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How can we reduce inflation?Well, low inflation is very hard to fight. We have to reduce domestic demand without generating a large recession. That, by definition, is an extremely hard task. However, when a country has low inflation one more point (or one less point) is not a huge deal. The central bank can deal with the labor market pressures slowly.

High inflations are, on the other hand, the easiest ones to reduce. The main reason is the dollarization. As was mentioned before, in Dollars the inflation rate is the US one. So, if the Central Bank introduces a new currency (the Rigobonian) fixed to the Dollar, then the inflation rate in the new currency should be low. However, if the main cause of the monetary expansion was an irresponsible government and the fiscal policy does not change after the introduction of the new currency, agents know that the fixed exchange rate will be abandoned in the future. This means that there is an expected devaluation of the Rigobonian, and therefore, the inflation rate will be larger than in US Dollars. The lack of credibility generates the problem of not being able to reduce inflation. The question is then how we deal with the problem of credibility?

Medium inflation rates are the hardest ones to control. There are two main reasons:

inertia and relative price disequilibrium.

First, the inertia is the result that current inflation rate highly depends on the previous year inflation rate. This is the result of both the behavior of the agents and the institutionalization of the inertia in wage contracts. For example, there is a clause that says that current wage increases will recover the real wage lost in the previous year. This is a backward looking indexation, generating inertia in the contracts. The stabilization program in this case, not only requires the same ingredients of the high inflationary programs but also needs institutions that can break the existing inertia in the contracts. These institutions have to be extremely credible in order to achieve its goal.

Second, when there is medium inflation, prices in domestic currency increase in a non-coordinating way (not all of them increase at the same time). For example, assume that shoes' prices increase in odd months, while socks' prices increase in even months. There is no coordination between the industries. If suddenly prices are stopped at the middle of an odd month, the price of shoes is relatively too high with respect to the price of socks. The reason is that shoes have just adjust their price, and socks is just going to do it (note that this does not happen in hyperinflation, when the prices are set in dollars and therefore the relative price is equal to the international relative price. This is equivalent of having price increases every day). This disequilibrium cannot be maintained. What happens? Well, the relative price has to move, and the usual way is that the good that is relatively too cheap increases its price. In other words, there is some inflation rate that occurs because relative prices have to adjust. This takes a couple of months, after that inflation should be small.

From the MicroEconomics Essentials
The Costs of Inflation

Economists do not pay much heed to the usual complaints about inflation. For most people the impact of rising prices is offset by rising wages. Those living on fixed incomes, such as welfare recipients or old-age pensioners, can (although may not) be protected through appropriate policy action. Arbitrary redistribution of wealth, such as rises in real estate values, comes about mainly if an inflation is unanticipated, in which case economists would condemn it.

From their study of microeconomics economists know that our economic system works well because prices act as signals to induce producers to produce the things we value most at the lowest cost—the right prices ensure that the economy maximizes the total welfare of its participants. This is what is meant when it is said that the price system is a very efficient way of allocating and distributing goods and services. To economists, the main cost of inflation is the resource misallocation it causes—the loss of efficiency that results because inflation distorts price signals. This happens in many different ways, some examples of which follow.

-During periods of inflation people are more interested in investing their savings in assets designed to protect them against inflation, such as real estate, rather than in productive investments that enhance the growth and efficiency of the economy. A classic example is people in Brazil holding wealth in the form of Volkswagens during high-inflation periods.

- During high inflation business finds it worthwhile to collect bills more promptly, using resources for this purpose that could otherwise have been used to produce goods or provide other services.

- Low inflations are steady and predictable; high inflations are volatile and unpredictable. This volatility creates uncertainty in the business community, reducing investment activity. Reduced investment in turn reduces economic growth. Some estimates suggest that reducing inflation from 10 percent to 5 percent will increase productivity by about 0.2 percent per year.

- Individuals reduce money holdings to cut wealth losses caused by rising prices lowering the purchasing power of their cash and checking accounts. Getting along with fewer money holdings is inconvenient, misallocating the individual's personal resources of time, energy, and leisure. The cost of this inconvenience is estimated to be equivalent to about 0.05 percent of GDP per extra percentage point of inflation above normal.

- In the extreme case of hyperinflation, inflation of over 100 percent per year, the currency system breaks down, and the economy reverts to the far less efficient barter system. During the spectacular German hyperinflation of 1923 prices at times rose by over 200 percent per week, severely affecting economic activity—people would work only if paid immediately, and spent every spare moment buying things to get rid of cash.

Offsetting these arguments, however, is the fact that many prices are inflexible or "sticky" in the downward direction. Many prices that should fall tend not to do so, instead just remaining constant. This implies that for the price system to operate efficiently, relative prices must change through selected price increases, rather than by having some prices rise and others fall. In reality the efficiencies of the price system can be gained only by allowing some inflation.

Most laypersons are amazed to discover that economists' measure of the harm done by inflation reflects phenomena of such seemingly little severity. It seems there are few substantive costs to modest inflation, and some benefits. Why, then, are we so paranoid about inflation?

For reasons explained at length later in this book, inflation is very quick to rise but very slow to fall. Although a low, steady rate of inflation does not carry significant cost, to bring inflation down to this level a high cost must be paid in the form of a prolonged period of high unemployment. We fear inflation because if it rises above the modest level we are willing to live with, we will have to pay a high unemployment cost to bring it back down.

Inflation is subject to recurring pattern over the course of year and so the CPI. Consumer behavior exhibit seasonal features; in many industrialized countries consumer spending goes up to Christmas, which often followed by price discounting in January; then demand for energy and warm cloths is higher in the cold winter months than in the summer and so on. To the extent that such behavior causes prices to fluctuate this should in turn be reflected by seasonal movements in the consumer price indices. Government behavior can also influence these cycles

Existence of Seasonality complicates the analysis of inflation-linked bond prices. There are significant advantage in a well-established index being employed, but such indices often exhibits seasonal pattern. Potential solution for this is to use a seasonally adjusted price index, but in general such series is less understood. Choice of a seasonal price index leads to two issues; expected nominal size of future cash flows will be impacted by their timing with respect to the seasonal pattern, and yields quoted using standard market convention will also be impacted.

CAUSES OF INFLATION

Inflation may be caused by an increase in the quantity of money in circulation. This has been seen most graphically when governments have financed spending in a crisis by printing money excessively, often leading to hyperinflation where prices rise at extremely high rates. Another cause can be a rapid decline in the demand for money as happened in Europe during the black plague.

The money supply is also thought to play a role in determining levels of more moderate levels of inflation, although there are differences of opinion on how important it is. For example, Monetarist economists believe that the link is very strong; Keynesian economics by contrast typically emphasize the role of aggregate demand in the economy rather than the money supply in determining inflation.

What is Inflation – Inflation is a situation in economy where, there is more money chasing less of goods and services. In other words it means there is more supply or availability of money in the economy and there are less goods and services to buy with that increased money. Thus goods and services command higher price than actual as more people are willing to pay a higher value to buy the same goods. In this inflationary situation, there is no real growth in the output of the economy per sector. It’s simply more money chasing few goods and services.

THE BASIC TYPES OF INFLATION

Demand-Pull Inflation
Demand-pull inflation places responsibility for inflation squarely on the shoulders of increases in aggregate demand. This type of inflation results when the four macroeconomic sectors (household, business, government, and foreign) collectively try to purchase more output that the economy is capable of producing.

• In terms of the simple production possibilities analysis, demand-pull inflation results when the economy bumps against, and tries to go beyond, the production possibilities frontier. Then end result is inflation.

• In more elaborate aggregate market analysis, demand-pull inflation results when aggregate demand increases beyond aggregate supply creating economy-wide shortages. As with market shortages, the price (or price level) rises. Then end result is inflation.

Cost-Push Inflation
Cost-push inflation places responsibility for inflation directly on the shoulders of decreases in aggregate supply that result from increase in production cost. This type of inflation occurs when the cost of using any of the four factors of production (labor, capital, land, or entrepreneurship) increases.

• In terms of the production possibilities analysis, this means that the production possibilities frontier is shrinking closer to the origin, causing it to bump down against the aggregate demand. Then end result is inflation.

• In the aggregate market analysis, aggregate supply decreases to less than aggregate demand creating economy-wide shortages. As with any market shortages, the price (price level) rises. Then end result is inflation.

Inflation Rate = (Current year's price index - Last year's price index) / Last year's price index