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Inflation Essay

August 20th, 2009

Inflation refers to a sustained, general increase in the price of goods and services. Inflation at a very fast rate is hyper inflation, medium is called strato-inflation and low level, creeping inflation. Demand pull inflation is where aggregate demand exceeds aggregate supply. Firms cannot increase supply without increasing prices since the economy is at full employment. Cost push inflation occurs when the costs of the factors of production increase without a equal or greater increase in output. This causes firms to increase the price of their goods and services.

The Human Resources Minister of Malaysia claims that an increase in salaries may boost inflation, costs of production and decrease their competitiveness. He maintains that a decrease in salaries would solve the problem of escalating inflationary pressure. This is a two pronged statement since decreasing wages may deflate the economy however in the long run it may lead to even worse consequences.

If wage rates are decreased this will allow for a decrease in demand pull and cost push inflation. In relation to demand pull inflation (D.P.I) workers salaries may be reduced. Demand pull inflation is caused by an increase in government injections (spending) into the economy or consumer spending (boosted confidence). This would cause aggregate demand (total expenditure) in the economy to fall. This is characterised by decreased consumption since households now have less purchasing power as the nominal value of their money falls. The fall in disposable income will nullify the escalating demand for goods and services since purchasing power has been diminished.

Decreasing wage rates will have the desired effect of reducing inflationary pressure. Cost push inflation (CPI) occurs when there is a rise in the cost of labour, imported raw materials or input materials. A main cost of a factor of production, labour (salaries), also fall. If wages fall then fixed costs per unit will also fall. This cause the price of the goods or services to also go down (cheaper prices) hence increasing competitiveness domestically and internationally. Because the main cause of CPI is an increase in wages without an equal or exceeding increase in productivity, an increase in wages must be coupled with an increase in productivity in order to cancel the effect of CPI.

Nevertheless, it is not a foolhardy theory that is being suggested by the Malaysian Minister. A major issue is that a decrease in wage rates may well cause an even worse effect in the long run. The economy may become so deflated, and as a result, falls into the recessionary period of the economic cycle. A decrease in wages does decrease aggregate demand but this develops to a decrease in economic activity. If wages are sustained at the low level or drop further in an additional attempt to decrease inflation a continual decline in economic activity occurs. A recession is where an economy experiences a fall in GDP over two or more successive years . This recessionary period is characterised by a decrease in demand for goods and services (aggregate demand) and decrease in consumption. This causes reduced investor and household confidence hence they hold back on spending or any investment. The decrease sales spells a fall in profits for firms if any at all are being made. It could well increase unemployment since the gap between welfare and paid employment contracts. It becomes more attractive to be unemployed! This may push a country into recession if it continues over two or more successive years. The international competitiveness of domestic firms is threatened since access to resources (Factors of Production).

Reasons exists supporting the Minister’s view that a decrease in wages will lead to a reduction in the inflationary pressure. On the other hand, the possible long term effects of a fall in wages may well be detrimental to an economy. A solution provided for CPI is that an advance in technology may allow for an increase in wages without an increase in inflation, overall costs of production and a fall in competitiveness. In terms of DPI, appropriately applying decreased interest rates (monetary policy) or increased taxes (fiscal policy) are just one of several ways of counteracting a rise in inflationary pressure.

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