Download Inflation and The Economy

Makayla Nielsen
Dennis Wilson
Macroeconomics 2020
4/25/2015
Inflation and The Economy
Within the world of Macroeconomics, there are multiple aspects than can build
instability within the economy. One of these aspects is known as Inflation. In order to
further comprehend as to how inflation affects the economy, one must learn what is
inflation, how inflation affects the areas within the economy, major historical events due
to inflation, and how to manage inflation. When these concepts have a better
understanding, one can toy with the idea of how inflation impacts macroeconomics as
well as the economy as a whole.
In order to further comprehend how inflation plays a role in the economy, an
understanding of what inflation is needs to be taken into account. Inflation can be defined
as “a rise in the general level of prices in an economy.” 1 When prices decrease, it is
known a deflation. With inflation, each dollar of an individual’s income will buy them
fewer goods and services than they had been able to purchase. However, during inflation
not all prices change. Some remain at a constant value or have very little change that
result in only a slight increase, products such as computers and automobiles. Now that the
inflation has been defined, the types of inflation will help to further understand as to what
is happening in the economy. There are a few types of inflation labeled with very specific
terms. The term Demand-Pull Inflation is used when excess demand bids up prices of
limited output. Cost-Push Inflation is the term relating to when rising prices are factors of
a raise per-unit production cost at each level of spending. It is typically Cost-Push
Inflation that can cause an economy to fall into a recession. Unanticipated inflation
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happens when the redistribution effects of inflation happen whether inflation was
expected or not. Anticipated inflation is when economists see an inflation occurring in the
near future and are better equipped to handle the situation or to prevent it entirely.
Hyperinflation occurs when there is extraordinarily rapid inflation that has a devastating
impact on real output and employment. Hyperinflation is believed to be the cause of The
Great Crash of 1929, which will be discussed later.
There are three major groups that work to create an economy. These groups are
known as households, firms or businesses, and the government. With inflation, these
areas can be either hurt, unaffected, or helped depending on the direction of the inflation.
Those who are hurt by inflation tend to be fixed-income receivers, savers, and creditors.
For fixed-income receivers, a noticeable fall in their income will arise when inflation
occurs. Savers see that purchasing power falls and the accumulation of their savings
deteriorates. As for creditors, since the purchasing power of the dollar goes down,
borrowers end up paying back less valuable income than when they had first borrowed
from the creditor. As for those who are unaffected or even helped by inflation, they
consist of flexible-income receivers and debtors. Flexible-income receivers can either
escape from the harm completely, or they may even benefit from it. When the Consumer
Price Index rises, some individuals such as union workers or those living off of social
security benefit from the inflation since their cost-of-living-adjustment still rises. As for
the debtors, they naturally benefit from the inflation. As discussed earlier, when a creditor
(lender) gives a debtor (borrower) a loan and the inflation increases, the dollar’s
purchasing power continually declines therefore debtors end up giving back less than the
initial amount they had received. When there is a change in inflation, it will either cause
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help or hinder. Whether it is an increase or decrease in inflation, both good and bad can
come from it. Cost-Push inflation results in decreased output since the demand for
services and goods drops significantly. However, without inflation, “the uses of
resources, time, and effort would not be needed and they could be diverted toward
producing more valuable goods and services.”2 Therefore inflation is needed to help
promote economic growth.
Understanding how inflation works and all the various types of inflation, one
particular type of inflation is reflected by a major historical event felt throughout the
United States. Hyperinflation is what is believed to be behind the financial crisis of Black
Tuesday. On October 29, 1929, the stock market had inflated so high that like an
overinflated balloon, it crashed causing depositors to go into a panic. Billions of dollars
were lost in the New York Stock Exchange. This event would forever be known as The
Great Crash of 1929. With the crash of the stock market prices dropped severely over a
single day and the United States fell into what would be known as The Great Depression.
However, since the markets hit an all time low, there was nowhere for the stock exchange
to go but up. By 1932 “ stocks were worth only about 20 percent of their value in the
summer of 1929.” 3Some modern economists believe that The Great Crash was the cause
of the Great Depression; others believed that it was merely a symptom in the economic
downfall. By 1933 half of the banks within the U.S failed and unemployment was rapidly
climbing to 30 percent of the workforce. At the time, President Franklin D. Roosevelt
attempted to lessen the effects of the Great Depression but it wasn’t until World War II
when the American industry began to pick up again. In 2007-2009 the 21st century
experienced a recession. Similar to the Great Depression, began with the rupture of an 8
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trillion dollar housing bubble. Loss of wealth and dollar value resulted in sharp cutbacks
of consumption and a collapse in business investment. Soon afterward unemployment
once again began to rise. This downturn was considered to be the most severe since the
Great Depression. Households were most impacted by the recession since it resulted in
loss of income, heath insurance, and even spiraled some into poverty. While noticeable
signs of inflation were prominent in the bubble, the bursting could not have been
prevented.
Now that the most severe cases of inflation have been brought to light, the
application of inflation management can be included in the discussion. There are multiple
ways to handle inflation within an economy. Some of these methods are: Monetary
Policy, Fiscal Policy, Wage Control, Monetarism, and reduction of economic growth.
Monetary policy consists of an increase in interest rates and a reduction in the growth of
aggregate demand. Fiscal policy occurs with governmental increases in taxes resulting in
a demand reduction in the economy. As for wage control, providing limited growth helps
to moderate inflation and reduce cost-pull inflation. However, it is difficult to control
through income policies such as unions fighting for higher real wages. Monetarism seeks
to “control inflation through controlling the money supply.” 4 Monetarists believe that if
you can control the growth of the money supply, then inflation would be brought under
control. Methods such as higher interest rates, reducing the budget deficit, and controlling
the amount of money created by the government would aid in a monetarists point of
view. Reducing the economic growth would be helpful in reduction of hyperinflation as
well as cost-push inflation. For hyperinflation one method to reducing it would be to
introduce a new use for the dollar or a completely new currency all together that would
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give individuals confidence in their currency. As for cost-push inflation, by reducing the
economic growth it would make this inflation eventually lead to a lower growth while
still being more difficult to control.
In conclusion, one can easily see that inflation makes a huge impact on the
economy. Whether domestic or foreign these impacts are felt around the world. Having
the full contemplation as to what inflation is, how it affects the economy, major historical
events due to inflation, and methods as to how to manage inflation all aid to create a
better and more successful economy. Within the field of Macroeconomics, inflation is
one that is needed to be watched for since it has an effect on the economy as a whole.
Whether positively or negatively, inflation must be managed in order to promote further
economic growth and to prevent turmoil such as that of The Great Crash of 1929.
Overall, inflation is neither good, nor bad, but if poorly maintained will cause either
problems or solutions for an economy and once the economy works together as a whole,
can it be fully beneficial for all.
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Bibliography
Textbook
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1) McConnell, Campbell R., Stanley L. Brue, and Sean M. Flynn. "Chapter 9
Business Cycles, Unemployment, and Inflation." Macroeconomics Principles,
Problems, and Policies. 20th ed. USA: McGraw-Hill, 2014. 260-69. Print.
Websites
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2) "What Is Inflation, How It’s Measured and Its Impact on Your Investments."
InvestorGuide Complete RSS. N.p., n.d. Web. 25 Apr. 2015.
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"The Great Recession." State of Working America. N.p., n.d. Web. 25 Apr. 2015.
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3) "Stock Market Crash of 1929." History.com. A&E Television Networks, n.d.
Web. 25 Apr. 2015.
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4) "Methods to Control Inflation." Economics Help. N.p., n.d. Web. 25 Apr. 2015.