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A process of steadily rising prices resulting in diminishing purchasing power of a given nominal sum of money. Inflation has been a marked characteristic of most economies since World War H and has received considerable attention from economists. Theories of its causes are often classified as cost-push theories and demand-pull theories, the latter of which would include the issue of the influence of the money supply on the price level. Solutions to the problem of inflation most often suggested include: (a) to use monetary policies and fiscal policies to restrain aggregate demand, increase unemployment and hence reduce inflationary pressure, and (b) to make a direct inter­vention in the markets for goods and factors of production to restrain price and wage increases. There have also been proposals that taxes related to the size of wage increases granted should be imposed on firms to ‘stiffen employers’ resistance’ to wage claims. However, apart from distorting the operation of the price mechanism in its allocative role, it is unlikely that measures of administrative intervention would restrain inflation completely in the absence of restraint on aggregatc monetary demand, since the administrative task of prevent­ing implicit wage and price increases would be enormous, for example). Many economists, who would usually be classed as ‘Keynesians’, see the real difficulty as one of balancing the costs of inflation against the costs of avoiding it, in terms of higher unemploy­ment and lower output of real goods and services. A low rate of inflation (perhaps about 2 to 3 per cent per annum) may not in general be considered objectionable, and indeed might be considered an inevitable consequence of an expanding economy. The ‘evils’ of inflation, however, are generally held to result from:

(a) The possibility that a slow rate of inflation may accelerate and become galloping inflation, the consequences of which could be a breakdown of the monetary system.

(b) The fact that there may be undesirable redistributions of real income, since those whose money incomes rise at a slower rate than the rate of inflation clearly lose, while the real incomes of those whose money incomes rise faster than the rate of inflation increase. At the extreme, those whose money incomes change infrequently, e.g. senior citizens, may become very badly off. Clearly, the difficulty arises here because the rate of inflation is not fully anticipated. If it were, then contracts could be made in real terms, and these redistributive effects might not take place

(c) Inflation may discourage saving since the real value of the sum sa ved falls through time. However, rates of interest will tend to rise to offset this, and many forms of saving exist which provide a HEDGE against inflation because their money values rise accord­ingly, e.g. real estate. Aga in, therefore, unanticipated inflation is what creates the problem.

(d) Where an economy engages extensively in international trade, with a fixed exchange rate, inflation may cause its prices to rise relative to those of other countries. This will cause exports to fall, imports to rise, and balance of payments deficits may develop. Note however the importance here of the rate of that country’s inflation relative to the others. If all countries were inflating at the same rate, relativities would remain unchanged. There would then be a redistribution of world wealth, since the real value of the liabilities of debtor nations would fall as would the real value of assets of the creditor nations. When exchange rates are floating rather than fixed, the changes in the balance of exports and imports caused by differential rates of inflation will bring about movements in exchange rates, so we expect, other things being equal, that the currency of a country inflating faster than other countries will undergo depreciation.

Reference: The Penguin Dictionary of Economics, 3rd edt.