Inflation Rate Effects And Theories
A second major problem that faces the nation is inflation. The economy can usually adapt to gradually rising prices. Unpredictable inflation, however, has a destabilizing effect on the economy. Consumers and businesses act differently than they would if the economy were growing at a stable rate. For example,during periods of anticipated high inflation, consumers may borrow an spend more. They realize that the dollars they use to make loan payments will be worthless and less as inflation rises. As a result, creditors eventually raise interest rates to maintain the level of profit they had before inflation began to rise rapidly. This, in turn, tends to have a slowing effect on the economy's growth. In the long run in a tie of anticipated high inflation, consumers and businesses often borrow less because of the high interest rates.
HIgher Inflation, Lower Living Standards
|Your Raise||Inflation Rate||Purchasing Power|
Inflation may also affect consumer's living standard. Suppose you receive a 5 percent raise in a year in which inflation has risen 8 percent. As shown in the figure above, you have actually lost purchasing power. Inflation is a particularly serious problem for people who live on fixed incomes, such as those who are retired. Each year a little of the purchasing power of that income is eaten away. Unfortunately, no single answer explains why inflation occurs. Two competing ideas have developed, however: the demand-pull theory and the cost-push theory.
Demand-Pull Theory of Inflation
According to the theory of demand-pull inflation, prices rise as the result of excessive business and consumer demand. If demand increases faster than total supply, the resulting shortage will lead to the bidding up of prices. Demand-pull inflation can occur for several reasons. Inflation can occur if the Federal Reserve causes the money supply to grow too rapid. Individuals, in their attempt to spend the additional dollars, will compete for the limited supply of goods and services. this increased demand will cause prices to rise. Increases in government spending and in business investments for expansion can also increase overall demand. It can also increase if taxes are reduced or consumers begin saving less. Either results in more money income being spent.
Cost-Push Theory of Inflation
The demand-pull theory indicates that inflation usually happens only when there is full employment in the economy. Before full employment is reached, increased demand will increase output and reduce unemployment. Experience, however, has shown that rising prices and unemployment can occur at the same time. This combination of inflation and low economic activity is sometimes called stagflation. The United States experienced this type of inflation for the first time during the 1969-1970 recession. It remained a problem through much of the 1970s. It appeared again in 1982 and to a leser extend, it was evident in 1990-1991.