Banking Diploma: Define Inflation-What are the Causes/ Source of Inflation? What are the Costs/ affects of Inflation?

Inflation can be defined as a sustained or continuous rise in the general price level or, alternatively, as a sustained or continuous fall in the value of money.

Several things should be noted about this definition. First, inflation refers to the movement in the general level of prices. It does not refer to changes in one price relative to other prices. These changes are common even when the overall level of prices is stable and the rise in the price level must be somewhat substantial and continue over a period longer than a day, week, or month.

What are the Causes/ Source of Inflation? 

Economists wake up in the morning hoping for a chance to debate the causes of inflation. There is no one cause that's universally agreed upon, but at least two theories are generally accepted:

Demand-Pull Inflation

This theory can be summarized as "too much money chasing too few goods". In other words, if demand is growing faster than supply, prices will increase. This usually occurs in growing economies.

Cost-Push Inflation

When companies' costs go up, they need to increase prices to maintain their profit margins. Increased costs can include things such as wages, taxes, or increased costs of imports. 


What are the Costs/ affects of Inflation?

Almost everyone thinks inflation is evil, but it isn't necessarily so. Inflation affects different people in different ways. It also depends on whether inflation is anticipated or unanticipated. If the inflation rate corresponds to what the majority of people are expecting (anticipated inflation), then we can compensate and the cost isn't high. For example, banks can vary their interest rates and workers can negotiate contracts that include automatic wage hikes as the price level goes up.

Costs/ affects arise when there is unanticipated inflation: 

1. Creditors lose and debtors gain if the lender does not anticipate inflation correctly. For those who borrow, this is similar to getting an interest-free loan.
2. Uncertainty about what will happen next makes corporations and consumers less likely to spend. This hurts economic output in the long run.
3. People living off a fixed-income, such as retirees, see a decline in their purchasing power and, consequently, their standard of living.
4. The entire economy must absorb repricing costs ("menu costs") as price lists, labels, menus and more have to be updated.
5. If the inflation rate is greater than that of other countries, domestic products become less competitive.

People often complain about prices going up, but they often ignore the fact that wages should be rising as well. The question shouldn't be whether inflation is rising, but whether it's rising at a quicker pace than your wages.

Lastly, inflation is a sign that an economy is growing. In some situations, little inflation (or even deflation) can be just as bad as high inflation. The lack of inflation may be an indication that the economy is weakening. As you can see, it's not so easy to label inflation as either good or bad - it depends on the overall economy as well as your personal situation.