Inflation And Inflation Expectations

Inflation Expectations

Written by Harnisha Patil

May 19, 2021

Inflation refers to the rise in the prices of most goods and services of daily or everyday use, such as food, clothing, housing, transport, consumer staples, etc.

Inflation expectations are simply the rate at which people, consumers, businesses, investors—expect prices to rise in the future.

Inflation measures the average price change in a basket of commodities and services over time.

TYPES OF INFLATION

DEMAND PULL: –

J. M. Keynes developed the concept of demand-pull inflation.

It arises due to the aggregate demand of goods and services being more than the supply of goods and services. The need for goods and services may be more due to an increase in the money supply.

It is generally associated with the level of total employment.

Full employment refers to a situation where the resources of the economy are fully employed.

In such a situation, if the money supply increases, demand for goods and services also increases.

COST-PUSH INFLATION: –

Cost-push inflation refers to the rise in the price level due to the increase in the cost of production.

Contrary to demand-pull inflation, some economists believe that a rising cost of production is the root cause of inflation, and this inflation is also known as cost inflation.

It may occur due to a rise in the wage rate or an increase in the profit rate. Of the various components of the cost of production, wages are a significant component.

When the demand for labor is more, wage rates tend to rise. It adds to the cost of production, and the employers try to pass the burden to the consumers by including it in the price.

Due to this cost of living will also increase, and the workers will ask for further revision in wages. This again will result in a rise in prices.

It may start in a particular sector but may spread to other sectors of the economy soon.

STAGFLATION: –

It refers to a situation where a high unemployment rate accompanies a significant rise in the price level.

It implies the co-existent of stagnation and inflation in the economy. During such times, economies experience what is called ‘jobless growth.’

It refers to a situation of inflation along with the high rate of national income. 

CAUSES OF INFLATION

Inflation arises due to a variety of factors.

It is a complex phenomenon.

It isn’t easy to attribute one particular cause for the rise in prices. The most critical causes of inflation are: – 

FACTORS INFLUENCING THE DEMAND SIDE

EXPANSION OF MONEY SUPPLY: – 

Money supply will expand whenever banks create too much credit, the government adopts deficit financing, and incurs huge defense expenditure.

The increased money supply will lead to more demand for goods and services, causing an inflationary spiral in the economy.

Increased money supply can be seen occurring using the M2 money supply data published by the US government on their Federal Reserve database website FRED.

INCREASE IN DISPOSABLE INCOME: –

Disposable income refers to the income available to the person for spending after meeting the tax commitments.

Whenever disposable income increases due to production in the tax rate or increase in revenue, demand for goods and services will increase, leading to inflation.

EXTERNAL DEMAND: – 

When demand from foreigners rises, the availability of goods to the domestic population will be affected, leading to the rise in prices.

RISE IN EXPENDITURE: – 

An increase in expenditure of the households and business firms will also lead to inflation. Households tend to spend more when there is an increase in their disposable income, use their past savings for present consumption, etc.

When demand for goods and services increases, investment of the entrepreneur will increase, leading to more employment, more income, and more demand for goods and services.

This increased demand will result in a rise in the price level.

FACTORS INFLUENCING THE SUPPLY SIDE

INADEQUATE RESOURCES: –

Lack of resources in terms of labor, raw materials, spare parts, etc., will lead to a shortage of goods and services, resulting in inflation.

HOARDING AND BLACK MARKETING: –

Traders resort to hoarding and black-marketing when they expect the shortage of goods and services.

This leads to artificial scarcity, and prices tend to rise. Households also like to store more if they expect scarcity of goods. This will result in more demand and leading to a further rise in the price level.

NATURAL CALAMITIES: –

Natural calamities like floods, droughts affect the supply of food grains and raw materials, resulting in a rise in the price level.

Thus, developing countries face inflation due to factors on both demand and supply sides: Effective measures are required to control the inflationary spiral in such economies.

MEASURES TO CONTROL INFLATION:

A variety of measures have to be used to control inflation.

Inflation is the result of disequilibrium between demand and supply.

Hence the measures are directed towards factors influencing demand and supply sides.

The following measures are generally adopted to control inflation.

  • (1) Monetary Measures
  • (2) Fiscal Measures
  • (3) Other Measures.

HOW TO CALCULATE THE INFLATION RATE?

Inflation is calculated by using the Consumer Price Index (CPI).

  1. The rate of the product before.
  2. The current rate of the product.
  3. Use the inflation rate formula (Initial CPI – Final CPI/ Initial CPI) *100. CPI is the rate of the product.

This gives the increase/decrease % in the price of the product. One can use this to compare the inflation rate over a period of time.

INFLATION EXPECTATIONS

Inflation expectations are simply the rate at which people, consumers, businesses, investors—expect prices to rise in the future.

As actual inflation depends on what we expect it to be. If everyone expects prices to rise, say, 5 percent over the next year, businesses will want to raise prices by (at least) 5 percent, and workers and their unions will want equal raises.

All else equal, if inflation expectations rise by two percentage points, actual inflation will tend to increase by two percentage points as well.

Inflation expectations are widely thought to capture forces important to the determination of inflation. E.g., inflation expectations likely to affect wage demands, which may, in turn, affect firms’ pricing decisions.

In addition, inflation expectations cast a central bank’s credibility and commitment to maintaining price sustainability.

Should that reliability ever come seriously into doubt, long-term inflation expectations would likely increase. Accordingly, many central banks worldwide carefully monitor long-term inflation expectations and view keeping these expectations ‘anchored’ as crucial in achieving their objectives.

In this setup, expectations don’t directly commute inflation; instead, they are auxiliary indicators of the not observed trend rate of inflation.

So to assess the bond between inflation expectations and inflation in a less prohibitory setup, we use vector autoregressions (VARs) to evaluate the response of inflation to shocks to inflation expectations and inflation expectations to various other shocks.

This approach allows us to assess the dominant expectations on inflation and the forces influencing inflation expectations. 

The variables in the model consist of either energy or food inflation, long-run inflation expectations, short-run expectations, core CPI inflation, the CFNAI, and the federal funds rate.

We obstruct the shocks to inflation expectations due to changes in fundamental forces outside the model’s scope rather than pure shocks to expectations.

In other words, movements in expectations may significantly affect actual inflation – summarize troops that are not adequately gained controlled by the other variables in the model. 

E.g., changes in long-term inflation expectations may be due to shifts in the anticipated credibility of monetary policy, which the model can’t effectively measure except through changes in inflation expectations.

However, our VAR-based approach doesn’t necessarily permit such structural solid interpretations. In addition, there is some probability that what appears to be shocking to expectations – specifically to short-run expectations – are, in fact, systematic responses to news on the inflation outlook not captured by the model.

Developing countries like India often have to face the problem of inflation. While advanced countries experience inflation after full employment is attained, developing countries face inflation even before full employment is attained.

Thus effects of inflation are many, and generally, inflation has adverse effects unless it is a mild one; if long inflation persists time, it disturbs the planning process, red competitiveness of the economy in the international market and reduces lowers the external value of the currency, To avoid the economic, political effects of inflation, all efforts should be to control it at the earliest.

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4 Comments

  1. Mayank Limkar

    Very detailed explanation

    Reply
    • Harnisha Patil

      Thank you so much

      Reply
  2. Deepali

    Very useful information .

    Reply
    • Harnisha Patil

      glad you found it useful

      Reply

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