Understanding Inflation: Causes, Impacts, & Management Strategies

Reviewed by

Rupali Miglani

Inflation is the sustained increase in the general price level of goods & services over time. Consumers' capacity to buy the same number of products & services with a constant amount of money is eroded, which has an impact on their purchasing power. The causes of high inflation rates, its effects on individuals, & management techniques are all covered in this article.

Causes of Inflation: Cost-push inflation and demand-pull inflation are the two basic causes of inflation. When the overall demand for products and services exceeds the supply, demand-pull inflation results. This frequently occurs when consumer spending rises, which is supported by elements like government stimulus plans or better economic conditions. Prices increase as a result of the more demand than supply. Figure 1: Demand-pull inflation depicts the connection between rising prices and increased demand.

On the other side, cost-push inflation develops when input costs, such labour and raw materials, rise. Higher production costs might be caused by external causes like geopolitical conflicts, supply chain interruptions, or increased energy prices. Businesses then raise their pricing to reflect these rising expenses for the benefit of the customer. Cost-push inflation is depicted in "Figure 2: Cost-push inflation" as the result of growing manufacturing costs.

The above figure 2 demonstrates how rising production prices force enterprises to incur additional expenses, which can result in a drop in overall output. As a result, the supply curve for all commodities and services moves to the left (AS), showing a reduction in the volume of goods and services that providers are ready to produce at a certain price level.

Impacts of Inflation: The effects of inflation affect people's daily life. Consumers' buying power decreases when prices increase, making it harder for them to afford the same amount of products and services. People with lower incomes experience this burden more keenly since they spend a bigger percentage of their money on necessities. In addition, if real earnings for employees decline, it becomes more challenging for them to maintain their level of living. The end outcome is a general reduction in the quality of life for those who are impacted.

Inflation Management: In order to preserve economic stability, central banks are essential to regulating inflation. Inflation targeting is a frequently used tactic in which central banks change interest rates to affect aggregate demand. By raising interest rates, central banks hope to restrict investment & consumer expenditure, which will lessen inflationary pressures. The link between interest rate changes & their effects on managing inflation is seen in "Figure 3: Interest Rate Adjustments and Inflation".

As shown in the above figure 3 the increase in the interest rates, reduces the consumption spending by the households. This is because the savings become more lucrative. People tend to save more when interest rates are higher so that they can get higher returns on their savings. People tend to keep more funds in their bank accounts rather than keeping with themselves. This leads to a fall in consumption sending as low income in hand is associated with low consumption. Further, the higher interest rate is associated with higher borrowing costs for businesses. Businesses need loans for investment in their business activities. If the interest rates increase, borrowing costs increase for businesses. This discourages further investment in business activities.

Due to this, the investment falls as it is expensive for businesses to borrow money for financing new projects. A fall in consumption and investment results in a decrease in aggregate demand and as a result the AD curve shifts downward. As a result, the price level and output decreases. Therefore, a contractionary monetary policy by the central bank helps in controlling the inflation level however, it also results in the fall of GDP. Additionally, In order to decrease disposable income and stifle demand, governments can also enact contractionary fiscal measures, such as tax increases or reduced government expenditure. Supply-side measures that encourage productivity and competitiveness can also aid in lowering manufacturing costs, which will ultimately cut prices.

Future outlook: While forecasting inflation rates is difficult, it is important to take into account prospective geopolitical conflicts and their effect on inflation. Conflicts or interruptions in the supply chains for essential resources are examples of factors that might exacerbate inflationary pressures. It is important to keep a close eye on these outside factors in order to identify and mitigate any possible inflationary concerns.

In conclusion, inflation causes serious problems for both people & economies. For the economy to be stable and for people to be healthy, it is necessary to comprehend its causes, effects, & practical management techniques. Policymakers may successfully reduce the negative consequences of inflation & promote sustainable economic growth by utilising tactics including inflation targeting, fiscal policies, and supply-side reforms.