Inflation is the rise in general price levels overtime. It is also rise in price of specific goods and services. According to mainstream economists, high inflation rates are as a result of money supply having high rate of growth. Changes in inflation are attributed to the fluctuations in available supplies or real demand for goods and services. Monetarists argued that, money supply is the main determinant of inflation while according to Keynesians, real demand was more important than change in money supply in determining inflation.
There are measures of inflation, for example, different price indices which measure the change in price that affect different people. Consumer price index measures consumer prices and gross domestic product deflator measures variations in prices which are associated with domestic production of goods and services. Producer price indices are used to measure prices which are received by producers. This is different from consumer price indices due to price subsidization, taxes and profits that cause amount received by producer to be different from what is paid by consumers. (Burda, 1997 pp119-121).
In measuring inflation, objective ways of separating changes in nominal prices and other influences that are related to the real activity are required. There is modification of inflation measures overtime in the way present goods are compared with goods from the past or relative weight of goods which are in the basket. This will include hedonic adjustments, reweighing and chained measures of inflation. With inflation, there is likelihood of prices of goods and services of any given good to increase overtime, therefore, consumers and businesses prefer to purchase sooner than at a later date.
This keeps economy active in short-term through encouraging spending and borrowing and encouraging investments in the long run. Inflation in the long run is a monetary phenomenon which is influenced by interest rates, prices and relative elasticity of wages in the short and long term. Demand pull inflation occurs where there is increase in aggregate demand as a result of increase in government and private spending. Supply shock inflation is caused by decrease in aggregate supply as a result of increase in price of inputs for example, sudden decrease in oil supply that increases oil prices.
Where producers have oil as part of their cost, then they would increase prices of products to the consumers. Built-in inflation is where workers keep wages up with prices which make employers pass high prices to consumers as high prices of goods and services as part of vicious circle. In order to control inflation, central bank for example, Federal Reserve sets interest rates high and slow down growth of money supply. (Geoff, 1999, pp60-70). The Spread of Inflation Targeting
This was introduced by New Zealand in 1990 and 24 countries have adopted it and 16 of them are developing countries and emerging markets. More emerging markets and developing countries will take the next 10 years to move to inflation targeting. Inflation targeting is popular because, developing and developed countries during 1970s and 1980s showed inflation was high and were not able to promote stronger growth, employment and external competitiveness on sustainable basis. Contrary, unpredictable and high inflation was bad for growth, equitable income distribution and affect employment in the long run.
(Batini, 2006 pp27-32). Uncertain inflation deters employment generation and productive investment and the only people who are able to protect themselves against inflation are those with high incomes and wealth. Contribution of central bank can make good economic performance in the long run by providing environment where inflation and expectations of inflation are being anchored at a reduced level. (Wyplosz, 1997 pp122-123). Financial markets and products affect relationship between financial activity and the real economy.
This results to money and credit aggregates to become less reliable and not useful as intermediate inflation target. In many emerging countries, relationship between money and inflation is unstable in short run. This problem occur also in countries that undergo structural and expansion of credit as a result of development processes and this makes monetary aggregates to be less reliable in predicting future growth and inflation. The increased international integration of financial and goods market is important factors which are behind the changes in monetary policy regimes.
With open capital accounts, flexible exchange rate framework is better for cushioning domestic performance of economy from external disturbances than nominal exchange rates which are fixed. The experience of industrial countries that have gross domestic products inflation targeting have been successful in policy flexibility and credibility resulting to better inflation and performance in growth and increased resilience to shocks and benefits of transparency of the policy for credibility of framework to targeting inflation and macroeconomic performance. (Terrones, 2001 pp20-25).
Most emerging countries have performed better in growth and inflation since the year 2000 than 1990s. Between the two periods, targeters of inflation succeed in cutting rates of inflation from 10% to 4%. This is two times more than non inflation targeters. Both groups of countries had increased in real domestic growth rate around two thirds percentage point. The difference in growth of two groups was not significant statistically at all. If a country uses strict inflation target and rely on relatively rapid impact to put inflation close to target, the approach increases volatility of employment and output.
Flexible approach relies on impact of excess demand on inflation that involves longer policy lags to reduce volatility of output and employment. A choice is made on the period in which inflation target is supposed to be achieved which matches length of lags that varies from one country to another. (Rogers, 2006 pp42-45). If inflation target is forward looking, policy maker is flexible to choose shocks to respond the specified period of time. In well anchored expectations of inflation, a country is able to accommodate supply shocks that are temporary with short term impact on inflation.
This does not need overreaction from monetary policy because; well anchored expectations are less likely to have second round effects of price shocks. This depends on anchoring inflation expectations well which is determined by credibility that central bank has already gained. The system real anchor is credibility of central bank commitment to achieving inflation target. (Marvin, 1997 pp35-40). Stable expectations of inflation allow extension of maturities of instruments that have fixed rate where a secondary market exists and lengthening yield curve affect growth and long term financing positively.
This means that growth is helped by expectations of stable inflation. IMF suggests that industrial or emerging market targeters of inflation cannot pursue target of inflation in a manner that ignores short term growth consequences. It is not clear how better macro-economic performance can be credited to change in monetary policy regime because, in most countries, changing monetary framework is part of wide range of structural and policy reforms which includes substantial fiscal consideration.
Many emerging countries have not adopted inflation targeting and have introduced reforms that are wide-ranging. Policy makers and private sectors need to accept the fact that international cost competitiveness is a fundamental issue of productivity. That is, efficient use of capital and labor to keep costs down. A weak exchange rate boosts competitiveness temporarily by cutting profits and wages but this does not talk about raising productivity. (Danziger, 1988 pp7-13).
Domestic factors triggers shift in market sentiment for example, in 2002, Philippines and Brazil had experience of episodes of turbulence where political development over fiscal policy in future played a key role. Last year, Iceland had experience of pressure in exchange market that reflected concern over the large imbalance in current account and vulnerabilities in banking sector which was associated with rapid growth in credit. Such episodes though painful strengthen credibility of the policy if central bank continues to focus on objectives of inflation.
Temporary controls of inflation complement recession as a means of fighting inflation. Controls improve efficiency of recession in order to fight inflation where they reduce the need to increase unemployment. As recession prevent distortions that are caused by control as demand become high, economists should not impose price controls but should liberalize prices through assuming that the economy will be able to adjust and do away with economic activities that are unprofitable. Lower activity place fewer demand on activities that used to drive inflation, whether resources or labor.
This will result to fall in inflation with total economic output. There will be severe recession as a result of productive capacity being reallocated which is unpopular with people who will have their livelihood destroyed. (Goshen, 1997 pp17-22).
Geoff K. (1999): modeling traded, non-traded and aggregate inflation in a small open economy: Manchester University, pp 60-70. Terrones M. (2001): fiscal deficits and inflation; a new look at emerging markets evidence: international monetary fund, pp20-25. Marvin G. (1997): a framework for the analysis of moderate inflations: Federal Reserve bank, pp35-40.Batini N. (2006): inflation targeting and the international monetary fund: international monetary fund board, pp27-32. Rogers S. (2006): an interview of inflation targeting in emerging market economies: bank of Thailand, pp42-45. Goshen E. (1997): identifying inflation grease and sand effects in labor market: Massachusetts, pp17-22. Danziger L. (1988): the welfare economics of inflation and disinflation: the American economic review, pp 7-13. Burda M. and Wyplosz C. (1997): Macroeconomics: a European text, pp 119-123.