There are three major causes of inflation:
- When demand is growing faster than supply which leads to increase in prices (demand- pull inflation).
- When companies operational costs increase due to increases in either the inputs, wages etc, which results in an increase in the price of their products in order to maintain a profit margin (cost-push inflation).
- Changes in exchange rates.
Consequences of inflation are:
- Creditors lose, as their money has less value when loans are repaid.
- Borrowers generally gain from inflation, as they pay back dollars with less purchasing power than when they borrowed it.
- Persons with fixed income such as pensioners, experience a decrease in their purchasing power and hence their standard of living.
- It leads to inaccurate forecasts as persons are not accustomed to thinking with inflation in mind, and they will also make costly errors by confusing real and nominal interest rates.
- Leads to individuals and firms being hesitant in entering into long term contracts, due to the rapidly increasing prices.
- It leads to even more inflation in terms of the costs that must be shouldered by consumers to cover increasing operational costs due to retailers having to re-price items regularly.
- Leads to exports becoming less competitive on the international market, if domestic inflation is higher than that of competing countries.
Government reduces inflation by:
- Implementing appropriate fiscal policies: Governments reduce their spending and increase taxes. This policy works in combating demand- pull inflation.
- Implementing a monetary policy: Central banks would reduce the money supply available for spending or increase interest rates. This policy works in combating demand- pull inflation.
- By designing policies which will spur productivity/reduce operational costs, such as giving grants to firms and giving tax breaks and other incentives.
- Direct Intervention: these are measures taken to restrict wage increases and price(s) of commodities. The two types of direct intervention are legislative (government freezes wages and prices) and voluntary.