Is inflation due to flawed monetary policy, or other reasons?What are the various reasons that cause inflation?

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santari eNotes educator| Certified Educator

Inflation generally refers to the increase in prices of goods and services, or in other terms it refers to the decline in real value of money. That is, every dollar you hold buys less since prices are higher.

Monetary policy can directly result in an increase or decrease in inflation because the Federal Reserve is the lender of last resort, and controls the interest rate at which it lends money. The higher the rate, the less likely that borrowing will occur, and as a result less money is circulating. So generally, the Fed tries to combat inflation by raising interest rates.

But given a choice, the Fed seems worried less about inflation than it is about a general slowdown in the economy. Hence, interest rates are historically low, and as one observer put it, "the Fed has announced its intention to paper the face of the earth" -- that is to print and lend money to such an extent that the yield on Treasury Bills is approaching zero.  What this means is that the big holders of government securities, such as China, which holds hundreds of billions in treasury bonds, will see little return on their investment.

In short, the Federal Reserve seems to be following a policy of "inflate or die": It appears ready to go to any length to spur economic activity, regardless of the amount of money it needs to print and lend.

enotechris eNotes educator| Certified Educator

Putting the visible hand of government monetary policy aside for a moment, Inflation (or deflation, for that matter) are terms that describe the upward or downward trend of the relative value of goods and services to the supply of money.  The relationship of Supply and Demand influences the direction of the trend; if there's little supply and lots of demand, prices inflate; conversely, if there's little demand and lots of supply, prices deflate. Where supply and demand are equal, or little supply, little demand, or much supply, much demand, prices are fixed. 

However, Supply and Demand can be applied to the concept of money as well -- if the government decides to print lots of money, (to cover its own debt to pay for a war, for example) this will guarantee inflation, since the value of that money decreases, so more money is needed to purchase goods or services; if there's little money in circulation, the value increases so less money is needed to make purchases.  If the government passes laws fixing prices, inflation will result if the price is set too low; this will cause supply to decrease and demand increase (inflate);  If set too high, it will cause supply to increase and demand to decrease (deflate).

santari eNotes educator| Certified Educator

In reply to #3 - "Papering the face of the Earth" sounds a bit ominous -- won't that lead to hyperinflation?

Possibly, yes. Here's an interesting statistic -- the closing price of gold per ounce at the end of the year for the last 8 years:

2000 -- $273.60
2001 -- $279.00
2002 -- $348.20
2003 -- $416.10
2004 -- $438.40
2005 -- $518.90
2006 -- $638.00
2007 -- $838.00
2008 -- $889.00

Gold is a good indicator of general confidence in the paper currency. Gold is intrinsic money, and has been for thousands of years. The only thing that makes dollars worth anything is our government telling us that it is legal tender for the settlement of debt. Our govermment creates money out of nothing, literally on a computer it creates "wealth". But you have to wonder what would happen if people started to question the amount of money we keep printing.  It seems to me with this approach inflation is inevitable!

enotechris eNotes educator| Certified Educator

In reply to #6 - Just looking at the price of gold over recent time does suggest we're inflating.  And why the paper money keeps being devalued and theoretically could become worthless is because the government has nothing to back it up.  There was a time when you could exchange your paper for gold or silver, but that's long past; what backs our currency now?  Governmental promises? 

litteacher8 eNotes educator| Certified Educator

Actually, governments have never been able to control inflation with monetary policy.  Sometimes, they do cause it.  In a gloabl economy, there are many opportunities for one country to affect another country's currency.  Therefore, I would argue that governments have to consider where their currency stands relative to other country's currencies because trade is so international now.

enotechris eNotes educator| Certified Educator

In reply to #3 - "Papering the face of the Earth" sounds a bit ominous -- won't that lead to hyperinflation?

krishna-agrawala | Student

Inflation refers to an increase in general increase in prices of goods and commodities in an economy.

Inflation is impacted indirectly by many different actions of business, and government. But the direct factors are always the relative position of combined demand and supply for collection of various types of goods and services purchased and sold in an economy. And when we speak of supply and demand, it in just the actual supply and demand, but also the expectation of people about what the supply and demand is likely to be in future.

The general levels of demand in an economy increases when people have or expect to have more money available for buying. Such increase is primarily because of increase in income of people, but is also impacted by other factors such as taxation and and availability of loans. The general level of demand decreases when opposite happens.

The general level of supplies tends to increase in an economy when prices of resources used in manufacturing drop, and it tends to decrease when prices of input resources increase. Prices of some resources like petroleum products which are used widely have greater impact on costs than other resources. The cost of manufacturing is also impacted by taxation and interest rates which are in turn substantially impacted by monetary and fiscal policies of government.

Manpower cost is the single most important input resource. But the impact of wages is two folds. While increase in wages tends to increase cost and therefore decrease supply, it also increases the money available with people for spending.

Thus these various factors interact with each other in a complex way to determine level of inflation or deflation.