Assingment on Inflation and Its Effect

Assingment on Inflation and Its Effect


During World War II, you could buy a loaf of bread for $0.15, a new car for less than $1,000 and an average house for around $5,000. In the twenty-first century, bread, cars, houses and just about everything else cost more. A lot more. Clearly, we’ve experienced a significant amount of inflation over the last 60 years.

When inflation surged to double-digit levels in the mid- to late-1970s, Americans declared it public enemy No.1. Since then, public anxiety has abated along with inflation, but people remain fearful of inflation, even at the minimal levels we’ve seen over the past few years. Although it’s common knowledge that prices go up over time, the general population doesn’t understand the forces behind inflation.

What is Inflation

Inflation is defined as a sustained increase in the general level of prices for goods and services. It is measured as an annual percentage increase. As inflation rises, every dollar you own buys a smaller percentage of a good or service.

Causes of Inflation
Economists wake up in the morning hoping for a chance to debate the causes of inflation as it has a great effect on economy. There is no one cause that’s universally agreed upon, but at least two theories are generally accepted:

Demand-Pull Inflation – This theory can be summarized as “too much money chasing too few goods”. In other words, if demand is growing faster than supply, prices will increase. This usually occurs in growing economies.
Cost-Push Inflation – When companies’ costs go up, they need to increase prices to maintain their profit margins. Increased costs can include things such as wages, taxes, or increased costs of imports.

Costs of Inflation
Almost everyone thinks inflation is evil, but it isn’t necessarily so. Inflation affects different people in different ways. It also depends on whether inflation is anticipated or unanticipated. If the inflation rate corresponds to what the majority of people are expecting (anticipated inflation), then we can compensate and the cost isn’t high. For example, banks can vary their interest rates and workers can negotiate contracts that include automatic wage hikes as the price level goes up.

Problems arise when there is unanticipated inflation:

  • Creditors lose and debtors gain if the lender does not anticipate inflation correctly. For those who borrow, this is similar to getting an interest-free loan.
  • Uncertainty about what will happen next makes corporations and consumers less likely to spend. This hurts economic output in the long run.
  • People living off a fixed-income, such as retirees, see a decline in their purchasing power and, consequently, their standard of living.
  • The entire economy must absorb repricing costs (“menu costs”) as price lists, labels, menus and more have to be updated.
  • If the inflation rate is greater than that of other countries, domestic products become less competitive.

People like to complain about prices going up, but they often ignore the fact that wages should be rising as well. The question shouldn’t be whether inflation is rising, but whether it’s rising at a quicker pace than your wages.

Finally, inflation is a sign that an economy is growing. In some situations, little inflation (or even deflation) can be just as bad as high inflation. The lack of inflation may be an indication that the economy is weakening. As you can see, it’s not so easy to label inflation as either good or bad – it depends on the overall economy as well as your personal situation.

Measures against inflation

THE price situation in Bangladesh, like the case with many other developing countries, has, of late, come under a fresh upward pressure. Its inflationary rate, as measured by consumers’ price index (CPI) has, thus, crept up. The latest available data from the Bangladesh Bureau of Statistics (BBS), the government agency, put this rate at 8.12 per cent in September 2010, up from 7.87 per cent a month ago. The rate of inflation has further gone up in last two months, though the updated official data about the same are still awaited. Thus, the official inflation rate, which is now coming closer to double digits, has prompted the country’s central bank, Bangladesh Bank (BB), to go for slowing down of monetary growth to tame the price pressure. The BB is likely to continue its tight monetary policies to help keep inflation at bay. The BB hiked last week the cash reserve requirement (CRR) for banks. Further squeeze in the statutory liquidity reserve (SLR) cannot be ruled out. For the central bank, this is otherwise a rational course of action.
Yet then, the question remains whether application of monetary policies like the above in a clinical fashion, would alone be effective in the Bangladesh context. For, the economy of this country does not operate on a framework of textbook theories that say that inflation reflected in rising prices of goods and services has too intimate a relationship with increased money supply – that creates demand which cannot be met under conditions of scarcity of existing stocks of goods and services. Thus, prices are driven up. If it were so easy to control the effects of what is understood as inflation — rising prices and charges — in the Bangladesh situation, then BB’s monetary policies of limiting inflation through monetary tools would have earlier paid off well.
On its part, the BB has otherwise been neither too tight-fisted in reducing money supply — to ensure that legitimate needs of credits could be met for the economy’s expansion — nor too reckless by being liberal in allowing the growth of money. It has been pursuing balanced monetary policies over the years. But that has not paid the desired dividends; tighter policies have not proved to be effective. Factors at work need to be traced for this. Such factors are not all within the bounds of rational economic theories. Price escalations of commodities or hiking up charges of services in many cases — and rather on a regular basis — are largely considered to be caused by simple profiteering instincts, market imperfections of diverse sorts, lack of timely policy-related actions or interventions on the part of the government etc. There are a large number of essential commodities over the selling of which effective price monitoring, appropriate policies to encourage supply-side responses and other accompanying measures from the side of the government, have not been in place in a proper form and setting.
In this backdrop, the BB will have to be more agile and should act promptly even in the realm of the supervision of the monetary affairs of the country. For instance, credible reports have appeared in the media to the effect that a great deal of money, lent out from the banks over nearly the last one year or more, have not gone into productive ventures or into industrialization but to the country’s volatile stock market. In this situation, it is certainly no wonder that inflationary pressure have been running strong.
Higher inflation does not, of course, signal proper economic management. The bringing down of the rate of inflation is tantamount to removing maladies in the country such as institutional weaknesses, lack of expected improvements in promoting good governance, irregularities, funds misappropriated or not utilized or utilized for wrong purposes, not increasing production and even misdirected subsidies in some cases. Both economic and non-economic factors are involved here. Hence, these all need to be properly addressed, if inflationary pressures are to be effectively tamed.

Bangladesh Inflation Rate

The inflation rate in Bangladesh was last reported at 10.2 percent in May of 2011. This page includes a chart with historical data for Bangladesh’s Inflation Rate. Inflation rate refers to a general rise in prices measured against a standard level of purchasing power. The most well known measures of Inflation are the CPI which measures consumer prices, and the GDP deflator, which measures inflation in the whole of the domestic economy.

Inflation Rate Definition

In mainstream economics, the word “inflation” refers to a general rise in prices measured against a standard level of purchasing power. Previously the term was used to refer to an increase in the money supply, which is now referred to as expansionary monetary policy or monetary inflation. Inflation is measured by comparing two sets of goods at two points in time, and computing the increase in cost not reflected by an increase in quality. There are, therefore, many measures of inflation depending on the specific circumstances.

The most well known are the CPI which measures consumer prices, and the GDP deflator, which measures inflation in the whole of the domestic economy. The prevailing view in mainstream economics is that inflation is caused by the interaction of the supply of money with output and interest rates. Mainstream economist views can be broadly divided into two camps: the “monetarists” who believe that monetary effects dominate all others in setting the rate of inflation, and the “Keynesians” who believe that the interaction of money, interest and output dominate over other effects. Other theories, such as those of the Austrian school of economics, believe that an inflation of overall prices is a result from an increase in the supply of money by central banking authorities.
Negative effects of inflation

The main negative effects of inflation are: (1) It redistributes income from people on fixed incomes (that do not rise with inflation) to people on variable incomes (that do rise with inflation). Since most people with fixed incomes are poor (for example, receive social benefits that do not rise in line with inflation), and people with variable incomes are relatively richer, the effect of income is to redistribute income from the poor to the rich. (2) Inflation erodes international competitiveness. Exports cost more abroad. This can cause a decrease in demand for exports. That in turn can lead to a decrease in demand for the currency and to a devaluation of the currency. The devaluation may restore exports, but at the cost of making imports more expensive, thus increasing inflation again! It is because inflation erodes international competitiveness that most governments make controlling inflation the central pillar of their economic policy.

Positive effects of inflation:

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.

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.

Mundell-Tobin effect:

The Nobel laureate Robert Mundell noted that moderate inflation would induce savers to substitute lending for some money holding as a means to finance future spending. That substitution would cause market clearing real interest rates to fall. The lower real rate of interest would induce more borrowing to finance investment. In a similar vein, Nobel laureate James Tobin noted that such inflation would cause businesses to substitute investment in physical capital (plant, equipment, and inventories) for money balances in their asset portfolios. That substitution would mean choosing the making of investments with lower rates of real return. (The rates of return are lower because the investments with higher rates of return were already being made before.) The two related effects are known as the Mundell-Tobin effect. Unless the economy is already overinvesting according to models of economic growth theory, that extra investment resulting from the effect would be seen as positive.

Instability with Deflation:

Economist S.C. Tsaing noted that once substantial deflation is expected, two important effects will appear; both a result of money holding substituting for lending as a vehicle for saving. The first was that continually falling prices and the resulting incentive to hoard money will cause instability resulting from the likely increasing fear, while money hoards grow in value, that the value of those hoards are at risk, as people realize that a movement to trade those money hoards for real goods and assets will quickly drive those prices up. Any movement to spend those hoards “once started would become a tremendous avalanche, which could rampage for a long time before it would spend itself.” Thus, a regime of long-term deflation is likely to be interrupted by periodic spikes of rapid inflation and consequent real economic disruptions. Moderate and stable inflation would avoid such a seesawing of price movements.

Financial Market Inefficiency with Deflation:

The second effect noted by Tsaing is that when savers have substituted money holding for lending on financial markets, the role of those markets in channeling savings into investment is undermined. With nominal interest rates driven to zero, or near zero, from the competition with a high return money asset, there would be no price mechanism in whatever is left of those markets. With financial markets effectively euthanized, the remaining goods and physical asset prices would move in perverse directions. For example, an increased desire to save could not push interest rates further down (and thereby stimulate investment) but would instead cause additional money hoarding, driving consumer prices further down and making investment in consumer goods production thereby less attractive. Moderate inflation, once its expectation is incorporated into nominal interest rates, would give those interest rates room to go both up and down in response to shifting investment opportunities, or savers’ preferences, and thus allow financial markets to function in a more normal fashion.


After reading this tutorial, you should have some insight into inflation and its effects. For starters, you now know that inflation isn’t intrinsically good or bad. Like so many things in life, the impact of inflation depends on your personal situation.

Some points to remember:

  • Inflation is a sustained increase in the general level of prices for goods and services.
  • When inflation goes up, there is a decline in the purchasing power of money.
  • Variations on inflation include deflation, hyperinflation and stagflation.
  • Two theories as to the cause of inflation are demand-pull inflation and cost-push inflation.
  • When there is unanticipated inflation, creditors lose, people on a fixed-income lose, “menu costs” go up, uncertainty reduces spending and exporters aren’t as competitive.
  • Lack of inflation (or deflation) is not necessarily a good thing.
  • Inflation is measured with a price index.
  • The two main groups of price indexes that measure inflation are the Consumer Price Index and the Producer Price Indexes.
  • Interest rates are decided in the U.S. by the Federal Reserve. Inflation plays a large role in the Fed’s decisions regarding interest rates.
  • In the long term, stocks are good protection against inflation.
  • Inflation is a serious problem for fixed income investors. It’s important to understand the difference between nominal interest rates and real interest rates.
  • Inflation-indexed securities offer protection against inflation but offer low returns.