Essence and reasons of Inflation occurrence, its types

UNIVERSITY OF INTERNATIONAL BUSINESS

“Finance and Credit” Department

 

 

Report

On the execution of educational practice

Essence and reasons of Inflation occurrence, its types

 

 

The place of the practice: “Finance and Credit” Department of the University of International Business

Student : Omargaliyeva Indira  Group: 208

 

 

 

Head from legal entity:

Practice leader:         

Mohammad Amin Sohrabian

Ph. D

 

 

 

 

 

 

Almaty, 2011

 

 

Contents

 

Introduction.............................................................................................................3

Inflation as an Economical Term..........................................................................5                                              

1.1 Definition and Meaning of Inflation……………………………………………5

Reasons of Inflation.................................................................................................7

2.1 Causes of Inflation……………………………………………………………...7

2.2 Causes of Rising Inflation in Kazakhstan……………………………………...9

2.3 Effects of Inflation………………………………………………………….....10

Types of Inflation………………………………………………...........................15                                                                                  

3.1 Keynesian Concept……………………………………………………………15

3.2 Monetarist view……………………………………………………………….16

3.3 Types of Inflation……………………………………………………………..17

3.4 Inflation Rate in Kazakhstan………………………………………………….21

Conclusion………………………………………………………………………..24   

List of used literature

 

 

 

 

 

 

 

 

 

 

Introduction

Inflation is a really important economical term in any country and worldwide, influencing each and every person in society. So Inflation happens when prices for goods and services become higher due to different circumstances. It can be positive if your salary is rising at the same time to particular part of nation or society, but frequently it is not that good scenario, as most probably it can be negative for the whole economy if it becomes unpredictable and high. No matter is it well growing, stable economy or a weak country without any production, dependant to import or so, it can happen due to any different external and internal factors or measures taken by government or even neighboring countries.

So, please do get familiar with my report, which falls into 3 big chapters covering all general information we have to know about INFLATION, starting from Chapter 1, which is inflation definition and meaning, then followed by Chapter 2, where I will be trying to describe what are the Causes and Reasons of Inflation, and a final Chapter 3 will give you detailed information on the possibly existing Types of Inflation.

There are 2 broadly known theories of Inflation:

 

• Quantity theory (buyer accepts currency valuing it as a means of payment for other goods and services at a later time)
• Quality theory (relates to the money supply, it’s velocity)

In this report you can find an interview, given by really commonly acceptable language to anyone to understand the causes of Inflation in Kazakhstan by Bulat Khussainov, who is a leading researcher of the Institute of Economics.

There are three major types of inflation, as part of what Robert J. Gordon calls the "triangle model":

• Demand Pull Inflation
• Cost-push inflation
• Built-in Inflation

Did you know there are several types of inflation? Each type of inflation affects the economy differently. In order to understand the effects of inflation, you need to understand what inflation is and how it works.

All possible types of Inflation are briefed below, but of course you will more have an idea of 4 main types Types of Inflation. On different grounds, economists have classified inflation into various types. According to the rate inflation there are four types of inflation:

• Moderate Inflation
• Running Inflation
• Galloping Inflation
• Hyper Inflation.

I am also providing a formula how an Inflation rate can be calculated and 2 methods are: - base period and - chain measurements.

You can also find a Conclusion part, given as a brief summary to tell you shortly of all parts described in my Course Work. For your further information I will be pointing out literature and websites, so you can go through and find more detailed information, if needed, from the given list.     

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Inflation as an economical term

 

1.1   Definition and Meaning of Inflation

                                                                                                                            Definitions of INFLATION

 

The term "inflation" originally referred to increases in the amount of money in circulation, and some economists still use the word in this way. However, most economists today call an increase in the money supply monetary inflation, to distinguish it from rising prices, which may also for clarity be called 'price inflation'. Economists generally agree that monetary inflation is one of the main causes of price inflation.

Other economic concepts related to inflation include: deflation – a fall in the general price level; disinflation – a decrease in the rate of inflation; hyperinflation – an out-of-control inflationary spiral; stagflation – a combination of inflation, slow economic growth and high unemployment; and reflation – an attempt to raise the general level of prices to counteract deflationary pressures.

Since there are many possible measures of the price level, there are many possible measures of price inflation. Most frequently, the term "inflation" refers to a rise in a broad price index representing the overall price level for goods and services in the economy. The Consumer Price Index (CPI), the Personal Consumption Expenditures Price Index (PCEPI) and the GDP deflation are some examples of broad price indices. However, "inflation" may also be used to describe a rising price level within a narrower set of assets, goods or services within the economy, such as commodities (including food, fuel, metals), financial assets (such as stocks, bonds and real estate), services (such as entertainment and health care), or labor. The Reuters-CRB Index (CCI), the Producer Price Index, and Employment Cost Index (ECI) are examples of narrow price indices used to measure price inflation in particular sectors of the economy. Core Inflation is a measure of inflation for a subset of consumer prices that excludes food and energy prices, which rise and fall more than other prices in the short term. The Federal Reserve Board pays particular attention to the core inflation rate to get a better estimate of long-term future inflation trends overall.

 
Inflation happens when prices of goods and services rise. This is usually an indication that the economy is growing and that consumers are spending money. Inflation can be good for you if your wages increase at the same time and rate as prices increase. It simply means there is plenty of give and take in the money supply as consumers consume and producers produce, paying their workers as they produce more products. Inflation while workers' incomes decrease is damaging for the economy in the long run because consumers stop spending to save money, causing vendors to be stuck with extra inventory and overpriced goods and services. This usually ends in a correction of the market as money supply and demand reconcile.

Antonymous-Deflation 
Deflation occurs when the prices of goods and services fall, the exact opposite of inflation. Deflation can increase the purchasing power of the dollar if wages do not fall at the same rate prices fall. However, deflation is usually an indication that the economy is lagging and that consumers are not spending. It can also be an indication that the market is correcting itself after a time of inflation.

 

Meaning of INFLATION

Inflation is commonly understood as a situation of substantial and rapid general increase in the price level and consequent fall the value of money over a period of time. Inflation means persistent rise in the general level of prices. Inflation is a long term operating dynamic process. By and large, inflation is also a monetary phenomenon. It is usually characterized by an overflow of money and credit. In fact, the root cause of inflation is the expansion of money supply beyond the normal absorbing capacity of the economy. The behavior of general prices is measured through price indices. The trend of price indices reveals the course of inflation or deflation in the economy. Crowther defines inflation as “a state in which the value of money is falling, ie., prices are rising”. Professor Samuelson defines “Inflation occurs when the general level of prices and costs is rising”.

 

 

 

 

 

 

 

 

 

 

 

 

Reasons of Inflation

 

1. Causes of Inflation

 

Historically, a great deal of economic literature was concerned with the question of what causes inflation and what effect it has. There were different schools of thought as to the causes of inflation. Most can be divided into two broad areas: Quality theories of inflation and Quantity theories of inflation.

The quality theory of inflation rests on the expectation of a seller accepting currency to be able to exchange that currency at a later time for goods that are desirable as a buyer.

The quantity theory of inflation rests on the quantity equation of money, which relates the money supply, its velocity, and the nominal value of exchanges. Adam Smith and David Hume proposed a quantity theory of inflation for money, and a quality theory of inflation for production.

Currently, the quantity theory of money is widely accepted as an accurate model of inflation in the long run. Consequently, there is now broad agreement among economists that in the long run, the inflation rate is essentially dependent on the growth rate of money supply. However, in the short and medium term inflation may be affected by supply and demand pressures in the economy, and influenced by the relative elasticity of wages, prices and interest rates. The question of whether the short-term effects last long enough to be important is the central topic of debate between monetarist and Keynesian economists. In monetarism prices and wages adjust quickly enough to make other factors merely marginal behavior on a general trend-line. In the Keynesian view, prices and wages adjust at different rates, and these differences have enough effects on real output to be "long term" in the view of people in an economy.

Monetary Theory of Inflation in economics is known as the Quantity Theory of Money. The quantity theory of money studies the positive relationship between the Quantity of money and the Nominal Value of the expenditures. This can be also expressed as the maintenance of the positive relationship of overall prices.

 

Equation of the Quantity Theory of Money

The Quantity Theory of Money follows the equation of M.V= P.T where m stands for the supply of money, V represents the velocity of circulation, P stands for price level and T represents Transactions or output. According to the assumption of the monetarists V and T are constant and the growth of money supply is directly proportional to each other. Sometimes in an economy excess money is generated and this money might also get translated into inflation. There are different ways to translate this money. One of the common ways is when individuals spend their excess money directly in purchasing goods and services. Inflation is directly influenced by this factor by raising aggregate demand. This instance leads to imported inflation and finally culminates into cost-push inflation.

 

Principles of Quantity Theory of Money

The quantity theory of money follows certain principles. The principles are:

The source of inflation is the increase in money supply

The demand of money is a stable function of interest rates, nominal income etc.

The supply of money is external

The real interest rate is determined by time, productivity of capital.

The inflow of money does not carry much importance in the long run

 

However, in the present days a school of economists think that the theory has lost much of its applicability. But it is still an important theory on which the analysis of inflation is based.

 

Inflation can be caused by federal taxes put on consumer products such as cigarettes or fuel. As the taxes rise, suppliers often pass on the burden to the consumer, the catch, however, is that once prices have increased, they rarely go back, even if the taxes are later reduced. So, what can be done about this and what will the disadvantages of such a step can be?

Make no mistake, there is only one causes of inflation and everything else happens as a result of that one major cause. In other words, everything else that happens becomes inflationary but not the cause of inflation. Rising prices are inflationary for sure, but not the cause of inflation. Only the manufacture of more money than the total available yesterday causes inflation. Rising prices are a reaction to this extra money in a system. Manufacturing money out of thin air eventually puts more money in the ordinary person’s pocket yet this endless production of extra paper money done by the central banks, does not require any extra effort on behalf of the worker so he ends up with more money in his pocket to buy “things” at no extra cost to him. That sounds nice but with more money to buy things, the money becomes worth less and to compare the “things” go up in price or else they would become cheaper for no real reason. The value of money is determined by dividing the number of “things” available by the total amount of money available. As the amount of money available increases, the value of “things” would go down if the system did not compensate by putting the value of those “things” up, hence an inflationary reaction to the extra amount of money available. This is not a complicated operation but rather hard to explain when money and the value of money are talked about. The value of money is different than the total amount of money available. The value of money rises of falls with the total amount of money available. If the central bank manufactures, out of thin air, more money than yesterday’s total, then the value of money would go down, which would be seen as prices of “things” going up to compensate for the extra amount of money available.       

2. Causes of Rising Inflation in Kazakhstan

 

What are the reasons for the inflation currently in Kazakhstan? What role have external factors played in this inflationary pressure? Could the government or the National Bank have prevented it? What is to be done now? In order to find out, The Exclusive interviewed several famous Kazakh economists. Below are their unedited answers.

Comments by Bulat Khusainov, the leading researcher of the Institute of Economics

• Certainly, Kazakhstan is not the only country that faces price increases on commodity goods, particularly in the food market. This phenomenon is happening in other CIS countries. The causes of such inflation are not monetary in nature. The reasons are in the structure of our industry, in the technological backwardness and, more importantly, in the lack of competition and extreme monopolization.

The inflation index can be compared to “the average temperature” of patients in a hospital. Great Britain and Russia have produced a special calculator, which enables us to count our own inflation. However, the inflation that is estimated with the consumer price index does not accurately reflect the real cost of living.

Why are we in this situation today?

• Here are some numbers. If one analyses prices for consumer goods and services in Kazakhstan since 1995, one can see that by the end of 2003 the index has increased by a factor of two or three. This inflation has three components: food commodities, non-food commodities and services. The third component has increased more than six fold. This is often caused by the prevailing practice of prepayment for services rendered. The example from our present day reality is mobile telephone service. In their business model they employ a one step payment system. If each mobile user daily pays one dollar for services that have not been made yet (there are about 5 million users in Kazakhstan), you can calculate how much money was charged for a service not yet rendered. A similar scenario happens in many sectors of the economy and will persist in the country until a sufficient number of competing companies-operators exist in the market place.

People in Kazakhstan are primarily concerned with the price increase for bread. Kazakhstan does not import crops, we export them. Our grain production exceeds our consumption. Total grain production is approximately 22 000 000 tons, while the internal consumption is about 4 000 000 tons, including seed banks and grain reserves. Therefore, the claims of some officials that the price increase is explained by worldwide growth in the price of agricultural commodities are not reasonable. References to global pricing and world grain reduction are meant for the naive. Certainly, bakers have increased their prices as a result of growth in tariffs and duties; however, it is not the only factor causing price increases.

Regarding other foodstuffs, their prices have grown as many of them are now imported. Do you recall a sudden increase in exchange rates that occurred in August? At the same moment, new customs regulations were introduced. According to the new regulations, to import commodities and services, the exporting party needs to present an export declaration. This is irrational. Nevertheless, a considerable volume of currency of the country’s four important banks was detained at the border for three or four days. The exchange rates fluctuated drastically, provoking panic. This, naturally, caused an increase in prices, even in our local market of Almaty, named Zelenyi Bazaar.

The inflation indexes we use, do not factor in the increase of the prices for real estate and the primary and secondary housing markets. According to official statistics, land prices in 2006 have grown 300% in the republic and 500% in Almaty. The prices for new apartments have grown 1,6- 1,7 times. In my opinion, it is not the inflation that needs to be calculated, but the cost of living with the help of a relevant index. Last year our statisticians roughly estimated the increase in the cost of living in Kazakhstan. We used the lowest rates for the housing and land. According to our estimations, the cost of living in the Republic has increased 1,5 times, and 1,75 in Almaty. In this estimation, we considered the real state price change, which is not taken into account in the inflation rate measured by the consumer price index (as per MFA method).

What can we do now?

• We can create more competition and decrease the import of foodstuffs. There is a threshold of imports of foodstuff, it is equal to 30 % of the total volume of consumption. We have passed this threshold long ago.

The mortgage crisis in the US chronologically coincided with the incompetent decision of the customs authorities; these factors led to the delay of cash inflow into the market. We have created an artificial economy, which does not obey classical or neo-classical economic theory.

3. Effects of Inflation

 

In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services, consequently, inflation is also erosion in the purchasing power of money – a loss of real value in the internal medium of exchange and unit of account in the economy.

Inflation's effects on an economy are manifold and can be simultaneously positive and negative. Negative effects of inflation include a decrease in the real value of money and other monetary items over time, uncertainty over future inflation may discourage investment and savings, and high inflation may lead to shortages of goods if consumers begin hoarding out of concern that prices will increase in the future. Positive effects include a mitigation of economic recessions and debt relief by reducing the real level of debt.

Economists generally agree that high rates of inflation and hyperinflation are caused by an excessive growth of the money supply. Views on which factors determine low to moderate rates of inflation are more varied. Low or moderate inflation may be attributed to fluctuations in real demand for goods and services, or changes in available supplies such as during scarcities, as well as to growth in the money supply. However, the consensus view is that a long sustained period of inflation is caused by money supply growing faster than the rate of economic growth.

Today, most mainstream economists favor a low steady rate of inflation. Low (as opposed to zero or negative) inflation may reduce the severity of economic recessions by enabling the labor market to adjust more quickly in a downturn, and reduce the risk that a liquidity trap prevents monetary policy from stabilizing the economy. The task of keeping the rate of inflation low and stable is usually given to monetary authorities. Generally, these monetary authorities are the central banks that control the size of the money supply through the setting of interest rates, through open market operations, and through the setting of banking.