The concept of inflation and its’ essential role in the economy

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Tashkent financial institute (Uzbekistan, Tashkent)

The concept of inflation and its' essential role in the economy

M.A. Mirzayev, senior lecturer

Abstract

inflation economic activities price

Inflation is one of the key categories of economic theory. Its regulation helps to solve various social and economic problems, and its timely forecasting contributes to the optimal management of economic activities of the subjects. The correct assessment of the future rate of change in prices for goods and services to achieve success in the implementation of projects, determine the break-even point and find the optimal price of products, which will help maximize profits. In addition, accurate forecasting of the level of inflation helps to reduce the costs in the future, which increase during the crisis phenomena in economic systems. This article discusses the main theoretical principles of inflation in terms of theoretical provisions that can be used to predict the speed of price indices for future periods.

Keywords: inflation, macroeconomic theory, gross national product (GNP), the consumer price index (CPI), hyperinflation, demand-pull inflation, cost-push inflation.

Inflation is one of the most frequently used terms in economic discussions and there are various schools of thought on inflation, but there is a consensus among economists that inflation is a continuous rise in the prices.

According to Pigou, “Inflation exists when money income is expanding more than in proportion to increase in earning activity”[1], Crowther defined inflation as, “a state in which the value of money is falling, that is prices are rising,”[2]. Most of the scholars gave their own definition to the term “inflation”. The general drawbacks of these definitions tells the cause of inflation rather than telling what the inflation is. But some recent and more appropriate definitions of inflation according to Ackley, “… is a persistent and appreciable rise in the general level or average of prices” [3]. Samuelson defines “inflation as a rise in the general level of prices [4].

Lets discuss it in detail, for instance, assuming that $10 can purchase 10 dresses in the current period, if the price of dresses double in the next period, the same $10 can only afford 5 dresses.

The Keynesian school however believes inflation results from economic pressures such as rising costs of production or increases in aggregate demand. Specifically, they distinguish between two broad types of inflation: cost-push inflation and demand-pull inflation [5].

- Cost-push inflation results from general increases in the costs of the factors of production. These factors - which include capital, land, labor and entrepreneurship - are the necessary inputs required to produce goods and services. When the cost of these factors rise, producers wishing to retain their profit margins must increase the price of their goods and services. When these production costs rise on an economy-wide level, it can lead to increased consumer prices throughout the whole economy, as producers systematically pass on their increased costs to consumers. Consumer prices, in effect, are thus pushed up by production costs.

- Demand-pull inflation results from an excess of aggregate demand relative to aggregate supply. For example, consider a popular product where demand for the product outstrips supply. The price of the product would increase. The theory in demand-pull inflation is that if aggregate demand exceeds aggregate supply, prices will increase economy wide.

Now, I want to digress briefly and draw the reader's attention to another intriguing problem with inflation management. There are agencies, in every nation, that are entrusted with the task of both forecasting inflation and trying to adopt policies that keep inflation under control. A nation's central bank tries to do this as does the treasury or ministry of finance. But this twin tasking gives rise to an intriguing conundrum, which is specific to the social and economic sciences and has few parallels in engineering and the natural sciences.

There are many methods used to control inflation, including some that work and some that don't work without damaging consequences such as a recession. For example, controlling inflation through wage and price controls can cause a recession and hurt the people whose jobs are lost because of it.

One popular method of controlling inflation is through contractionary monetary policy. The goal of a contractionary policy is to reduce the money supply within an economy by decreasing bond prices and increasing interest rates. This helps reduce spending because when there is less money to go around, those who have money want to keep it and save it, instead of spending it. It also means less available credit, which also reduces spending. Reducing spending is important during inflation because it helps halt economic growth and, in turn, the rate of inflation.

There are three main ways to carry out a contractionary policy. The first is to increase interest rates through the Federal Reserve. The Federal Reserve rate is the rate at which banks borrow money from the government, but, in order to make money, they must lend it at higher rates. So, when the Federal Reserve increases its interest rate, banks have no choice but to increase their rates as well. When banks increase their rates, less people want to borrow money because it costs more to do so if that money accrues interest. So, spending drops, prices drop and inflation slows.

The second method is to increase reserve requirements on the amount of money banks are legally required to keep on hand to cover withdraws. The more money banks are required to hold back, the less they have to lend to consumers. If they have less to lend, consumers will borrow less, which will decrease spending.

The third method is to directly or indirectly reduce the money supply by enacting policies that encourage reduction of the money supply. Two examples of this include calling in debts that are owed to the government and increasing the interest paid on bonds so that more investors will buy them. The latter policy raises the exchange rate of the currency due to higher demand and, in turn, increases imports and decreases exports. Both of these policies will reduce the amount of money in circulation because the money will be going from banks, companies and investors pockets and into the government's pocket where they can control what happens to it [6].

In a nutshell, inflation affects different people or economic agents differently. Broadly, there are two economic groups in every society, the fixed income group and the flexible income group. During inflation, most prices rise, but the rate of increase of individual prices differ. Prices of some goods and services rise faster than others while some may even remain unchanged. On the other hand, the businessmen, industrialists, traders, real estate holders, speculators and others with variable incomes gain during rising prices.

References

1. Pigou A.C. «Types of War Inflation», December 1947, p. 409.

2. M.Crowther. An Outline of Money, 106 p.

3. Ackley, Gardner, Macroeconomic Theory, 421 p.

4. Samuelson P.A. and Nordhaus.W.D. Economics, (15th International Edn. 1995), 574 p.

5. Pigou A.C. «The Veil of Money», 34 p.

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