B. Causes of inflation
There are many different reasons that can account for the
inflation in goods and services, depending on a number of factors:
Ø Cost Push Inflation
Cost-push inflation occurs when businesses respond to rising
production costs, by raising prices in order to maintain their profit margins.
There are many reasons why costs might rise:
a) Rising imported raw materials costs
b) Rising labour costs: caused by wage
increases which exceed any improvement in productivity.
c) Higher indirect taxes imposed by the
government: for example a rise in the rate of excise duty on alcohol
and cigarettes, an increase in fuel duties or perhaps a rise in the standard
rate of Value Added Tax or an extension to the range of products to which VAT
is applied.
Ø Demand Pull Inflation
Demand-pull inflation is likely when there is full employment
of resources. In these circumstances an increase in aggregate demand will lead
to an increase in prices. Aggregate demand might rise for a number of
reasons:
a) A depreciation of the exchange rate, which
has the effect of increasing the price of imports and reduces the foreign
price. If consumers buy fewer imports, while foreigners buy more exports,
Aggregate Demand will rise. If the economy is already at full employment,
prices are pulled upwards.
b) A reduction in direct or indirect
taxation. If direct taxes are reduced consumers have more real
disposable income causing demand to rise. A reduction in indirect taxes
will mean that a given amount of income will now buy a greater real volume of
goods and services.
c) The rapid growth of the money supply when
the monetary authorities permit an excessive growth of the supply of money in
circulation beyond that needed to finance the volume of transactions produced
in the economy.
d) Rising consumer confidence and an increase in the
rate of growth of house prices: both of which would lead to an
increase in total household demand for goods and services
e) Faster economic growth in other countries:
providing a boost to exports overseas.
Ø The wage price spiral -
«expectations-induced inflation»
Rising expectations of inflation can often be self-fulfilling.
If people expect prices to continue rising, they are unlikely to accept pay
rises less than their expected inflation rate because they want to protect the
real purchasing power of their incomes.
C. Measuring Inflation
According to Report of European Central Bank (Jan 2009:25)
Most countries have a simple common-sense approach to measuring inflation,
using the so called «Consumer Price Index» (CPI).
For this purpose, the purchasing patterns of consumers are
analyzed to determine the goods and services which consumers typically buy and
which can therefore be considered as some how representative of the average
consumer in an economy. As such they do not only include those items which
consumers buy on a day-to-day basis (for example bread and fruit), but also
purchases of durable goods (for example cars, Computer, washing machines, and
so on.) and frequent transactions (for example rents). Putting together this
«shopping list» of items and weighting them according to their
importance in consumer budgets leads to the creation of what is referred to as
a «market basket».
Each month, a host of «price surveyors» checks on
the prices of these items in various outlets. Subsequently, the costs of this
basket are then compared over time, determining a series for the price index.
The annual rate of inflation can then be calculated by expressing the change in
the costs of the market basket today as a percentage of the costs of the
identical basket the previous year.
However, the developments of the price level as identified by
such a basket only reflect the situation of an average» or representative
consumer. If a person's buying habits differ substantially from the average
consumption pattern and thus from the market basket on which the index is
based, that person may experience a change in the cost of living that is
different to the one shown in the index. There will therefore always be some
people who experience a higher «inflation rate» for their
«individual basket» and some who face a lower «individual rate
of inflation». In other words, the inflation measured by the index is only
an approximate measure of the average situation in the economy; it is not
identical to the overall price changes faced by each individual consumer.
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