On the way to Bikrompur, one of my friends was asking me “Say, I have 10 units of product and 10 units of money and that’s the total size of the economy, how does inflation occur?”
I became very much confused to answer the question as I never faced such a question and don’t know how to explain inflation so concisely. Though I tried to explain him, could not make him satisfied. Thus indirectly, it promoted me to write this post where I’ll try to explain this issue in so concise way that anyone can get a view about inflation as it is very much common and important in our daily life.
For our convenience, let’s first define inflation and then go for discussion after multiplying both units and money by 1000. That means, assume that the economy has 10,000 units of product and money.
“In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.”1
“The term "inflation" usually refers to a measured rise in a broad price index that represents the overall level of prices in goods and services in the economy.”2
“Inflation means a sustained increase in the aggregate or general price level in an economy.”3
Inflation can be simply defined as the reduction of purchase power of money. It can be expressed as the proportion of supply of products and money to purchase these products. If the portion of money supply is greater than that of previous time, it is considered as inflation.
Let’s now come to the question of my friend. We have 10,000 units of product available in the economy. Simultaneously, have 10,000 of money. That is the average price of each unit is 1 (one) units of money.
Try to think, there must be some units of product that is for consumption throughout time. If other things remain same, the economy must loose some product during a specified time, say its one year, consumed quantity is 500. Then at the end of the year, we have 9500 (10,000-500) units of product. But, what about these money? It remains same. Because, money is not destroyed rather just its ownership is changed within the economy. So, the situation is 10,000 units money is available for 9,500 of units. As a result, average cost is 1.053 which means product prices is increased by 5.3%. This 5.3% should be referred as inflation.
A question may arise that each and every time we are consuming goods and destroying some units of product. So, all the time inflation will occur. No, that’s not all. Each and every economy is producing goods using natural resources, new technologies and so on which is fulfilling these gaps. And, rate of inflation depends of that production. If the production is higher than the consumption, purchase power of that fixed units of money will be increased and vice versa.
The government of a country can also control though it’s monetary policy. Say for example, 1,000 units of product are added to the economy, and government has added same quantity of money supply in the market, the purchase power of money will remain same. Again, when quantity of product is lowered down, government can also make the money supply lower to maintain the purchase power of currency. And all these action government can do through central bank and usually do so.
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