Inflation is defined as sustained increase in general price level of goods and services in an economy over a period of time. A moderate and stable level of inflation is generally experienced in countries which are registering a steady economic growth. However, an acceleration in the inflation rate is usually experienced in a overheated economy.
Cost of Living
Cost of living refers to the amount of household spending. Including financial obligations. For instance car and housing loan to maintain a certain standard of living . This spending or cost of living is determined by both household spending patterns and the prices faced by households.
Consumer Price Index, CPI
The inflation rate, as measured by the change in the Consumer Price Index, CPI reflects the average rate of increase in the price of a basket of goods and services. The CPI is constructed by assuming that there is a single basket of goods and services which represents the consumption basket of all households in the country . CPI inflation, which captures the increases in consumer prices. Is often used to assess changes in cost of living .
Factor Affecting Inflation
In general, the inflation rate of an economy can be impacted by various factors which include the following:
- Demand pull inflation
- Demand pull inflation arises when demand for goods and services in the economy rises more rapidly than the supply of goods and services. This can happen if a period of strong economic growth or steep gains in a stock market investment leads to an increase in purchasing power. This will allow consumers to buy a larger quantity of goods and services. Causing the their prices to rise as supply cannot rise fast enough to fulfil higher demand. Demand pull inflationary pressure is commonly described as too much money chasing too few goods.
- Cost push inflation
- Cost push inflation results from an increase in cost of production as a result of rising wages or raw material prices. The increase in production costs will prompt producers to pass on higher costs to their customers by raising selling prices. An example of cost push inflation is an increase in oil prices causing energy and transportation costs for a wide range of goods and services to be elevated. The inflationary era of the 1970s was driven by cost push inflationary pressures as a result of the oil embargo imposed by OPEC
- Quantitative Easing
- The money supply is the total amount of currency and other liquid instruments in circulation in an economy. A sharp increase in the money supply will result in lower cost of borrowing which would encourage consumer spending. Thus, money supply growth is generally closely monitored by central banks to ensure that there is no excessive increase in money in circulation which would lead to elevated inflationary pressures.
- Exchange rate
- Inflationary pressures can also arise from higher cost of imported goods. For example, depreciation in the exchange rate of a country will raise the cost of importing foreign goods. This can exert upward pressure on the general level of prices. Causing inflationary pressures to build up.
- In comparison, an appreciation of a country’s currency will lead to downward pressure on the domestic inflation rate as imports which are denominated in foreign currencies become cheaper and more affordable.
Effect of Inflation
Inflation is also posing a side effect to the economy. Among them are:
- Purchasing Power
- A sustained increase in the inflation rate will result in an erosion of purchasing power in an economy. It will also lead to an erosion in the real value of an individual’s savings. As a given amount of money will be able to buy fewer goods and services if prices rise.
- Raising Interest Rate
- To contain a sustained increase of the inflation rate, the central bank can resort to measures which include raising interest rates to increase the cost of borrowing. This will dampen excessive consumer and investment spending in the economy. Causing inflationary pressures to subsequently ease to more manageable levels.
- Quantitative Tightening
- Other policy measures to reduce the money supply of an economy include raising the reserve requirement ratio of banks and selling government bonds.
- Cost of Living Revisited: Causes and Consequences, BNM
- Inflation and the Cost of Living, BNM
- Inflation: Perception vs Reality, BNM