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Inflation and Inflationary Causes

09 May 2022

How to build strategy during high inflation? Today, we are experiencing the impact of inflation first hand, both as an individual and as a business owner. The commodity prices are record high from Q4 2020. In the face of soaring prices, how do we make sure that our purchasing power stays strong, and we make the most of what is happening around us in a positive way?  

We’ll be looking at how we can equip ourselves in building a strategy during high inflation and understanding the Inflation and Inflationary Causes.

 

What is inflation?  

We understand inflation is an increase in pricing. But where does it originate from? How do government or banks look at inflation?   

Let us go back to the first principle of aggregate demand and aggregate supply (AD-AS Model).  

First look at the horizontal axis, which is the aggregate output, the GDP gross domestic product. The vertical axis is about your price levels. Now, if we are looking at the red line (aggregate demand curve or line) which is going down. It’s inversely proportionate, and it means as price increases, the aggregate demand in the economy goes down, and vice versa. It’s an inverse relationship that you are seeing. The green line is SRAS, which is short-run aggregate supply. As price increases, the supply goes up. So, it is directly proportional. When you have this aggregate demand and aggregate supply meeting at a point, the intersection is where there is an equilibrium price. There is equilibrium price level and equilibrium output that you see at that level. Just keep this at the back of your mind.  

 

 

Now, from the government’s point of view and from the economy’s point of view, there is this black vertical line called the long-run aggregate supply (LRAS). This is really a particularly important concept to understand when you look at what the government or banks are trying to do. And when the monetary policies are concerned. They are constantly trying to shift this equilibrium point towards this line, and this line is where there is a full employment level, and this is the maximum long-run aggregate supply. It’s vertical because whatever happens to pricing, the output cannot increase. At this point, the economy is at full employment level. It’s at its full capacity, so the government tries to push this line by having more investments, by creating more efficiencies to push this long-run aggregate supply, but it takes a long time, and it happens over a period of time. The equilibrium prices are where they are, people will try to move the equilibrium by shifting short run aggregate demand and short run aggregate supply towards that point.  

So, if you were to just imagine that they would give you right fiscal policies and have expansionary fiscal policies, they would try to move aggregate demand towards the right. And also, the supply will match over a period. If the economy is looking at a full employment level, what are some important principles to see, what are the dilemmas or issues for institutions, when these things are happening, where they’re trying to achieve, and where the economy is right now? 

Another point that you need to be mindful of is that inflation is not bad. When we go back to the first principle of aggregate demand and aggregate supply (AD-AS Model). There is a good demand in the economy, which is the red line and there’s this nice support that’s happening in the economy. It’s bound to shift towards the right. And if it’s shifting towards the right with supply matching, there will be an increase in pricing. And the output is also increasing. So, it means inflation is not that bad, and moderate inflation is a sign of good, vibrant, healthy economy.  

The problem happens when the inflation is extremely high. So good inflation is like 0.5%, or 1% to 2%. That is where the economy has been over the last few years. But then when it goes up to the levels of 5%, 6%, 8% that’s when it’s a sign that it’s an overheated economy. Something is going wrong here. The purchasing power of people obviously goes down, and that’s where the problems happen.

What are the inflationary causes?    

It’s important to note that there are two key causes of inflation. 

  1. Demand pull inflation 

The inflation is happening in the economy. In this demonstration, you can first focus on the Equilibrium point O, Aggregate Demand point O, and there is short run aggregate supply (SRAS), Because there is higher demand in the economy, there are expansionary fiscal policies. The monetary policies are providing more money supply to people. The Aggregate Demand (AD) has shifted to AD1. At the same price level there is more demand, so aggregate demand has shifted towards the right and suddenly equilibrium point has moved from E0 to E1. At this point you will see the price level has gone up and output has also gone up. So, this is a demand-pull inflation. Just be mindful that inflation is not just related to the pricing of certain goods and services. We are talking about inflation as a sustained, continued and the overall increases in prices of products and services. it happens in certain situations that the government tries to keep it under control by changing the interest rates, money supply, the tax policies, etc. 

 

     2. Cost push inflation (Stagflation) 

 

This graph shows the aggregate demand remains at this level. And the shift is happening in the aggregate supply, from 0 to 1, a left shift. It means that at the same price, the economy is producing lesser output. There are a few reasons to that. Primarily, it’s because of the increase in cost of raw material. In the 1970s, for example, oil shortage happened, and OPEC countries increased the oil price. Due to raw material cost increase, the economy was producing lesser outputs at the same price. The supply shifted inward. It could also happen because of the devaluation of currency. If the inputs are becoming more expensive, cost of production increases, and therefore the supply curve is shifting inward. This is exactly what the economy is facing right now. The government was trying to push the output. They were trying to support the demand and have more investments in the economy because the economy has shrunk, which means it has gone below the LRAS. The government was trying to push aggregate demand and support the supply. But now the supply is going inward, and cost push inflation is happening. So, the Government has to be very careful right now because stagflation is a tricky situation. The attempt would be to move the supply curve towards right, by trying to create efficiencies or impose some limits on how much oil prices or raw material costs are going up. Because of the Russia Ukraine issue, US is talking about releasing oil reserves, trying to have more supply in the economy, so oil prices don’t go up. And they’re trying to push supply curve towards the right-hand side to control inflation. And similarly, different economies are doing different things, trying to push supply on the right-hand side.  

It is important to appreciate and understand the measures which the government will undertake. At a broader level, long term or medium term, the question really is what you should be understanding and doing in your business to take care of stagnancy. We want continued growth and protection of our margins. We need to see what the opportunities are right now in the economy, and in the business world for us to harness.  

 

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