This paper is a literature review about the factors that are influencing the inflation. Inflation is a very important factor in the economy that has a direct effect on economic growth, it has to be always on a normal basis, and for keeping it on a normal basis economists have to understand the factors that influence the inflation. There are many factors that affect the inflation directly or indirectly, that is what the research is going to tackle. From the factors that the researcher is going to test with the inflation in this paper (Exchange rate, Unemployment rate, and interest rates).
Inflation is defined as the continuous rise of goods and services that means that the same units of money that was buying a certain amount of goods will now buy less goods. Also inflation can be defined as There is another way that inflation can happen by which is "Monetary" that is when the quantity of money increases in the economy.
The main measure of the inflation is the "inflation rate" which is the rate of increase in the consumer price index.
There are three main causes of inflation:
1. "Demand Pull Inflation": it means that the economy demands more goods and services than what is supplied, this causes a rise in the prices.
2. "Cost push inflation": when something like a natural disaster for instance happen that causes a shortage in the supply this cause a rise in the prices.
3. "Money Supply": this happens when the money velocity is high. If the money supply grows faster than its use, then inflation occurs.
People always look to inflation as a negative issue, may be its negatives are more, but actually it has also some positives.
From its negative effects is that:
1. The people will try to get rid of the money before its value depreciate, and buy by it commodities mainly gold, because commodities are inflation hedge.
2. The prices of goods go higher, this explains the previous point about that people buy goods when they expect an increase in inflation, they may be doing this as a way of keeping the value of their money the same or as a way of investment.
3. The people or the institutions that lend money as banks will be harmed by the rise of the inflation because the borrowers will not return the same value of money they borrowed. But in my opinion it is not a big problem because these creditors can raise the interest rate according to the inflation.
4. The people with fixed income will be hurt because the amount of their income will not increase, while its value decreases.
5. If the inflation increased in one country only, this will cause an increase in the price of its imports.
And there are still a large numbers of negatives that are caused by inflation.
When the inflation is moderate it has some positive effects from it
1. is good for the economy, as it would allow labor markets to reach equilibrium faster."
2. "Debt Relief": The debtors will benefit from inflation if they are baying a fixed interest rate because when the value of the money decreases and they pay the same amount of money with the new value they gain profit and they do return only a percentage from the real value of the money to the creditors.
3. "Tobin Effect": When the inflation is moderate the investment in the economy will increase, because the investors will not hold money and they will try to invest to avoid inflation.
Now the researcher will give an introduction for the factors that are going to be tested with the inflation. The first one is
The exchange rate is the rate at which one currency is converted to another country's currency by. This rate is very important in the economy, because according to it each country determines how much to import.
After reading more about the exchange rate the researcher found that there is a linkage between the inflation and the exchange rate. Inflation is defined as That means that as the inflation increase the value of money decrease, which means that the exchange rate of the currency will change.
For example if we assumed that there are only two countries in the economy X and Z, and the prices of goods in each country is the same as the other for instance the price of a football in country X is 20 Euros and in country Y 20 Pounds. If after a period of time inflation of 50% occurred in country X then the price of football will be 30 Euros, and country Y still have no inflation so the price of football is still 20 Pounds. That means that the 30 Euros is equal to 20 Pounds, then our Euro to Pound exchange rate is 1.5, which means that the cost of one Euro is 1.5 Pounds.
The simplest way to define it is; when someone borrows money from another then he have to pay him the price of using the money this is interest rate.
The relationship between interest rate and inflation is that interest rate compensates the money owner from the loss of money value that is caused by inflation. For example if you have 100 pounds and the inflation rate is 7% then at the next year the 100 pound value will be 93 pounds. In developed countries the central bank set the interest rate equals to the inflation rate so that it protect the money from decreasing, so if people saved the 100 pounds in a bank in a developed country it will remain 100 pounds the next year.
Unemployment is defined as; when someone has the ability to work but cannot find a job. The unemployment is measured by the unemployment rate. There are many types of unemployment like the one that occurs because the type of job offered need a certain skill or education level that the individual who it is offered to do not have, also there is voluntary unemployment which occurs when the individual do not need the income that comes from work may be he has his own wealth so he/she do not work, and there are many other types.
There is an inversely proportional relationship between unemployment and inflation, when unemployment increases the inflation decreases and vice versa.
As the researcher defined the inflation at the beginning as the rise in the prices of goods and services this can have a relation with the unemployment rate because the price of the good or service is determined after summing the costs of producing it and the wage of the workers is a main variable in the cost of production, so when there is a high unemployment rate the unions that are made by workers for asking for their rights will not be able to ask the managers for an increase in their wages, because there are many people unemployed and are ready to do the same job with low wage, so it will be easier and cheaper for the manager to fire the workers who want to increase their wages and get another.
This means that when there is a high unemployment rate the prices of goods and services will not increase, so this explains why the unemployment rate is inversely proportional with the inflation.
Inflation and exchange rate
A paper written by (Amit Kara and Edward Nilson in sept. 2002), this paper was mainly focusing on the connection between the exchange rate and the inflation by several different ways the first is called "monetary approach" it is used in open economies.
Πt = ( 1 - SM) πtD + SM πtM = (1 - SM) (πtw + ∆St) + SM ( πtW + ∆St ) = πtw + ∆St
Πt: CPI inflation
SM: The import share
πtM: Index of imported consumer prices
∆St: annualized quarterly change in the nominal exchange rate.
πtD: 4.∆log pDt
pD: The index of goods prices that are sold and produced domestically.
This derived the researchers to
Another paper made by (Eugen Falnita and Ciprian Sipos at 15 Jan. 2007) it was about factors influencing inflation in Romania, the researchers see that there is a strong connection between the inflation and the exchange rates.
Inflation and Interest rate
When talking about inflation and interest rate together so we have to talk about the "Fisher effect" which is a theory talking about the long-run relationship between the inflation and interest rate.
rr = The real interest rate
rn = The nominal interest rate
πe = Expected rate of inflation
The real interest rate is assumed to be constant, and when the inflation rise the nominal interest rate rise.
A paper made by Andreas Beyer , Alfred A. Haug and William G. Dewald about the Fisher effect. "They retrieved quarterly data, on various days in March 2008, for the (CPI) and short-term interest rates from the International Monetary Fund's IFS online data base for 15 OECD countries."
In this paper the researcher will test three factors (independent variables) and there relation with the inflation (dependent variable). A time series method will be used from 1980 till now. The paper will test each variable with the inflation in a simple linear regression model and then it will use a multiple regression model like this: