Inflation (I)
Inflation is a rise in the general level of prices
of goods and services (it effects all of the sectors in the economy)
and continues (for a prolonged period of time).
Inflation is a reflexion that
money looses value, therefore to acquire goods you have to hand
over a greater amount of money.
Inflation is measured by some indicators which
notice the increase in prices. The two most common indicators
are:
The Consumer Price Index (CPI): measures
the average price of consumer goods and services purchased by
consumers.
The GDP deflator: measures the prices
of all of the goods and services which help make up the GDP
economy.
Let's see some examples:
If the price of imported cars increase,
this increase effects the CPI (it is a good that is consumed)
but this increase does not effect the GDP deflator (imports
do not form part of GDP).
If the price of bricks made in the
country increase, the increase will not effect the CPI (as this
is not a good that is usually consumed), but the increase will
effect the GDP.
Inflation measures the increase of these
indicators:
The inflation in 2001 of an economy
(measured by the CPI) will be:
Inflation 2001 = (CPI
2001 - CPI2000) / CPI2000
For example: the CPI in Portugal in
the year 2000 was 156 and in 2001 it was 162. Now calculate
the inflation.
Inflation 2001 = 162
- 156 / 156 = 3,8%
When a country experiences extreme price increases,
we say that the country is hyperinflated (taxes greater than 100%).
How does a country get to this situation?
A country has a high level of expenses
(soldiers, burocracy, inefficiency, corruption, etc) and their
income is dramatically reduced (fiscal fraud). To help the country
with its expenses, the Central Bank starts to emit large quantities
of money, which causes things to loose value and inflation to
shoot up.
Factors that favour inflation:
Strong increase in the economy,
with so much offer that it is not able to satisfy the demand.
This provokes a rise in prices.
Pressure on the costs: a strong
increase in salaries because of the trade unions, increase in
petrol prices, increase in the cost of imports as a result of
a deterioration in the exchange rate, etc. All of this means
an increase in prices.
Although the two previous factors
would explain an increase in prices, in order for it to go into
an inflation spiral, it is essential there is a large increase
in the quantity of money, so that money decreases in value and
prices rocket.
Quantity theory of
money
This theory says:
The increase in the quantity of money
overcomes the real increase in the economy and ends up creating
an increase in prices.
Increased
rate of the quantity of nominal money = increased
rate of real income + rate of inflation
Let's look at an example:
If an economy in real terms increases
by 3% and the quantity of money in circulation increases by
10%, the difference (7%) means an increase in prices.
The Quantity theory of money maintains that
when the Central Bank quickly increases the monetary offer the
result is a high rate of inflation.
To explain this theory let's first look at the
"velocity of money": it meausres the speed at which
money circulates (changes hands).
V = ( P * Y ) / M
Where:
" V ": is the velocity
at which money circulates
" P ": is the level
of prices in the economy
" Y ": GDP in real
terms (refined the effect of the prices)
" P * Y ": Nominal
GDP
" M ": quantity of
money in circulation
This formula tells us that if the GDP of an
economy is 1 billion euros (= P * Y ) and the quantity of money
is 0,1 billion euros, this money has to change hands 10 times
in the space of the year.
Here is a formula to work out the level of prices:
P = ( V * M ) / Y
Taking into account that the velocity of the
circulation of money is usually quite stable and admitting that
money is neutral (it does not effect of the level of production)
it can be deduced that if the quantity of money increases this
ends up causing an increase in prices.
