Inflation is a sustained increase in the general price level 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 reflects a reduction in the purchasing power of money.
Inflation has a significant impact on the economy; Inflation affects all aspects of the economy, from consumer spending, business investment and employment rates to government programs, tax policies, and rates. Inflation has the following impacts on the economy.
- Inflation causes the purchasing power of a currency to decline, making a representative basket of goods and services increasingly more expensive.
- Inflation erodes purchasing power as an overall rise in prices reduces the purchasing power of consumers, as a fixed amount of money affords progressively less consumption.
- Inflation harms the poor and needy as lower income consumers tend to spend a higher proportion of their income overall and on necessities than those with higher incomes, so they eventually have less of a cushion against the loss of purchasing power.
- Prolonged inflation can lead to a wage-price spiral, where expectations of further inflation continue, and therefore a demand of larger wage increases continue. Consequently, employers must increase prices for sustainability, increasing costs for consumers. This leads to a vicious cycle.
- Inflation makes it more difficult to meet liabilities, as more money is spent on consumption and acquiring essentials, leaving less funds available to meet liabilities.
- In the long run, inflation can cause unemployment and job losses, as businesses layoff variable costs such as labour to service other expenses.
- Inflation brings an imbalance in prices and cause a mismatch between asset classes and their prices.
- When inflation increases, prices are changed more frequently, but not frequently enough to maintain the previous dispersion of relative prices. As a result, relative prices move out of line, leading to a misallocation of resources.
- Higher than expected inflation makes the value of debt lower in real terms, but it also makes the real returns on assets lower. Therefore, unexpected inflation serves to hurt investors and benefit those who have a lot of debt.
- Changes in business costs and profits: Inflation can impact the costs of production for businesses, which may lead to changes in profits. If prices are rising faster than businesses can increase their own prices, it can lead to margin compression and reduced profits.
- Changes in the value of money over time: Inflation can erode the value of money over time. As prices rise, the purchasing power of a unit of currency falls, which means that it can buy fewer goods and services than it could before. This can lead to uncertainty about the future value of money.
- Impact on economic growth: Inflation can impact economic growth in a number of ways. High or unpredictable inflation can lead to reduced investment, as businesses may be uncertain about the future value of money and the costs of production. Inflation can also lead to slower economic growth if it reduces the purchasing power of consumers.
There are several factors that can contribute to inflation, including:
- Demand-pull inflation: This occurs when the demand for goods and services exceeds the supply, leading to an increase in prices.
- Cost-push inflation: This occurs when the cost of producing goods and services increases, leading to an increase in prices. This can be due to factors such as rising raw material costs or increases in wages.
- Excess money supply: When the supply of money increases faster than the growth in the economy, it can lead to an increase in prices as more money chases a limited supply of goods and services.
- Expectations: If people expect prices to rise in the future, they may be more willing to pay higher prices today, which can contribute to inflation.
As can be gauged from the above, inflation is not beneficial for the economy nor in favour of people. There are some inflation-causing variables that can be controlled and minimised, whilst others are more reactionary. Islamic economics has certain controls and principles which create a harmonious environment to keep inflation at bay. We will look at these in the next post on inflation.