INFLATION

INFLATION
 Inflation is defined as a persistent increase rise in the general price level.
 Generally inflation is measured in terms of price indices such as the consumer price index (CPI) or the
producer price index (PPI)
Consumer Price Index
 Measures changes in the price level of a market basket of consumer goods and services.
 Calculation of the CPI: CPI 2
CPI 1
 CP1 is usually index of 100.
 Where: 1 is usually the comparison year.
Types of Inflation
Creeping Inflation
 When prices are gently rising, it is also known as mild or low inflation i.e. when prices rise by not more
than 3% per annum.
Hyper Inflation
 Refers to a situation where prices rise at an alarming rate.
 The prices rise so fast that it becomes very difficult to measure its magnitude.
 In quantitative terms prices rise above 1000% per annum.
 During the worst case of hyperinflation the value of national currency is reduced to almost zero.
 Paper money becomes worthless people resort to trading in either gold or silver or resort to barter trade.
Stagflation
 Is a combination of inflation, small economic growth and high unemployment?

CAUSES OF INFLATION
Demand Pull Inflation
 This occurs when there is excess aggregate demand in an economy, businesses respond to high demand by
raising their prices to improve profit margins.
 Demand pull inflation is associated with a boom phase in the business cycle.
 The most important factor that raises the price level is an increase in the quantity of money that is not
accompanied by a proportionate increase in output (too much money chasing very few goods).
 An increase in the quantity of money in the hands of people increases aggregate demand for goods and
services.
 If aggregate supply does not follow suit, prices will increase, in other words people are willing to buy
goods and have more money to buy to buy goods but they are not enough things to buy.
 According to the demand and supply model, this will cause an increase in the price of goods.
 This is due to the scarcity of goods and services relative to the increase in the amount of money in the
hands of customers.
 A weak exchange rate will lead to an increase in AD because exports are cheaper and the demand for
exports increases. If the economy is close to full employment the higher AD will cause inflation

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 A decrease in taxes will cause an increase in aggregate demand as consumers have more disposable
income.
 An increase in money supply. If money supply rises faster than an increase in output inflation will occur

 If an economy is at or close at full employment, an increase in aggregate demand leads to an increase in

the price level as firms reaches full capacity.

 Also near full employment workers can get high wages which increase their spending power.
 Aggregate demand can increase due to an increase in any of its component that is C + G + I + (X-M)

COST PUSH INFLATION

 Cost push inflation occurs as a result of an increase in production costs.
 It occurs when costs rather than demand factors push up prices
 Cost push theories assume a degree of monopoly power in one or more of the major markets of the macro
economy
 Trade unions cause wage push inflation through their bargaining power especially if the wages are
unjustified (real wages rise faster than productivity)
 Wage increases themselves do not cause inflation. It is wage increases that are not related productivity
growth which are inflationary(i.e. % wage increases are greater than % increases in productivity)
 Unjustified price increases by firm when there is no increase in output or costs can fuel cost push inflation.

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 The increase in price reduces disposable income, workers ask for higher wages and in order to cater for
the increase in wages firms will increase prices again and workers demand more wages, the process
repeats itself. This is known as the wage price spiral
 Devaluation of the local currency may lead to inflation especially when firms depend on offshore funding.
 A persistent increase in the cost of capital might also lead to cost push inflation

 Faced with rising costs the firm will pass the burden to consumers if its product is inelastic. The other
option would be to reduce production
 In the diagram above an increase in production costs will cause the firm to reduce output, the AS curve
moves from SRAS 1 to SRAS 2
 Output is cut down from Y1 to Y2 and prices increases from p1 to p2

Imported inflation
 Where there is an increase in import costs, domestic producers are forced to increase prices of
commodities produced from these imported goods e.g. car parks.
Other causes
 A weaker exchange rate which increases the price imports and reduces the price of exports.
 An increase in direct taxation production costs will increase.
 Faster economic growth in other countries.

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 Increases in the price of raw materials.
 Profit push inflation.
 Decline in productivity.

EFFECTS OF INFLATION
Negative Effects
 Inflation leads to high nominal borrowing rates as lenders aim/strive to attain positive real interest rates.
This leads to a strain in production as producers find it costly to expand their production.
 The unpredictable behavior of inflation rates also causes uncertainty, high uncertainty increases risk
thereby discouraging investment.
 Investors will prefer investing in short term financial assets.
 Inflation may lead to balance of payment deficit, this comes from increased imports and reduced exports
in an economy with fixed exchange rates. If the price of goods in Zimbabwe increases faster than those of
foreign countries, foreign goods become more attractive to Zimbabwean citizens leading to a BOP deficit.
 Inflation redistributes income from creditors to debtors, that is, from those who loan (lenders) money
borrowers.
 It impacts negatively on fixed income earners e.g. pensioners, scholarship holders.
 People will reduce savings in commercial banks because they prefer not to hold money whose purchasing
power is also declining e.g. a person deposits money with 28% interest on deposit and the inflation rates
were 27%, the true earning is 1%.
 Inflation may lead to high levels of poverty e.g. in Zimbabwe were progressive tax is used. Nominal
income earners are pushed into a higher tax bracket and this reduces their real disposable incomes causing
a fall in living standards, this phenomenon is called fiscal drag.
 Inflation leads to numerous socio – economic upheavals such as industrial action, corruption and increases
in crime rates which could lead to political instability.
 It has been argued that inflation discourages financial intermediation by encouraging the purchase of
unproductive assets as inflation rises.
 Inflation is a possible cause of high unemployment in the medium term if one country has a much higher
rate of inflation than another leading to a loss in international competitiveness and worsening trade
performance.
 Discourages investment and long term economic growth. People spend less and the decrease in
consumption directly or inversely affects the economy because it is bad for businesses.
 Budgeting becomes a problem as firms are not sure of what will happen to their costs. Most businesses
will cancel or postponed projects until economic conditions improve.
 Planning is difficult. It increases menu costs i.e. extra costs to firms of changing price information
especially those who use catalogues.
 Social unrest – there is an increase in dissatisfaction among workers as they demand more wages to
sustain their present level of expenditure.
 The central bank increase interest rates.

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 Shoe leather cost – cost of time and effort, that is opportunity cost of time and energy that people spend
trying to counter act the effects of inflation such as holding less cash and and making frequent trips to
banks.

Benefits of Inflation / Positive Effects

 A low and stable rate of inflation between 1% and 3% allows businesses to reduce their costs from
increased prices whilst at the same time workers can expect to see an increase in pay. This increases
investment and productivity.
 Tax Revenue - The government gains from inflation through the fiscal drag effect e.g. taxes that are ad
valorem in nature e.g. V.A.T so as price increases the amount of tax revenue to the government also
increases.
 Cutting The Real Value Of Debt - Low and stable inflation reduces the real value of outstanding debts
for mortgage holders and even the government.
 Avoiding Deflation - One of the key benefits of inflation is that the economy is that is avoids the dangers
associated with deflation.
 Inflation can boost growth especially because at very low levels of inflation the economy may be stuck in
a recession and targeting a higher rate of inflation may boost economic growth.
 Moderate inflation enables adjustment of wages.
 Moderate inflation enables adjustment of prices.

MONETARIST THEORY/VIEW OF INFLATION

 Monetarists argue that if money supply (MS) rises faster than the rate of growth of national income there
will be inflation. If MS increases in line with in output there will be no inflation. Milton Freidman stated
that “inflation is and everywhere phenomenon”.
The Key Features of Monetarist Theory:
 The main cause of inflation is excess money supply leading to “too much money chasing few goods”.
 Tight control of money and credit is required to control price stability.
 Attempts by government and central bank to use monetary and fiscal policy to fine tune the rate of growth,
the AD are effective. Fiscal policy has a role in stabilizing the economy providing that the government is
successfully able to control its borrowing.
 The key is for monetary policy to be credible i.e. in the hands of an independent central bank so that
people’s expectations of inflation are controlled.

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an increase in money
supply or credit

increased DD for financial

ncreased DD for goods and
i
assets including housing
services and bonds

igher levels of AD (C + I + G + X-M)

h
rise in flationery rising house pricing
AD may rise above the economy's pressure stimulate welth effect
potential output

THE QUANTITY THEORY OF MONEY

 The above equation must hold the value of expenditure of goods and services equal to the value of output.
 They argued that it is increases in money supply which causes inflation.
 Monetarists believe that velocity of circulation is constant because the rate at which money circulates is
determined by institutional factors e.g. how often workers are paid does not change very much.
 Monetarist also believes that output (Q / T / P) is fixed.
 An increase in money supply causes increases in DD for bonds and increase in DD for assets.
 It may vary in the short run but not in the long run because long run supply is inelastic.
 Money supply should be reduced to control inflation because an increase in money supply has an effect of
increasing AD which leads to an increase in prices.

Keynesian View/Theory of Inflation

 According to the Keynesians Inflation occurs when the AD for goods and services exceed AS at full (or
near full employment).
 The Keynesians argue that excess increase in total expenditure e.g. investment and government
expenditure are the sources of excess demand and hence inflation.

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REMEDIES OF INFLATION
Demand Pull Inflation
Monetarist Approach: Solution
 Try to reduce MS growth until it matches the growth of output i.e. till the percentage growth in money
supply is equal to percentage growth in output.
 This is done by the use of restrictive monetary and fiscal policy.
 However: this can lead to an increase in interest rates which means low economic growth.
 It slows down production because companies try to reduce the number of goods they produce and cease
planned expansion.
 It increases unemployment because there is a tradeoff between inflation and unemployment (Philips
curve).
Keynesian Approach: Solution
 Reduce aggregate expenditure, AD = (C+I+G).
 This will involve the reduction of consumption by increasing tax rates so that people will spend less.
 Reduction of investment by increasing co-operate tax so that businesses are discouraged from investing.
 Reducing government expenditure (G) by either of the following ways:
(a) Downsizing of the civil services by eliminating areas of duplication
(b) Reducing government subsidies and the funding of projects.
 However, this bound to face political and public resistance.

Cost Push Inflation: Solution

 Wage Price Guidelines – this is a voluntary measure, employers and producers are asked to keep their
prices and wages within the limits provided.
 Wage Price Controls – they are mandatory and people tend to follow them. If people charge high prices
or pay higher wages than the stipulated increase they will be penalised. However, controls only suppress
inflation; they do not eliminate the problem of inflation.
 Tax Based Income Policy – tax can be used as either a penalty for raising wages or as an incentive for
firms that don’t raise wages.

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 Subsidizing Cost of Production – when the government subsidizes the cost of production there are lower
costs faced by firms and hence they will charge lower prices.
However the problem of subsidizing is that:
 They instill laziness in firms.
 Firms will not use efficient production techniques because they know the government will support them.
 Subsidies are generated from tax therefore, an increase in subsidies means an increase in tax. The result is
that one problem is solved while triggering another.

Structural Inflation: Solution

Measures that improve supply side of the economy:
 Disaster funds
 Tax exemptions on savings account.
 Stock piling products when there is a good harvest to prepare for drought.

HOW IS INFLATION MEASURED

 The measurement of inflation is done using the consumer price index (CPI); retail price index (RPI)
Producer price index (PPI), Cost of living index and the GDP deflator.
 The CPI or RPI measure the level of consumer prices.
 It involves looking at price changes of a basket of goods.
 The goods and service are given different weights according to the % of income the household spends on
each item.
 Weights are determined by the result of a family expenditure survey.
 What constitute a typical basket will change every time as people buying habits change.
 When calculating indices the items are weighed to take account of their relative importance.
 The GDP deflator attempts to show changes in the level of prices of all goods and services.
 A base year established i.e. is the year that will be compared with the current price.
 Base year and current year prices are then compared to measure inflation.
 Price index = present cost of the basket of goods x 100
Cost of goods in the base year
Or current year prices x 100
Base year prices
Another Explanation
 Inflation is referred to as the general increase in prices
 Indexes (CPI) are used to determine the actual worth of the unit of money in a given time.
 The use of index numbers is essential as they are statistical devices which the price level at any given time
is compared to the price level at a standard time called the base.
Construction of an Index
1. Select a base year (without an economic problem like excess inflation).
2. Select the basket of goods (this must be bought by the majority of the population).

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3. Weights are assigned to the goods depending on how much the consumer spends or purchases on each
good.
An Index Calculated By the Formula
Pxa x 100 x wt + Pya x 100 x wt + Pza x 100 wt
Pxb Pyb Pzb

ITEM BASE YR PRICE CURRENT YR PRICE WEIGHTS INDEX

A 50 60 1 60/50x100 x1
= 120
B 30 10 5 10/30x100x5
= 166.67
C 10 5 10 5/10 x100x10
= 500
Total 786.57

Index for 1992 = 786.67 = 786.67

1+5+10 16 = 49.2
Differ in price level = 100 – 49.2 = 50.8
NB: the base your index is always taken to be 100.
Conclusion: the general price level has fallen by 50.8

WHAT ARE THE PROBLEMS FACED IN MEASURING INFLATION

The Family Expenditure Survey
 It does not include everyone, pensioners are excluded
 It is updated once a year thus it can be outdated because of changes in tastes
 The basket of goods may not represent the whole population
Changes in the Quality of Goods
 Changes in quality means that prices will change
 This may not reflect inflation but simply that the good is better e.g. computers now have many more
features than 10 years ago
 It therefore becomes difficult to compare the prices of computers today with those sold 10 years ago
Once Off Shocks
 These may give misleading rates of inflation
 A rise in oil prices leads to high levels of inflation
 However this rise could just be temporary
Which Measure Do We Use
 The problem is that RPI includes mortgage interest thus when interest rates are falling the RPI gives
negative inflation rates
 The CPI does not include mortgage interest and as such would give a positive inflation rate

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People Have Different Inflation Rates
 Different sections of society are affected by increases in prices differently e.g. rising electricity prices will
affect those in the urban areas more than those in the rural areas
 There is also a tendency for the cost of living of pensioners to rise more than the recorded inflation rates
Selection of the Basket
 The expenditure pattern of the base year must be the same as that of the current year
 However if there is a significant difference, the results no longer reflect changes in purchasing power
 One can’t choose a base year that is very far from the current year
 Index numbers are of limited use for comparisons over periods of time because population changes over
time and this can lead to changes in the demand for goods
 A large gap between the base and current year may not take into account growing prosperity of a nation
leading to higher incomes and therefore changes in expenditure patterns
 Different income groups do not share the same basket of goods
 Even people in the same income group do not buy the same commodities in the basket or buy similar
proportions
Weights
 The assignment of weights involves a certain amount of guesswork
 Weighting is done according to the relative expenditure on a variety of goods and services
 However it is difficult to obtain this information because the general public does not favour an invasion of
their privacy
 Another problem is what quality or brand to use because different brands have different prices

HOW DOES INFLATION AFFECT THE FUNCTIONS OF MONEY

Money has 4 functions which may be affected by inflation
These functions include:
Acting As a Medium of Exchange
 It means that goods and services can be exchanged for it and everybody accepts it
 Inflation can cause people to lose confidence in money, if there are high rates of inflation people will
refuse to accept money in exchange for goods and services
Acting as a Store of Wealth
 Money is an alternative form in which one can hold wealth. It has the advantage of liquidity over other
forms
 If there is hyperinflation people prefer to hold their wealth in other forms e.g. real estate
 This is because a high rate of inflation makes money worthless
Money acts as a standard of deferred payments
 If it has stable purchasing power people are prepared to offer goods and services and get paid in the future
 If inflation is high money fails to perform this function.
 This means that businesses do not offer credit because inflation transfers wealth from lenders to borrowers

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Acting as a Unit of Account
 Money gives the value of goods and services more accurately because it has many denominations
 This allows us to take stock of wealth
 High levels of inflation distort the use of money as a unit of account because it becomes difficult to price
goods and services

QUESTIONS
1. Why is inflation viewed as a public enemy (10)
2. Discuss how authorities can reduce inflation in your country (15)
3. Assess the effectiveness of policies used to cure inflation (10)
4. Explain the effect inflation has on moneys ability to perform its function. (12)
5. Is it important to control the rate of inflation in your country (12)
6. Discuss the policies the government can adopt to counter a high rate of inflation (13)
7. Explain the effects of high interest rates in the economy (12)
8. Discuss how interest rates can be used to solve inflation in a country. (13)
9. Why is inflation often viewed as an enemy of the state (10)
10. Discuss the effectiveness of policies aimed at reading inflation in your country (10)
11. How does inflation affect the four functions of money (10)
12. Comment on the ways the monetary theories could take to control inflation in your country (15)
13. Discuss the effectiveness of measures meant to combat inflation in your country. (25)
14. Explain the causes of inflation in your country. (10)
15. Should the government be concerned in controlling inflation counting (15)
16. Analyse the effects of inflation on the function of money (12)
17. Assess the effectiveness of price controls and supply side policies counter inflation. (15)
18. Analyse the problems of compiling the consumer price index (10)
19. Assess the effectiveness of fiscal and monetary policies aimed at reducing inflation (15)
20. To what extent is it governments responsibility to intervene to reduce inflation (15)

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