Causes of Inflation and Deflation

WITH THE AID OF DIAGRAMS, ILLUSTRATE THE CAUSES OF INFLATION AND DEFLATION, AND BY COMPARING THEIR ECONOMIC EFFECTS CONSIDER HOW BOTH CAN AFFECT THE CORPORATE SECTOR.

The essay will describe causes of inflation and deflation and explain how they can affect the corporate sector.

1. INTRODUCTION

DEFINITION OF INFLATION AND DEFLATION

Inflation is a process in which the price level is rising and money is losing value. (Parkin, Powell, Matthews p654)

Inflation tends to rise when at the current price level, demand for goods and services in the economy are greater than economy’s ability to produce goods and services.

The graph below shows continuously growing inflation, occurred by a rising price level.

If the price level is rising, the inflation rate is positive. If the price level rises at a faster rate, the inflation rate increases.

Inflation is measured with a price index.

The two main measures of inflation are: the Retail Price Index (RPI) and Consumer Price Index (CPI).They measure an average of the prices paid by costumer for a fixed basked of goods and services included such items as food, heating, housing goods, bus fares and petrol.

One of the several variations on inflation is hyperinflation. When it occurs, the value of money becomes worthless. Although it is extremely rare it may lead to the breakdown of a nation’s monetary system. One of the most famous happened in Germany between 1921 and 1923 and Turkey in 1999 when inflation reached 70%.

Deflation is very unusual although some countries such as Japan and China have experienced price deflation in their economies in recent years.

Falling prices can arise from too much supply or too little demand. There are four causes for deflation.

Decreasing Money Supply

Increasing Supply of Goods

Decreasing Demand for Goods

Increasing Demand for Money

AS line is representation of aggregate supply, in relation to price level and GNP. When supply of goods increases, AS moves downwards to AS’ and there is productivity growth. Point A where AS meets AD (aggregate demand) moves in this instance to B, creating deflation. This situation is bad for companies, therefore bad for profits as businesses can not raise prices and the real debt rises.

AD is the line for aggregate demand. As the demand for money increases, AD moves downwards to AD’. This represents a monetary stimulus that leads to lower interest rates, point B moves to C, where the new AS’ and AD’ meet. Inflation comes to force, which is better for companies their profits and pricing power and the real debt falls.

2. CAUSES OF INFLATION

There are different schools of explaining causes of inflation as it can be caused by different things at different times. Inflation often follows a war, when government has to spent large sums on military equipment and has not raised enough taxes to pay for it.

*Monetary inflation - quantity theory

By Monetarism, inflation is an effect of the supply of money being larger than the demand for money.

(http://en.wikipedia.org/wiki/Inflation)

The Monetarist explanation of inflation operates through the Fisher equation where:

M.V = P.T

M = Money Supply

V = Velocity of Circulation

P = Price level

T = Transactions or Output

As