INFLATION
A. DEFINITION OF INFLATION
Inflation is defined as a continuous/sustained/persistent increase in the general price
level of goods and services.
A once-and-for-all increase in price level is not considered as inflation. Only a
continuous increase in price level is inflation.
An increase in the prices of several commodities is not considered as inflation.
There should be an increase in the general price level at times of inflation.
B. MEASURING THE CHANGES IN GENERAL PRICE LEVEL
Price index – The ratio of current-period value of a basket of goods to its base-
period value (times 100). The price index in the base period is 100.
1. Consumer price index (CPI)
It is a measure of the weighted average price of a basket of consumer goods and
services to reflect changes in the general price level.
It is a measure of cost of living.
CPIs are constructed by selecting a basket of consumer goods which represent the
expenditure pattern of an typical household. Since households of different
expenditure groups have different consumption patterns, four CPI series are
compiled to reflect the effect of price changes on the lower expenditure group, the
middle expenditure group, the higher expenditure group and the household sector
as a whole.
Index Series Average Monthly % of Households
Household Expenditure Covered
CPI (A) $4,000 - $15,499 50
CPI (B) $15500 - $27,499 30
Hang Seng CPI $27,500 - $59,999 10
Composite CPI $4,000 - $59,999 90
N.B. : The remaining 10% of households – at the top and the
bottom of the household expenditure scale – are excluded.
2. Implicit GDP deflator
It is a price index showing the weighted average price of all the currently
produced goods and services included in GDP.
Implicit GDP deflator
= GDP at current market price / GDP at constant market price x 100
Differences between CPI and Implicit GDP deflator
1. CPI reflects the change in the price level of a fixed basket of consumer goods.
The weights are also fixed.
GDP deflator reflects the change in the price level of the currently produced
basket (GDP basket) of goods and services. Since the composition of the
currently produced basket changes every year, the weights are variable.
2. The implicit GDP deflator has a wider coverage of goods and services than CPI
because it covers all the currently produced goods and services in the GDP while
CPI only covers a basket of consumer goods.
Inflation Rate
Inflation rate is the percentage change in the price index with respect to the last
period.
C. INFLATION AND QUANTITY THEORY OF MONEY
Equation of Exchange : MV = PY
M = money stock (nominal money supply)
V = velocity of circulation of money
P = general price level
Y = real output (real GDP)
PY = nominal GDP = the total market value of currently produced final goods and
services.
MV = total expenditure on currently produced final goods and services entering into
the nominal GDP.
MV must be equal to PY.
Velocity of circulation of money : The velocity of circulation of money is the number
of times an average dollar changes hands--- as a medium of exchange to facilitate
market transactions of currently produced goods and services entering into the
nominal GDP of a certain time period. It is equal to the ratio of nominal GDP to
money stock.
From equation of exchange to the quantity theory of money :
V is assumed to be constant because it is determined by some institutional factors
such as the payment technology and the income payment frequency which do not
change frequently.
1. In the short run, both P and Y may change.
Therefore % change in M = % change in P + % change in Y = % change in
nominal GDP.
2. In the long run, real output is assumed to be constant at the potential level (i.e. the
full employment level).
Therefore % change in M = % change in P
With a change in M, P will change in the same direction and proportion.
With an increase in money supply, people will spend the excessive money
balances on goods and services. Since real output is constant at the full
employment level, there will be excess demand for goods and services which bids
up the general price level. – ‘Too much money chasing too few goods”
In the long run, money is neutral. i.e. change in money supply will not affect real
output level. The real output level is affected by its resource endowments,
production technology and the productivity of factors of production.
D. ECONOMIC EFFECTS OF INFLATION
1. Effects on purchasing power of money
When there is inflation, the amount of goods that can be purchased with a given
amount of money will decrease. Thus, inflation reduces the purchasing power of
money.
2. Effects on real income
When inflation rate is greater than the rate of wage increment, people’s real
income falls. Their money income can be exchange for fewer goods and services
than before.
3. Effects on cost of living
With inflation, people’s cost of living will rise.
4. Effect on fixed income earners
For fixed income earners (e.g. pensioners) their income will not be adjusted
according to inflation rate. They will lose in times of inflation as the real value of
their fixed income decreases.
5. Redistribution Effects under anticipated inflation
An unanticipated inflation occurs if the inflation rate is not fully foreseen by
people. It will bring a redistribution of income among the following groups.
Some will gain from inflation while some will lose.
(a) Redistribution effect between borrowers(debtors) and lenders(creditors)
*Relationship between nominal interest rate and real interest rate
Nominal interest rate = Real interest rate + expected change in price level.
If the actual (realized) inflation rate > expected inflation rate, actual real
interest rate < the expected real interest rate.
The real value of interest paid by borrowers will reduce in terms of purchasing
power..
The real value of interest received by lender will reduce in terms of
purchasing power.
Borrowers gain while lenders lose. There is redistribution of income/wealth
from lenders to borrowers.
(b) Redistribution effect between bankers and depositors
Suppose actual inflation rate > expected inflation rate:
Bankers gain because the real value of interest paid to depositors decreases in
terms of purchasing power.
Depositors lose because the real value of interest received is lower.
Income/Wealth is redistributed from the depositors to the bankers.
(c) Redistribution effect between employers and employees
If the money wages are fixed or the money wages increase at a lower rate than
the actual inflation rate :
Employers gain because they pay lower real wages in term of purchasing
power.
Employees lose because they receive lower real wages in terms of purchasing
power.
Income is redistributed from employees to employers.
(d) Redistribution effect between the insurance companies and the policy holders
Actual inflation rate > expected inflation rate :
Insurance companies gain because the value of insurance payments decreases
in terms of purchasing power.
Policy-holders lose because the real value of policy decreases in terms of
purchasing power.
Income is redistributed from the policy-holders to the insurance companies.
***Underanticipated inflation (actual > expected)
Net monetary debtors will gain at the expense of net monetary creditors.
***Overanticipated inflation (expected > actual)
Net monetary creditors will gain at the expense of net monetary debtors.
6. Effect on the choice of wealth
Under inflation, people would prefer to hold physical assets (houses, gold,
jewellery) other than money because the purchasing power of money has
decreased but the prices of physical assets will increase in times of inflation.
7. Effect on tax revenue
When there is a rise in money wage during inflation, a person’s income may
exceed tax allowance, or fall into a high tax bracket (high tax rate). As a result,
government’s tax revenue will increase.
8. Effects on cost of production and exports
As inflation increases, the prices of raw materials and wages, cost of production
will increase. This may increase the export prices and thus reduce volume of
exports.
E. DEFLATION AND DISINFLATION
Deflation – a continuous decrease in general price level of goods and services.
Disinflation – Price level is increasing at a decreasing rate.
Unexpected deflation will also cause redistribution effects among different groups.
