CHAPTER ONE: LITERATURE REVIEW
1. Introduction
This chapter attempt to define the key concept and theory related to our research topics
1.1. Definition of inflation
Inflation is simply defined as sustained rise in general price level. Inflation is usually measured over periods that are sufficiently long to eliminate any bias arising from short term phenomena. Inflation is now worldwide, and it is one of the greatest challenges facing most nations. One significant feature of the present inflationary trend is its ability to defy solution in most countries (Johnson, 1972).
Inflation rates reflecting expansionary macroeconomic policies implemented by the government to stimulate economic growth.
1.1.1. Types of Inflation
1.1.2. Creeping Inflation
Creeping or mild inflation is inflation is when prices rise 3% a year or less. According to the U.S. Federal Reserve, when prices rise 2% or less, it’s actually beneficial to economic growth. That’s because this mild inflation sets expectations that prices will continue to rise in the future, by increasing demand, mild inflation drives economic expansion (Oliver, 2010).
1.1.3. Walking Inflation
This type of strong, or pernicious, inflation is between 3-10% a year. It is harmful to the economy because it heats up economic growth too fast. People start to buy more than they need, just to avoid tomorrow’s much higher prices. This drives demand even further, so that suppliers can’t keep up. More important, neither can wages. As a result, common goods and services are priced out of the reach of most people.
1.1.4. Galloping Inflation
When inflation rises to ten percent or greater, it wreaks absolute havoc on the economy. Money loses value so fast that business and employee income can’t keep up with costs and prices, foreign investors avoid the country, depriving it of needed capital, the economy becomes unstable, and government leaders lose credibility. Galloping in flat
1.1.5. Hyperinflation
Hyperinflation is when the prices skyrocket more than 50%- a month. It is fortunately very rare. In fact, most examples of hyperinflation have occurred when the government printed money recklessly to pay for war. Examples of hyperinflation include Germany in the 1920s, Zimbabwe in the 2000s, and during the American Civil War (Oliver, 2011).
1.1.6. Stagflation
Stagflation is just like its name says: when economic growth is stagnant, but there still is price inflation. This isn’t enough demand to stoke economic growth? It happened in 1970s when the U.S. went off the gold standard. Once the dollar’s value was no longer tied to gold, the number of dollars in circulation skyrocketed. This increase in the money supply was one of the causes of inflation. Stagflation didn’t end until then –Federal Reserve Chairman Paul Volcker raised the Fed funds rate to the double—and kept it there long enough to dispel expectations of further inflation. Because it was such an unusual situation, it probably won’t happen again (Robert, 1988)
1.1.7. Core Inflation
The core inflation rate measures rising prices in everything except food and energy. That’s because gas prices tend to escalate every summer, usually driving up the price of food and often anything else that has large transportation costs. The Federation Reserve uses the core inflation rate to guide it in setting monetary policy. The Fed doesn’t want to adjust interest rates every time gas prices go-up—and you wouldn’t want it to ( Mundell, 1963) .
1.1.8. Deflation
Deflation is the opposite of inflation—it’s caused when an asset buddle bursts. That’s what happened in housing in 2006. Deflation in housing prices trapped those who bought their homes in 2005. In fact, the Fed was worried about overall deflation during the recession. That’s because deflation can turn a recession into a depression. During the Great Depression of 1929, prices dropped 10% — a year. Once deflation starts, it is harder to stop than inflation (Robert, 1988).
1.2. Causes of inflation
Inflation means there is a sustained increase in the price level. The main causes of inflation are either excess aggregate demand (economic growth too fast) or cost push factors (supply side factors) (Robert, 1991).
1.2.1. Demand pull inflation
If the economy is at or close to full employment then an AD leads to an increase in the price level .As firms reach full capacity, they respond by putting up prices, leading to inflation. Also, near full employment, workers can get higher wages which increases their spending power.
1.2.2. Cost push inflation
If there is an increase in the costs of firms, then firms will pass this on to consumers. There will be a shift to the left in the AS.
Cost push inflation can be caused by many factors
1.2.2.1. Rising wages
If trades unions can present a common front then they can bargain for higher wages. Rising wages are a key cause of cost push inflation because wages are the most significant cost for many firms. (Higher wages may also contribute to rising demand).
1.2.2.2. Import prices
One third of all goods are imported in UK. If there is a devaluation then import prices will become more expensive leading to an increase in inflation. A devaluation / depreciation means the Pound is worth less, therefore we have to pay more to buy the same imported goods.
1.2.3. Raw Material Prices
The best example is the price of oil, if the oil price increase by 20% then this will have a significant impact on most goods in the economy and this will lead to cost push inflation. E.g. in early 2008. There was a spike in the price of oil to over $ 150 causing a temporary rise in inflation.
1.2.4. Profit Push Inflation
When firms push up prices to get higher rates of inflation. This is more likely to occur during strong economic growth.
1.2.5. Declining Productivity
If firms become less productive and allow costs to rise, this invariably leads to higher prices.
1.2.6. Higher taxes
If the government put up taxes, such as VAT and Excise duty, this will lead to higher prices, and therefore CPI will increase, however, these tax rises are likely to be one-off increases. There is even a measure of inflation (CPI-CT) which ignores the effect of temporary tax rises/ decreases.
1.2.7. Printing more money
If the Central Bank prints more money, you would expect to see a rise in inflation. This is because the money the supply plays an important role in determining price. If there is more money chasing the same amount of goods, then prices will rise. Hyperinflation is usually caused by an extreme increase in the money supply.
However, in exceptional circumstances-such as liquidity trap/ recession. It is possible to increase the money supply without causing inflation. This is because in recession, an increase in the money supply may just keep more bank reserve (Robert, 1991).
1.2.8. Inflation expectations
Once inflation sets in it is difficult to reduce it for example, higher prices will cause workers to demand higher wages causing a wage price spiral. Therefore, expectations of inflation is important. If people expect high inflation, it tends to be self –serving.
The attitude of the monetary authorities is important for example if there was an increase in AD and the monetary authorities accommodated this by increasing the money supply then there would be a rise in the price level.
1.3. Economic growth
Economic growth means a sustained increase in per capita national output or net national product over a long period of time. It implies that that the rate of increase in total output must greater than the rate of time. It may be asked here; is there no growth in a country where nation’s output and population increase at the same rate so that per capita output remains constant? And, is there growth in a country where both output and population decease-the former decreasing at lower rate than the latter-so that per capita output increase? The answer to these questions is certainly in the negative. If output and population grow at the same rate, there would be no increase in per capita income and there would be no improvement in the general standard of living, despite increase in output. Such a growth is considered to be a good as stagnation in the population than decrease in the output amounts to general decay in the economy.
Thus, economic growth implies a considerable and sustain increase in per capita with or without increase in population. Another qualification of economic growth is that the national output should be composed of such goods and service which satisfy the maximum number of people. Besides, for economic growth to be, the increase in output must be sustained over the long period.
Short-run increase followed by a similar decrease in the output does not mean economic growth. Also seasonal, occasional and cyclical increase in output do not satisfy the condition of sustained economic growth (DWIVED, 2005).
1.3.1. Determinant of economic growth
There are four most important determinant of economic growth:
1. Human resources and its quality,
2. Natural resources,
3. Capital formation, and
4. Technological development.
These four factors are considered the “four wheels” of economic growth. The social and political factor. Let us now see how see how those factors contribute to economic growth of country.
Human resources and its quality
Human resources of a country is the most crucial factor in it economic growth. Human resources are comprised of available labor force and their qualities of labor depend on the level of its education, training, skills, and its inventive and innovative abilities. Quantity and
Quality of manpower are both equally important. A large supply of unskilled labor forces a long with its skill in the sources of all goods and services.
An excess of labor force kind works as barrier rather than a force in economic growth. An important aspect of human resources is that excess and scarcity of labor force are both an advantage and a disadvantage in the process of economic growth. The excess of labor force in Indian has proved a burden on the economy and a barrier to rapid economic growth, particularly the uneducated, untrained and unskilled manpower. According to an estimate, there are 30 million unemployed people in Indian, Unemployed people consume without producing it reduces the rate of saving and investment. On the other hand, scarcity of labor in oil rich Middle East countries constrained their real growth severally during the 1970s and 1980s. They had to depend on imported labor for all kinds of their manpower needs and they still do to a great extent (DWIVED 2005-470).
Natural resources
Natural resources of a country include the area of usable land, and resources on natural water (rivers and lakes). Forest, landscape, etc. Underground resources include oil and natural gas and minerals. Favorable climate and environmental conditions add to the natural resources endowments of a country. The countries with rich natural resources endowments have a much larger growth potential an those lacking natural (DWIVED, 2005).
Resources. However, natural resources are passive factors of growth. The exploitation and use of natural resources depends on the quality of manpower, availability of capital and motivated manpower can do miracles in economic growth. These factors which may be co said contributed to rapid growth of United States, France, and Germany, U.K… Canada and Australia. However, there are countries which only one natural resources, e.g., Saudi Arabia, UAE and Kuwait, but they have the highest per capita income in the world. In contrast, there are tiny countries like Hong Kong, Singapore and Taiwan which have a (DWIVED. 2005). Small resources endowment, but they have the high rate of economic growth, Japan is one of the most prominent examples of countries having achieved the highest growth rate during the post war 2 period with a small area of land natural resources. The quality of manpower has played a vital role in the economic growth of these among these among the developing countries, these among the developing countries. These examples apart countries rich in natural resources, and skilled manpower with high level of motivation and driven provided a more foundation for a high growth rate.
Capital formation
Capital is defined as man-mad of production. It includes machinery, plant and building, means of transport and communication, electricity, plant and social overheads like, railways, road, schools colleges, hospitals, etc. building man-made means of production is known as capital formation. Capital enhances the productivity of lobar. In other word, large a large quantity of good and services are produced per unit of time. This means that a high growth rate.
Capital formation require saving men and material resources form their use in consumer goods and transforming them into producer goods. In economic jargon, capital formation means sacrificing current consumption and saving to be invested in capital gods (machinery, plant, building, and equipment etic). In general, the countries with high rate of saving and investment have a high rate of economic growth (DWIVED, 2005).
Technology
Technology used in the fourth vital determinate of economic growth. Technologies refer to scientific method and technique of production. In effect, technology means the amount of labor. Capital-labor ratio is a broad measure of technology. Technological development means improving the technique of production through research and innovation.
Technological development results in large output for a given amount of mean, material and time. Invention of steam engines and railways, telephones and wireless, electricity Airplane and computer are few examples of technological development over the past two countries. Evidence available in economic history show that countries which technological development at a higher pace have made stronger stride in the fold of economic growth economically backward countries which are unable to a chive technological development on their own have to import technology form other countries. Countries using inefficient technology have evidently grown at a slower pace. An important aspect of technological development or technological innovation is the choice of appropriate technology. The choice and use of inappropriate often lead to a higher social cost of production.
A choice of labor saving technology by a labor surplus economy lead to grow with unemployment. Under such condition, not only are the advantages of technological development lost but there are social and political tensions in the country due to growing unemployment and unequal distribution of income (DWIVED, 2005)
Social and political factors
Social and political systems, organizations, institution, social value etic. Also an important role in the development process of an economy, social factors like customs, traditions, beliefs harmony, and attitude towards the materials life and well-being, determine, to a considerable extent, the pace of economic growth. A society of illiterate and rational organization of society. Such a society finds it very difficult to achieve a high growth rate (DWIVED, 2005).
Form of government and its economic role and policies matter to a greater extent in determining the level and rate of economic growth of a country. The role of government has been discussed in detail in one of the subsequent chapter.
Here, it may briefly that government plays a promotional role, provides adequate and efficient industrial infrastructure, build an efficient system of utilities invested in industries in which private investment is inadequate, remove weakness of the market system helps economic growth.
On the other hand, a government that throttles business activities through it economic policy, controls and regulations as did Indian government prior to the 1991reformes through its license, permit, quota raj encourages inefficient and mal allocation resources and restrains economic growth.
Furthermore political stability has always provide conducive to economic growth by encouraging industrial endeavors. An honest, sincere and efficient government builds public confidence optimism and the light kind of attitude towards society and country, and commitment towards the nation and public welfare. In the contracts, if the government is dishonest ministers, bureaucrats and government administrative infrastructure, it promote inefficient even the private business, increases cost of production, encourages mal practices in the private sector. All these hamper growth. More dangerously, it build a corrupt system, a corrupt society and degrades social and human value, in this social environment, individuals care only for their private gains, one can imagine the impact of hawala, fodder, government housing and JMM (bribe) scandals, security scan and shoddy defense deal exposed by tahalek on the society and business in Indian.
1.3.3. Measures of economic growth
Economic growth is a sustained expansion of production possibilities measured as increase in real GDP over given period. Rapid economic growth maintained over a number of years can transform a poor nation into rich one. Also economic growth is an increase in the amount of the goods and services produced by an economy over time. It is conventionally measured as the percent rate of increase in real gross domestic product, or real GDP. Growth is usually calculated in real terms, i.e. inflation-adjusted terms, in order to net out the effect of inflation on the price of the goods and services produced.
In economics, “economic growth” or “economic growth theory” typically refers to growth of potential output, i.e., production at “full employment,” which is caused by growth in aggregate demand or observed output.
For purposes of evaluating how economic growth can fit into economic development, it is often helpful to focus on the growth rate of GDP per capital that is output per person rather than simply on overall output. Mathematically, GDP per capital is expressed as: GDP per capital-GDP/population
General macroeconomic conditions are very important in terms of changes in investment. So; economic growth will depend to some extent upon the stability of the economy like fiscal balance, and reasonably predictable level of inflation. Macroeconomic stability reduces the risks of investments and might therefore be seen as a necessary condition for growth. Fiscal balance ensures that there is less risk of inflation, because there will be less risk of governments printing money. This may also stabilize the exchange rate and allow interest rates to be set at reasonably low level, so further encouraging investment. Stability is also an important factor in the amount of foreign direct investment a country may be able to attract. For developing counties this may be the only realistic source of investment funds (MECHAEL, 2010)
1.3.3.1. Factors Affecting Economic Growth
Industries tries experience cycles of economic growth and contraction based on many factors. These include the overall health of the markets, consumer preferences and even seemingly unrelated world news and events. Although some companies perform better than others in their industry, the global factors that affect the industry as a whole must be contemplated when planning to start or grow a business.
? Interest Rates
Interest rates can impact the growth of an industry in several ways. In large-ticket industries such as vehicle manufacturers or cruise companies, an increase in interest rates can prevent customers form borrowing to finance the purchase of these types of products and services. High interest rates also deter companies form investing in new capital and expansion. On the other hand, falling interest rates can stimulate industries to grow, which can stimulate industries to grow, which can lead to innovation and higher employment levels.
? Currency Strength
The value of the U.S. dollar compared to other foreign currencies such as the Yuan, yen and the pound is important even for companies that do not import or export goods. Consumers have a choice to purchase goods or services originating in the United States or in other countries. If the U.S. dollar strengthens, companies in the industry that purchase inputs form other countries are able to be more competitive in pricing. In industries that are heavily reliant on foreign raw materials and processing, such as the clothing industry, the entire sector can be lifted or depressed with a strengthening or weakening of the dollar.
? Government Intervention
Many industries are regulated by the government in one form or another. Government agencies such as the Environmental protection Agency, the Food & Drug Administration or the U.S. Department of Agriculture maintain standards that all operators in an industry must follow for the safety of consumers, employees, or natural resources. Some industries are more heavily regulated than others and new laws and rules can shake up an entire industry and depress growth. For example, new child toy safety laws implemented under the consumer product Safety improvement Act in 2009 threatened to wipe out many small toy producers as the requirements to test and certify the toys were cost-prohibitive to all but large toy manufacturers. Proposed changes to the Act may help alleviate the burden on small manufacturers and resellers.
? Environmental Impact
Economic growth in an industry can be impacted not only by the environmental effect the products or services have but also by consumers’ perceptions of that impact. For example, the market for fur apparel declined drastically over the course of a few years in the 1990s when consumers perceived that raising and killing small animals for their fur was both inhumane and a poor use of land. Although the industry is once again picking up with international demand, the number of fur farmers in the country has substantially declined. If the public views an industry’s products or services as being harmful or unsafe, most companies within the sector can experience a marked decline in sales quickly.
? Overall Economic Health
The economic state of the country and consumer confidence can also spur growth and development or harm it. In recessionary times, consumers begin limiting their purchases to the essentials, foregoing luxury or big-ticket items. Companies also scale back production, hiring and the development of new products and services to ensure that their finances can weather the storm. In periods of overall economic growth, these companies once again expand.
The opposite is true in industries that dear in basic consumer goods that everyone needs regardless of the economy: food, diapers, and staple goods. Demand picks up for these necessities as consumers stock up on them and substitute basic goods for luxury goods (example: people buy more groceries to eat in rather than go to a restaurant). In inflationary times, the demand for staple goods declines as consumers can afford more luxury substitutes (Delong, 1996-58).
1.4. Relationship between economic growth and inflation
If economic growth is caused by rising Aggregate demand increases faster that productive capacity (LRAS) – then economic growth is likely to cause inflation. The relationship between inflation and growth rate (GDP) plays out like a very delicate dance. For stock market investors, annual growth in the GDP is vital. If overall economic output is declining or merely holding steady, most companies will not be able to increase their profits, which is the primary driver of stock performance. However, too much GDP growth is also dangerous, as it will most likely come with an increase in inflation, which erodes stock market gains by making our money (and future corporate profits) less valuable. Most economists today agree that 2.5-3.5% GDP growth per year is the most that our economy can safely maintain without causing negative side effects (Delong, 1996).
Over time, the growth in GDP causes inflation, and inflation begets hyperinflation. Once this process is place, it can quickly become a self-reinforcing feedback loop. This is because in a world where inflation is increasing, people will spend more money because they know that it will be less valuable in the future. This causes further increases in GDP in the short term, bringing about further price increases. Also, the effects of inflation are not linear; 10% inflation is much more than twice as harmful as 5% inflation. These are lessons that most advanced economies have learned through experience; in the U.S., you only need to go back about 30 year to find a prolonged period of high inflation, which was only remedied by going through a painful period of high unemployment and lost production as potential capacity sat idle ( Delong, 1996-58). In general, the findings reveal that there is a negative relationship between inflation and growth that is statistically significant and of an economically interesting magnification magnitude. These findings were put through numerous robustness check. As an interesting by-product of their studies, the authors developed a sequential decision “tree” technique in order to prove that inflation is not only a statistically significant determinant but also one of the most important determinants of growth.
At very low rates of inflation (around 2-3 percent a year or lower), inflation and growth are positively correlated. Otherwise, inflation and growth are negatively correlated, but the relationship is convex, so that the decline the decline in growth (Bruno, and easterly. 1995).
1.4.1. Growth and low inflation
It is possible that we can have economic growth without causing inflation. If growth is caused by increased productivity and investment, then the productive capacity of the economy can increase at the same rate as Aggregate Demand. This enables economic growth without inflation. For example, between 1993 and 2007, the UK experienced low inflationary growth. This is partly due to economic growth being sustainable i.e. close to the 2.5% average; it was also due to productivity improvements such as privatization and more flexible labor markets.
1.4.2. Why can economic growth lead to inflation?
• If demand rises faster than firms can increase supply, firms respond to the excess demand and supply constrains by putting up prices.
• In a period of rapid growth, firms will employ more workers and unemployment will fall. As unemployment falls, firms may find it harder to fill job vacancies; this shortage of labor will cause wages to rise.
• If wages rise, firm’s costs increase and therefore firms pass these cost increases on to consumers.
• Also, with rising wages, workers have more disposable income to spend – causing a further rise in aggregate demand (AD)
• With higher economic growth, people may start to expect inflation – and this expectation of rising prices can become self-fulfilling.
• Therefore, rapid economic growth tends to cause upward pressure on price and wages – leading to higher inflation rate (Gregorio, 1991).
