INFLATION

MEANING OF INFLATION
The rate of inflation measures the annual percentage increase in prices. The most usual measure is
that of consumer prices: i.e. retail prices. The UK government publishes a consumer prices index
(CPI) each month, and the rate of inflation is the percentage increase in that index over the previous
12 months. This index is used throughout the EU, where it generally goes under its full title of the
Harmonised index of consumer prices (HICP). The HICP covers virtually 100 per cent of consumer
spending (including cross-border spending) and uses sophisticated weights for each item.

Following figure shows the rates of inflation for the USA, Japan, France, the UK and the OECD. As
you can see, inflation was particularly severe between 1973 and 1983, and relatively low in the mid-
1980s and since the mid- 1990s. Although most countries have followed a similar pattern over time,
the average rates of inflation have differed substantially from one country to another.

Calculations:
The inflation rate is calculated from the following formula:

Where, Pt is the price index for year t and Pt-1 is the price index for the previous year. Thus if the
price index for year 1 is 149.1 and for year 2 is 149.0, then inflation in year 2 is:

The costs of inflation

In reality, people frequently make mistakes when predicting the rate of inflation and are not able to
adapt fully to it. This leads to the following problems, which are likely to be more serious the higher
the rate of inflation becomes and the more the rate fluctuates.
Redistribution. Inflation redistributes income away from those on fixed incomes and those in a weak
bargaining position, to those who can use their economic power to gain large pay, rent or profit
increases. It redistributes wealth to those with assets (e.g. property) that rise in value particularly
rapidly during periods of inflation, and away from those with types of savings that pay rates of
interest below the rate of inflation and hence whose value is eroded by inflation. Pensioners may be
particularly badly hit by rapid inflation.
Uncertainty and lack of investment. Inflation tends to cause uncertainty among the business
community, especially when the rate of inflation fluctuates. (Generally, the higher the rate of
inflation, the more it fluctuates.) If it is difficult for firms to predict their costs and revenues, they
may be discouraged from investing. This will reduce the rate of economic growth. On the other hand,
as will be explained below, policies to reduce the rate of inflation may themselves reduce the rate of
economic growth, especially in the short run. This may then provide the government with a policy
dilemma.
Balance of payments. Inflation is likely to worsen the balance of payments. If a country suffers from
relatively high inflation, its exports will become less competitive in world markets. At the same time,
imports will become relatively cheaper than home-produced goods. Thus exports will fall and
imports will rise. As a result, the balance of payments will deteriorate and/or the exchange rate will
fall. Both of these effects can cause problems.
Resources. Extra resources are likely to be used to cope with the effects of inflation. Accountants
and other financial experts may have to be employed by companies to help them cope with the
uncertainties caused by inflation.
The costs of inflation may be relatively mild if inflation is kept to single figures. They can be very
serious, however, if inflation gets out of hand. If inflation develops into ‘hyperinflation’, with prices
rising perhaps by several hundred per cent or even thousands per cent per year, the whole basis of the
market economy will be undermined.

Causes/Types of inflation
a) Demand-pull inflation
Demand-pull inflation is caused by continuing rises in aggregate demand. In Figure 1.1, the AD
curve shifts to the right (and continues doing so). Firms will respond to a rise in demand partly by
raising prices and partly by increasing output (there is a move up along the AS curve).

General Price
Level AS

P2

P1

AD2

AD1
0
Y1 Y2 National Income

Figure 1.1 Demand-pull inflation

Just how much they raise prices depends on how much their costs rise as a result of
increasing output. In other words, it will depend on the shape of the AS curve.
The aggregate supply curve will tend to become steeper as the economy approaches the peak of the
business cycle. In other words, the closer actual output gets to potential output, and the less slack
there is in the economy, the more will firms respond to a rise in demand by raising their prices.
What we have illustrated so far is a single increase in demand (or a ‘demand shock’). This could be
due, for example, to an increased level of government expenditure. The effect is to give a single rise
in the price level. Although this causes inflation in the short run, once the effect has taken place
inflation will fall back to zero. For inflation to persist there must be continuing rightward shifts in the
AD curve, and thus continuing rises in the price level. If inflation is to rise, these rightward shifts
must get faster.
Demand-pull inflation is typically associated with a booming economy. Many economists therefore
argue that it is the counterpart of demand-deficient unemployment. When the economy is in
recession, demand-deficient unemployment is high, but demand-pull inflation is low. When, on the
other hand, the economy is near the peak of the business cycle, demand-pull inflation is high, but
demand-deficient unemployment is low.
 b) Cost-push inflation
It caused by persistent rises in costs of production (independently of demand).
Cost-push inflation is associated with continuing rises in costs and hence continuing leftward
(upward) shifts in the AS curve. Such shifts occur when costs of production rise independently of
aggregate demand.
If firms face a rise in costs, they will respond partly by raising prices and passing the costs on to the
consumer, and partly by cutting back on production. This is illustrated in Figure 1.2. There is a
leftward shift in the aggregate supply curve: from AS1 to AS2. This causes the price level to rise to P2
and the level of output to fall to Y2.

AS2
General Price
Level AS1

P2
P1

AD

0
Y2 Y1 National Income

Figure 1.2 Cost push inflation

Just how much firms raise prices and cut back on production depends on the shape of the
aggregate demand curve. The less elastic the AD curve, the less will sales fall as a result of any price
rise, and hence the more will firms be able to pass on the rise in their costs to consumers as higher
prices.
Note that the effect on output and employment is the opposite of demand-pull inflation. With
demand-pull inflation, output and hence employment tends to rise. With cost-push inflation,
however, output and employment tends to fall.

If there is a single leftward shift in aggregate supply, there will be a single rise in the price level. For
example, if the government raises the excise duty on oil, there will be a single rise in oil prices and
hence in industry’s fuel costs. This will cause temporary inflation while the price rise is passed on
through the economy. Once this has occurred, prices will stabilize at the new level and the rate of
inflation will fall back to zero again.
Rises in costs may originate from a number of different sources. As a result, we can distinguish
various types of cost-push inflation:
• Wage-push inflation. This is where trade unions push up wages independently of the demand for
labor.
• Profit-push inflation. This is where firms use their monopoly power to make bigger profits by
pushing up prices independently of consumer demand.
• Import-price-push inflation. This is where import prices rise independently of the level of
aggregate demand. An example is when OPEC quadrupled the price of oil in 1973/74.

Additional causes of cost-push inflation include the following:

• Tax-push inflation. This is where increased taxation adds to the cost of living. For example, when
VAT in the UK was raised from 8 per cent to 15 per cent in 1979, prices rose as a result.
• The exhaustion of natural resources. If major natural resources become depleted, the AS curve
will shift to the left. Examples include the gradual running-down of North Sea oil, pollution of the
seas and hence a decline in incomes for nations with large fishing industries, and, perhaps the most
devastating of all, the problem of ‘desertification’ in sub-Saharan Africa. Temporary inflationary
problems could also arise due to short-run supply problems, such as a bad harvest.
c) Creeping Inflation
Circumstance where the inflation of a nation increases gradually, but continually, over time.
This tends to be a typically pattern for many nations. Although the increase is relatively small in the
short-term, as it continues over time the effect will become greater and greater.
d) Galloping inflation
Very rapid inflation which is almost impossible to reduce. In other words, it is an informal
term for double digit inflation or hyperinflation. The term conjures the image of a horse running at
top speed.

Policies to tackle inflation

We will be examining a number of different anti-inflationary policies in later chapters. These
policies can be directed towards the control of either aggregate demand or aggregate supply, and
hence are referred to as demand-side and supply-side policies respectively.

Demand-side policies
Policies designed to affect aggregate demand. There are two types of demand-side policy:
Fiscal policy. Fiscal policy involves altering government expenditure and/or taxation. Aggregate
demand can be reduced by cutting government expenditure (one of the four elements in aggregate
demand) or by raising taxes and hence reducing consumer expenditure. These are both examples of
contractionary (or deflationary) fiscal policy.
(Fiscal policy could also be used to boost aggregate demand if there were a problem of demand-
deficient unemployment. In this case, the government would raise government expenditure and/or
cut taxes. This is called expansionary (or reflationary) fiscal policy.)
Monetary policy. Monetary policy involves altering the supply of money in the economy or
manipulating the rate of interest. The government or central bank (Bangladesh Bank) can reduce
aggregate demand (a contractionary monetary policy) by reducing the money supply, thereby
making less money available for spending, or by putting up interest rates and thus making
borrowing more expensive. If people borrow less, they will spend less.
Supply-side policies
The aim here is to reduce the rate of increase in costs. This will help reduce leftward shifts in the
aggregate supply curve. This can be done either (1) by restraining monopoly influences on prices
and incomes (e.g. by policies to restrict the activities of trade unions, or policies to restrict
mergers and takeovers), or (2) by designing policies to increase productivity (e.g. giving various
tax incentives, encouraging various types of research and development, giving grants to firms to
invest in up-to-date equipment or in the training of labor).