Explain what is meant by the rate of inflation and  analyse the main causes of inflation

Inflation is a sustained increase in the general price level leading to a fall in the purchasing power or value of money. The rate of inflation is measured by the annual percentage increase in the level of consumer prices. The UK government has set a target of 2% using the consumer price index. The rate of inflation is measured in two ways, the Consumer Price Index (CPI) or the Retail Price Index (RPI).The CPI measures the change in the general level of prices charged for goods and services bought for the purpose of household consumption. The CPI measures a wide range of prices. The index represents the average change in price across a wide range of consumer purchases. This is calculated by recording the prices of a typical selection of products per month using a large sample of shops and outlets in the UK. The contents’ of the basket is fixed for a period of 12 months and the basket should reflect the spending patterns of the average family. Since all items in the basket are not of equal importance to the family, the items will be weighted for example domestic fuel will have a large weight whereas meals ate outside of the home will have a low weight. The index indicates what we would need to spend in order to purchase the same things we bought in an earlier period. A base year is chosen, this is the year to which price comparisons are to be made. During the middle of each month price collectors record approximately 110,00 prices from around 560 items going to a variety of shops in around 150 locations comparing each.  An example would be the index for January 2010 was 112.4 indicating that £112.40 would buy the same amount of goods and services as £100.00 would have in 2005, presenting a rise in price of 12.4%. The annual rate of inflation is the percentage change in the latest index compared to the value recorded 12 months previously.    There are three main causes of inflation these include the Demand pull theory, Cost push theory and the Monetarist theory. The underlying cause of inflation is excess demand in the economy which cannot be accommodated by increases in supply. The pressure from demand causes the price to increase as shown in the basic demand and supply diagram with the price increasing from p1 to p2 with a shift in the demand curve from D1 to D2.  Increases in aggregate demand causes the price to rise in the short run. But the price will not be sustained over the longer period if aggregate supply responds to an increase in aggregate demand.  Some would suggest that demand pull is due to full employment. However in reality few economies ever experience full employment but they do suffer from demand pull inflation. An economy which is booming, going close to full employment is likely to experience skill shortages. These skill shortages put pressure on the labour market as firms attempt to recruit extra people to increase output. Wages will increase which will push prices up. Inflation is usually generated by an excess of demand over supply, to contain inflationary pressures demand needs to grow roughly in line with output. Output grows over time at a rate which largely depends on factors which increase productivity. The main causes which may increase aggregate demand may include a reduction in tax, if taxes are reduced consumers will have more disposable income causing demand to increase. Another reason may include rising consumer confidence and an increase in the rate of growth of house prices, both of which would lead to an increase in total household demand for goods and services.  Another cause of inflation may be the cost push theory. Cost push theorists explain inflation in terms of structural or institutional conditions which prevail on the supply side of the economy. The sources of decrease in aggregate supply operate by increasing costs. Firms wishing to maintain profit margins respond to an increase in costs by raising price. Rising wages with constant prices levels leaves firms to decrease quantity of labour employed and cut back on production. The aggregate supply curve will shift to the left and the impact on the economy is to increase the price level from p1 to p2.   As a consequence output levels in the economy fall, the economy is suffering from rising prices plus lower output with higher levels of unemployment. This phenomenon of high prices, high unemployment became known as stagflation. As the cost of living increases this causes workers to push for higher pay to maintain real income levels, these higher wages increase firms’ costs and fuel inflationary measures causing an even higher wage demand. Some economists believe that high levels of inflation result from inadequate government control of money supply. Inflation will only be sustained over the longer period if the government allows the money supply to rise to accommodate the inflationary pressures within the economy. An increase in money supply would increase aggregate demand and in turn reduce unemployment however in the long run a policy like this is purely inflationary. Both demand pull and cost push inflation will burn themselves out because they are not validated by an increase in money supply. The monetary theory is based on the fisher equation MV=PT. If the government print more money to cope with an economic crisis the increase in money supply bids up prices and currency rapidly becomes worthless. This is called monetary inflation; it is summed up by the simple statement “too much money chasing too few goods.” The solution to monetary inflation is to cut money supply and in turn in the long run raise productive capacity. The most appropriate way to control inflation in the short run is for the government and the Bank of England to keep control on the level of aggregate demand. The best way to control aggregate demand is through the use of the monetary policy rather than an over reliance on the fiscal policy as an instrument of demand management. However given that inflation tends to be through caused through a variety of ways, a variety of measures should be employed.