ABSTRACT

The aim of this project is to examine inflation and all the issues concerning this topic.

This essay contains two parts. The first part A analyzes in theory the causes of

inflation and the rising effects supported by numerous articles, cases and studies.

In addition, the second part will introduce data for one particular country- Great

Britain. This illustrates the inflation rate for Great Britain through GDP, GDP

deflator, CPI and unemployment rate.

 Table of Contents

1. Introduction

Section A

2. Causes of Inflation
2.1 Demand Pull Inflation
 Monetarists
 Keynesians
 Quantity Theory of Money

2.2 Cost Push Inflation

2.3 Hyperinflation
2.4 Inflation and Oil Prices

3. Effects of Inflation
3.1 Anticipated Inflation
3.2 Unexpected Inflation
3.2.1. Redistribution of Income
3.3. Unemployment
3.3.1 The short run Phillips Curve
3.3.2 The long run Phillips Curve

4. Conclusion
 INTRODUCTION

In this project we will analyze the phenomena called inflation; its causes and
emerging effects. Inflation represents an increase in the general price level in an
economy (Begg, 2005). In other words, the prices of goods and services rise, whereas
the incomes remain the same. Moreover, inflation is a process that instigates a
decrease in the purchasing power of money, which means that people can’t afford to
buy as much products and service as they could before the inflation occurred.
In addition, we are going to discuss the two fundamental causes. Those are the
Demand Pull Inflation which is caused by the increase in the general demand; and
Cost Push Inflation which is initiated by the increase of the factors of production.
Another important cause of inflation is the changes in oil prices.
Regarding the causes of inflation, two main schools developed in the 20th century- the
Monetarists and Keynesians. Moreover, inflation has enormous effects to each
separate individual and for the economy as a whole.
Furthermore, we will analyze the anticipated inflation as well as the surprise inflation,
the Phillips curve as the relationship between the inflation and unemployment.
The essential effects of inflation consist of: unemployment, unexpected inflation,
redistribution of income and changes of exchange rates.
 Section A

2. Causes of Inflation

2.1. Demand-Pull Inflation

Demand pull inflation occurs when the demand is exceeding the amount of goods and
services supplied. When the demand surpasses supply, then there is a shortage on the
market and the economy is not in equilibrium state. Accordingly, there is an increase
in the prices of goods and services which could lead to inflation. Moreover, demand
pull inflation can happen due to increase in money supply or by fiscal expansion.
Fiscal expansion occurs when government reduces the taxes and increases possible
spending. In this situation, income increases, therefore, demand exceeds supply which
results in inflation.
Monetary expansion can occur when the government is printing more money, in order
to increase the national income. Furthermore, this increases the spending power of
consumers which also leads to more demand than the economy is capable of
supplying. Suppliers take advantage of the situation and they push up the prices of
goods and services, and inflation occurs.
In addition, two major schools of thought developed over the years having opposed
opinions about what causes inflation. One of them were the Monetarists who believed
that the main cause for inflation was the excess of money that circulates in the
economy.
Monetarists argued that to reduce and control inflation, the government should
implement tight control of money supply.
On the other hand, there were Keynesians who believed that inflation should be
resolved by reducing the power of the main setters of the prices.
They also believed in the relationship between inflation and unemployment which is
shown in the so called Phillips curve. According to them a small percentage of
inflation is needed in order to reduce the unemployment rate. Moreover, they believe
that the amount of money supply alone is not the key determinant to instigate inflation
but also how fast the money is spent.

2.1.1 The Quantity Theory of Money

“The Quantity Theory of Money implies that changes in nominal money lead to
equivalent changes in the price level but have no effect on output and employment”
(Begg, 2005). Moreover, the Monetarists have agreed that if the level of money
supply rises, therefore, the level of average prices will increase as well, and inflation
will occur.

2.2 Cost-Push Inflation

Unlike demand pull inflation which happens due to excess of demand, cost push
inflation occurs when there is an increase of the factors of production.
When the costs of production increase, consequently the prices of the goods and
services will also rise, so that companies can not sustain their profits. Thus, the labor
costs will increase which will lead to cost push inflation. Cost push inflation might
happen due to an increase in: labor costs, oil price increase, etc.

2.5 Hyperinflation

“Hyperinflation is a period of very high inflation in which a real quantity of money

changes quickly and by high values” (Begg, 2005). Hyperinflation is a phenomenon
that happened the mostly in the 20th century. The most recent example had been in
Serbia (1992-1999) due to war conflict in former Yugoslavia and sanctions put by
UN. Another common example of hyper inflation is the one that happened in
Germany after the World War One when there was democratic society but little
stability (http://william-king). Production was significantly reduced due to striking,
therefore, prices rose. The government sector did not have choice but to increase the
money supply which led to inflation.
Hyperinflations are caused by rapid growth of the money supply which was the case
in Germany as well as in Serbia. In reality, hyperinflations are in a way taxations
imposed by the government. This means that the government needs to pay for its
spending, therefore prints large quantities of money and this results in overall increase
in prices, as had been in the case of Serbia.

2.6 Inflation and Oil Prices

Inflation could occur as result of increase of oil prices, especially in the countries
which depend on import of energy sources. Oil represents significant part of
production or transportation costs of goods and services. Increase in oil prices has
direct or indirect impact on increase of selling prices of goods and services,
consequently inflation could be in the same correlation.

3. Effects of Inflation

3.1 Anticipated Inflation

“Anticipated inflation happens when people can predict the level of inflation and the
economy can adjust” (www.bized.co.uk). This means that the general increase in
prices will not have great effect on the society since the population had time to adjust
because the inflation is partially expected.
However, complete adjustment is not possible and the inflation still has some effects
over the economy. There are some costs that can not be avoided like the shoe-leather
costs and the menu costs.
“The shoe leather costs are the extra time and effort in transacting when we
economize on holding money” (Begg, 2005). This means, that when money starts to
lose its value, people will try to keep less real money, which results in going to the
banks more often, wasting time and effort.
Another cost is the Menu Costs of Inflation which means that when firms will need to
change their prices more often when the inflation is higher which is costly.

3.2 Unexpected Inflation

Unlike the Anticipated Inflation that can be predicted, unexpected inflation is not
predicted by economists or consumers and has bigger effects on the economy as a
whole.

3.2.1 Redistribution of Income

When the prices rise unexpectedly, people are more reluctant to lending and
borrowing money. When surprised inflation occurs, income is redistributed between
borrowers and lenders. “One person’s gain is another person’s loss” (Begg, 2005).
Moreover, income is redistributed between the young and the old generations as well,
nevertheless, the old ones are usually savers and the young generations are usually
having debts and mortgages. “Surprise inflation leads to redistribution from old to
young generations, where each generation is younger than the previous, raising
intergenerational inequality” (Begg, 2005). In addition, income redistribution
sometimes might lead to economic dislocation and some people even declare
bankruptcy (Begg, 2005).

3.3 Unemployment
“The fraction of the labour force without a job but registered as looking for work is
the unemployment rate” (Begg, 2005). The relationship between the unemployment
and inflation is presented in the Phillips Curve which was named by Professor Phillips
who found this relationship in 1958 in the UK.
The Phillips Curve shows that “a higher inflation rate is accompanied by a lower
unemployment rate, so we can trade of more inflation for less unemployment, or vice
versa” (Begg, 2005).

3.3.1 The Short-Run Phillips curve

The short run Phillips Curve shows that when the inflation is lower, the
unemployment rate is higher and the opposite.
The curve shows that there is an inverse relationship between unemployment and
inflation in the short run. If the aggregate demand increases, the equilibrium state
moves from one point A to the point B. In the new equilibrium the price level has
risen, there the inflation rate has increased as well (www.wikipedia.com). In addition,
the level of output has increased which means that there are more employees and
consequently the unemployment rate has decreased conversely to the inflation rate.

3.3.2 Long-Term Phillips Curve

The long term Phillips Curve illustrates that the trade off between unemployment and
inflation is only temporary and in the long run equilibrium the economy will get back
to the same unemployment rate regardless of the inflation rate.
In the long run equilibrium, the economy is at both potential output and equilibrium
unemployment which are referred as natural level of output and natural level of
unemployment (Begg, 2005). This means that the level of unemployment in the long
run does not depend on inflation. Moreover, the natural rate of unemployment can
only be achieved with a stable inflation rate. Unlike in the short run, regardless of the
inflation rate, in the long run Phillips curve, the unemployment rate will always come
back to its natural rate (Begg, 2005).
 Conclusion

To conclude, after analyzing in details the causes and effects of inflation, it can be
stated that it is a phenomena rising from changes in money supply, interest rates and
real wages. Inflation is a process that can emerge unexpectedly or it can be predicted.
Nevertheless, it affects the whole economy as well as each individual separately. In
the short run, higher inflation could reduce unemployment, however, that is only
temporary because in the long run, both unemployment and inflation will rise.
 Section B

1. Analysis of Great Britain for the period 1990-2004

Figure 1.

Growth rates of GDP deflatora and the CPI

25
20
15
10
Growth of GDP defletor
5
Growth of CPI
0
90

91

92

93

94

95

96

97

98

99

00

01

02

03

04
-5
19

19

19

19

19

19

19

19

19

19

20

20

20

20

20
-10
-15
years

Source: Eurostat, 2006

By observing the change in the prices of different goods and services we
measure the inflation rate in the economy (Wikipedia, 2007).

The Gross domestic product (GDP) represents a measure of the output

produced in the domestic economy, regardless of who possesses the production
input. The value of GDP distinguishes between market (current), including
indirect taxes, and basic (constant) prices, excluding indirect taxes. GDP deflator
illustrates the ratio of nominal GDP to real GDP, presenting the present level of
prices relative to the level of prices to the base year (Begg et al, 2005). The
Consumer price index (CPI) measures the price of the most commonly purchased
goods, approximating the Living cost index (Wikipedia, 2007).
 Figure 1a

Inflation Rate
8
7.6
7
6
5
4 4.1
3 2.7
2.5 2.5
2 2 1.8 1.6 1.4
1.3 1.2 1.3 1.3
1 0.8
0
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
years
Inflation

Source: Eurostat, 2006

Figure 1a shows the inflation rate in the UK in the period 1990-2004, derived
by using GDP deflator and CPI, presented in percentages. This connection has
been used since the imported goods, that are being purchased by consumers, do
not alter the GDP, but are however part of the CPI as a part of the consumer’s
basket.
As shown in Figure 1, the CPI shows no great fluctuations over the examined
period, unlike the GDP deflator that fluctuates far more. Further on, CPI declines
steadily until the mid 1993, whereas GDP has been increasing rapidly until mid
1991 and then decreases even more, down to -4 in the mid 1993. Nonetheless,
GDP follows an increasing trend, reaching its peak in 1998, significantly greater
than the CPI. It is obvious from Figure 1 that the GDP and CPI curves follow
different paths. By comparing Figure 1 with Figure 1a, we can see that the CPI
curve and the inflation rate curve have more or less the same fluctuation, or in this
case stability.
It can be concluded that in the case of the United Kingdom the CPI growth is a
better approximation for the inflation rate than the GDP growth, as suggested by
the shapes of the two curves.
Figure 2.
 Growth rate of Real GDP

5
4.4
4 3.9
3.3 3.1 3.1
3 2.9 2.8 2.9
2.3 2.3 2.2
2 1.8
1
0 0.17 0.19

-1 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
-1.3
-2
years Rate of Real GDP
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