Inflation

Inflation is the rise in the price level on average. If the price of one good rises and the price of another good falls by the same amount the other goods price rose then there is no inflation, inflation is an ongoing process and not a one time process, prices rise and keep rising through time and inflation is not when a price just rises but then the price rise is over. There are two types of inflation called demand pull and cost push inflation. Demand pull inflation is inflation stimulated by an increase in aggregate demand; aggregate demand can be increased by a rise in government expenditure, increase in exports, and an increase in money supply. Cost push inflation is started by an increase in costs for example a rise in wage rates or the increase in price of raw material inputs. Anticipated inflation is when people correctly predict that there will be inflation in the future and so people build this information into their behaviour by bidding for higher wages. Inflation has costs such as shoe leather costs, menu costs, and tax distortions. Shoe leather costs are the costs of going to the bank more often than usual because people want money to earn interest in times of inflation. Menu costs are the costs that firms face for having to continually change their price levels, the more customers the firm has the more price changes have to be notified to the customers and the more expensive it gets. Tax distortions are when taxes on goods like cigarettes, alcohol, and petrol stay the same even though the price level on average has gone up.
Unanticipated inflation has costs on the labour market. When people anticipate inflation they decide to get higher paying jobs and to re negotiate salaries to get higher salaries. The data must show a relationship between inflation in some period and an increase in the bids for higher wages in some period that is before the period. Redistribution of income is one cost; when unexpected aggregate demand creates inflation the employers gain over the workers. This is because the inflation has not been anticipated at all, wages are low but prices are high so the firms profits are high. On the other hand if aggregate demand is expected to rise but it doesn’t the employees gain over the employers from the redistribution of income. Wages are high but prices remain as they were so firms profits are low.
Anticipated inflation effects the level of employment through the real wage rate. The real wage rate is the wage rate that takes into account inflation. If firms don’t anticipate inflation but inflation occurs the real wage rate falls, firms try to hire more labourers to increase production to maximise profits but new workers aren’t attracted as the real wage rate is too low, the firm pays overtime to existing workers to increase production, at higher levels of production the firm incurs more costs of machine maintenance and repairs. Some workers leave the firm because the real wage rate has fallen and try to find jobs that offer the original wage they received before the inflation set in. the workers looking for new jobs thus incur job search costs as it takes some time to find new jobs.
What if people anticipate inflation but it does not occur? In this case the real wage rate is too high and the firm makes redundancies so the level of unemployment rises. The level of output of the firm and thus its profits fall.
The capital markets are affected by anticipated inflation. There are redistributions of income between lenders and borrowers of money. When unanticipated inflation occurs the interest rate is too low to sufficiently compensate lenders for the falling value of money, so borrowers can get money quite cheaply because interest rates are low hence borrowers gain at the expense of lenders; on the other hand when inflation is anticipated but it does not occur the rate of interest is set too high and lenders gain at the expense of the borrowers. Thus it is prudent to conclude that there are incentives for borrowers and lenders to anticipate inflation correctly.
Whether or not inflation is correctly anticipated has implications for the costs faced by lenders and borrowers. If the inflation turns out to be lower than expected the lenders will want to lend more and the borrowers will want to borrow less, on the other hand if inflation is higher than expected the borrowers wish they had borrowed more and the lenders wish they had borrowed less.
People use all available information to make forecasts of future inflation rates, people are assumed to form RATIONAL EXPECTATIONS that means that the expectations are correct on average, sometimes they are wrong, and the expectations take account of all available relevant information.