CHAPTER 6
INFLATION
1
Objectives
• Define Inflation.
• Describe how inflation is measured.
• Distinguish between different measures of Inflation.
• Explain why inflation is regarded as a problem.
• Distinguish between the approaches to explaining Inflation.
• Explain demand–pull and cost-push inflation.
• Mention policies that can be used to combat inflation.
Inflation
• Inflation is the continuous and considerable rise/increase in general price level.
• Note: Inflation is not just a once off increase in price but a continuous process. It is a
general increase and not an increase of price of a particular good/service.
The measurement of inflation.
• Inflation is measured in 3 different ways:
Consumer price Index (CPI) – the most commonly used indicator (measure) of
inflation. Remember we looked at the CPI in chapter 13.
The unadjusted CPI for all urban areas is referred to as Headline CPI.
Be able to calculate Inflation rate, month on month and annual average on
annual average as we did in chapter 13.
The Producer Price Index (PPI) – PPI measure prices
at the level of first significant commercial transaction
(e.g., Price at the factory, at the farm or a country’s
boarder)
Look at table 20-2 Pg 383 for the differences
between CPI and PPI.
The Implicit GDP deflator – GDP at current Price
(nominal GDP) and GDP at constant price (Real GDP)
is used to measure inflation.
GDP deflator = nominal GDP
Real GDP X 100%
The effects of inflation
We will look at 3 sets of effect of inflation as well as expected inflation: distribution,
economic, social, and political effects of inflation as well as expected inflation.
Distribution effect of inflation – Inflation affects the distribution of income and
wealth among participants of the economy.
• Inflation benefits debtors (borrowers) at the expense of creditors (lenders), if Real
interest rate is lower than inflation. Real interest is interest after adjusting for
inflation.
• Inflation redistributes income and wealth from the elderly to the young, because
young people are usually net borrowers and the old have fixed nominal income.
• Inflation redistributes income from private sector to the government through tax
and government borrowing.
Economic effects of inflation include lower economic growth and higher
unemployment as a result of:
• Investors/ private sector anticipating inflation rather than seek profitable new
production opportunities.
• Inflation Stimulating speculative practices.
• Inflation discouraging saving in its traditional form.
• Balance of payment problems – inflation affects a country’s international
competitiveness due higher domestic prices.
Social and political effects of inflation – Increase in general price leads to increase
in cost of living.
• Social and political unrest.
• Uncertainty and despair among the society
• All these do not provide a conducive environment for economic progress.
Expected inflation – Problem with inflation is the inflation it causes.
What is hyperinflation?
Causes of inflation
The theories/approaches that explains the causes of inflation are:
Demand-pull and Cost-push approach.
Structuralist approach.
The conflict approach.
Demand-pull Inflation: This occurs when aggregate (total) demand (AD) for goods
and services increases while Aggregate (total) Supply (AS) remains unchanged.
This excess demand then pulls up prices.
See fig. 20-1 for illustration Pg. 389. At E3 there is full employment and therefore
no excess resources to increase production. Beyond E3, prices increase while
production and income remain constant at Yf - referred to as stagflation.
Demand-pull inflation is caused by:
Increase in consumption spending by households (C).
Increase in investment spending by firms (I).
Increase in government spending (G).
Increase in export earnings (X).
Demand pull inflation can be combated by:
Applying a restrictive monetary policy – involves increasing interest
rates and reducing money supply.
Applying a restrictive Fiscal policy – involves reducing government
spending and increasing tax.
These 2 policies would reduce aggregate demand (AD) and therefore
price. However, it may also have negative effect on production, income, and
employment.
Cost-push Inflation – is triggered by increase in the costs of
production. This type of inflation is therefore caused by factors
which push up the costs of production.
Sources/causes of cost-push inflation are:
Increase in wages and salaries.
Cost of imported capital and intermediate goods.
Increase in profit margins.
Decreased productivity.
Natural disasters – floods, drought, earthquakes etc.
See fig 20-2 Pg. 390 for the illustration of the cost push
inflation.
Policies to combat cost push inflation: To avoid cost push inflation,
measures should be taken to avoid increases in costs of production. For
example
Increases in wages, salaries and profits have to be kept in control (i.e.,
applying an income policy).
Income policy is a form of government intervention in determining
wages, salaries, and prices.
Increase productivity of the FOP.
Structuralist approach to inflation: Inflation process is the result of the
interaction between 3 interrelated sets of factors:
The underlying factors
The initiating factors
The propagating factors
See table 20-4 Pg. 391 for more information.
The conflict approach of inflation. Inflation is a symptom of
fundamental disharmony in society which results in a continuous
imbalance between the rate of growth in the real national income
and rate of growth of the total effective claims on this income. See
Pg. 394 for details.
Both the structuralist and conflict approach suggest income
policy to combat inflation.
NOTE: The policy that is applied to combat inflation will depend on
the type or the cause of the inflation.
Look at inflation targeting, its advantages and disadvantages.
