Understanding Inflation In Economics

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Definition of Inflation Inflation is a sustained increase in the general price level. It means that there will be an increase in the cost of living and people will need more money to buy the same goods.

How is Inflation Measured?

To measure inflation, government’s undertake a price survey and also a survey to find out a typical basket of goods.

The first thing the government need to do when measuring inflation is to discover a typical basket of goods. This enables the goods to be given a weighting, depending on how influential they are. For example spending on gasoline may account for 12% of the total basket. Spending on clothes may account for 7% and spending on mineral water 1%. Clearly if gasoline prices increase it will be more important than mineral water.

Every month the government will check prices. The price changes will then be mulitiplied by the weighting of the goods. This can then be converted into a price index e.g. in UK the Consumer Price Index CPI is used.

Problems of Measuring Inflation

1. Goods may change in quality. E.g. mobile phones may increase in price but, this may be due to improvements in features rather than a reflection of inflation.

2. Some consumers may have different effective rates of inflation. Consumers who smoke will be effected by rising cigarette prices. Old people who live in cold houses will be more effected by rising energy prices. Young people may benefit from falling prices of consumers

Problems / Costs of Inflation – Why is Inflation Bad?

  1. Rising prices creates uncertainty in the economy. When inflation is high it also tends to be more volatile and unpredictable. This discourages firms from investing because they are more uncertain about future costs and future prices. Lower investment leads to lower economic growth in the long term. Countries with high rates of inflation tend to have a poorer economic performance over the medium term.
  2. Inflationary Growth is unsustainable. If economic growth is above the long run trend rate then it causes inflation because demand is rising faster than supply. To reduce inflation, the monetary authorities will increase interest rates; this will reduce inflationary pressures but at the expense of lower growth. It could even cause a recession in the long term. Keeping inflation low will help avoid a boom and bust economic cycle.
  3. Menu Costs. This is the cost of changing price lists. When prices are rising, it takes time to update price labels. This has become less significant with modern technology.
  4. Shoe Leather Costs. When inflation is high people expend more time and effort in finding the lowest prices
  5. Decline in Exports. If a country has inflation higher than its main trading partners then it will become uncompetitive and sell less exports.

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