Inflation

Introduction:

Nowadays, more people pay their attentions on one word, “inflation”, because of the weak global economy. Inflation is when rising of general price level for goods and services happens with decreasing of purchasing power for people. In a short sentence, when inflation happens, people cannot use same amount of money to buy same amount of purchases as much as before.
For finding out if inflation happens and what extent it has done, we always use CPI (Consumer Price Index) and RPI (Retail Price Index), CPI shows the trend and what extend of changing price for purchasing of goods and services in a specific period. RPI also shows the changes of price level for goods and services in a specific period. CPI and RPI rises may means that inflation is happening. (Investopedia UCL, 2012)

In this essay, I will generally talk about how does inflation form, how does government control it by demand-side and supply-side policies, and how does those policies make other impacts to the economy.

Part 1 Causes of Inflation

There are two main types of inflation: demand-pull inflation and cost-push inflation. Generally demand-pull inflation is caused by overly increasing in demand. On the other hand, cost-push inflation is caused by an increasing in cost. I will specific talk about causes of those two types inflation.

A diagram of demand-pull inflation is shown as following:

Figure 1 (Riley J. 2012)

Demand increase overly when AD1 curve shifts right to AD2, the price level is increasing from P1 to P2. Then a demand-pull inflation is forming. There are several reasons that make AD curve shift right. If any one factor from equation AD = Cd + G + I + X (-M) changes, the AD curve will be influenced.

First, a depreciation of exchange rate will make AD curve shift right. Depreciation of exchange will cause rising of price of import and decreasing of price of exports. Demand of domestic productions will increase. Second, reduction of tax will make AD curve shift right. For consumers, a reduction of tax means they get more money to consume, so their purchasing power will increase. For firms, a reduction of tax means lower cost, and lower price will be caused. Both of those can enhance aggregate demand. Third, growth of money supply will make AD curve shift right. Increasing of money supply will lead decreasing of interest rate and increasing of liquidity of money. And then people will invest and consume more, the aggregate demand will increase. Last, a rising of expected price will make AD curve shift right. If people think the price of the production will increase, increasing of the demand will increase.

In addition, a diagram of cost-push inflation is shown as following:

Figure 2 (Riley J. 2012)

In this diagram, when the AS curve changed from AS1 to AS2, the price level P1 changed up to P2. However, the national income reduces to Y2 from Y1. Then cost-push inflation is forming. There are also several points that make the AS curve rises.

First, rising of price of resource or imported raw material can lead a decreasing of AS. When this happens, companies will reduce the quantity of production and enhance the price for keeping excepted profits. Second, rising of labour costs will make AS decrease. When the improvement of wages exceeds the improvement of productivity, an overly increasing labour cost is caused. This will make the cost of production increase, and then the price level will rise. Third, increasing of tax can make the AS decrease. Higher tax will cause higher cost for companies, and the higher cost will cause a higher price level.

Part 2 Approaches to Control Inflation

When an inflation is forming, it always lead rising of price level. Then people will feel poorer, so government pays a lot of attention to control inflation. Government will use both demand-side and supply-side policy to control inflation. Sometimes government except lower inflation to lead more stable