What is the difference between inflation and price level?In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time. When the price level rises, each unit of currency buys fewer goods and services; consequently, inflation is also an erosion in the purchasing power of money a loss of real value in the internal medium of exchange and unit of account in the economy.Inflation is best defined as a sustained increase in the general price level leading to a fall in the purchasing power or value of money.

What are the measures of inflation?Commonly used measures of inflationExamples of common measures of inflation include: consumer price indices (CPIs) which measure the price of a selection of goods purchased by a "typical consumer". Cost-of-living indices (COLI) which often adjust fixed incomes and contractual incomes based on measures of goods and services price changes list index summary analysis (LISA) which measures the change in volume of peoples' voices. producer price indices (PPIs) which measure the price received by a producer. This differs from the CPI in that price subsidization, profits, and taxes may cause the amount received by the producer to differ from what the consumer paid. There is also typically a delay between an increase in the PPI and any resulting increase in the CPI. Producer price inflation measures the pressure being put on producers by the costs of their raw materials. This could be "passed on" as consumer inflation, or it could be absorbed by profits, or offset by increasing productivity. wholesale price indices, which measure the change in price of a selection of goods at wholesale, prior to retail mark ups and sales taxes. These are very similar to the Producer Price Indexes. commodity price indices, which measure the change in price of a selection of commodities. In the present commodity price indexes are weighted by the relative importance of the components to the "all in" cost of an employee. GDP Deflators measures price increases in all assets rather than some particular subset. The term "deflator" in this case means the percentage to reduce current prices to get the equivalent price in a previous period. The US Commerce Department publishes a deflator series for the US economy.

What are the effects of inflation?Inflation can have positive and negative effects on an economy. Negative effects of inflation include a decrease in the real value of money and other monetary items over time; uncertainty about future inflation may discourage investment and saving, and high inflation may lead to shortages of goods if consumers begin hoarding out of concern that prices will increase in the future. Positive effects include a mitigation of economic recessions, and debt relief by reducing the real level of debt.Economists generally agree that high rates of inflation and hyperinflation are caused by an excessive growth of the money supply. Views on which factors determine low to moderate rates of inflation are more varied. Low or moderate inflation may be attributed to fluctuations in real demand for goods and services, or changes in available supplies such as during scarcities, as well as to growth in the money supply. However, the consensus view is that a long sustained period of inflation is caused by money supply growing faster than the rate of economic growth.If inflation is high in an economy there are three main problems it can cause:1. People on a fixed income (e.g. pensioners, students) will be worse off in real terms due to higher prices and equal income as before; this will lead to a reduction in the purchasing power of their income. 2. Rising inflation can encourage trade unions to demand higher wages. This can cause a wage spiral. Also if strikes occur in an important industry which has a comparative advantage the nation may see a decrease in productivity and suffer. 3. If inflation is relatively higher in one country, exports will become more expensive for other countries to purchase, this will create a deficit on the current account.Effects of inflation:1. General effects of inflation2. Negative effects of inflation3. Positive effects of inflationThese effects are summarized below:1. General effects of inflationAn increase in the general level of prices implies a decrease in the purchasing power of the currency. That is, when the general level of prices rises, each monetary unit buys fewer goods and services. The effect of inflation is not distributed evenly in the economy, and as a consequence there are hidden costs to some and benefits to others from this decrease in the purchasing power of money. For example, with inflation lenders or depositors who are paid a fixed rate of interest on loans or deposits will lose purchasing power from their interest earnings, while their borrowers benefit. Individuals or institutions with cash assets will experience a decline in the purchasing power of their holdings. Increases in payments to workers and pensioners often lag behind inflation, especially for those with fixed payments. Increases in the price level (inflation) erodes the real value of money (the functional currency) and other items with an underlying monetary nature (e.g. loans and bonds). However, inflation has no effect on the real value of non-monetary items, (e.g. goods and commodities, gold, real estate)2. Negative effects of inflationHigh or unpredictable inflation rates are regarded as harmful to an overall economy. They add inefficiencies in the market, and make it difficult for companies to budget or plan long-term. Inflation can act as a drag on productivity as companies are forced to shift resources away from products and services in order to focus on profit and losses from currency inflation. Uncertainty about the future purchasing power of money discourages investment and saving. And inflation can impose hidden tax increases, as inflated earnings push taxpayers into higher income tax rates.With high inflation, purchasing power is redistributed from those on fixed incomes such as pensioners towards those with variable incomes whose earnings may better keep pace with the inflation. This redistribution of purchasing power will also occur between international trading partners. Where fixed exchange rates are imposed, rising inflation in one economy will cause its exports to become more expensive and affect the balance of trade. There can also be negative impacts to trade from an increased instability in currency exchange prices caused by unpredictable inflation.High inflation can cause the following negative effects:Cost-push inflation Rising inflation can prompt employees to demand higher wages, to keep up with consumer prices. Rising wages in turn can help fuel inflation. In the case of collective bargaining, wages will be set as a factor of price expectations, which will be higher when inflation has an upward trend. This can cause a wage spiral. In a sense, inflation begets further inflationary expectations. Hoarding People buy consumer durables as stores of wealth in the absence of viable alternatives as a means of getting rid of excess cash before it is devalued, creating shortages of the hoarded objects. Hyperinflation If inflation gets totally out of control (in the upward direction), it can grossly interfere with the normal workings of the economy, hurting its ability to supply. Allocative efficiency A change in the supply or demand for a good will normally cause its price to change, signalling to buyers and sellers that they should re-allocate resources in response to the new market conditions. But when prices are constantly changing due to inflation, genuine price signals get lost in the noise, so agents are slow to respond to them. The result is a loss of allocative efficiency. Shoe leather cost High inflation increases the opportunity cost of holding cash balances and can induce people to hold a greater portion of their assets in interest paying accounts. However, since cash is still needed in order to carry out transactions this means that more "trips to the bank" are necessary in order to make withdrawals, proverbially wearing out the "shoe leather" with each trip. Menu costs With high inflation, firms must change their prices often in order to keep up with economy wide changes. But often changing prices is itself a costly activity whether explicitly, as with the need to print new menus, or implicitly. Business cycles According to the Austrian Business Cycle Theory, inflation sets off the business cycle. Austrian economists hold this to be the most damaging effect of inflation. According to Austrian theory, artificially low interest rates and the associated increase in the money supply lead to reckless, speculative borrowing, resulting in clusters of malinvestments, which eventually have to be liquidated as they become unsustainable.3. Positive effects of inflationInflation can cause following positive effects:Labor-market adjustments Keynesians believe that nominal wages are slow to adjust downwards. This can lead to prolonged disequilibrium and high unemployment in the labor market. Since inflation would lower the real wage if nominal wages are kept constant, Keynesians argue that some inflation is good for the economy, as it would allow labor markets to reach equilibrium faster. Debt relief Debtors who have debts with a fixed nominal rate of interest will see a reduction in the "real" interest rate as the inflation rate rises. The real interest on a loan is the nominal rate minus the inflation rate.[dubious discuss] (R=n-i) For example if you take a loan where the stated interest rate is 6% and the inflation rate is at 3%, the real interest rate that you are paying for the loan is 3%. It would also hold true that if you had a loan at a fixed interest rate of 6% and the inflation rate jumped to 20% you would have a real interest rate of -14%. Banks and other lenders adjust for this inflation risk either by including an inflation premium in the costs of lending the money by creating a higher initial stated interest rate or by setting the interest at a variable rate. Room to maneuver The primary tools for controlling the money supply are the ability to set the discount rate, the rate at which banks can borrow from the central bank, and open market operations which are the central bank's interventions into the bonds market with the aim of affecting the nominal interest rate. If an economy finds itself in a recession with already low, or even zero, nominal interest rates, then the bank cannot cut these rates further (since negative nominal interest rates are impossible) in order to stimulate the economy - this situation is known as a liquidity trap. A moderate level of inflation tends to ensure that nominal interest rates stay sufficiently above zero so that if the need arises the bank can cut the nominal interest rate. Tobin effect The Nobel prize winning economist James Tobin at one point had argued that a moderate level of inflation can increase investment in an economy leading to faster growth or at least higher steady state level of income. This is due to the fact that inflation lowers the return on monetary assets relative to real assets, such as physical capital. To avoid inflation, investors would switch from holding their assets as money (or a similar, susceptible to inflation, form) to investing in real capital projects.How inflation will effect the employer & employee? Inflation _______ real wage (w)How inflation will effect borrowers and debtors? Real interest rate(r)______ i = r + so r = i

Effects of inflation on other variables:Impact on other variablesUncompensated inflation reduces incomes, thus consumption and savings. Through a Keynesian multiplier, income and consumption will cumulatively fall further.If inflation is mainy demand-pulled, it vanishes the increases in nominal effective demand and it frustrates consumption expectations.By contrast, if inflation is mainly due to efforts of increasing margins and profits, it is possible a rise in consumption in high-income groups.Investment should be discouraged by uncertainty about future engendered by inflation and its wide fluctuation. Still, to the extent that benefits of inflation are mainly reaped by domestic firms, the real interest rate for investment fall inversely with mounting inflation. Thus, a low or moderate inflation may help investments, at least to the extent they are actually influenced by real interest rates and until a central bank intervention.In fact, central banks can try to control inflation through a sharp increase in real interest rates, more than proportionally reflected in nominal interest rates.This move usually provokes a fall in investment and a revaluation of currency. The first effect brakes domestic demand, the second the foreign one.Summarizing some of these arguments, higher inflation leads to higher nominal interest rates. In a first phase, the latter may not keep pace with inflation, thus real interest rates may fall. But afterwards, if the central bank does not accomodate inflation, the real interest rates are kept much higher than before.Still, too many elements are intertwinned, so that these relationships should be treated with great caution.In absence of central bank reaction, it is for example common that inflation tends to provoke currency devaluation, opening a vicious circle.This is certainly the case with hyperinflation. In fact, in this case, central banks often choose to fix a certain exchange rate target as a nominal anchor in the battle against inflation: with fixed exchange rates, inflation makes import cheaper in comparison to domestic products, so that domestic firms face more intense competition, which should brake inflation.Until the fall in inflation does not takes place, domestic goods become more expensive in a international comparison, typically with a fall in exports and a rise of imports, heavily deteriorationg the trade balance.At the same time, if indexed, local wages and incomes will improve their international purchasing power, thanks to fixed nominal exchange rate.On financial markets of fixed-interest bonds, an increase of inflation will reduce the burden of debt and interest payments.In the case of large public debt, inflation is an important relief for the State (also through larger tax revenues and lower personnel costs), menacing to engender a political tolerance toward inflation. ___________________________________________________________

Types of inflation:A transversal classification distiguish inflations, basing on their broadly-defined origins:1. domestic demand;>Demand pull inflation>Domestic inflation2. domestic costs, as wages;>Cost push inflation>Tax based cost push inflation3. external sources, >Imported inflationas oil price increases or currency relative devaluation.Types of Inflation

There are four main types of inflation. The various types of inflation are briefed below.

Wage Inflation: Wage inflation is also called as demand-pull or excess demand inflation. This type of inflation occurs when total demand for goods and services in an economy exceeds the supply of the same. When the supply is less, the prices of these goods and services would rise, leading to a situation called as demand-pull inflation. This type of inflation affects the market economy adversely during the wartime.

Cost-push Inflation: As the name suggests, if there is increase in the cost of production of goods and services, there is likely to be a forceful increase in the prices of finished goods and services. For instance, a rise in the wages of laborers would raise the unit costs of production and this would lead to rise in prices for the related end product. This type of inflation may or may not occur in conjunction with demand-pull inflation.

Pricing Power Inflation: Pricing power inflation is more often called as administered price inflation. This type of inflation occurs when the business houses and industries decide to increase the price of their respective goods and services to increase their profit margins. A point noteworthy is pricing power inflation does not occur at the time of financial crises and economic depression, or when there is a downturn in the economy. This type of inflation is also called as oligopolistic inflation because oligopolies have the power of pricing their goods and services.

Sectoral Inflation: This is the fourth major type of inflation. The sectoral inflation takes place when there is an increase in the price of the goods and services produced by a certain sector of industries. For instance, an increase in the cost of crude oil would directly affect all the other sectors, which are directly related to the oil industry. Thus, the ever-increasing price of fuel has become an important issue related to the economy all over the world. Take the example of aviation industry. When the price of oil increases, the ticket fares would also go up. This would lead to a widespread inflation throughout the economy, even though it had originated in one basic sector. If this situation occurs when there is a recession in the economy, there would be layoffs and it would adversely affect the work force and the economy in turn.

Other Types of Inflation

Fiscal Inflation: Fiscal Inflation occurs when there is excess government spending. This occurs when there is a deficit budget. For instance, Fiscal inflation originated in the US in 1960s at the time President Lydon Baines Johnson. America is also facing fiscal type of inflation under the presidentship of George W. Bush due to excess spending in the defense sector.

Hyperinflation: Hyperinflation is also known as runaway inflation or galloping inflation. This type of inflation occurs during or soon after a war. This can usually lead to the complete breakdown of a countrys monetary system. However, this type of inflation is short-lived. In 1923, in Germany, inflation rate touched approximately 322 percent per month with October being the month of highest inflation.

The main causes of inflation Inflation can come from several sources: Some come direct from the domestic economy, for example the decisions of the major utility companies providing electricity or gas or water on their prices for the year ahead, or the pricing strategies of the leading food retailers based on the strength of demand and competitive pressure in their markets. A rise in government VAT would also be a cause of increased domestic inflation because it increases a firms production costs.Inflation can also come from external sources, for example an unexpected rise in the price of crude oil or other imported commodities, foodstuffs and beverages. Fluctuations in the exchange rate can also affect inflation for example a fall in the value of sterling might cause higher import prices which feeds through directly into the consumer price index.We make a simple distinction between demand pull and cost push inflation.Demand-pull inflation Demand-pull inflation is likely when there is full employment of resources and aggregate demand is increasing at a time when SRAS is inelastic. This is shown in the next diagram:

In the diagram above we see a large outward shift in AD. This takes the equilibrium level of national output beyond full-capacity national income (Yfc) creating a positive output gap. This would then put upward pressure on wage and raw material costs leading the SRAS curve to shift inward and causing real output and incomes to contract back towards Yfc (the long run equilibrium for the economy) but now with a higher general price level (i.e. there has been some inflation).The main causes of demand-pull inflation Demand pull inflation is largely the result of the level of AD being allowed to grow too fast compared to what the supply-side capacity can meet. The result is excess demand for goods and services and pressure on businesses to raise prices in order to increase their profit margins. Possible causes of demand-pull inflation include:1. A depreciation of the exchange rate which increases the price of imports and reduces the foreign price of UK exports. If consumers buy fewer imports, while exports grow, AD in will rise and there may be a multiplier effect on the level of demand and output 2. Higher demand from a fiscal stimulus e.g. via a reduction in direct or indirect taxation or higher government spending. If direct taxes are reduced, consumers will have more disposable income causing demand to rise. Higher government spending and increased government borrowing feeds through directly into extra demand in the circular flow 3. Monetary stimulus to the economy: A fall in interest rates may stimulate too much demand for example in raising demand for loans or in causing a sharp rise in house price inflation 4. Faster economic growth in other countries providing a boost to UK exports overseas. Export sales provide an extra flow of income and spending into the UK circular flow so what is happening to the economic cycles of other countries definitely affects the UK Cost-push inflation Cost-push inflation occurs when firms respond to rising costs, by increasing prices to protect their profit margins. There are many reasons why costs might rise:1. Component costs: e.g. an increase in the prices of raw materials and other components used in the production processes of different industries. This might be because of a rise in world commodity prices such as oil, copper and agricultural products used in food processing 2. Rising labour costs - caused by wage increases, which are greater than improvements in productivity. Wage costs often rise when unemployment is low (skilled workers become scarce and this can drive pay levels higher) and also when people expect higher inflation so they bid for higher pay claims in order to protect their real incomes. Expectations of inflation are important in shaping what actually happens to inflation! 3. Higher indirect taxes imposed by the government for example a rise in the specific duty on alcohol and cigarettes, an increase in fuel duties or a rise in the standard rate of Value Added Tax. Depending on the price elasticity of demand and supply for their products, suppliers may choose to pass on the burden of the tax onto consumers Cost-push inflation can be illustrated by an inward shift of the short run aggregate supply curve. The fall in SRAS causes a contraction of national output together with a rise in the level of prices. Which government policies are most effective in reducing inflation? Most governments now give a high priority to keeping control of inflation. It has become one of the dominant objectives of macroeconomic policy. Inflation can be reduced by policies that (i) slow down the growth of AD or (ii) boost the rate of growth of aggregate supply (AS). The main anti-inflation controls available to a government are:1. Fiscal Policy: If the government believes that AD is too high, it may reduce its own spending on public and merit goods or welfare payments. Or it can choose to raise direct taxes, leading to a reduction in disposable income. Normally when the government wants to tighten fiscal policy to control inflation, it will seek to cut spending or raise tax revenues so that government borrowing (the budget deficit) is reduced. This helps to take money out of the circular flow of income and spending 2. Monetary Policy:A tightening of monetary policy involves higher interest rates to reduce consumer and investment spending. Monetary policy is now in the hand of the Bank of England it decides on interest rates each month. 3. Supply side economic policies: Supply side policies include those that seek to increase productivity, competition and innovation all of which can maintain lower prices. The most appropriate way to control inflation in the short term is for the British government and the Bank of England to keep control of aggregate demand to a level consistent with our productive capacity. The consensus among economists is that AD is probably better controlled through the use of monetary policy rather than an over-reliance on using fiscal policy as an instrument of demand-management. But in the long run, it is the growth of a countrys supply-side productive potential that gives an economy the flexibility to grow without suffering from acceleration in cost and price inflation.