Economics

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1.0 Introduction

Although inflation is generally thought of as an inordinate increase in the general price level, throughout the history of economics the causes of inflation and the definition of inflation itself remained as an unresolved issue. There is a general agreement that, in the long-run, inflation is a monetary phenomenon. In short-run, however, many other factors could cause inflation that instigates unsettled debate on the causes of inflation. Every school of economists tries to define inflation and explain the causes of inflation in their own way. The heterogeneity of views on inflation does not only exist among various groups of economists but it is strong enough also among economists of the same group.

Bangladesh has been experiencing a rapid growth in the general price level in recent years. The rate of inflation has crept up steadily since July 2009, rising from an average of 2.3 per cent during 2008/09 to a peak of 12 per cent in September 2011. The inflation rate declined to 9.9 percent in April 2012. The rapid rate of inflation has become a major economic and social problem. Unless this is tackled forcefully and with some urgency it could become a substantial political debacle for the Government when it seeks re-election in the next 18 months. It is also important that right policy choices are made in the effort to control inflation based on sound analysis.

Inflation is not only a phenomenon in developing countries but it has also accelerated tremendously in developed economics as well. Some critical scholars argue that such inflation in developed economies generates “imported inflation” in developing countries. There are channels through which imported inflation affects the local economy. In most open economies, foreign inflation is transmitted to the domestic economy through import prices. Furthermore, due to the unequal relationship in the terms of trade and the dependence – dominance role of developed market, the price of exports of developing countries tend to absorb the induced pressure of the foreign inflation.

The Policy Debate: There is much policy debate, often influenced by populist perceptions, about what factors cause inflation. One popular debate concerns the role of nominal exchange rate in managing inflation.  There are quite a few policy makers, researchers and businesses who believe that the depreciation of the exchange rate is the primary culprit underlying rapid inflation in Bangladesh.  This group believes that the government should basically pursue a fixed nominal exchange rate policy.  The underlying logic is the standard cost-push argument for inflation. Exchange rate raises the taka price of imported inputs that pushes up the cost of production and that in turn fuels inflation.

However, the so-called ‘inflationary gap ‘or ‘excess demand’s considered to be the main cause of inflation in the mainstream Keynesian economics. On the other hand, Professor Frederic S.Mishkin writes that as long as inflation is appropriately defined to be a sustained inflation, macroeconomic analysis, whether of the monetarist or Keynesian persuasion, leads to agreement with Milton Friedman’s famous dictum, “Inflation is always and everywhere a monetary phenomenon

The two specific questions for this paper are:
* What are the causes of inflation?
* What is the relationship between inflation and economic growth?

2.0 Literature Review

Inflation is a common experience of developing countries. The causes of persistent inflation are many: excessive money growth, wage, drought or poor harvests and deficit financing. In general, the causes of inflation in developed countries are broadly identified as growth of money supply. According to Friedman’s theory the growth in the quantity of money is the primary determinant of inflation rate. None of these can, however, explain inflation consistently over time or across countries.

2.1 Price Theoretical Explanation

This theory...
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