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By information.com — Published September 26, 2017
Inflation is one of the most important monetary phenomenon in economics. It affects our everyday lives from how much pizza takeaway costs to interest rates on student loans and mortgages.
In simple words, inflation is the rate of sustained increase in general prices of commodities and services accompanied by a decrease in the purchasing power of money. While inflation has a lot of negative effects on the economy, it does have some positive effects when the rate of increase is not extreme. Such changes are essential to keep an economy running. For this reason, governments around the world aim to limit or control inflation, while effectively avoiding deflation, which is a decrease in prices.
While there is no universally accepted cause of inflation, there are a few hypotheses that economists agree on how inflation works. The four most prominent hypotheses are mentioned below.
According to the demand-pull effect, inflation occurs when the income of people increase as a result of a growing or thriving economy and the demand for consumer goods go up. They have more money to spend, and hence, in order to keep up with this increase in demand, companies price their products and services at a higher rate than before. If the demand is increasing at a faster rate than supply, prices of goods and services will increase.
Another theory called the cost-push effect states that inflation occurs in an economy when production costs of companies like prices for raw materials, machineries and wages of employees go up. They increase the prices of their products and services so as to maintain their profitability.
Inflation could also be a result of increase in money supply, especially when this supply is greater than a country’s economic growth. Just like everything else in economics, the value of money decreases when there is an oversupply of it. To balance this out, the prices of goods and services must increase too.
When a particular country’s currency has a low exchange rate, foreign goods which are imported to that country have an increased price. At the same time, goods exported from that country will be available in other countries at a lower price than usual. This shows that exchange rates are one of the most important factors influencing an economy.