The Banking Executive Magazine - July 2022 Issue

Back to Basics ing the pandemic but then fell sharply in late 2021. Inflation in Saudi Arabia has risen a bit since 2021 but it is still just 1.6%. An interim report from the OECD found that April 2022 inflation rates ran ahead of March 2022 figures in 32 of the group of 38 OECD member countries. BACK TO BASICS: WHAT IS INFLATION? Inflation is the decline of purchasing power of a given currency over time. A quantitative estimate of the rate at which the decline in purchasing power occurs can be reflected in the increase of an average price level of a basket of selected goods and serv- ices in an economy over some pe- riod of time. The rise in prices, which is often expressed as a percentage, means that a unit of currency effec- tively buys less than it did in prior pe- riods. Inflation can be contrasted with de- flation, which occurs when the pur- chasing power of money increases and prices decreases. TYPES OF INFLATION There are various types of inflation including demand-pull, cost-push, and built-in inflation. These are overviewed below: Demand-Pull inflation Demand-pull inflation occurs when an increase in the supply of money and credit stimulates overall demand for goods and services in an econ- omy to increase more rapidly than the economy's production capacity. With more money available to indi- viduals, positive consumer sentiment leads to higher spending, and this in- creased demand pulls prices higher. It creates a demand-supply gap with higher demand and less flexible sup- ply, which results in higher prices. Cost-Push inflation Cost-push inflation is a result of the increase in prices working through the production process inputs. When additions to the supply of money and credit are channelled into a com- modity or other asset markets and es- pecially when this is accompanied by a negative economic shock to the supply of key commodities, costs for all kinds of intermediate goods rise. These developments lead to higher costs for the finished product or serv- ice and work their way into rising consumer prices. For instance, when the expansion of the money supply creates a speculative boom in oil prices the cost of energy for all sorts of uses can rise and contribute to ris- ing consumer prices, which is re- flected in various measures of inflation. Built-in Inflation Built-in inflation is related to adap- tive expectations, the idea that peo- ple expect current inflation rates to continue in the future. As the price of goods and services rises, workers and many people expect that prices will continue to rise in the future at a similar rate. As a result workers de- mand more wages to maintain their standard of living. Their increased wages result in a higher cost of goods and services, and this wage-price spi- ral continues as one factor induces the other and vice-versa. CAUSES OF INFLATION An increase in the supply of money is the root of inflation, though this can play out through different mechanisms in the economy. A country's money supply can be in- creased by the monetary authori- ties by: • Printing and giving away more money to citizens. • Legally devaluing (reducing the value of) the legal tender currency. • Purchasing government bonds from banks on the secondary mar- ket. In all of these cases, the money ends up losing its purchasing power. Ac- cording to John Maynard Keynes, in- flation is an imbalance between the aggregate demand and aggregate supply of goods and services. There- fore, if the aggregate demand ex- ceeds the aggregate supply, then the prices keep rising. The various causes of inflation include: • Primary causes: In an economy, when the demand for a commodity exceeds its supply, then the excess demand pushes the price up. • Increase in public spending: In any modern economy, government spending is an important element of the total spending. It is also an important determinant of aggregate demand. • Deficit financing of government spending: There are times when the spending of government in- creases beyond what taxation can finance. Therefore, in order to incur the extra expenditure, the government resorts to deficit fi- nancing. For example, it prints more money and spends it. This, in turn, adds to inflationary pressure. • Increased velocity of circulation: In an economy, the total use of money is the money supply by the government multiplied by the ve- locity of circulation of money. When an economy is going through a booming phase, people tend to spend money at a faster rate increasing the velocity of cir- culation of money. • Population growth: As the popula- tion grows, it increases the total de- mand in the market. Further, excessive demand creates infla- tion. • Hoarding: Hoarders are people or entities who stockpile commodi- ties and do not release them to the market. Therefore, there is an arti- ficially created demand excess in the economy. This also leads to in- flation. • Genuine shortage: It is possible that at certain times, the factors of production are short in supply. This affects production. Therefore, sup- the BANKING EXECUTIVE 40 ISSUE 163 JULY 2022