There are three major causes of inflation:

– When demand is growing faster than supply which leads to increase in prices (demand- pull inflation).

– When companies operational costs increase due to increases in either the inputs, wages etc, which results in an increase in the price of their products in order to maintain a profit margin (cost-push inflation).

– Changes in exchange rates.

Consequences of inflation are:

– Creditors lose, as their money has less value when loans are repaid.

– Borrowers generally gain from inflation, as they pay back dollars with less purchasing power than when they borrowed it.

– Persons with fixed income such as pensioners, experience a decrease in their purchasing power and hence their standard of living.

– It leads to inaccurate forecasts as persons are not accustomed to thinking with inflation in mind, and they will also make costly errors by confusing real and nominal interest rates.

– Leads to individuals and firms being hesitant in entering into long term contracts, due to the rapidly increasing prices.

– It leads to even more inflation in terms of the costs that must be shouldered by consumers to cover increasing operational costs due to retailers having to re-price items regularly.

– Leads to exports becoming less competitive on the international market, if domestic inflation is higher than that of competing countries.

Government reduces inflation by:

– Implementing appropriate fiscal policies: Governments reduce their spending and increase taxes. This policy works in combating demand- pull inflation.

– Implementing a monetary policy: Central banks would reduce the money supply available for spending or increase interest rates. This policy works in combating demand- pull inflation.

– By designing policies which will spur productivity/reduce operational costs, such as giving grants to firms and giving tax breaks and other incentives.

– Direct Intervention: these are measures taken to restrict wage increases and price(s) of commodities. The two types of direct intervention are legislative (government freezes wages and prices) and voluntary.


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