Essay Sample on Inflation & Deflation: Impact on Economic Growth & Stability

Introduction

Inflation and deflation are the measures of price stability in an economy, which in turn causes a significant effect on economic growth and stability as well. Price stability is an economic state whereby it doesn't experience severe and substantial price movements either upwards or downwards. Inflation occurs when general prices in an economy move upward, while deflation occurs when prices go down. Many factors that play the type of inflation: demand-pull inflation, the cost-push type of inflation, and imported inflation. Demand-Pull Inflation is attributed to the rise in the aggregate demand commodities in a particular economic zone, which in turn leads to excess production capacity in the same economy. Cost-Push Inflation is brought by increased production cost, which leads to a considerable increase in the prices of the final product hence inflation. This paper will explore out the definition of inflation, the types of inflation, and the causes of inflation.

Is your time best spent reading someone else’s essay? Get a 100% original essay FROM A CERTIFIED WRITER!

Save 25%

Definition of Inflation

Inflation is the overall rise in product prices in a country's economy for a specified period (Mankiw, 2018). It means that the prices rise for a specified period, which can be controlled by the authorities by the use of specific tools used to regulate the condition. For inflation to occur, there should be a substantial increase level of prices for a specified period. Therefore, an increase in prices, which occurs as a one-time occasion, cannot be termed as inflation since it has not been a persistent increase and did not occur for a certain period but only once. Therefore, inflation is a situation where there is a generalized upward shift in prices which occur persistently for a specified period, but not a one-time price increase. Consequently, there are various causes of inflation, which are discussed here below.

Types of Inflation by Causes

According to Mankiw (2018), inflation can be caused by different factors depending on the period given. There are those factors that play better in the long run, and there those that play in both short-run and long-run. There are three types of inflation attributed to different causes. There are three common types of inflation classified according to causes, which include the following: an inflation type known as demand-pull inflation, a second one known as the cost-push type of inflation, and imported inflation. The discussion will focus much on two first two types of inflation in a detailed way, specifically by their causes.

Demand-Pull Inflation

Kim. (2019) states that this form of inflation is attributed to the rise in the aggregate demand commodities in a particular economic zone, which in turn leads to excess production capacity in the same economy. It means that the demand is higher than the aggregate supply, thence, leading to a gap between supply and demand whereby there happens to be high demand and lower supply, leading to an upward movement of general prices of in the entire economy. For instance, if during low seasons in the agricultural sector, the production rate of vegetables lowers, creating lower supply and the demand for such products increases due to the shortage created by low supply.

According to Amitrano and Vasconcelos (2019), Keynesian economists argue that money supply is a determinant of aggregate demand, which in turn affects the prices of products in the economy. In this case, an increase in money circulation in the market leads to a consequent rise in individuals' purchasing power, which in turn leads to higher spending and thus increased demand hence a rise in prices of the products generally. Money supply can be increased by when the government prints more money and releases the same to the economy or when the government devalues the country's currency leading to loss of purchasing power of the money. Amitrano and Vasconcelos (2019) also argued that demand-pull inflation could be caused by reduced money demand, like it was experienced in the time of Black Death in Europe, and also in the Occupied Territories which happened in Japan before the defeat of its in which occurred in the year1945.

As illustrated in the diagram below, the aggregate supply (AS), as shown by the curve, is at maximum; therefore, a unit aggregate demand (AD) increase leads to upward price movement from P1 to P2.

Figure 1: Demands pull inflation

Cost-Push Inflation

It is an inflation type brought about by increased production cost, which leads to a considerable increase in the prices of the final product hence inflation (Mankiw, 2018). First, it may be caused by the rise in labour cost, whereby wage rates increase, leading to an overall upward shift of production cost brought about by increased payout of wages to the employees. In turn, these costs are shifted forward to the final product by increasing the price of the product, which is now incurred by the consumers to cover the high costs in the production process, hence inflation. When firms are faced with this critical condition of high wage costs, they tend to maintain their profits by pushing the prices higher.

Secondly, this inflation type may occur as an impact of increased raw materials costs and those of significant inputs. Kim (2019) argued that an increase in the cost of raw materials such as fuels leads to a subsequent rise in production costs, which are, in turn, covered through the rising prices of the final product and therefore affecting the pricing techniques within the economy. Firms are consequently impacted to raise the prices their final product to maintain their profit margins hence causing cost-push inflation. An example is an occasion which was experienced during the oil crisis in 1973-1974 and 1970-80 which created a shortage of oil supply hence increase in the prices of oil in many countries which resulted to raised cost attributed to the activity of production and thus caused inflation (Amitrano & Vasconcelos, 2019).

Thirdly, cost-push may occur when the home currency depreciates, therefore, leading to increased prices of imported raw materials and capital equipment, which in turn causes an upward movement of production cost and hence a consequential upward movement of the prices of the final products. As much as the economy approaches full employment, there happens to be greater fear and problem of a shortage of skills.

Figure 2: Cost-push Inflation

A significant rise in the cost of production will lead to the shift of the supply curve (AS) from AS1 to AS2 while the prices will, in turn, move from P1 upward to P2.

Likely Consequences of Tax Reduction

Effect of Reducing Income Tax Rate

If the tax rate of income tax is decreased or cut down, there happens to be an increase in the spending power of consumers, which in turn leads to aggregate demand increase and thus leading to higher growth of the economy and possible inflation. In addition to this, lower-income rates encourage hard work among employees craving to reap more incomes as obtained from overtime compensations, which, therefore, results in increased productivity, thus leading to economic growth as well (Kim, 2019). Cutting income tax rates may encourage people from other countries to move to such a state to reap more.

However, decreasing the income tax rates may also lead to higher economic growth, which results from the increase in aggregate demand caused by the increased spending power of the consumers. Increased spending means that there is an increased number of transactions being carried out within the economy, thus leading to economic growth. Economic growth, in this case, is also caused by increased productivity in the economy due to the increased aggregate demand and increased investments within the economy. Consequently, low tax rates reduce the tax revenues of the government, which leads to an increase in government borrowing to cater for its expenditure.

Effect of Reducing Profit Tax Rate

Amitrano and Vasconcelos (2019) explain that cutting of taxes on profits reduces the burden on profits giving companies additional money to hire more employees and to re-invest back into the business. Small businesses create new jobs by creating more slots to increase their productivity, which in turn leads to a reduction in unemployment and increased economic growth. Cutting on corporation tax reduces corporation tax enabling corporations to have higher profits, which allows them to invest such funds and boost their spending on durable goods and also capital goods as well. An example of such an incident was evident when "The American president, Donald Trump, signed an Act on December 22, 2017, aimed at cutting tax and. The corporate tax rate was cut from 35% to 20%, which began in 2018."

Conclusion

Inflation can be viewed as a general upward movement of prices of products in an economic zone for a specified period. Demand-pull inflation, cost-push inflation, as well as imported inflation, are the main viewed types of inflation. The leading cause of demand-pull inflation is the economy's aggregate demand moving upwards, which causes shortages in supply because demand exceeds supply, hence an increase in prices. Additionally, cost-push inflation is common as a result of the rise in costs of production, which thus, causes an increase in the prices of the final product. Finally, cutting on taxes causes a significant effect on the economy through increasing consumer incomes as well as increasing the profits of companies. It leads to increased productivity, increased investments, and a decrease in unemployment hence an increase in economic growth.

If the tax rate of income tax is decreased or cut down, there happens to be an increase in the spending power of consumers, which in turn leads to aggregate demand increase and thus leading to higher growth of the economy and possible inflation. However, decreasing the income tax rates may also lead to higher economic growth, which results from the increase in aggregate demand caused by the increased spending power of the consumers. Cutting of taxes on profits, on the other hand, reduces the burden on profits giving companies additional money to hire more employees and to re-invest back into the business.

References

Amitrano, C. R., & Vasconcelos, L. (2019). Income distribution, inflation, and economic growth: A post-Keynesian approach. Panoeconomicus, 66(3), 277-306. DOI: http://dx.doi.org/10.2298/PAN1903277A

Kim, H. (2019). A missing element in the empirical post-Keynesian theory of inflation-total credits to households: A first-differenced VAR approach to US inflation. Journal of Post Keynesian Economics, 1-17. https://www.tandfonline.com/doi/abs/10.1080/01603477.2019.1672559

Mankiw, N G (2018) Principles of Economics, 8th edn, Singapore: Cengage Learning Asia.