INFLATION: AN INTRODUCTION
Prof. Lic. Fernando Julio Silva, MSc.

As a definition: The inflationary process deals with a persistent increase in the general price level.

Types of inflation:

· Hyperinflation: Prices raise at a phenomenal level. Other names are galloping o run away inflation. Can people “create” hyperinflation? The answer is yes, don’t forget that under this situation, an extreme case, people in general don’t trust their currency so the try go get rid of it son they continue buying products just in case their price level goes up, not seeing that those extra buys are producing more inflation. I’m going to explain this in a deeper way later.

· Suppressed inflation: It takes place whenever demand exceeds supply. Effects on prices can be minimized using policies such as price control or rationing. This situation may lead to the appearance of black markets.

· Creeping inflation: This is the most common type of inflation. Usually it moves between 1-6%

Causes of inflation:

They are classified in two main groups:

A) Demand Pull
B) Cost Push

A). Aggregate Demand (AD) exceeds Aggregate Supply (AS) in a persistent way, so prices are pulled upwards.
In order to have this type of inflation we need to be under conditions of full employment, if not an increase in AD won’t have any effect over prices level because you can increase the number of the factors of production needed in order to increase your level of output; but if demand continues increasing, at a certain point full employment conditions will be reached and then yes inflation may appear.
Situations under which this type of inflation may appear are:

I.- Wartime conditions: local resources (factors of production) are going to be used in order to produce products for war and the availability for local products is going to be reduced but on the other hand we are going to have full employment conditions that will increase people’s income. Shortage will appear. Associate this concept with P.P.C. and opportunity cost theories.
Government solutions will come by the hand of rationing and price control policies.

II.- Exports surplus will also increase country’s income, so more money is going to be available producing an increase on demand, but supply is going to be reduced because part of the production now is exported. A possible solution can be to increase the level of imports.

III.- Economic growth: whenever a country tries to increase the rate of their economy, they’ll have to reduce their production of consumer goods and increase their production
of capital goods. Producing this decision a reduction of the level of consumer goods on the short term; even thought this will benefit the country in the long term because the increase in the level of capital goods will allow the country to increase their production for consumer goods in the long term. Solutions that government can take in order to reduce the effect of this situation are related with an increase of taxes and/or saving

IV.- Government spending: an increase on government spending may lead to inflation if it’s financed by increasing borrowing (central banks will have to increase M {amount of money in circulation} or by increasing taxation {people will try to reduce their level of saving rather than reducing their stand of living in the short term}

Inflationary process under Demand Pull inflation:

Supply is increasing the demand for factors of production because they are able to sell more products in the market and if you remember that we are talking about having all he resources fully employed, an increase on the demand for them will be followed by an increase on their prices too. So suppliers will have to increase their products prices (not been worried about this situation because they know that the demand exists); on the other hand, now consumers will have more money in their pockets (don’t forget consumers are also part of the factors of production and now they get better payments for their work). This situation will lead to a new increase on the demand and the situation will continue

B). This type of inflation is produced ‘cause of an increase on the cost of the factors of production that can’t be absorbed by the producer, you have to be aware that this is not a situation produced by an excess of demand.

Examples can take the form of:
* Increase on price of imports
* Increase on indirect taxation
* Increase on wages that are higher tan the increases on productivity


Inflationary process under Cost Push:

This situation is related to what is known as the “wage price spiral” which shows that an increase on wages given in order to compensate for an increase in prices will be followed by another increase in prices that will take to another increase in wages and so on. So an increase in costs will be followed by an increase in demand.


Cost inflation and unemployment:

In the old days it was said that if unemployment was high inflation was supposed to be low because as demand was having less money the if prices were high, consumers were not going to be able to buy products; so the solution was a reduction on the price level
On the other hand, when people were fully employed (unemployment was reduced) then inflation was taking place cause now consumers were having the chance to buy an prices were increasing.
But around the 80’s it was probed that something different was taking place and countries were facing a high level of unemployment followed by an increase in prices.

How was this possible? Because wages were increasing too!

Why? Because the unemployed people were not the ones that the companies were needing, these unemployed were unskilled workers, people that had been out of the market for such a long time that the were considered – at a certain point – as a part of the “permanent unemployed” people


Differentials:

A very important feature of the “wage price spiral” s related with the wages differentials because an increase on wages of one sector of the economy will produce a reaction on other sectors because they want to maintain the existing wage differentials between different jobs. The main point appears whenever the first sector was able to receive an increase on their wages ‘cause of an increase on productivity so, as you can see, this won’t have any effect on prices; but as the differential effect to be maintained increases on wages of other sectors of the economy that are not produced ‘cause of the same reason will have a direct effect over the price level.

Bibliography:

“Introductory Economics” – Fifth edition, G.F. Stanlake. Longman Group UK Ltd, 1990