Inflation occurs when there is general and consistent increase in price levels of goods and services over a given period of time. The increase in price levels may be attributed to excessive money in the hands of individuals and businesses; or stated differently, excessive money in the hands of the public, relative to the supply of goods and services within the economy. Conversely, inflation does not occur when increase in price could be offset with decrease in demand for goods and services.
Challenges
The economic challenges often introduced by inflation are manifold. To illustrate, the purchasing power of money plummets during inflationary periods; while the values of non-interest-bearing financial assets experience full depreciation effect. Further, inflation undermines the effectiveness of money as store of value; more money is needed to purchase the same quantity of the product when the economy is characterised by consistent surge in prices of goods.
Money may cease to be a medium of exchange during periods characterised by hyper-inflation as witnessed in the former Soviet Union (now Russia) between 1918 and 1922; and witnessed in economies such as Germany and Poland in relative periods. Equally worrying is the fact that the acceptable level of liquidity and choice of good protection against inflation become a challenge to investors.
The purchasing power of financial assets decreases during economic periods characterised by high inflationary levels. Thus, continuous holding of funds in financial assets requires adequate compensation. Generally, assets with very low liquidity attract high interest rates. Contrarily, assets with very high liquidity attract low interest rates. Nonetheless, unexpected surge in inflationary level or rate could reduce the protection enjoyed by investors in financial assets investments.
Inflation increases the incidence of high default risk and distortions in the redistribution of wealth and income. During inflationary periods, borrowers are impelled to pay back loans in devalued currencies; while pensioners’ benefits are negatively affected. Further, the purchasing power of the relatively fixed benefits or income is weakened by price increases.
It is often difficult to assess the effect of future inflation rates on long-term contracts. The uncertainty of the future encourages many individuals and businesses to consider short-term contracts at the expense of long-term contracts; albeit the former does not ensure efficiency in positive economic growth.
Frequent price fluctuations in inflationary periods tend to have adverse financial implications for producers and sellers of goods. Provision of trade credit tends to be unattractive to sellers since debtors pay back at low old prices. During periods of inflation, the cost, in terms of money, effort and time of market survey; and research into appropriate price, tends to be high.
Beneficiaries
Generally, inflation results in lower payments (in terms of value) by borrowers to lenders; while governments repay loans with inflationary money. This enables them to repay government securities holders and lending financial institutions (banks) at maturity dates with relative ease.
Further, the inflation premium charged by banks on loans allows them to be protected against, and benefit from inflation; lenders who provide house mortgage loans benefit from inflation when the value of their homes exceeds the inflation rate significantly. These lenders record substantial benefits than persons with savings in building societies and other mortgage providers.
A mild inflation can stimulate economic growth. During periods of increased money supply, individuals use the excess to purchase goods and services. This would result in excess demand over supply, leading to upward price adjustment; or increase in prices. The price increase may encourage producers to consider surge in production and supply of goods and services. All else held constant, the increase in production would contribute to economic growth and development through job creation; and improved living standards, among others.
Causes
The causes of inflation can be categorised into three major factors. These include cost-push inflation; demand-pull inflation; and continuous or cyclical inflation. Cost-push inflation arises out of increased cost of production inputs such as wages and materials; and the desire for higher profit. These factors tend to affect the supply; and impel consumers to chase fewer goods in the market. Increased commodity prices, higher nominal wages and rising oil prices remain typical examples of cost-push inflation factors.
Under wage push inflation, workers’ agitation for increased wages and salaries results in higher remuneration. The percentage increase is passed on to the final consumer in the form of higher prices. Profit-push inflation is occasioned when producers develop interest in recording higher profits even though cost of production inputs remain unchanged. To realise this objective, businesses review prices upwardly. However, ceteris paribus, general increase in price by producers across given geographical area or areas may result in inflation.
Inflation may be triggered by imported materials for production. Fall in value or depreciation of the country’s currency implies more money would be required to import the same quantity of materials into the country. All else held constant, the producer would pass on the (cost) increase to consumers in the form of higher prices of goods.
Sometimes, materials required for production may be obtained within the country. However, prices of these materials may be increased by suppliers to off-set increase in their operation cost. Producers would eventually pass on the increased cost of local raw materials to consumers; and this trend is termed as non-imported materials inflation.
Increase in incomes often encourages individuals to purchase more goods and services. All else held constant, excess aggregate demand over supply would result in surge in price, leading to inflation. General price increase instigated by the foregoing is known as demand-pull inflation.
The concept of continuous or cyclical inflation posits inflation is endless. That is, surge in cost of one (production) component leads to rise in the cost of another. To illustrate, increase in wages of employees would lead to surge in production cost. This cost difference would be passed on to consumers in the form of increased prices of goods and services. Workers, who are consumers, would again agitate for higher wages to offset the price increase in the market. Producers would again, pass on the increase in production cost to consumers; and this trend may continue over a considerable period.
Recommended Measures – Cost-Push Inflation
Inflation that is triggered by cost-push factors can be mitigated through government interventions; reduction in transport bottlenecks; flexibility in energy policies; introduction of policies on pricing (price cap on monopolies); incomes and import controls. Analysts describe significant reduction in production costs as the most ‘appropriate’ solution to inflation triggered by cost-push factors. Though supply-side solution has been hailed as good, it generally takes a considerable time to affect; or manifest overtly and positively in the activities of individuals and businesses within an economy.
Government’s pursuit of deflationary monetary policy tends to be less effective towards reducing cost-push inflation since higher interest rates are likely to spur on recession and unemployment as cost of borrowing increases; and consumer spending and investment are discouraged or reduced. The dilemmas faced by policymakers during periods characterised by cost-push inflation are rising inflation and slower growth in economic activities.
However, an immediate remedial measure is government’s decision to subsidise wages by absorbing part of the labour costs incurred by businesses. Further, the introduction of higher interest rates could cause appreciation in the exchange rate; and reduction in the prices of imported goods in the market. The effect of this policy (introduction of higher interest rates) is reduction in inflation; and reduction in economic activities. However, the overall impact in the medium- to long-term is economic growth.
An economy may be plagued with recession and unemployment when demand-side policies are considered towards reducing cost-push inflation. The general expectations are cost-push inflation would remain transient, not permanent. This explains why central banks in most global economies allow inflation to remain high during economic periods characterised by cost-push inflation.
Recommended Measures – Demand-Pull Inflation
Inflation that is caused by demand-pull factors can be controlled through government’s introduction of demand management strategies or techniques, including the introduction of restrictive fiscal policy and monetary policy measures.
The fiscal policy of a country has two essential components. These include government’s expenditure and revenue. Government could change existing tax rates to augment revenue or ensure efficiency in the management of national expenditure. Restrictive fiscal measures advocate for reduction in government expenditure and increase in national revenue through increased tax rate; strengthening of existing tax collection systems; and widening of existing tax nets.
Generally, the inflation gap that arises from excess aggregate demand over aggregate supply could be controlled when the government takes steps to decrease overall national spending; defer or transfer payments; increase taxes to decrease individual and household spending; and takes bold steps to restructure external debts to reduce external debt burdens; and ease pressures on the local currency in terms of forex exchange for external debt settlements.
Classic illustration in recent periods is relative stability in the Ghana Cedi against major foreign currencies such as the United States Dollar, British Pound Sterling and European Euro, following successful implementation of the government of Ghana and IMF’s debt restructuring programme.
Available data affirmed significant improvement in the Ghana Cedi – United States Dollar depreciation rate from 53.9% (as at the 2023 National Budget reading period in November 2022) to 22.1% in July 2023. Similarly, depreciation of the Ghana Cedi relative to the British Pound Sterling improved from 45.7% to 28.3%; while the Ghana Cedi – European Euro depreciation rate improved to 26.0% from 46.9% during the same period.
Apart from the fiscal measures, government could draw on monetary policy to stem the tide of inflation on economic activities. For instance, the government, through the central bank, could introduce measures that would control money supply; minimise expenditure and aggregate demand by individuals and companies. These potential measures include raising minimum interest rates on borrowings; limiting withdrawals from bank accounts; and increasing banks’ minimum reserve requirements, among others.
Practical implementation of the foregoing measures could generally limit money supply; affect aggregate demand; and induce deflation or downward review of prices of goods and services. The government could combine both fiscal and monetary policy measures to ensure reasonable inflationary control; or tame inflation to appreciable level within the economy.
However, it is worth-noting, effective or good economic marriage of fiscal and monetary policies sometimes poses a challenge to economists. The challenges notwithstanding, Bank of Ghana’s monetary policy tightening stance has contributed to the improvements in volatilities inherent in the local currency (Ghana Cedi) relative to the major foreign currencies such as those enumerated in the preceding paragraphs.
Monetarists’ or Quantity Theorists’ Views
The question on the determination of inflation; and whether fiscal or monetary policy may be used to counter inflation is often not answered by cost-push and demand-pull strategies. This question is often answered through the monetarist approach. The Monetarist Theory is premised on the theorem or equation of Irving Fisher commonly called the equation of exchange. The equation is expressed as:
MV = PT
Where:
M = Stock of money
V = Velocity of money circulation
P = Average price level
T = Number of transactions per period
The basic event in the analysis of the equation of exchange is transaction. That is, transfer of goods and services in return for money. The equation suggests M x V equals the total value of expenditure over a given time period. This is because M represents the stock of money and V explains the frequency or number of times with which money turns over.
Further, P refers to the price or value of each transaction; and T represents the actual volume of transactions recorded during the period. The foregoing implies M x V and P x T are not different, they are the same: MV perfectly equals PT.
In the absence of assumptions, the equation of exchange presents limited information on causes of inflation. Fisher admits the numerous factors outlined in the model (equation of exchange) do not have the same causes. For instance, the price of a commodity is determined by several factors; and not a single factor. Moreover, price is believed to be a passive element in the equation.
Views of the monetarists or quantity theorists are premised on two assumptions:
V is constant over relatively long considerable periods. The reason for this assumption is velocity depends on the banks; and the existing payment systems, which respond to change on gradual basis. T would be at or close to full-employment level and over time, would change gradually.
The foregoing assumptions mean V and T are constant; and M x 1 = P x 1. That is, M = P.
Quantity theorists hold the belief (assume) that the underlying objective of money is to determine the general price level suitable for the conclusion of transactions. Individuals are rational beings seeking to maximise their utility; and money itself cannot maximise utility unless it is used as medium of exchange. The usefulness of money therefore lies in its ability to help individuals obtain goods and services.
Monetarists affirm the trend of velocity of money circulation (V) in the long run is stable; and predictable. Moreover, the number of transactions (T) has value in the long run; and this value is determined by forces in the economy. The economy is self-directed towards full employment. Nonetheless, realisation of full employment in the short run may be affected by economic rigidities and disturbances. Monetarists hold that the permanent operation of an economy is challenged whenever it travels beyond its natural level of employment.
Economic rigidities cause an increase in money supply in the short run to result in employment; and output rising above natural long run values due to increase in the level of aggregate demand. Nominal interest rates are likely to fall in periods of excess money supply because individuals may invest part of the excess money supply in financial assets; and increased demand over supply of financial assets would cause their price to rise while the interests or yields provided by sellers would fall.
The impact of increased money supply on the real levels of employment and output in the long term is very minimal or non-existent. However, it has an impact on price levels, leading to inflation. Monetarists do not support the use of monetary policy as viable economic tool; they believe the effect of fiscal policy on the economy is limited. They propose the introduction of policies that would eliminate or minimise the short run economic rigidities. It is believed the elimination would accelerate the economy’s path to full employment, especially when the full employment journey has been marred by external shocks such as lower prices of exported commodities such as gold and cocoa.
Keynesians’ Views
Contrary to the views held by Monetarists, Keynesians believe factors such as interest rate changes make the velocity of money circulation (V) volatile. That is, the velocity of money becomes unpredictable and variable. For instance, all things held constant, fall in interest rates would discourage individuals from investing in financial assets; people would be interested in keeping larger money balances thereby impacting (negatively) on the volume of money in circulation.
Money can be defined in several ways. As a result, Keynesians believe Monetarists are proposing economic control by a variable which lacks one definition; and whose velocity is unpredictable. Keynesians believe the impact of money supply on inflation is not high (as claimed by the Monetarists); while the influence of monetary policy on the economy is minimal. The role of monetary policy in the development process is supportive; it ensures interest rate stability, an essential requirement for productive and meaningful investment.
Stated in different terms, Keynesianism emphasises fiscal policies as critical to economic growth.
Value of Money in Inflationary Periods
The value of money in a modern economy is expressed as function of the commodities it can purchase. That is, the value of money is indexed to its purchasing power relative to the ‘quantity’ of goods and services to be derived. Differences in the value of money are observed through price differences. Economists generally categorise money into two groups. These include Nominal value of money and Real value of money.
Nominal value refers to the quantity of money that is available at any given time period. It is measured in monetary unit, based on face value; whereas real value relates to the goods and services that given quantity of money can purchase over a given period. It is measured in terms of consumers’ purchasing power; and expressed in constant prices ruling in a given base year. The inference is nominal value is deflated by the price index to obtain real money value.
Determination of Price Index
Price index of current year = [(Total price of basket of current year – Total price of basket of base year) ÷ Total price of basket of base year] x 100%
Purchasing power of current year = (Total price of basket of base year ÷ Total price of basket of current year) x 100%
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