Inflation is a phenomenon that has accompanied us since the beginning of money as a medium of exchange, and just a few people know exactly what inflation is and what it does. Therefore, this term paper will introduce the reader to inflation and whether there arise problems from low inflation.
The first part of this paper is about inflation, its effects, causes, and how it is measured. Then low inflation will be defined and afterwards the negative effect of inflation - deflation - will be explained and with several figures, a time of low inflation in the EU will be analysed and used as an example to show whether low inflation is a problem or not.
Table of content
I. Abbreviations
II. List of figures
1. Introduction
2. Inflation
3. Results of low inflation
3.1. How to define low inflation
3.2. Deflation
3.3. Time of low inflation in the European Union
4. Conclusion
5. References
6. List of annex
I. Abbreviations
CPI Customer price index
EU European Union
ECB European central bank
FED Federal Reserve Board
GDP Gross domestic product
II. List of figures
Figure 1: inflation rate in Venezuela
Figure 2: inflation rates in the EU
Figure 3: real GDP growth in the EU
Figure 4: unemployment rate in the EU
Figure 5: development of real wages in the EU
Figure 6: development of nominal wages in the EU
Figure 7: interest rates from the ECB
1. Introduction
Inflation - a phenomenon that has accompanied us, humans, since the beginning of money as a medium of exchange and just a few people know exactly what inflation is and what it does. Therefore this term paper will introduce the reader to inflation and whether there arise problems from low inflation.
The first part of this paper is about inflation, its effects, causes, and how it is measured. Then low inflation will be defined and afterwards the negative effect of inflation - deflation - will be explained and with several figures, a time of low inflation in the EU will be analysed and used as an example to show whether low inflation is a problem or not.
2. Inflation
In our capitalistic economy governments concentrate on a balance of economic growth and price stability. Therefore in a growing economy that is in the phase of the economic cycle like expansion or peak, prices for goods and services rise because of great economic performance, good expectations for the future, and the ability as well as the willingness of individuals to spend their money. This phenomenon is called inflation.
Basically, inflation is the reason why one could buy ice for 1€ in 2010 and today it costs 1.50€. So one sees inflation robs the consumer of their purchasing power and devalues money (Case, Fair and Oster, 2012, p. 100).
In order to do something about inflation governments and central banks need to know the amount of inflation at a certain time. So to measure inflation there is the consumer price index (Loria, 2018). A basket of goods that the majority of the population needs is bought at time 1 and again the same products are bought at time 2. Now economists can compare the prices and calculate the percentage with which the second basket was either more expensive or cheaper. The EU uses the harmonised index of consumer prices. In this context harmonised means that all EU countries use the same methodology to calculate the index so that they are comparable. This CPI shows the change in prices for the consumer. Additionally, there is also an index that depicts the change in prices from the producer's point of view, the producer price index. This one uses the cost of the producer's product before it gets to the customers. So again there is a basket of goods/services that is bought twice and then compared by experts.
Thirdly the gross domestic product deflator is also used to show the price change and therefore the inflation rate (Tolksdorf, 2021a). First, there is a base year and then one calculates the deflator. The nominal numbers are divided by the real numbers and then multiplied by 100. Now experts can compare the deflators and interpret the results.
In order to know how to use or counteract inflation the central banks and governments need to know how inflation arises and its effects on the economy. In Keynesian theory, inflation is explained through demand and supply (Sawyer and Arestis, 2006). If the demand for products is greater than the supply from the producers the price goes up, the so-called demand-pull inflation. Secondly, the costpush inflation happens when costs for production e.g. labour goes up. These increasing costs are relayed to the customer through increasing prices.
In the quantity theory of money, however, inflation is classified as a monetary phenomenon (Tolksdorf, 2021b). Inflation is explained with the help of the quantity equation, M x V = P x Y. While V, velocity of money and Y, GDP, are treated as constants only M, the quantity of money and P, price level are variables. So if the quantity of money is increased, the price level also increases since market prices are flexible and there is inflation. Since nominal figures include inflation and real numbers do not, one can increase/decrease the nominal numbers but in the end, the real figures will not be affected. Therefore money is just a tool of exchange and inflation is just a monetary phenomenon.
This phenomenon however can have huge effects on the economy and individuals (Bundesbank, 2016). The weakest members of society are overall harmed the most by inflation since they are affected the most by increasing prices and decreasing purchasing power. This harms the social cohesion of the state as well. People who save all their money in the bank also have a problem with inflation because their money loses value that they saved for retirement for example. In contrast to savers, debtors are in favour of inflation. The debt loses value as well so it is easier to pay back loans. However, if the inflation gets too high there is a high danger of hyperinflation meaning that prices rise very high in a very short time like in Germany 1923 or most recently in Venezuela (Bundesbank, 2016). In Figure 1 one can see that the inflation rate from 2017 to 2018 was ca. 65,374%. This high inflation decreases economic growth strongly (Altig, 2003). It is harder for companies to get loans from banks because they want securities that companies do not have, therefore fewer investments are resulting in even slower growth.
3. Results of low inflation
3.1. How to define low inflation
Central banks like the European central bank or the Federal Reserve Bank both want inflation to be around 2% in order to achieve economic growth but also price stability (ECB, 2021; Federal Reserve Board, 2016). Generally one can say that central banks around the world want inflation to be under 5% (Altig, 2003). Because of fear of hyperinflation the governments do not want inflation above this certain percentage. If the rate however decreases under 0% there is deflation which is also a problem. So the central banks have some borders that they want to avoid via monetary policy to achieve their goal but what about inflation rates that are between 0% and 1% are they optimal?
Therefore in the next paragraphs deflation will be explained and with the example of the European Union what effects the years with a low inflation rate of under 1% had on the European economy.
3.2. Deflation
While inflation is the increase of the price level in a certain period of time, deflation is the exact opposite. The general price level decreases and this has severe effects on economies and that is why central banks are afraid of too low inflation because the chances that it can lead to deflation are high (Fleckenstein, Longstaff and Lustig, 2013). In most economic depressions deflation played a major role in them like the great depression in the 1930s in the USA also leading to one in Germany (Fleckenstein, Longstaff and Lustig, 2013).
Since the prices are dropping consumers expect that the goods will be even cheaper in the near future and are therefore saving their money instead of spending it. So companies are making less profit in these times resulting in reduced production, rising unemployment because companies want to save costs so employees are fired and there are much fewer investments (Stüber and Beißinger, 2011). This leads to sinking income for consumers, more poverty, and even less consumption. Now the circle is repeating itself and it gets worse and worse with the time - a vicious circle. Additionally, the government loses a lot of money because the tax income decreases while the social expenses are rising. If you are a debtor in a time of deflation, one's debt is increasing and harder to pay back because of sinking income. So overall this price-deflation harms governments, companies, and individuals alike (Bundesbank, 2016). To fight deflation central banks need to increase the money supply via printing money or they increase the velocity of money transactions via lower interests rates (Bagus, 2015). While some economists today fear that deflation can lead to a liquidity trap in the state. This liquidity trap arises if during a deflation the nominal interests rates are already zero, the central bank can't lower them anymore, and with the purchase of bonds the deflation will just be prolonged instead of stopped. To find a way out of this vicious cycle is very hard and the ineffectiveness of monetary policy is feared by these experts (Bagus, 2015). There are also some economists nowadays who think there is good and bad deflation. Good deflation originates from a positive aggregate supply shock. This shocks results in a price decrease but increases the overall productivity. The bad inflation however comes from a negative demand shock resulting in excess supply and lower prices (Bagus, 2015).
3.3. Time of low inflation in the European Union
Figure 2: inflation rates in the EU
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After the Euro crisis in 2010, the EU inflation rates dropped from 2.7% in the Eurozone in 2011 to 0.2% in 2016. Especially in the years 2014, 2015, and 2016 the inflation rates were all under 0.5% according to figure 2. In order to see which effects this low inflation had on the economy of the EU one can look at key figures like the unemployment rate, the development of GDP, and nominal and real wages since these figures are affected by inflation or deflation as explained in the previous texts.
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Figure 3: real GDP growth in the EU
While the GDP growth in 2012 and 2013 was negative because of the effects of the financial crisis from 2014 and onwards the GDP increases 2014 around 1.4% and 2015 and 2016 around 2% compared to the previous years (figure 3). The same development can be seen in the unemployment rate of the Euro-zone, during the crisis the unemployment rose and after 2013 it declined steadily until 2019 as seen in figure 4. Lastly to be able to make a statement about the wages of the EU citizens one can look at the development on the nominal and real wages. While the nominal wage is the paid work in a monetary unit, the real wage is the actual purchasing power of that wage. Both of these developed from 2014 to 2016 positively compared to the previous year (figure 5; figure 6).
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Figure 4: unemployment rate in the EU
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Figure 5: development of real wages in the EU
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Figure 6: development of nominal wages in the EU
All of these key figures that show effects of inflation or deflation had a positive development in times of low inflation and a strong crisis before that low inflation. Even the increase in real wages and therefore the increased purchasing power suggests that citizens will consume more in the near future which should help the inflation. This result can be seen as the inflation rate from 2016 to 2017 jumped from 0.2% to 1.5% in the Euro-zone (see figure 2). So one can conclude that the only problem of low inflation is the danger of deflation. This danger is increasing since the tool to fight deflation, interest rates, were reduced by the European central bank from the financial crisis and since 2017 they are at 0% according to figure 7. The question remains now what does the ECB in times of deflation to fight it and can they avoid the feared liquidity trap in case of deflation?
Abbildung in dieser Leseprobe nicht enthalten
Figure 7: interest rates from the ECB
4. Conclusion
To conclude this term paper the reader learned about inflation. The different measurements: customer price index, GDP deflator, and producer price index as well as the cause of inflation explained by the Keynesian theory and the quantity theory of money, and lastly the effects and risks of inflation like hyperinflation were mentioned.
After defining low inflation as an inflation rate between 0% and 1%, the possible risk of deflation was thoroughly explained. The negative effects of the vicious cycle on the economy were shown and the means of the central banks to fight deflation but also the danger of a liquidity trap.
As the reader could read in the last text the EU had a time of low inflation but with the key figures like GDP, unemployment rate, and wage development it was shown that this low inflation had no negative impact on the economy except the higher risk of deflation.
5. References
Altig, D.E. (2003) ‘What Is the Right Inflation Rate?'.
Bagus, P. (2015) In defense of deflation. Teilw. zugl.: Madrid, Univ. Rey Juan Carlos, 2007. (Financial and monetary policy studies, 41). Cham: Springer.
Bundesbank, D. (2016) ‘Die Deutsche Bundesbank'.
Case, K.E., Fair, R.C. and Oster, S.M. (2012) Principles of macroeconomics. 10th edn. Boston: Prentice Hall.
ECB (2021) The ECB's monetary policy strategy statement. Available at: https:// www.ecb.europa.eu/home/search/review/html/ecb.strategyreview_monpol_strategy_ statement.en.html (Accessed: 10 July 2021).
Federal Reserve Board (2016) The Federal Reserve System : Purposes and Functions.
Fleckenstein, M., Longstaff, F. and Lustig, H. (2013) Deflation Risk. Cambridge, MA. Loria, L. (2018) Inflation, Deflation, and Unemployment. (Understanding Economics Ser). Chicago, IL: Britannica Educational Publishing. Available at: https:// ebookcentral.proquest.com/lib/gbv/detail.action?docID=5400169.
Sawyer, M.C. and Arestis, P. (2006) A handbook of alternative monetary economics. (Elgar original reference). Cheltenham, U.K: Edward Elgar.
Stüber, H. and Beißinger, T. (2011) ‘Geldpolitik und Beschäftigung: Ist niedrige Inflation Gift für den Arbeitsmarkt?' IAB Kurzbericht (No. 2/2011).
Tolksdorf, M. (2021a) ‘Course Letter nr.2'.
Tolksdorf, M. (2021b) ‘Course Letter nr.5'.
Zentralbank, E. (2011) Die Geldpolitik der EZB. 3rd edn. Frankfurt am Main: Europ.
Zentralbank. Available at: https://www.ecb.europa.eu/pub/pdf/other/ monetarypolicy2011de.pdf?f5249956bbc90b5119e78a0ab2fec769.
6. List of annex
Eurostat. (2021). Europäische Union1 & Euro-Zone: Arbeitslosenquote von 2010 bis 2020. Statista. Statista GmbH. Zugriff: 08. Juli 2021.
https://de.statista.com/statistik/daten/studie/156283/umfrage/entwicklung-der- arbeitslosenquote-in-der-eu-und-der-eurozone/
Eurostat. (2021). Europäische Union1 & Euro-Zone: Inflationsrate von 2010 bis 2020 (gegenüber dem Vorjahr). Statista. Statista GmbH. Zugriff: 08. Juli 2021. https://de.statista.com/statistik/daten/studie/156285/umfrage/entwicklung-der- inflationsrate-in-der-eu-und-der-eurozone/
Eurostat. (2021). Europäische Union1 & Euro-Zone: Wachstum des realen Bruttoinlandsprodukts (BIP) von 2010 bis 2020 (gegenüber dem Vorjahr). Statista. Statista GmbH. Zugriff: 08. Juli 2021.
https://de.statista.com/statistik/daten/studie/156282/umfrage/entwicklung-des- bruttoinlandsprodukts-bip-in-der-eu-und-der-eurozone/
IMF. (2021). Venezuela: Inflationsrate von 1980 bis 2020 und Prognosen bis 2022 (gegenüber dem Vorjahr). Statista. Statista GmbH. Zugriff: 08. Juli 2021. https://de.statista.com/statistik/daten/studie/321194/umfrage/inflationsrate-in-venezuela/
Statistisches Bundesamt, EZB. (2021). Entwicklung der Inflationsrate Deutschlands und der gemittelten Leitzinsen der EZB von 1999 bis 2020. Statista. Statista GmbH. Zugriff: 08. Juli 2021. https://de.statista.com/statistik/daten/studie/5534/umfrage/entwicklung-der- inflationsrate-und-der-leitzinsen-seit-1999/
WSI. (2020). Europäische Union1: Entwicklung der Nominallöhne von 2010 bis 2020 (gegenüber dem Vorjahr). Statista. Statista GmbH. Zugriff: 08. Juli 2021. https://de.statista.com/statistik/daten/studie/687868/umfrage/entwicklung-der- nominalloehne-in-der-eu/
WSI. (2020). Europäische Union1: Entwicklung der Reallöhne von 2010 bis 2020 (gegenüber dem Vorjahr). Statista. Statista GmbH. Zugriff: 08. Juli 2021. https://de.statista.com/statistik/daten/studie/687858/umfrage/entwicklung-der-realloehne- in-der-eu/
Frequently asked questions
What is the main topic of this document?
This document explores inflation, particularly the results of low inflation, using the European Union as a case study.
What is inflation, according to the document?
Inflation is defined as the rise in prices for goods and services in a growing economy. It erodes purchasing power and devalues money.
How is inflation measured?
The document mentions several ways to measure inflation: the Consumer Price Index (CPI), the Producer Price Index, and the Gross Domestic Product (GDP) deflator.
What are the causes of inflation according to the document?
According to Keynesian theory, inflation is caused by demand-pull (demand exceeding supply) and cost-push (rising production costs). The quantity theory of money attributes inflation to an increase in the money supply.
What are the effects of inflation?
Inflation can harm the weakest members of society, decrease savings value, and lead to hyperinflation, which hinders economic growth. Debtors benefit somewhat from low inflation because their debt is devalued.
How does the document define low inflation?
Low inflation is defined as inflation rates between 0% and 1%, a level that carries the risk of deflation.
What is deflation?
Deflation is the decrease in the general price level, which can lead to decreased spending, reduced production, rising unemployment, and a vicious economic cycle.
What are the central banks doing about deflation?
Central banks attempt to fight deflation by increasing the money supply or lowering interest rates. However, economists worry about deflation leading to a liquidity trap, where monetary policy becomes ineffective.
What effects did the low inflation have on the European Union economy according to the text?
The document analyzes the period of low inflation in the EU after the Euro crisis. It states the low inflation had no negative impact on the economy other than a higher risk of deflation. GDP growth increased, unemployment declined, and both nominal and real wages improved during this period.
What is the conclusion of the document?
The document concludes that the key problem with low inflation is the increased risk of deflation. The EU's experience during a period of low inflation showed no other immediate negative effects, although the threat of deflation was a major concern.
What key figures are analyzed in the EU example?
Key figures analyzed include the unemployment rate, real GDP growth, and the development of nominal and real wages.
What abbreviations are defined in the document?
CPI (Customer Price Index), EU (European Union), ECB (European Central Bank), FED (Federal Reserve Board), GDP (Gross Domestic Product).
- Quote paper
- Johannes Stopa (Author), 2021, Insights into the Phenomenon of Inflation. Is too little Inflation a Problem?, Munich, GRIN Verlag, https://www.hausarbeiten.de/document/1130584