June 18, 2024

Understanding Inflation Devices: An Overview

Causes of Rising Prices

There are several factors that contribute to rising prices in an economy over time. One of the primary causes is increasing production costs. As costs for materials, labor, transportation, and other inputs go up for businesses, they tend to pass these higher costs on to consumers in the form of higher prices. For example, if the price of oil rises globally, it leads to increased costs for manufacturing, distribution, and more which then feed into consumer inflation. Another major cause is excess demand. When consumer spending is very strong and the demand for goods and services outstrips the available supply, businesses can charge more without reducing sales too much. They take advantage of customers’ willingness to pay higher prices. Additionally, monetary policies also influence inflation. When a central bank deliberately expands the money supply faster than the rise in goods and services, it results in too much money chasing too few products. This excess liquidity gets passed on as higher consumer prices.

Effects of Persistent Inflation Devices

Sustained high inflation can have negative consequences for both the economy and individuals. For businesses and industries, inflation raises input costs in an unpredictable manner making it difficult to plan budgets and set prices. The rising prices tend to discourage investments as the returns become unpredictable. Inflation Devices also slows down capital formation in an economy. For individuals, inflation eats away their purchasing power over time. Even with pay raises, consumers find that their wages are unable to keep pace with surging consumer prices. This affects their standard of living and spending power. Persistent high inflation also places the greatest burden on those on fixed incomes like pensioners whose incomes don’t adjust for inflation. It disproportionately impacts the poor and low-income households. High and variable inflation also impacts international trade as exchange rate fluctuations become pronounced. This uncertainty discourages cross-border trade and investment flows.

Tools to Control Inflation

Central banks have various tools at their disposal to temper rising inflation pressures in the economy. One of the main mechanisms is adjustment of interest rates, particularly the short-term policy rates that banks charge one another for overnight loans. By raising interest rates, central banks make borrowing more expensive for businesses and consumers, which tends to cool down demand pressures in the economy. As demand moderates, its impact on prices also diminishes over time. Central banks can also adjust banks’ reserve requirements i.e. the minimum reserves they must hold as deposits with the central bank. By raising reserve requirements, the central bank withdraws liquidity from the system. They can also use open market operations to influence money supply. By selling securities to banks, it reduces the money in circulation. In addition, many central banks have inflation-targeting frameworks which guide their monetary policies toward achieving and maintaining price stability over the medium term. Effective communication of these inflation-targeting goals and measures also influence public expectations about future inflation trends. Coordinated fiscal measures to rationalize government spending can further supplement monetary squeeze.

Central Banks’ Balancing Act

While keeping a check on inflation devices is a key mandate, central banks must ensure a balance is maintained as excessively tight monetary policies can also stall economic growth and job creation. Aggressive interest rate hikes or liquidity withdrawal can slow the overall pace of economic activity and output too quickly. This can potentially trigger a recession, especially if carried out when the economy is already weakening. Likewise, curbing inflation has to be done gradually over the medium term rather than brought down sharply in the short run as that may destabilize expectations and exacerbate fluctuations. Central banks look through temporary supply-side spikes in inflation and focus more on demand factors and underlying trends. Their actions are thus data-dependent and aimed at maintaining price stability over the long run in a way that also supports ongoing economic growth and maximum sustainable employment levels. Effective communication of this balanced approach keeps expectations of prices, interest rates and growth anchored even as policies are calibrated to address specific inflationary or recessionary risks in real time.

1. Source: Coherent Market Insights, Public Source, Desk Research
2. We have leveraged AI tools to mine information and compile it