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Inflation

Oct 25, 2021

Inflation

inflation

One of the oldest and most constant things about economic life is that prices of goods and services keep rising. For example, a few years ago, a bag of water used to be sold for just 80 Naira, but today if you get a bag of water at 150 Naira, you would consider it an excellent bargain. This constant rise in prices can be credited to an economic term known as INFLATION.

Inflation can be defined in many ways; it can be defined as a decrease in the purchasing power of a currency; it can also be defined as an increase in the general price level of goods and services. Both definitions essentially mean the same thing; When there is inflation in an economy, the value of money decreases because a given amount of money will buy fewer goods and services than before due to a general increase in prices of goods and services. Although consumers generally hate rising prices, economists believe a moderate degree of inflation is healthy for a nation’s economy. Usually, central banks aim to maintain inflation rates within 2% to 3% and a significant increase beyond this range can lead to fears of possible hyperinflation, a devastating scenario in which inflation rises rapidly out of control.

The task of defining inflation although daunting is relatively easy compared to giving a reason as to why inflation occurs. Several economists are of different schools of thought as to what causes inflation. Although numerous theories exist, arguably the two most influential schools of thought on inflation are those of Keynesian and monetarist economics.

Keynesian Economics

The Keynesian school believes inflation results from economic pressures such as rising costs of production or increases in aggregate demand. The Keynesian school distinguishes between two broad types of inflation: cost-push inflation and demand-pull inflation.

Cost-push inflation:

This is when the cost of production (or running a business) rises and it's then passed on to customers. There can be a lot of reasons for the rise in prices ranging from:

  • Scarcity of raw materials due to high demand leading to a hike in the prices of the raw materials.
  • Increased labor cost: Workers demanding higher pay and eventually succeeding at getting it.
  • An increase in land rents.
  • There could also be unexpected causes of cost-push inflation such as earthquakes, fires, floods, or tornadoes. If such a disaster occurs and it leads to damage to a production facility, it could disrupt the production chain. The company would have no other choice but to increase prices to help recoup some of the losses incurred from such a disaster.

When the cost of these factors rises, producers wishing to retain their profit margins must increase the price of their goods and services. When these production costs rise on an economy-wide level, it can lead to increased consumer prices throughout the whole economy, as producers pass on their increased costs to consumers. Consumer prices, in effect, are thus pushed up by production costs. Cost-push inflation occurs when overall prices increase (inflation) due to increases in the cost of wages and raw materials. Higher costs of production can decrease the aggregate supply (the amount of total production) in the economy. Since the demand for goods hasn't changed, the price increases from production are passed onto consumers creating cost-push inflation. The most common example of cost-push inflation occurs in the energy sector – oil and natural gas prices.

Pretty much everyone needs a certain amount of gasoline to fuel their car or natural gas to cook. Refineries need a certain amount of crude oil to create gasoline and other fuels. Electric power suppliers need high levels of natural gas to create electricity.

When global policies, war, or natural disasters drastically reduce the oil supply, gasoline prices rise because demand remains relatively stable even as supply shrinks. For example, in the early 1970s OPEC imposed an oil embargo on the United States and some other countries; what followed was. The impact of the supply cut led to a surge in gas prices; the price of a barrel of oil skyrocketed from $3 to $12, as well as higher production costs for companies that used petroleum products.

Demand-pull:

Demand-pull inflation occurs when there is an increase in the number of people who want a good or service whose supply can’t keep up. Demand-pull inflation is the tendency for prices to increase due to increasing aggregate demand, or the amount of goods and services the entire population buys. The most common cause of demand-pull is a rather good thing; it is usually associated with a strong economy. When an economy is thriving, employment rates tend to increase; as such more people make money, and as a result, they spend more money. In Keynesian economic theory, an increase in employment leads to an increase in aggregate demand for consumer goods. In response to the demand, companies hire more people so that they can increase their output. The more people firms hire, the more employment increases. Eventually, the demand for consumer goods outpaces the ability of manufacturers to supply them. There are five causes of Demand-Pull Inflation:

  • A growing economy: When consumers feel confident, they spend more and take on more debt. This leads to a steady increase in demand, which means higher prices.
  • Increasing export demand: A sudden rise in exports forces an undervaluation of the currencies involved.
  • Government spending: When the government spends more freely, prices go up.
  • Inflation expectations: Companies may increase their prices in expectation of inflation in the near future.
  • More money in the system: An expansion of the money supply with too few goods to buy makes prices increase.

Demand-pull inflation occurs when consumer demand outpaces the available supply of many types of consumer goods, demand-pull inflation sets in, forcing an overall increase in the general cost of living. When the aggregate demand in an economy strongly outweighs the aggregate supply, prices go up.

Monetarist Economics;

As its name suggests, monetarism is concerned principally with the role of money in influencing economic developments. Specifically, it is concerned with the economic effects of changes to the money supply. Monetarist economists believe inflation stems from the expansion of the money supply and that central banks should maintain stable growth for the money supply in line with GDP. If the Money Supply increases faster than real output then, ceteris paribus, inflation will occur. If you print more money, the amount of goods doesn’t change. However, if you print money, households will have more cash and more money to spend on goods. If there is more money chasing the same amount of goods, firms will just put up prices.

According to the man credited for the monetarist school of thought; Milton Friedman, “inflation is always and everywhere a monetary phenomenon.” This view is in contrast to the Keynesian school of thought. The monetarist believes the underlying principal factor causing inflation has little to do with things like labor, materials costs, or consumer demand. Instead, it is all about the supply of money. Monetarists argue that if the Money Supply rises faster than the rate of growth of national income, then there will be inflation. If the money supply increases in line with real output then there will be no inflation. The monetarist's theory has come under serious criticisms because in practice the link between the money supply and inflation is often very weak. Also, the large increase in the monetary base following the 2009 recession did not cause any inflationary pressures.

Types of Inflation

The optimal inflation rate is often considered to be around 2%. This is because when inflation is above 2%, inflation expectations will rise and it will be harder to reduce inflation in the future. Keeping inflation less than 2% will keep long-term expectations low. There are four main types of inflation, categorized by their speed. They are creeping, walking, galloping, and hyperinflation.

  1. Creeping Inflation: it is also known as mild inflation. This kind of inflation occurs when prices persistently rise over a period of time at a mild rate. Mild increases in the inflation rate of up to 3% are considered creeping inflation. Usually, this sort of inflation is not regarded as bad because it benefits economic growth. This kind of inflation encourages consumers to buy now to beat higher future prices because when creeping inflation occurs consumers expect prices to continue rising, which boosts demand for consumers to buy now instead of later when the product will be more expensive.
  2. Walking Inflation: it occurs when the economic growth of a country is too accelerated to sustain. Inflation at this rate is usually a warning signal for the government to control the inflation rate before it exceeds 10% and becomes running inflation. Walking inflation is harmful to the economy because people start to buy more than they need to avoid tomorrow's much higher prices. This increased buying drives demand even further so that suppliers can't keep up. More importantly, neither can wages. As a result, common goods and services are priced out of the reach of most people.
  3. Running inflation: when prices rise rapidly like the running of a horse. This occurs when the inflation rate goes above 10%-20%. This sort of inflation wreaks havoc on the economy because money loses value very quickly, to the extent that businesses and employee income can not keep up with the rapidly increasing costs and prices. When this occurs the economy becomes very unstable and so does the nation because government leaders will lose credibility.
  4. Hyperinflation: When the inflation rate rises above 50% per month it is known as hyperinflation. hyperinflation is a term used to describe aggressive, rapid, and out-of-control general price increase in an economy. Hyperinflation rarely occurs in countries, most times hyperinflation occurs when governments print money to pay for wars. It is generally caused by an oversupply of paper currency without a corresponding rise in the production of goods and services. The most recent example of hyperinflation is in Venezuela, prices rose 41% in 2013 and by 2018 inflation was at 65,000%. Another good example is Germany post world war 1 when the country suffered severe economic and political shocks largely due to the treaty of Versailles that ended the war and ordered repatriations to be paid by the German government. When the government could not meet up with payments they printed more paper currency and it led to hyperinflation. The value of the German paper currency was reduced so badly that it was more favorable to burn the paper to use for heating than to purchase wood. Hungary post-world war II also experienced the worst ever case of hyperinflation for the same reasons as Germany. Economists estimate that Hungary peaked at 41.9 quadrillion percent per month. At this point, prices doubled every 15 hours and the Hungarian government had to completely devalue the current banknotes in circulation and started issuing a different currency.
  5. Stagflation: Stagflation is when economic growth is stagnant, but there still is price inflation. Stagflation can be alternatively defined as a period of inflation combined with a decline in the gross domestic product (GDP). Stagflation refers to an economy that is experiencing a simultaneous increase in inflation and stagnation of economic output.

Inflation is a constant concern because it makes money saved today less valuable tomorrow. Inflation erodes a consumer's purchasing power. For example, if a bank customer saves a sum of money in their savings account with an annual interest of 2.5%, if at the end of the year the inflation rate of the country is higher than 2.5% the customer has made no profit from saving his money and the value of the money saved is now even less than when it was saved. Inflation is an enemy to a saver. Fiat currencies such as the US dollar, Nigerian Naira, British Pounds are inflationary by design so that people don't hoard currency because the more your money loses value every year, the less likely you are to keep it sitting in a bank. This availability of money in the market encourages the growth of the economy. This ability of the central banks to print fiat currency at will is also the major undoing of fiat currency as governments in a bid to stimulate the economy could print too much fiat currency resulting in inflation or in some cases hyperinflation. Amongst the countries with the highest inflation rate are Yemen with 26.18%, Venezuela with 2335.15%, Iran with 36.5%, Zimbabwe with 557.21%, Nigeria with 16.5%, Angola with 22.8%, Turkey with 13.25%.

Benefits of Inflation

  • Investors can enjoy a boost if they hold assets in markets affected by inflation. For example, if an investor invests in energy companies, he might see a rise in their stock prices if energy prices are rising.
  • Also, business owners can deliberately withhold supplies from the market, allowing prices to rise to a favorable level before selling.
  • Companies could also benefit from inflation if they can leverage the economic situation and charge more for their products as a result of a surge in demand for their goods.
  • Debtors also benefit from inflation because a basic rule of inflation is that it causes the value of a currency to decline over time. Thus, inflation lets debtors pay lenders back with money that is worth less than it was when they originally borrowed it.
  • Lastly, Some amount of inflation usually around 2%, 3%, maybe 4% turns out to be very beneficial for the Economy because when the economy is not running at capacity, meaning there is unused labor or resources, inflation theoretically helps increase production. More dollars translates to more spending, which equates to more aggregated demand, and more demand, in turn, triggers more production to meet that demand. Milton Friedman, also known as the father of monetarist economics believed that some level of inflation was necessary to prevent the Paradox of Thrift. This says, 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. Inflation also helps the economy combat Deflation.

Deflation

While inflation is the general increase of the price of goods and services, Deflation is the general decline of the price of goods and services. Deflation is the opposite of inflation. Essentially, you can buy more goods or services tomorrow with the same amount of money you have today. It occurs when too many goods are available or when there is not enough money circulating to purchase those goods. As a result, the price of goods and services drops. Prolonged periods of deflation can stunt economic growth and increase unemployment. Japan's "Lost Decade" is a recent example of the negative effects of deflation.

What causes deflation?

Deflation can be caused by a combination of different factors, including having a shortage of money in circulation, which increases the value of that money and, in turn, reduces prices; having more goods produced than there is demand for, which means businesses must decrease their prices to get people to buy those goods. Economists agree that the two major causes of deflation in an economy are:

  • Fall in the money supply: usually caused when the central bank tries to use tighter monetary policy by increasing interest rates thus making people prefer saving their money instead of spending it. Also increasing interest rates lead to higher borrowing costs, which also discourages spending in the economy.
  • A decline in confidence: Negative events in the economy of a country such as a recession, may also cause a fall in aggregate demand because, during a recession, people become more pessimistic about the future of the economy.

Effects of Deflation

Deflation is considered an adverse economic event and can cause many negative effects on the economy, including;

  1. Increase in unemployment: this occurs because price levels are decreasing and producers tend to cut their costs in several ways such as laying off their employees.
  2. Increase in the real value of debt: Deflation is associated with an increase in interest rates, which will cause an increase in the real value of debt. Therefore consumers are most likely to defer their spending and avoid debts.
  3. Deflation Spiral: this occurs as a chain reaction from several decreasing price levels that leads to lower production, lower wages, decreased demand, and even lower price levels. The deflation spiral is the most significant challenge during a recession because it further worsens the economic situation.

Benefits of Deflation

  • Deflation is a good way to get rid of asset bubbles building up inside the market. This is because deflation causes a decrease in the value of financial assets and it becomes very hard to accumulate wealth with the aim of causing artificial inflation. Adversely, this can lead to distress selling and ultimately result in the collapse of the market economy. However, state-mandated deflation would effectively diminish panic and force the value of accumulated wealth to drop.
  • Deflation causes the prices of goods and services to fall. From a consumer's perspective, this would essentially mean that they have been afforded more spending power.
  • The production scale of a deflationary society would be astounding. With such aggressive price competition existing in the market, suppliers, as well as retailers, would have to modify the way they approach customer retention.

How Inflation and Deflation Affect Crypto Assets

One attribute that has made crypto assets, particularly bitcoin so appealing to investors is that they are more resistant to inflation than fiat currencies. Usually, with Fiat currency your purchasing power decreases over time, however Bitcoin on the other hand has generally increased in value, going from virtually worthless in 2010 to more than $60,000 in 2021 at the time of writing. Cryptocurrencies aren't immune from experiencing the effects of inflation, however, they just have better and more effective mechanisms set in place to control it. Even Bitcoin experiences inflation as more of it is mined (as does gold). But because the amount of new bitcoin is automatically reduced by 50 percent every four years, Bitcoin’s inflation rate will also decrease.

What Makes Crypto Assets More Resistant To Inflation?

  • They can not be manipulated by governments through adjusting interest rates or printing money.
  • Scarcity is one key to making a store of value(silver, gold) resistant to inflation. But unlike Gold or silver, the total supply of Bitcoin is known; as of now there are 19 million bitcoins already mined, 6.25 bitcoin will be mined every 10 minutes and sometimes in 2024 the mining reward will be brought down to 3.125 and repeat will happen in another four years until Bitcoin reaches 21 million. At this point, bitcoin has reached its max supply and no bitcoins would ever be made.

Deflanationary Nature of Crypto Currencies

Traditional Fiat currencies such as the USD, EUR, GBP, NAIRA, etc, are inflationary. What this means is that there is no limit to how much currency is created and can be on the market at any given time. If a system needs more currency, the central bank will introduce more bills and coins thus aiding the economy that uses this specific currency. However, the main issue with inflationary currencies is that, as the supply of currency grows, its value decreases.

A deflationary cryptocurrency is a form of cryptocurrency with a depreciating supply of coins. In simple terms, the number of coins in circulation decreases, making an individual coin more valuable. Bitcoin although Deflationary in nature is currently an inflationary currency and will remain like this until it reaches the 21 million coin mark. At that point in time, there will be no more Bitcoins to mine and it will become a deflationary cryptocurrency. Aside from crypto assets with hard caps, some cryptocurrencies are deflationary due to their high burn rates. A cryptocurrency burn can take several forms:

  • Some currencies and tokens opt for a flat burn rate per transaction, with a certain percentage of each transaction destroyed, or burned.
  • Alternatively, some blockchain foundations or organizations may implement a buyback scheme. Here, it buys a significant amount of cryptocurrency, and then sends it to a dead wallet, taking the currency out of circulation.
  • Finally, halving. Here, the total block reward halves at a fixed point in time usually after a certain number of blocks. This isn’t deflation per se but causes a reduction in the inflation rate. But not all cryptocurrencies are designed like Bitcoin. For instance, some cryptocurrencies like Ethereum, and Dash have opted for the inflationary currency model by allowing for new coins to be continually created. Also, an increasingly popular category of digital money called stablecoins, many of which are pegged to fiat currencies like the dollar, can be a useful, low-volatility place to save some money. But if a stablecoin is pegged to a fiat currency, your investment will be impacted by inflation and could lose value over time as their reserve currency loses value.

Determining which of the two models works best for cryptocurrencies is difficult as both have their pros and cons. At this point, a deflationary cryptocurrency may seem like the more reasonable option if we can assume that its value will rise as the supply rate decreases and eventually comes to a halt. However, one major criticism this model has received is that it creates a hoarding culture so that no one will want to spend money that appreciates.

It’s more likely that price volatility is more of a threat than deflation to bitcoin right now. Bitcoin is quite dividable. This could play a factor since a virtual currency is much easier to break down into smaller parts than that of today’s fiat system. Bitcoin is currently divisible down to .00000001 of one BTC. That seems like a small amount right now, but someday it could prove to be useful.

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