Published on International Journal of Economics & Business
Publication Date: May 11, 2019
Umar Lawal Aliyu
Faculty of Management, Department of Business Administration
LIGS University Hawaii, USA
Journal Full Text PDF: Inflation and Economic Growth.
The trust of the paper is to examine inflation and economic development in Nigeria. It can hardly be denied that inflation have considerably hindered with economic development of many counties in recent times. These days, majority of us keep imagining how inflation has affected the lives of people in one way or the other. Inflation is one of the most frequently used terms in economic discussions, yet the concept is variously misconstrued. Inflation is a rise in prices of goods and services. A more exact definition of inflation is a situation of a sustained increase in the general price level in an economy. “Inflation means that your money won’t buy as much today as you could yesterday and so it leads to a decline in the value of money.” Inflation can be defined as an increase in price of goods and services. However, Inflation can affect economies in various positive and negative ways and this means that, while there is there are advantages to inflation some disadvantage or negative aspects of inflation also exist. The positive effects of inflation include reducing unemployment due to nominal wage rigidity by allowing the central bank more leeway in carrying out monetary policy, encouraging loans and investment instead of money hoarding, and avoiding the inefficiencies associated with deflation. On the other hand, the negative effects of inflation include an increase in the opportunity cost of holding money, uncertainty over future inflation, which may discourage investment and savings, and a n increase in prices of goods and services. An increase in inflation causes decline in the purchasing power of money, which reduces consumption and therefore decreases GDP. In this paper, I intend to examine empirically the relationship between inflation and economic growth.
Keywords: Deflation, Economic Development, Goods, Inflation, Money, Price Level, Services.
An increase in inflation means that prices have risen and it means you have to pay more for the same goods and services. Inflation is an increase in price of goods and services. A number of factors, one of which is inflation, affect economic growth. The relationship between economic growth and price growth is complex one so empirical studies have shown that the relationship between economic growth and inflation may be positive, negative and neutral.
To put it simply, inflation is the long-term rise in the prices of goods and services caused by the devaluation of currency. Inflation can occur due to many factors such as rise in aggregate demand for goods and services in an economy, an increase in supply of money, an increase in prices of production etc. When inflation is too high of course, it is not good for the economy or individuals. Inflation will always reduce the value of money, unless interest rates are higher than inflation. In addition, the higher inflation gets, the less chance there is that savers will see any real return on their money.
When prices of goods and services rise, it inevitably boomerang and affects the cost of living, the cost of doing business, borrowing money, mortgages, corporate and government bond yields, and every other facet of the economy. However, the empirical and theoretical evidences provide three types of relationship between the inflation and the economic growth, positive, negative and neutral. Thus, these three relationships have resulted to studies in examining the dynamics of the relationship between inflation and economic growth.
2. LITERATURE REVIEW
2.1 Theoretical Framework
According to G. Ackley, he defined inflation as ‘a persistent and appreciable rise in the general level or average of prices’. Plenty writers have given many definitions of inflation but Professor Umar Lawal Aliyu feels that definition of inflation must include the change attributed in price level and value of money. Professor Umar Lawal Aliyu sees price level and value of money entangle to each other in effecting inflation because they have a direct relationship. He therefore concluded by saying that the two, price and value, have direct relationship in affecting inflation because they behave like the long plank balanced in the middle on a fixed support, on each end of which children sit and swing up and down by pushing the ground alternately with their feet (seesaw). This is to ideally say that when price of goods and services rise the value of money falls and vis-à-vis if value of money falls prices of goods and services rise. He therefore concluded that definition of inflation must include the change attributed in price level and value of money. Professor Umar Lawal Aliyu therefore, defines inflation as “a persistent increase or rise in the value of money or persistent decrease or fall in the value of money or purchasing power of money.”
In this thesis, the relationship between inflation and economic growth will extensively been reviewed and investigated. Examination of the inflation-growth relationship has been a major issue in economic research. In my country Nigeria, many of us might have heard that dated back 1960’s a bar of chocolate cost N5:00, a packet of sweet cost N1:50K, filling the tank of a car with fuel cost N45:00 etc. Today that same chocolate bar costs N950:00, packet of sweet cost N400:00 and filling the tank of a car with fuel cost N7500:00 and above. How does such a massive increase happen? Inflation, the rise in the price of goods and services over a period of time or a decrease in the value of money.
It is good to note that an unhealthy, unmanageable level of inflation, however, is disastrous for nearly everyone. If inflation spirals out of control, people lose faith in their currency. Financial institutions suffer as people pull their money out of them. Businesses suffer as their goods become too expensive for most people. In fact, inflation has a tremendous effect in an entire country’s economy and it affects not only the government, but also the little things in the average person’s daily life. Inflation can devalue the currency significantly and at worse, has been a key component to recessions.
Therefore, Governments of countries all over the world irrespective of their economic and political policies keep trying to control inflation at all cost. Thus, managing inflation efficiently and significantly can spur economic growth and development of a country and ignoring it can result to devastating rise in prices of goods/ services.
2.2 Types of Inflation
To put it simply, inflation is the long-term rise in the prices of goods and services caused by the devaluation of currency. The effects of inflation are very devastating because it affects almost all aspects of human endeavours. Inflation does not only affect areas like our salaries and the cost of purchasing a new home but it hits us from every angle and aspects of our life. School fees rise, Food prices go up, transportation prices increase, gas prices rise, cost of various other goods and services skyrocket over time and overall the value of money decline or falls. However, there are different types of inflation; creeping, walking, galloping and hyperinflation. Some experts say demand-pull and cost-push inflation are two more types, but they are causes of inflation. Thus, one may observe different types of inflation in the contemporary society:
Based on Causes:
• Credit inflation: the printing of currency notes causes this type of inflation. Credit inflation being profit-making institutions, commercial banks sanctions more loans and advances to the public than what the economy needs. Such credit expansion leads to a rise in price level.
• Currency inflation: a situation in which more money becomes available without an increase in production and services, causing prices to rise: The market can experience price inflation without currency inflation, but the market cannot experience currency inflation without price inflation.
• Deficit-induced inflation: When the prices rise because of the deficit in the government expenditure (i.e., when the public expenditure exceeds public income), there is expansion of money and credit resulting in inflation. Since it is induced by deficits in the public expenditure, it is called deficit-induced inflation.
• Demand-pull inflation: Demand-pull inflation results from strong consumer demand. Many individuals purchasing the same good will cause the price to increase, and when such an event happens to a whole economy for all types of goods, it is called demand-pull inflation. Demand-pull inflation is used by Keynesian economics to describe what happens when price levels rise because of an imbalance in the aggregate supply and demand. When the aggregate demand in an economy strongly outweighs the aggregate supply, prices go up. Economists describe demand-pull inflation as a result of too many dollars chasing too few goods.
• Cost-push inflation: Cost-push inflation is a situation in which the overall price levels go up (inflation) due to increases in the cost of wages and raw materials. Cost-push inflation develops because the higher costs of production factors decrease in aggregate supply (the amount of total production) in the economy. Since there are fewer goods being produced, (supply weakens) and demand for these goods remains consistent, the prices of finished goods increase (inflation).
Based on Speed or Intensity:
• Creeping or Mild Inflation: If the speed of upward thrust in prices is slow but small then we have creeping inflation. The moderate inflation, also called as Creeping Inflation refers to a single digit annual increase in the general price level. During the moderate period, the price increases persistently, but at a mild or moderate rate, i.e. less than 10% or a single digit inflation rate.
• Galloping and Hyperinflation: Walking inflation may be converted into running inflation. Running inflation is dangerous. If it is not controlled, it may ultimately be converted to galloping or hyperinflation. When prices rise between 20% to 100% per annum or even more, it is called galloping or hyperinflation. Such a situation brings a total collapse of the monetary system because of the continuous fall in the purchasing power of money. It is an extreme form of inflation when an economy gets shattered. “Inflation in the double or triple digit range of 20, 100 or 200 p.c. a year is labelled “galloping inflation”.
• Walking or Trotting Inflation: When prices rise moderately and the annual inflation rate is a single digit (3%-10%) it is called walking or trotting inflation. Inflation at this rate is a warning signal for the government to control it before it turns into running inflation.
2.3 Causes of Inflation
There are many causes of inflation and there is not a single, agreed-upon answer, but there are varieties of theories, all of which play some role in inflation:
Cost-Push Effect: An increased input costs like raw goods and materials or wages, they will preserve their profitability by passing this increased cost of production onto the consumer in the form of higher prices. Cost-push inflation develops because the higher costs of production factors decrease in aggregate supply (the amount of total production) in the economy. An example is a rise in price of sugar or milk may cause a rise in price of chocolate.
Demand-Pull Effect: Increase in wages will result to people having more money to spend on consumer goods and this increases liquidity and demand for consumer goods results in an increase in demand for products. Thus, as a result of the increased demand, companies will raise prices to the level the consumer will bear in order to balance supply and demand. It involves inflation rising as real gross domestic product rises and unemployment falls, as the economy moves along the Phillips curve. This is commonly described as “too much money spent chasing too few goods.”
Exchange Rates: Inflation can be made worse by our increasing exposure to foreign marketplaces. Inflation is closely related to interest rates, which can influence exchange rates. Nevertheless, low interest rates do not commonly attract foreign investment. Higher interest rates tend to attract foreign investment, which is likely to increase the demand for a country’s currency. (See also, The Mundell-Fleming Trilemma.)
Money Supply: Inflation is primarily caused by an increase in the money supply that outpaces economic growth. Thus, Increasing the money supply faster than the growth in real output will cause inflation. The less currency there is in the money supply, the more valuable that currency will be. When a government decides to print new currency, they essentially water down the value of the money already in circulation. The reason is that there is more money chasing the same number of goods. Therefore, the increase in monetary demand causes firms to put up prices.
Public or National Debt: If you increase national debt by borrowing to spend money on expanding the economy then inflation could result.
2.4 Effects of Inflation
Negative Effects of Inflation: Inflation has the following harmful consequences:
• Effect On Distribution Of Income And Wealth: During inflation, usually people experience rise in incomes. However, some people gain during inflation at the expense of others. Some individuals gain because their money incomes rise more rapidly than the prices and some lose because prices rise more rapidly than their incomes during inflation. Thus, it redistributes income and wealth. “Nikita Dutta”.
• Effect On Economic Growth: inflation has negative effect on medium to long-term economic growth and showed that the relationship is influenced by countries with extreme values (either very high or very low inflation). However, the negative effects of inflation on economic growth more than outweigh its positive effects.
• Effect On Production: Inflation may or may not result in an increase in production. In addition, inflation has a positive impact on production as long as the economy does not reach full employment stage. Further, if the wages and production costs start rising rapidly, then it negatively affects production activities.
• High Interest Rates: Inflation results to high interest rates in the end. As inflation rises, in addition to businesses being forced to raise their prices, banks are forced to raise interest rates in order to maintain a profit margin and higher rates means that marginal businesses will fail, thus increasing unemployment and harming the overall economy.
• Increase In Tax
• Inefficient Government Spending:
• Lower Exports: Higher prices of goods mean that other countries will find it less attractive to purchase our goods. This will lead to a decline in exports and lower production and higher unemployment in our country. “Source: John Bouman at inflateyourmind.”
• Lower Savings: Inflation encourages consumption instead of saving. Higher prices induce people to purchase more products now, before they become more expensive. They discourage people from saving, because money saved for future use will have less value. Savings are needed to increase funds in the financial markets. This allows businesses to borrow money for investments in capital goods and technology. Increases in technology and capital goods create long-run economic growth. Inflation leads to increased consumption, which discourages savings and slows down economic growth. “Source: John Bouman at inflateyourmind.”
• Mal-investments: Inflation leads to increased consumption, which discourages savings and slows down economic growth. Inflation leads to mal-investments. When prices rise, the value of certain investments increases faster than others do. More money is invested in these assets than other, more-productive assets during increasing inflation.
Positive Effects of Inflation: According to famous British economist John Maynard Keynes, he believed that some inflation was necessary to prevent the “Paradox of Thrift.” If consumer prices are allowed to fall consistently because the country is becoming too productive, consumers learn to hold off their purchases to wait for a better deal. The net effect of this paradox is to reduce aggregate demand, leading to less production, layoffs and a faltering economy. It will be good to note that some economist believes that inflation can sometimes have a positive effect and be a good thing. In addition, When the economy is not running at capacity, meaning there is unused labour or resources, inflation theoretically helps increase production. More dollars translates to more spending, which equates to more aggregated demand. More demand, in turn, triggers more production to meet that demand. Early economist also where of the idea that there is a real inverse relationship between inflation and unemployment and that rising unemployment could be fought with increased inflation. Therefore, a healthy rate of inflation is considered a positive because it results in increasing wages and corporate profitability and keeps capital flowing in a presumably growing economy.
Inflation has been a highly debated phenomenon in economics. Even the use of the word “inflation” has different meanings in different contexts. The thesis has defined inflation as “a persistent increase or rise in the value of money or persistent decrease or fall in the value of money or purchasing power of money.”
Some economist believe that inflation benefits some businesses or individuals at the expense of most others while other argue that inflation is less important and even a net drag on the economy. Thus, the research have finally opined that even though inflation have both positive and negative sides or advantages and disadvantages, the negative aspect of inflation is very devastating and so inflation must be controlled and stopped at all cost.