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Inflation is an increase in the prices paid for commodities within an economy at the expense of a constant real income. It is closely linked to increased money supply.
The increase in the liquidity of an economy is intended to stimulate economic activities such as increase demand, productivity and reduce the level of unemployment. However, the actions result to increased inflation with more money chasing few goods. This study seeks to establish the relationship between product prices and the supply of money in an economy. Therefore, it seeks to verify the statement that prices increases when the government prints too much money.
Many authors including Dywer & Hafer (1999) have noted Price increase as a factor that represents inflation. It may also be defined as the continuous loss of value of money. The increase in the prices should be continuous, in addition, a given commodity price should increase relative to other commodity prices.
According to Makinen (2003, p. 3), inflation should continue for some time such as a week, a month or one year. Many countries have experienced drastic inflations in during different periods in history. One of the significant nations is the U.S that has experienced high inflation over time especially since World War II.
Inflation can be caused by many factors with the most significant being the supply of money. For instance, the level of inflation in the U.S is closely linked to the increase in the money supply in the economy. Makinen (2003, p. 3) notes that an increase in the supply of money in an economy relative to the output in the economy could lead to inflationary pressure on prices of goods and services in the economy.
It is believed that an increase in the supply of liquidity in the country could lead to increased amount of money used to purchase few available goods. Increased money supply therefore leads to increased demand for goods and services yet the amount of goods remains literally the same. Due to the law of demand and supply, equilibrium would be attained when the prices of goods and services increase hence inflation (Dywer & Hafer, 1999, p. 4).
The Federal Reserve while in other countries, the central banks such as the European central bank (ECB), controls the level of liquidity in the U.S economy. As economists blame the Federal Reserve and central bank for inflation, the two provide different reasons for increased inflation in an economy. it is believed that inflation in the U.S is caused by other factors other than money supply such as activities that have a negative impact and upward pressure on prices.
For instance, any attempt by labor unions to obtain increased wages for employees in the economy could increase operating costs of firms in the country leading to reduced productivity. OPEC activities could also affect negatively the operations of firms in an economy leading to reduced productivity.
For instance, if OPEC pursues monopolistic oil pricing strategies, an increase in the price of oil could affect operating expenses of firms negatively hence reducing productivity. Other activities that affect productivity negatively include fluctuations in the exchange rates such as a decline in the USD and crop failure.
According to Dywer & Hafer (1999, p. 5), a decline in output results to an increase in unemployment. In order to stimulate the economy and reduce the levels of unemployment, the Federal reserve and the central bank pursues expansionary monetary policies that ensures that it pumps money into the economy in order to increase demand and output. This increases inflations because the prices of commodities would increase following increased demand.
These theories are mainly applied in the U.S and UK economies. For instance, the initial two causes of inflations as stated above are believed to be the causes of inflation in the U.S especially after the II world war in which the Federal Reserve used to pump money in the economy to stimulate production and reduce unemployment while resulting to inflation.
However, the last reason as explained above is entrenched among British economists who hold that inflation is not only caused by increased liquidity. They attributed the inflation affecting UK over time to the money substitutes that cause inflation in the guise of credit.
Economic Costs of Inflation
Economic costs of inflation are discussed among economists as unemployment that leads to other negative economic effects. According to Makinen (2003, p. 9), recounting the costs of inflation could be confusing because of the confusion over the cost of the entire economy versus the cost to a specific individual. In addition, some inflationary costs are incurred due to unanticipated inflation while others are incurred due to anticipated inflation.
Makinen (2003, p. 10) notes that in fully indexed economies, contractions in the economy are adjusted in the price level of commodities in the economy including prices of bonds, wages and salaries. In such economies, a floating exchange rate leaves exchange rates to float freely.
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Holding money during inflation is costly because the value of money is reduced. Therefore, transactionary cost of holding money is high. Firms experience rising operating costs while individuals experience uncertainty about the future. In spite of this inflationary cost, it has been reduced in the U.S today.
The other cost of inflation is the menu cost that involves increased time as resources used are involved in frequent price adjustment during inflation that leaves firms losing not only profit, but also useful time.
In partially indexed economies, inflation may be either anticipated or unanticipated. In spite of the anticipation of inflation, its costs are inevitable. For instance, the U.S is not fully indexed an inflation has many costs. For instance, anticipated inflation in the U.S could lead to drastic negative effects on the economy.
Tax is usually deducted from the nominal income of employees. The interaction between taxation and inflation results to reduced real income causing low motivation for work, reduced savings and investments in the economy. Lack of indices in an economy could leave inflation to have its drastic effects.
For instance, taxation in a progressive tax regime could the real income of employees hence acting as a disincentive for work. The U.S reduced this inflationary cost in the 1980s by formulation and enacting of a legislation that reduced the levels of progressivity of the income tax of the federal government (Makinen, 2003, p. 6).
In summary, inflation causes reduced real income in an economy. Participants in a market economy undertake the functioning of the price system to be for granted. However, inflation can affect the price system causing its malfunctioning and negatively affecting the allocation of resources in the economy. The measurement of inflation is conducted using several measures. However, the most common is the use of the consumer price index (Milton & Schwartz, 1982, p. 1869).
Status of Inflation
Inflation has occurred over time hence affecting many countries worldwide. In spite of the many effects that it has had on the economy, this study would examine only two countries, the U.S and the UK. The U.S began realizing high inflation since the Second World War. In the 1970s, the country experienced significant rates of inflation in which the consumer price index rose at an annual rate of 7.5%.
In spite of the increase in inflation, the money supply M1 increased at an annual rate of 3%. Te increase in the inflation was caused by other factors other than the rise in the money supply in the U.S economy. This was attributed the increase in the oil prices by OPEC that led to a sharp increase in material inputs used in manufacture of various products.
With an increase in the consumer prices, the cost-push inflation had to be supported by an increase in the money supply in the economy. Therefore, money supply is related to cost push inflation if the inflation is caused by factors other than money supply.
The UK experienced more inflation in the 20th century compared to the U.S. the inflation in the UK was associated with increase in the money supply rather than other factors in the economy. Similar to the levels of inflation in the U.S, inflation in the UK was closely related to the changes in the money supply relative to the real income (Dywer & Hafer, 1999, p. 6).
During the great depression, the decrease in value of money was attributed increased price levels in the economy. According to Milton & Schwartz (1982) the high level of inflation realize in the UK since the Second World War is attributed to the increase in the money supply to the economy relative to the real income in the UK economy.
Therefore, it is evident that there is a significant relationship between the rise in the level of inflation in an economy and the increase in the supply of money in the economy (Dywer & Hafer, 1999, p. 7).
The above discussion has been about the relationship between the supply of money in an economy and the level of inflation. It is evident that inflation is recorded whenever the prices of commodities in an economy increase relative to the real income of consumers. It is mainly captured using the consumer price index.
It is evident that there is a link between the increase in inflation and the level of money supply. As indicated in the U.S and the UK, an increase in the money supply in the course of the 20th century is reported as the reason behind the rising inflation during the same period especially after the Second World War.
Following these revelations, this study concludes by agreeing with the statement that prices rises when the government prints too much money through the Federal Reserve or the Central Bank.
Dywer, G. & Hafer, R. (1999) Are Money growth and inflation still Related. Federal Reserve Bank of Atlanta. Economic Review. Available at: https://www.frbatlanta.org/
Makinen, G. (2003) Inflation: Causes, Costs, and Current Status. CRS Report. Web.
Milton, F. & Schwartz, A. (1982) Monetary Trends in the United States and the United Kingdom: Their Relation to Income, Prices, and Interest Rates, Chicago: University of Chicago Press. 1867–1975.