INFLATION

                                                 

                                                

Jelgava 1999
  Inflation

What is Inflation?

Most people associate inflation with price increases on spesific goods and services. We must be careful to distinguish the phenomenon of inflation from price increases for spesific goods. Inflation is an increase in the average level of prices, not a change in any spesific price.

In almost every presidental campaign candidates call inflation a bad thing and vow to control it once elected. The rising cost of groceries, clothes and everything else is a main topic of conversation among consumers. Business firms realize that higher prices for materials, labour, eqipment, and other things they buy reduce business profits unless they are successful in passing these higher costs on to the consumer in the form of higher consumer prices. A stated national goal of government economic policy is to stabilize the price level. All groups comprising the population - consumers, unions, business firms, and government - are concerned about inflation.

We first determine the average price of all output - the average price level - then look for changes in that average. A rise in the average price level is referred to as inflation.

The average price level may fall as well as rise. A decline in average prices - a deflation - occurs when price decreases on some goods and services ouweigh price increases on all others.

Because inflation and deflation are measured in terms of average price levels, it is possible for individual prices to rise or fall continuously without changing the average price level.

A general inflation - an increase in the average price level - does not perform this same market function. If all prices rise at the same rate, price increases for specific goods are of little value as market signals. Inflation may be suppressed. This occurs when output demanded is greater than output supplied at the current price level, but the price level does not rise because of government price controls.

Anticipated Inflation             

Although inflation can have serious consequences for our economic welfare, its impact need not always be so harsh. Modest rates of inflation - particularly if they are constant, and thus predictable - may actually stimulate output. If producers are certain that prices will continue to rise at a moderate rate, they have an incentive to produce output now (at lower costs) for sale later (at higher prices).

Theoretically, there is reason to believe that a fully anticipated inflation would do little real harm. In practice, however, not everyone has the ability or energy to make all the required adjustments in market behavior. Also, there is no way to foresee completely all average and relative price increases. As a consequence, inflation is likely to benefit those who have the best information and the greater ability to adapt their market behavior.

Measuring Inflation

The most common measure of inflation is the Consumer Price Index (CPI). As its name suggests, the CPI is a mechanism for measuring changes in the average price of consumer goods and services. The CPI does not refer to the price of any particular good, but rather to the average price of all consumer goods. Inflation rate is the annual rate of increase in the average price level.

In addition to the familiar Consumer Price Index, there are three Producer Price Indexes (PPIs). The PPIs keep track of average prices received by producers. One index includes crude materials, another covers intermediate goods, and the last covers finished goods. The three PPIs do not include all producer prices but primarily those in mining, manufacturing, and agriculture.

Over long periods of time, the PPIs and the CPI generally reflect the same rate of inflation. In the short run, however, the PPIs usually increase before the CPI, because it takes time for producers' price increases to be reflected in the prices that consumers pay. For this reason, the PPIs are watched closely as a due to potential changes in consumer prices.

Types of Inflation

The most familiar form of inflation is called demand - pull inflation. The name suggests that demand is pulling up the price level, and this is pretty much what happens. If the demand for goods and services increases faster than production, there simply won't be enough goods and services to go around. Prices will rise as consumers try to outbid one another for the available supply. In the process, the price level will move up, and we will be saddled with an inflation.

Cost - push inflation is caused by increases in the cost of production or other forces that reduce aggregate supply. A common source of cost - push inflation is an increase in labour costs, often resulting from aggressive labour - union bargaining.

Producers can also contribute to supply - side inflation. If producers decide they want higher incomes, they may try to attain them by raising profit margins. They can increase profit margins by raising product prices faster than costs. The result is a rising price level that is, inflation.

Inflationary Causes and Cures

Two approaches are taken to explain the causes of inflation and the cures to inflation. The first approach is the quantity theory of money. This theory stresses the importance of money in the inflationary process. The second approach is an aggregate demand and supply approach. The central message of the quantity theory of money is that behind every inflation there is a rapid growth in the money supply, and the way to stop inflation is to control the growth in thr money supply. In a demand - pull inflation, it is excess aggregate demand that initiates and causes inflation. In a cost - push inflation, aggregate supply decreases resulting in upward pressures on prices. The cure for demand - pull inflation is the appropriate use of monetary and fiscal policies. There is no certain solution to cost - push inflationary pressures other than restoring competitive markets and making sure that inflatinary pressures do not exist because of an excessive growth in the money supply. An incomes policy that provides ivcentives to foster competitive wage and price behavior has been recommended as a possible solution to cost - push inflation but has not yet been implemented.

Prices and Inflation in Latvia

Consumer prices in 1991 went up 262.4%, and in 1992 reached the level close to hyperinflation, that is 958.6%. Liberalisation of prices at the outset of economic reforms and growth of production costs (especially the huge increase of prices of energy resources) should be mentioned among the reasons for the rise of consumer prices in this period.

Starting with December 1992 stabilisation of prices and lowering of inflation rate took place and in 1993 consumer prices went up only by 34.9%. Since then, inflation rate continues going down every year and in June 1999 against June 1998 consumer prices have gone up only by 1.9%. To stop hyperinflation the Bank of Latvia implemented a strict monetary policy and control over money supply achieved by high interest rates and granting of limited loans to other banks and the government. However, none of the most optimistic forecasts of the development could foresee as fast a decline of inflation as in the second half of 1998 and in 1999.

Looking at annual inflation of Central and Eastern Europe we see that in the first months of 1999 inflation does not exceed a single digit number. Yet, a year ago such situation existed only in one half of the states. Average annual inflation in countries of Central and Eastern Europe in March 1998 was 17% and in March 1999 - only 6.7%. Although the tendency on the whole seems to be positive still often alongside with the general world economis tendencies we hear concerns about threats to economy presented by the deflation.

Food products is the group of goods where prices are falling since July 1998. As food stuffs have a substantial weight in the total consumption basket deflation in this sector essentially influenced the total inflation. This is quite recognisable from the point of view of a consumer - prices go down and it is possible to buy more goods. Yet, for producers it is quite difficult to get adjusted to the falling prices and the only way to keep profitability is to try to cut down costs.

As non - food products and services have rather stable rate of price growth Latvia at the moment is not threatened by deflation.

In total terms, consumer prices in May 1999 have gone up by 1.9% in comparison with May 1998 of which prices of food products have gone down by 1.6% and for clothes and footwear - risen by 7.6%.

Changes of producer prices may be described with the help of the producer price index in industry. In Latvia the producer price deflation was observed starting with the fourth quarter of 1998 and prices continue falling every month. In the first quarter of 1999 against the first quarter of 1998 producer prices have fallen by 4%. Producer  prices have decreased in almost all sectors of manufacturing and in some of them - rather dramatically. For instance, in processing of fish and fish products prices over year have fallen by 34.5% (March 1999 against March 1998). The exception is production of pharmaceutical, medical and phyto - chemical products where prices over the year have gone up by 11.4%.

Changes in price levels in exports of the state in the reviewed period against the base period can be described by the export price index. Export prices in the period from beginning of 1996 have grown least of all. Their annual rate does not exceed 2%. Changes of prices are different in different groups of goods. For instance, at the end of 1998 prices for exported food products were by 40% lower than in 1995. The most substantial growth of prices was in the group of metals and products of machine building - by more than 25%.

A very small increase of export prices was in 1998 when prices went up by only 0.5%. The export prices of wood and machine building and textile goods went down. In turn, there was an increase of prices of food products and transport vehicles.

Conclusions and Thesis

Inflation is an increase in the average level of prices, not a change in any spesific price.

Deflation is a decline in average prices.

Consumer Price Index is a measure of changes in the average price of consumer goods and services.

Inflation rate is the annual rate of increase in the average price level.

Demand - pull inflation in an increase in the price level initiated by excessive aggregate demand.

Cost - push inflation is an increase in the price level initiated by an increase in the cost of production.

Consumer prices in Latvia in 1991 and 1992 were very high but starting with December 1992 the prices stabilised and inflation rate lowered.

Latvia at the moment is not threatened by deflation because non - food products and services have stable rate of prise growth.

Producer prices have decreased in almost all sectors of manufacturing.

Literature Use

Economic Development of Latvia. Report. - R. : 1999., 74 pp.

Economics of Social Issues. - United States of America: 1990.,431 pp.

The Macro Economy Today. - United States of America: 1991., 597 pp.