CHAPTER 20

Inflation

Chapter 20 Inflation
ECONOMICS FOR SOUTH AFRICAN STUDENTS 6e
CHAPTER OUTLINE
LEARNING OUTCOMES

20.1 DEFINITION OF INFLATION

20.2 THE MEASUREMENT OF INFLATION

20.3 THE EFFECTS OF INFLATION

20.4 THE CAUSES OF INFLATION

20.5 ANTI-INFLATION POLICY

20.6 UNEMPLOYMENT AND INFLATION: THE PHILLIPS CURVE

IMPORTANT CONCEPTS

Chapter 20 Inflation
ECONOMICS FOR SOUTH AFRICAN STUDENTS 6e
LEARNING OUTCOMES

Once you have studied this chapter, you should be able to

• Define inflation
• Describe how inflation is measured
• Distinguish between different measures of inflation
• Explain why inflation is regarded as a problem
• Distinguish between three approaches to explaining what causes inflation
• Explain demand-pull and cost-push inflation
• Mention policies that can be used to combat inflation

Chapter 20 Inflation
ECONOMICS FOR SOUTH AFRICAN STUDENTS 6e
20.1 Definition of inflation LO: Define inflation

20.1 DEFINITION OF INFLATION

Inflation

It is a continuous and considerable rise in prices in general

• Four important aspects

– neutral definition (does not mention causes)
– continuous rise – process
– considerable increase in prices
– general price level – not individual prices

Chapter 20 Inflation
ECONOMICS FOR SOUTH AFRICAN STUDENTS 6e
 LO: Describe how inflation is measured
20.2 The measurement of inflation
LO: Distinguish between different measures of inflation

20.2 THE MEASUREMENT OF INFLATION

The consumer price index
• Based on CPI, but CPI is index of price of basket, not a rate
• Calculate the rate of change in CPI, i.e. calculate the percentage change in
the CPI from one period to the next

Two methods of calculating

• Month on same month of previous year
• Year on year (annual average on annual average)

Chapter 20 Inflation
ECONOMICS FOR SOUTH AFRICAN STUDENTS 6e
 LO: describe how inflation is measured
20.2 The measurement of inflation (cont.)
LO: distinguish between different measures of inflation

Table 20-1 The consumer price index and Click on the numbers to see calculations.
Click again to hide.
inflation in South Africa 2017–2018 (p. 427)

1 Month on same month of

previous year
Year
2Compare theon year
index (annual
value for December
average
2017 and 2018 on annual average)

109.4 – 104.7 X 100 = 4.5%

104.7the index value using the
Compare
average per year

107.8 – 103.0 X 100 = 4.7%

103.0

Chapter 20 Inflation
ECONOMICS FOR SOUTH AFRICAN STUDENTS 6e
 LO: describe how inflation is measured
20.2 The measurement of inflation (cont.)
LO: distinguish between different measures of inflation

The producer price index

• Also important price index but differs from CPI
• PPI measures prices at the level of the first significant commercial
transaction

Manufactured goods are priced when they leave the

factory, not when they are sold to consumers.

Chapter 20 Inflation
ECONOMICS FOR SOUTH AFRICAN STUDENTS 6e
 LO: describe how inflation is measured
20.2 The measurement of inflation (cont.)
LO: distinguish between different measures of inflation

Differences between CPI and PPI

Table 20-2 Main differences between the CPI and PPI (p. 427)

Chapter 20 Inflation
ECONOMICS FOR SOUTH AFRICAN STUDENTS 6e
 LO: describe how inflation is measured
20.2 The measurement of inflation (cont.)
LO: distinguish between different measures of inflation

Two methods of calculating

• Month on same month of
previous year
• Year on year (annual average on
annual average) see Table 20-3

Table 20-3 Annual rates of increase in CPI

and PPI, 2018 (p. 428)

Chapter 20 Inflation
ECONOMICS FOR SOUTH AFRICAN STUDENTS 6e
 LO: describe how inflation is measured
20.2 The measurement of inflation (cont.)
LO: distinguish between different measures of inflation

The implicit GDP deflator

• CPI and PPI use basket of goods but economists might want to look at the
prices of all goods and services
• GDP = the prices of all goods and services
• The difference between nominal GDP and real GDP = implicit GDP
deflator

Chapter 20 Inflation
ECONOMICS FOR SOUTH AFRICAN STUDENTS 6e
20.3 The effects of inflation LO: explain why inflation is regarded as a problem

Click on the arrows to reveal more information.

20.3 THE EFFECTS OF INFLATION

Click again to hide.

Is inflation a problem? Why?

Social and political

Distribution effectseffects
Distribution
Economic
• People effectsor groups lose while others benefit
effects
unhappy
some individuals
• Social
impact
who loses on and
and employment
political
whounrest
wins? andmaygrowth
ensue
• inflationeffects
Economic tends to stimulate speculative activity
• resources
debtorsSeetendused
Box toto
20-1gaintrydestructive
The attothe
liveexpense
with
poweror
of gain
of from
creditors
inflation inflation
(p. 430)
• productive
See Boxactivity
̶ Affected by real
20-2 neglected
Fallinginterest rate
prices: a consumer’s heaven? (p. 431)
Social
• saving
and political
discouraged
effects
young tend to gain at the expense of elderly
• exports
government
Deflation may tends
suffer to gain at expense of private sector
• imports maycreep,
̶ – bracket
continuousbe fall
stimulated
fiscal dividend
in prices in general
• poor households
– falling prices more
even moreaffected by inflation
damaging than rising prices

Chapter 20 Inflation
ECONOMICS FOR SOUTH AFRICAN STUDENTS 6e
20.3 The effects of inflation (cont.) LO: explain why inflation is regarded as a problem

Expected inflation

• inflation may result in the expectation of further inflation

• self-fulfilling prophecy
• may give rise to hyperinflation
– very high inflation which tends to escalate out of control

See Box 20-3 Hyperinflation (p. 431)

See In the real world 22-5 Venezuela: Where did things go wrong? (p. 477)

Chapter 20 Inflation
ECONOMICS FOR SOUTH AFRICAN STUDENTS 6e
 LO: distinguish between three approaches to explaining what causes inflation
20.3 The causes of inflation LO: explain demand-pull and cost-push inflation

20.4 THE CAUSES OF INFLATION

Three approaches:
• the demand-pull and cost-push approach
• the structuralist approach
• the conflict approach

Chapter 20 Inflation
ECONOMICS FOR SOUTH AFRICAN STUDENTS 6e
 LO: distinguish between three approaches to explaining what causes
20.3 The causes of inflation (cont.)
inflationLO: explain demand-pull and cost-push inflation

Demand-pull and cost-push inflation

Demand-pull inflation
• Prices pulled up by increase in aggregate demand
• Could be the result of any or combination of components
of AD
– C, I, G, X
– usually accompanied by increase in M (money stock)

Chapter 20 Inflation
ECONOMICS FOR SOUTH AFRICAN STUDENTS 6e
 LO: distinguish between three approaches to explaining what causes inflation
20.3 The causes of inflation (cont.)
LO: explain demand-pull and cost-push inflation

Figure 20-1 Demand-pull inflation (p. 433)

Chapter 20 Inflation
ECONOMICS FOR SOUTH AFRICAN STUDENTS 6e
 LO: distinguish between three approaches to explaining what causes inflation
20.3 The causes of inflation (cont.) LO: explain demand-pull and cost-push inflation

Cost-push inflation
• Prices pushed up by increase in costs

• Sources of cost push

– increased wages and salaries
– increased cost of imported capital and intermediate goods
– increased profit margins
– decreased productivity
– natural disasters

Chapter 20 Inflation
ECONOMICS FOR SOUTH AFRICAN STUDENTS 6e
 LO: distinguish between three approaches to explaining what causes inflation
20.3 The causes of inflation (cont.) LO: explain demand-pull and cost-push inflation

Figure 20-2 Cost-push inflation (p. 434)

Chapter 20 Inflation
ECONOMICS FOR SOUTH AFRICAN STUDENTS 6e
 LO: distinguish between three approaches to explaining what causes inflation
20.3 The causes of inflation (cont.)
LO: explain demand-pull and cost-push inflation
Click on the arrows to reveal more information.
Click again to hide.
The structuralist approach to
inflation See Table 20-4 Underlying, initiating and
Inflation process is the result of the propagating factors in the inflation process (p. 435)
interaction between these three
interrelated sets of factors:

Underlying factors

Initiating factors

Propagating factors

See Box 20-4 The inflation process: a case

study (p. 437)
Chapter 20 Inflation
ECONOMICS FOR SOUTH AFRICAN STUDENTS 6e
 LO: distinguish between three approaches to explaining what causes inflation
20.3 The causes of inflation (cont.) LO: explain demand-pull and cost-push inflation

The conflict approach to inflation

• Ex ante = before the fact

• Ex post = after the fact

Figure 20-3 A simplified view of the

conflict approach (p. 439)

Chapter 20 Inflation
ECONOMICS FOR SOUTH AFRICAN STUDENTS 6e
20.5 Anti-inflation policy LO: mention policies that can be used to combat inflation

20.5 ANTI-INFLATION POLICY

• Demand-pull inflation
– use restrictive monetary and fiscal policy
– prices decreases but production and income also decreases
– trade-off situation
• Cost-push inflation
– cannot use restrictive monetary and fiscal policy
– restrictive policy would increase unemployment further
– ideal is to increase supply
– Incomes policy
– difficult in practice
• Structuralist approach
• Conflict approach
Chapter 20 Inflation
ECONOMICS FOR SOUTH AFRICAN STUDENTS 6e
20.5 Anti-inflation policy (cont.) LO: mention policies that can be used to combat inflation

The costs of anti-inflation policy

Negative effects on:
• Economic growth
• Full employment
• Balance of payments stability

Policy makers need to take many factors into consideration.

Chapter 20 Inflation
ECONOMICS FOR SOUTH AFRICAN STUDENTS 6e
20.5 Anti-inflation policy (cont.) LO: mention policies that can be used to combat inflation

Indexation
When inflation cannot be stopped attempt to reduce its negative effects.

Indexation

means that prices, wages, pensions and so on are linked to price indices
(for example, the CPI) to eliminate the distribution effects of inflation.

Chapter 20 Inflation
ECONOMICS FOR SOUTH AFRICAN STUDENTS 6e
20.5 Anti-inflation policy (cont.) LO: mention policies that can be used to combat inflation

Inflation targeting

What is inflation targeting?

• Key features
– announcement of quantitative targets
– price stability primary goal of monetary policy
– broad approach to inflation diagnosis
– transparency
– accountability

Chapter 20 Inflation
ECONOMICS FOR SOUTH AFRICAN STUDENTS 6e
20.5 Anti-inflation policy (cont.) LO: mention policies that can be used to combat inflation

The case for inflation targeting

• Advantages (include):
– easy to understand (transparent)
– explicit yardstick (helps accountability)
– provides good guide for decision makers
– anchor for inflation expectations
– limits discretion of policymakers

• Disadvantages (include):
– complicated approach
– incorrect forecasts can impair central bank credibility
– external economic shocks problematic
– many elements of the inflation process beyond central bank control

Chapter 20 Inflation
ECONOMICS FOR SOUTH AFRICAN STUDENTS 6e
20.5 Anti-inflation policy (cont.) LO: mention policies that can be used to combat inflation

Inflation targeting in South Africa

• have a target range not a point target

• revised on a rolling basis
• repo rate = policy instrument

Chapter 20 Inflation
ECONOMICS FOR SOUTH AFRICAN STUDENTS 6e
 LO: Explain what the Phillips curve means and how it is
20.6 Unemployment and inflation The Phillips curve
related to the aggregate supply curve

20.6 UNEMPLOYMENT AND INFLATION:

THE PHILLIPS CURVE
Table 20-5 Aggregate demand, production, prices and unemployment (p. 442)

Chapter 20 Inflation
ECONOMICS FOR SOUTH AFRICAN STUDENTS 6e
 LO: Explain what the Phillips curve means and how it is
20.6 Unemployment and inflation The Phillips curve (cont.)
related to the aggregate supply curve

• Inverse relationship
between inflation and Figure 20-4 The Phillips curve
unemployment (p. 442)

Chapter 20 Inflation
ECONOMICS FOR SOUTH AFRICAN STUDENTS 6e
 LO: Explain what the Phillips curve means and how it is
20.6 Unemployment and inflation The Phillips curve (cont.)
related to the aggregate supply curve

The trade-off principle

• The Phillips curve was regarded
as an indication that
unemployment and inflation
could be traded off against each
other
• But… the Phillips curve does not
provide for stagflation (high
unemployment and high
inflation)
Figure 20-5 A simultaneous increase in inflation
and unemployment (p. 443)

See Box 20-5 A vertical Phillips curve? (p. 444)

Chapter 20 Inflation
ECONOMICS FOR SOUTH AFRICAN STUDENTS 6e
20.6 Unemployment and inflation The Phillips curve (cont.) LO: Explain what an incomes policy is

Incomes policy

An anti-inflationary policy to establish a balance between the growth in

incomes and the growth in productivity

• Cost-push inflation or stagflation creates a policy dilemma

• In the 1970s several countries experimented with incomes policies to
reduce both inflation and unemployment
• Extremely difficult to implement an incomes policy successfully
• Incomes policy inhibits the market mechanism

See Box 20-6 The problems of applying an incomes policy: an analogy (p. 445)

Chapter 20 Inflation
ECONOMICS FOR SOUTH AFRICAN STUDENTS 6e
20.6 Unemployment and inflation The Phillips curve (cont.)

Other supply-side policy actions

• e.g. US in 1980s: Decrease in tax rates to stimulate saving and investments
+ tightly controlled inflation  higher interest rates, increased budget
deficit, negative influence on investment, no improvement to
unemployment despite controlled inflation

Is there a trade-off between inflation and unemployment?

• Hotly debated
• Is a short-run trade-off stable enough to use as basis for policy making?

Chapter 20 Inflation
ECONOMICS FOR SOUTH AFRICAN STUDENTS 6e
IMPORTANT CONCEPTS
• Inflation • Hyperinflation • Indexation
• Consumer price index • Deflation • Inflation
• Headline inflation • Demand-pull inflation targeting
• Producer price index • Cost-push inflation • Phillips curve
• GDP deflator • Stagflation
• Distribution effects • Incomes policy
• Real interest rate • Underlying factors
• Bracket creep • Initiating factors
• Fiscal dividend • Propagating factors
• Economic effects • Conflict approach
• Social and political • Effective claims
effects
Chapter 20 Inflation
ECONOMICS FOR SOUTH AFRICAN STUDENTS 6e