What is Inflation and Why Must the Central Bank Fight Hard to subdue this Monster?

A. What Is Inflation? - Inflation is one of the most frequently used terms in economic discussions, yet the concept is variously misconstrued. There are various schools of thought on inflation, but there is a consensus among economists that inflation is a continuous rise in the prices. Simply put, inflation depicts an economic situation where there is a general rise in the prices of goods and services, continuously. It could be defined as ‘a continuing rise in prices as measured by an index such as the consumer price index (CPI) or by the implicit price deflator for Gross National Product (GNP)’. Inflation is frequently described as a state where “too much money is chasing too few goods”. When there is inflation, the currency loses purchasing power.

The purchasing power of a given amount of naira will be smaller over time when there is inflation in the economy. For instance, assuming that N10.00 can purchase 10 shirts in the current period, if the price of shirts double in the next period, the same N10.00 can only afford 5 shirts. In the definition of inflation, two key words must be borne in mind. First, is aggregate or general, which implies that the rise in prices that constitutes inflation must cover the entire basket of goods in the economy as distinct from an isolated rise in the prices of a single commodity or group of commodities. The implication here is that changes in the individual prices or any combination of the prices cannot be considered as the occurrence of inflation. However, a situation may arise such that a change in an individual price could cause the other prices to rise. An example is petroleum product prices in Nigeria.

This again does not signal inflation unless the price adjustment in the basket is such that the aggregate price level is induced to rise. Second, the rise in the aggregate level of prices must be continuous for inflation to be said to have occurred. The aggregate price level must show a tendency of a sustained and continuous rise over different time periods. This must be separated from a situation of a one-off rise in the price level.

Broadly, inflation can be grouped into four types, according to its magnitude.

1. Creeping Inflation: This occurs when the rise in price is very slow. A sustained annual rise in prices of less than 3 per cent per annum falls under this category. Such an increase in prices is regarded safe and essential for economic growth.

2. Walking Inflation: Walking inflation occurs when prices rise moderately and annual inflation rate is a single digit. This occurs when the rate of rise in prices is in the intermediate range of 3 to less than 10 per cent. Inflation of this rate is a warning signal for the government to control it before it turns into running inflation.

3. Running Inflation: When prices rise rapidly at the rate of 10 to 20 per cent per annum, it is called running inflation. This type of inflation has tremendous adverse effects on the poor and middle class. Its control requires strong monetary and fiscal measures.

4. Hyperinflation: Hyperinflation occurs when prices rise very fast at double or triple digit rates. This could get to a situation where the inflation rate can no longer be measurable and uncontrollable. Prices could rise many times everyday. Such a situation brings a total collapse of the monetary system because of the continuous fall in the purchasing power of money.

Basically, two causes of inflation have been identified, namely, demand-pull and cost-push.

i. Demand-pull inflation is caused by an increase in the conditions of demand. These could either be an increase in the ability to buy goods or an increase in the willingness to do so.

ii. Cost-push inflation arises from anything that causes the conditions of supply to decrease. Some of these factors include a rise in the cost of production, an increase in government taxation and a decrease in quantity of goods produced.

B. Why Must The Central Bank Fight Inflation?

Central banks the worlds over are obsessed about inflation and, therefore, devote a significant amount of resources at their disposal to fight inflation. Hence, the primary objective of monetary policy is to ensure price stability. The focus on price stability derives from the overwhelming empirical evidence that it is only in the midst of price stability that sustainable growth can be achieved. Price stability does not connote constant (or unchanging) price level, but it simply means that the rate of change of the general price level is such that economic agents do not worry about it. Inflationary conditions imply that the general price level keeps increasing over time. To appreciate the need to fight inflation, it is imperative to understand the implications of frequent price increases in the system. Some of these implications include:

•   Discouragement of long term planning;
•   Reduction of savings and capital accumulation;
•   Reduction of investment;
•   Shift in the distribution of real income and consequent misallocation of resources; and
•   Creating uncertainty and distortions in the economy.

To avoid any of the situations above, central banks ensure that the price level remains stable. This is achieved by implementing policies that guard against inflation. Indeed, instability in the general price level undermines the function of money as a store of value and discourages investment and growth.

C. How Does Inflation Affect The Ordinary Man?

Inflation affects different people or economic agents differently. Broadly, there are two economic groups in every society, the fixed income group and the flexible income group. During inflation, those in the first group lose while those in the second group gain. The reason is that the price movement of different goods and services are not uniform. During inflation, most prices rise, but the rate of increase of individual prices differ. Prices of some goods and services rise faster than others while some may even remain unchanged. The poor and the middle classes suffer because their wages and salaries are more or less fixed but the prices of commodities continue to rise. On the other hand, the businessmen, industrialists, traders, real estate holders, speculators and others with variable incomes gain during rising prices. The latter category of persons becomes rich at....

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