Illustrate The Causes if Inflation And Deflation Essay

With the aid of diagrams, illustrate the causes if inflation and deflation, and by comparing their economic effects consider how both can effect the corporate sector This essay will aim to cover the causes of inflation and deflation and see how their economic effects influence the corporate sector. By first defining any key terms, then looking at the causes of inflation and deflation, looking at their different effects on the economy and in turn analysing how those effects shape the corporate sector. Before this can be done the terms ‘inflation’, ‘deflation’ and ‘corporate sector’ must first be defined. ‘Inflation is a rise in the average price of goods over time’. (Begg, D., Fischer, S. and Dorndusch, R., 2000, p462) and ‘The most usual measure is that of retail prices’ (Sloman, J. and Sutcliffe, M., 2001, P533) (this information being gathered from the retail price index [RPI]) and ‘A rise in inflation means a faster increase in prices†¦fall in inflation means a lower rise in prices’ (Sloman, J. and Sutcliffe, M., 2001, p533). To illustrate the importance of inflation ‘The COS (Central Statistical Office) says it gets more queries from the public about the RPI than any other statistic, a refection of the influence inflation has on every ones life.’ (Vaitilingam, R., 1994, p132). Now deflation must be defined. ‘Deflation is the mirror image on inflation’ (McAleese, D., 2004, p285) and is defined by the Collins English dictionary as ‘reduction in economic activity resulting in lower output and investment’ (Anon, 1998, p140). Corporate means ‘relating to a business corporation’ (Oxford University Press, 2006) so the corporate sector is all profit making businesses. This report will now examine the main causes of inflation. There are two main types of inflation: demand pull and cost push. ‘Demand pull inflation occurs when a rise in aggregate demand leads to an increase in overall prices’ (Begg, D. and Ward, D., 2004, p237). Sloman, J. and Sutcliffe, M., (2001, p537) represented this graphically stating ‘The AD curve shirts to the right and continue to do so. Firms will respond to a rise in aggregate demand partly by raising prices and partly by increasing output (a move up the AS curve)’ and this is illustrated in the following diagram: This new, higher level of demand my happen for many reasons Atkinson, B. and Miller, R., (1998, p378) tell us that ‘The high level of demand may originate from consumers, from firms, from overseas or from the government’. The other main cause of inflation is cost push inflation. ‘Cost push inflation occurs when a reduction in supply leads to an increase in overall prices’ (Begg, D. and Ward, D., 2004, p237) or ‘when costs of production rise independently from the level of demand’ (Atkinson, B. and Miller, R., 1998, p378). This can be denoted graphically as: Sloman, J. and Sutcliffe, M., (2001, p357) describe this graph as ‘Cost-push inflation is associated with continuing rises in cost and hence continually leftward (upward) shifts in the AS curve. If the firm face a rise in cost, they will respond partly in raising prices and passing the costs onto the consumer and partly by cutting back on production (there is a movement along the AD curve)’ Monetarists believe that inflation is caused solely by the supply of money in circulation. ‘The monetarist view of inflation, encapsulated in Milton Friedman’s dictum, inflation is always and everywhere a monetary phenomenon†¦Inflation occurs when the growth of the money supply persistently exceeds the growth of real output’ (McAleese, D., 2004, p281). This can also be shown graphically as: McAleese, D., (2004, p281) goes on to say that ‘A rise in money supply from M0 to M1 shifts the AD curve outwards from AD (M0) to AD (M1). The eventual equilibrium will move from E0 to E1 and prices will rise from P0 to P1†¦In the short run†¦the AS curve may be positively sloped†¦In that event a rise in money stock will cause higher prices, but will also lead to more output†¦In the longer term, pay levels will ‘catch up’ on inflation and, over time†¦ The economy then approximates more and more closely to the vertical AS.’ This theory is backed by much evidence including this from the US Department of Commerce As deflation is the opposite inflation it can be caused by the same factors. McAleese, D. (2004, p285) stated ‘†¦it can be caused by supply or demand shocks. Supply shocks include†¦sustained productivity improvements and technological innovation that lowers prices of inputs and outputs†¦Demand shocks can arise for several reasons: a collapse in the stock market or property prices, a sustained strengthening of the exchange rate, wars†¦that undermined business confidence.’ ‘From a monetary perspective deflation is caused by a reduction in the velocity of money and/or the amount of money supply per person.’ (Wikipedia contributors, 2006). Kai, V., L. (2004) showed this graphically as Know we how inflation and deflation is caused we must examine their effects on the economy as a whole and their effects on the corporate sector. Sloman, J. and Sutcliffe, M., (2001, p534) believe that ‘If you could accurately predict inflation and adjust incomes and prices to meet it then it would not be problem’. And Griffiths, A. and Wall, S., (2004, p463) reinforce this by stating if we have ‘an economy in which inflation is proceeding at a steady and perfectly foreseen rate, and in which all possible adjustments for the existence of inflation have been made†¦the main cost of inflation would arise from the fact that interest is not normally paid on currency in circulation’, so individuals would make more trips to the bank in order to collect interest on their money. ‘These extra trips to the bank are often called ‘shoe-leather’ costs of inflation.’ (Griffiths, A. and Wall, S., 2004, p463) The other cost of anticipated inflation is ‘menu’ costs. Menu costs are costs from having to update catalogues, menus, vending machines, etc (Atkinson, B. and Miller, R., 1998, p384). These costs are very minute so would not greatly effect the corporate sector as a whole. Businesses such as restuants, catalouge based comapies and those who produce vending machines would incounter minor expenses. This forseen inflation econany can be represented graphically as: But normally high inflation is not accurately predicted so other economic costs arise. There are four main, other, expenses: redistribution, uncertainty, balance of payments and resources. This report will now look at these factors in turn. Firstly high inflation ‘redistributes wealth to those with assets (e.g. property) †¦ and away from those with savings that pay rates of interest below the rate of inflation and hence who’s value is eroded by inflation’ (Sloman, J. and Sutcliffe, M., 2001, p534). This may include people on fixed pensions. Atkinson, B. and Miller, R., (1998 p384) show redistribution also effects ‘creditors , those who are owed money, will also suffer, since when they are paid back, the value of money will be worth less, while debtors, those who owe money, will benefit.’ So ‘Firms can also borrow more for investment as real value of debt decreases’ (Atkinson, B. and Miller, R., 1998, p386). This will be a benefit to firms to wishing to borrow money but bad for those who offer long term credit options on their products. Secondly ‘inflation tends to cause uncertainty and firms may be reluctant to plan ahead and take long term decisions regarding investment as they are unable to predict future costs and revenues.’ (Atkinson, B. and Miller, R., 1998, p384) ‘This will reduce the rate of economic growth.’ (Sloman, J. and Sutcliffe, M., 2001, p534). So the corporate sector will suffer from poor planning and low investment. Furthermore ‘inflation is likely to worsen the balance of payments†¦its exports will become relatively less competitive in the world markets. At the same time imports will become relatively cheaper than home produces goods. Thus exports will fall and imports will rise. As a result the balance of payments will deteriorate and/or the exchange rate will fall.’ (Sloman, J. and Sutcliffe, M., 2001, p534). This will, therefore, affect companies who rely on the global economy. They will face difficulties to exporting products and selling them abroad. They will also face increased competition from imports so may even struggle to sell their products to the home market. Finally ‘extra resources are likely to be used to cope with the effects of inflation. Accountants and other financial experts may have to be employed by companies to help cope with the uncertainties caused by inflation.’ This will then increase a firm’s costs. ‘With higher costs, firms are less able to make profit. Some firms exit the market and, as a result, aggregate supply is less†¦with national output falling and inflation increasing.’ (Begg, D. and Ward, D., 2004, p238) firms are forced to pass on increasing costs onto the consumer which may result in reduced sales. This could result in being fatal to a firm in a high inflationary economy. So the economy as a whole will suffer from high inflation, firms will find new obstacles in the way of maximising profits and the individual in the economy will each face new difficulties as a result. Sloman, J. and Sutcliffe, M., (2001, p536) report ‘The costs of inflation are likely to be relatively mild if kept to the single figure’ problems arise if inflation turns into hyperinflation (where inflation accelerates out of control) and go onto say ‘If inflation develops into â€Å"hyperinflation†Ã¢â‚¬ ¦ Firms constantly raise prices in attempt to cover their rocketing costs. Workers demand huge pay increase in an attempt to stay ahead of the rocketing cost of living. Thus prices and wages chase each other in an ever rising inflationary spiral’. Even though the effects of hyperinflation, and even inflation, can be devastating to an economy and the corporate sector, most economist fear deflation more. This section will now examine the effects of deflation on the economy and businesses. McAleese, D., (2004, p286) reported ‘In assessing the economic effects of deflation the problem stems less from the shock itself than from the sequence of events that follow and magnify its initial impact. Price declines become self reinforcing’. This means if deflation is affecting an economy, consumers will expect prices to fall as they have been. This will mean they will postpone buying a certain product now as they believe that in the future it will be cheaper ‘or as they become more concerned about their future economic security, particularly if unemployment is rising. The prolonged economic slowdown in Japan has raised concerns about future income prospects among its aging labour force, which may well be one reason for its deflation of the last few years’ (Brooks, D. H. and Quisingp P., F., 2002). This all means demand will fall. ‘Weakening consumer demand passes into investment. Investors’ begin to loose nerve. Sales forecasts are cut back. The appetite for risk weakens. Faced with declining sales, corporate debt that once looked rock solid now looks less secure†¦ firms cut back on the number of employees†¦Ã¢â‚¬â„¢ (McAleese, D., 2004, p286). So not only does the corporate sector suffer from declining sales, they are forced to reduce their prices even more. They have reduced investment opportunities as capital becomes extremely hard to raise. ‘Deflation has opposing influences on creditors and debtors†¦ Consequently, the real value of debt and debt servicing rises. There is thus a potential benefit for creditors†¦By itself; this redistribution of real net wealth is not necessarily negative for the economy as a whole.’ (Brooks, D. H. and Quisingp P., F., 2002). For firms with a high level of debt this means decreased security as the cost of their debt is increasing. This will also have negative implications on investment as another route of raising capital becomes increasingly more difficult to peruse. Firms that offer credit options will benefit as the real value of they owed increases. The effects of deflation are seen more server in today’s economy as McAleese, D., (2004, p286) believes ‘In an open world economy, there is an added fear that deflationary impulses in a large economy could be transmitted across countries through trade and investment linkages.’ Inflation and deflation both affect the corporate sector in various ways. ‘Constantly low inflation should bring increased stability. Businesses seeking to invest millions of pounds over many years will be assured by increases price stability. Predictions regarding costs and revenues are much easier to make and firms face less uncertainty when assessing investment risk.’ (Begg, D. and Ward, D., 2004, p286) and low inflation ‘is likely to increase the turnover and profit levels of a firm’. Workers may also feel happier with pay increase therefore more productive ‘under the illusion they are better off even though their real wage has not increased.’ So in conclusion low inflation can be beneficial to the corporate sector but higher inflation can have many negative affects but ‘It is generally better to have mild inflation than deflation. Deflation†¦can create a potentially dangerous situation, as occurred during the depression of the 19 30’s.’ (Atkinson, B. and Miller, R., 1998, p386). Biblography Anon, 1998, Collins Gem – English dictionary (Nineteenth Edition), HarperCollins Publishing, Glasgow Atkinson, B. and Miller, R., 1998, Business economics, Pearson Education Limited, Essex Begg, D., Fischer, S. and Dorndusch, R., 2000, Economics (Sixth Edition), McGraw-Hill Publishing Company, Berkshire. Begg, D. and Ward, D., 2004, Economics for business, McGraw-Hill Education, Berkshire Brooks, D. 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