The use of a basket of goods is supposed to be an indicator of the economys position. So what causes inflation? Inflation occurs in two different ways: demand pull inflation and cost push inflation (Moffat n. d. ). Demand pull inflation is a price increase caused by the increase in demand for goods and services. The law of demand and supply causes the price level to increase when there is an increase in demand. This increase is not necessarily bad as it can indicate an increase in the national income.
However, if the economy is at full employment (a state where the national output cannot be increased) then the inflation becomes harmful. The factors that cause an increase in demand can also be stated as having an effect on the demand pull inflation. These are: increase in money supply, increase in the spending level by the government and an increase in general world prices (Moffat n. d. ). The other type of inflation is the cost push inflation. This is the inflation resulting from an increase in the cost of production.
This causes a decrease in supply, which according to the law of supply, will result in an increase in price. This can be caused by factors that increase the cost of the supply, which may include an increase in wages or increase in the price of any other factor of production. This kind of inflation is also harmful (Moffat n. d. ). Inflation affects the stability of the economy in several ways. An increase in the price level is especially harmful to those in the economy with fixed rated of income. This is because due to wage rigidity, the rate of adjustment to the inflation is slow.
It also leads to accounting difficulties, especially in the calculation of profits and value of assets. The effect of inflation on assets is that they seem to increase in value. If one is involved in the trade of assets, they may mistakenly take this increase as a profit. This can also be extended to governments, who use inflation to finance budget deficits. Some quarters argue that inflation can cause an increase in spending which is ultimately harmful. They argue that the speculative spending by consumers may increase due to speculation that future prices will continually increase.
This creates a rush of demand and causes an increase in the price level. The second way is that since there is inflation, the consumers find borrowing an attractive prospect as opposed to saving. This is because holding on to money causes a decrease in it s value. This reduces savings and causes an increase in spending which serves only to increase the inflation levels (Rothbard; Chazeau, 8-10, 1949; World Bank). Deflation is also a dangerous economic distabilizer. Deflation, as mentioned earlier, occurs when the value of money increases relative to a basket of goods.
This occurs in various ways. In summary, it can be said to take place when there is a decrease in aggregate demand or an increase in the aggregate supply. It can be caused by a decrease in money supply or an increase in money demand. It can also be caused by an increase in the supply of goods or a decrease in the demand of the supplied goods. It is, as seen, the opposite of inflation in its causing factors (Moffat n. d. ). Deflation increases the value of money causing people to prefer to hold on to the money as opposed to transact with it. This causes an increase in the savings.
Due to the demand for money, the interest rate increases and with such an increase, there is seen a drop in the investment levels in the economy. This leads to unemployment due to lack of demand and lack of investment. It may also lead to high levels of liquidity where the populace, seeing it more profitable to hold on to money as opposed to property, seeks ways to dispose of their assets. Another effect is caused by the nature of price rigidity. This is because since deflation causes a decrease in price levels, the resultant decrease should be followed by a drop in wages.
However, workers consider their wages in nominal rather than real terms and will therefore resist the cuts that are to adjust to the inflation. That said they may take the cuts if they prefer a lower wage as opposed to job loss, since this is a period of high unemployment (Moffat; Dalton, 2003). Both inflation and deflation are controlled in similar manners, but in opposite measures. During inflation, the aim of control is to decrease the aggregate demand. This is done by a combination of several measures. The Federal Reserves influence on these measures is mainly in the influence of money supply.
This manipulates bonds and interest rates to achieve the desired effects. In an inflationary period, the Federal Reserve sells bonds to the market. This causes an increase in the interest rate due to increased supply and a resultant drop in price of bonds. The market prefers to hold on to the bonds and would therefore buy, decreasing the amount of money supply in the economy. By increasing interest rate they also reduce the investment spending in the economy. Another way is by using moral persuasion and reserve rates to influence banks lending of credit.
By reducing their lending, the investment level is reduced causing a reduction in spending and aggregate demand. In deflationary periods, the Federal Reserve does the opposite of this in order to control the imbalance. In general, the Federal Reserve uses monetary policy in the influencing of the various variables in the economy to cut or increase aggregate demand as applicable (Federal Reserve; World Bank; tutor2u). In as much as these policies sound straight forward, control of these disequilibriums through monetary policy is subject to a lot of issues.
The World Banks policy research paper states that sometimes governments are sluggish to implement control measures due to political ambitions. Some of the measures that are put in place by the Federal Reserve would reduce the level of investment in an economy and raise the interest rate levels. These are seen as potentially harmful to the business community and thus there would be caution in applying principles with these results. In fact they boldly state that democracy may slow down much needed reforms.
Furthermore, inflation sometimes can also be a source of revenue for the government making it difficult for the government to decide to control it. It may be caused by printing money to finance a deficit budget (Dalton, 188, 2003). Another problem cited is the difficulty of tabulating results and indicators accurately enough for prediction purposes. Despite the highest level of accuracy, the number of players in the economy makes it very difficult to tabulate accurate results and thus issue appropriate control measures (tutor2u).
There is also the cost of controlling inflation and deflation. Sometimes these costs are high and the government might not be motivated to control them in time (World Bank 1991). References Dalton Hugh (2003) Principles of Public Finance. Routledge Federal Reserve (n. d). How the Fed Guides Monetary Policy. Federal Reserve System in Brief. Sourced on 7 April 2009 http://www. frbsf. org/publications/federalreserve/fedinbrief/guides. html Moffat Mike (n. d. ). What is Deflation and How Can It Be Prevented. Sourced on 7 April 2009 http://economics. about.
com/cs/inflation/a/deflation. htm Rothbard N. Murray (n. d. ). Government Meddling with Money: Economic Effects of Inflation. Ludwig von Mises Institute. Sourced 7 April 2009 http://mises. org/money/3s2. asp Tutor2u (n. d. ) Economic Policies to Control Inflation. Sourced 7 April 2009http://tutor2u. net/economics/content/topics/inflation/controlling_inflation. htm World Bank, (November-December 1991). Inflations Addiction. World Bank Policy Research Bulletin Vol 2. No. 5. Sourced 7 April 2009 http://www. worldbank. org/html/dec/Publications/Bulletins/PRBvol2no5. html