“Inflation is taxation without legislation.” – Milton Friedman
Inflation is a commonly used term in economics which relates to a constant hike in the price of goods and services over a time period. Inflation possesses a serious threat to the global economy and is one such phenomenon which needs to be controlled and proper care taken in order to balance an economic order in global markets. Inflation affects both internal and external stakeholders of markets ranging from producers and consumers to corporate and government.
Inflation takes on a market or a country or a region as a whole as it is not restricted by geographical boundaries until the market is involved in any sort of global trade. Globalisation has so far played an important role in paving the way for local markets to upgrade globally. This has made the world into one colossal marketplace where the survival and existence of each and every market were indirectly dependent on every other market. Thus inflation grew as a threat to the global market which cut short the purchasing power of the currency and consumers belonging to the affected countries. During the phase of inflation, every unit of currency had comparatively less purchasing power and could only afford lesser amount of goods or services in return. Starting with prices of goods and services, inflation takes on debts, assets, investments, employment, taxes etc.
When the currency of a nation gradually loses its value, it throws the economy of the country into turmoil. Hyperinflation refers to one such phase where the inflation goes out of control and is extremely dangerous. Hence inflation needs to be controlled and the balance of the economy should be maintained properly for the economic welfare of the nation.
History of Inflation
Inflation, even though the term gained popularity after globalisation the characteristics of the phenomenon traces back to the beginning of the 15th century. The gold and silver coins were popularised at this stage as a commonly used medium of exchange. The European continent was experienced the first blow of inflation as they spread their markets and transactions were made through silver and gold. As the population shot up in European countries the medium of exchange was not sufficient to cater to the population. Hence, it led to the infamous ‘Price Revolution’ at the beginning of the 15th century. Within a short span of 150 years, it went 6 times high and silver played the major role behind.
This was the first recorded event on inflation but even before, the introduction of paper currency in Asian countries like China and the aftermath can also be considered as an event of inflation. The first paper currency as a medium of exchange was introduced in China under the regime of the Song dynasty. Unfortunately, this led to a huge increase in the money flow and gradually led to the stage of inflation. As Ming dynasty overthrew the regime and came to power, they dropped the idea and discouraged the usage of paper currency as a medium of exchange in markets. They even restored the application of coins made out of copper which was used as a medium of exchange before.
The history of China and the European continent brings out the fact that how dangerous inflation can be and why is it important to keep the flow of money under proper control. An uninterrupted hike in the money supply will reduce the value of every unit of currency or any other medium of exchange. The prices of goods and services tend to increase while currency value drops down. It turns out to become even worse during trade between two different nations dealing with different currency units. The nation which is affected by inflation will be forced to do the sacrifice to the latter.
The use of paper currency was encouraged as a medium of exchange during the 18th century in many countries. Unfortunately, most of them resulted in an inflationary stage in local markets of the countries. As the government couldn’t control the flow of money it even led to political instabilities and hyperinflations.
Europe was one of the worst hit regions by inflation. The paper currency took the form of banknotes at the beginning of the 19th century. These banknotes were used as emergency money as it can be redeemed anytime to the metal form of currency anytime which was common in use. Alike paper currency, banknotes also failed in maintaining the balance of demand and supply in the economy. Soon the number of banknotes exceeded the amount of metal currency available and redemption of them was not possible. The oversupply of banknotes couldn’t be controlled and the attempt was a failure too.
Causes and Effects of Inflation
The economic factors of a nation should be balanced and well maintained in order to guarantee its growth and development. The supply and flow of money in and out of domestic markets plays a major role in causing an inflationary state. Hence the uncontrolled hike in money supply along with other small factors like demand and supply of goods and services, borrowing rates etc. acts as a major cause for inflation. The United Kingdom faced inflation in its economy when demand surpassed the supply of goods in 1980. Similarly, they faced an inflationary period during 2011 due to a hike in the price of imported products.
Inflation in an economy also depends on other factors like increments in wages and taxes, when firms increase prices of their products for better profits etc. Thereby inflation affects the economy of the country as a whole, possess a threat to every financial systems and transaction from interest rates to taxes and employment problems.
How to measure Inflation
A variety of tools are been used by economists for measuring the rate of inflation. Consumer Price Index (CPI) is one such tool which is widely used to measure the inflation rate along with the Retail Price Index (RPI).
Production Price Index (PPI) which possess similar characteristics to CPI functions to measure the ups and downs in the prices in which the producers sell their products.
Commodity Price Index is another tool to measure the changes in prices of a set of goods of similar nature and characteristics.
Core Price Index takes the set of goods which is vulnerable to small and infrequent changes into measuring the scale of Inflation.
GDP Deflator which covers all the products been produced domestically into consideration and value they possess.
These tools are applied not only for measuring the current inflation rate but also to anticipate the fluctuations in near future too. Application of these tools in measuring the inflation rate is a difficult job as inflation depends on uncontrollable factors other than price too. They use the weighted price of goods and services and as different indices vary with the factors concerned, the median opts.
Advantages and Disadvantages of Inflation
The inflationary period is one of the hardest times a country or a region has to undergo and it affects the people belonging to them as a whole. It destroys the financial structure and acts as a hindrance even for ordinary people. Inflation spreads fear of uncertainty all over and it prevents people from investments and savings. It also leads to hoarding of goods as the producers save them in hope of rise in prices for better profits.
Many revolts and oppressions have taken place so far due to inflation. The products which are highly priced flooded the markets. Employee revolts were strong demanding higher wages. Firms cannot make long term plans or make decisions due to the existence of the factor of uncertainty and they had to make frequent changes in prices. Moreover, after globalisation the domestic markets were dependent on the global market and inflation thus curbed the activities of the global market to an extent.
Even though inflation creates havoc in the region, it certainly provided some notable benefits to the markets. Unemployment was found to be reduced drastically during the inflationary period. More investments were made on physical assets as the element of uncertainty possessed investments in intangible assets.
Controlling Inflation
Inflation is one such phenomenon which can only be prevented by proper management of financial structure and economy. For controlling inflation all the factors which pave the way for inflation need to be controlled. An uncontrolled money supply which acts as the primary reason behind inflation can be controlled by regulating the money supply and printing of currency notes. The banks can enter into open market operations and also regulate and move the interest rates of banks in an efficient manner.
Fixing a comparatively high rate of interest discourages the public from borrowing and it regulates the flow of money in and out of the market. The central banks which possess the authority to fix the amount that the banks have to hold with themselves will be shot up in order to prevent additional lending activities.
As of now the element of uncertainty on inflation and its aftermaths are a point of concern that the governments are aware of. The end of the twentieth century witnessed the formation of independent central banks that had full authority over all sort of economic operations inside its territory. Hence these central banks formed and modified the economic present and will design an effective future battling all odds.
-Ajay Sreeram
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