look at the role of the amount of money in the economy. The quantity theory of money shows how increased growth in the money supply can cause inflation. This happens because the extra money boosts the level of demand, and so causes demand-pull inflation.

By Keynes's theory inflation occurs when the demand for goods and services is greater than the supply. It calls for the government to control inflation by adjusting levels of spending and taxation and by raising or lowering interest rates.

(http://www.britannica.com/ebc/article-9367968?query=inflation&ct=)

*Demand Pull inflation occurs when total demand for goods and services exceeds total supply. This type of inflation happens when there has been excessive growth in aggregate demand such as: increase in the monetary supply, increase in government expenditure or increase in exports.

Demand-pull inflation is often monetary in origin - because the authorities allow the money supply to grow faster than the ability of the economy to supply goods and services. The phrase that is often used is that there is "too much money chasing too few goods".

DEMAND PULL INFLATION

An increase in aggregate demand shifts the AD curve from AD1 to AD2. This results in a new equilibrium where inflation rises to P2 and output to Y2.

Inflation has been pulled up by an increase in aggregate demand.

*Cost push inflation

The main causes of cost push inflation are:

Rising imported raw materials or by a fall in the value of the pound in the foreign exchange markets or increase in the money wage rates.

An increase