Inflation
What is inflation?
A sustained increase in the general price level of goods and services over
a period of time
Inflation reduces the “purchasing power” of money.
A common method to compute inflation is Consumer Price Index (CPI) or
Retail price Index(RPI).
The main difference is that RPI includes the cost of housing, such as
mortagage interest payments and other housing costs while The CPI
includes cost paid for financial services
Constructing the CPI
Constructing the CPI involves three stages:
1. Selecting a base year
2. Finding out how households spend their money
3. Finding out price changes
4. Construting a weighted price index
CPI basket
Constructing a weighted price index
A weighted price index is constructed by multiplying weights by a price index-
for each category.
A weighted price change can be found by multiplying weights with price
changes.
Demand-pull inflation
A demand-pull inflation is caused by aggregate demand
rising faster than the aggregate supply of goods and
services
When the economy has plenty of spare capacity, with
unemployed workers and unused machines, higher AD will
result higher output but no increase in price
When the economy is experiencing a shortage of some
resources, for example, skilled workers, AS will increase
and inflation occurs
In a situation of full employment of resources, it would not
be possible to produce any more output.
Demand-pull inflation
Monetary Inflation
Rises in the price level causes by an excessive growth of
the money supply
Money supply increase faster than output
Printing controlled by central banks, heavily influenced by
national government
Cost-push inflation
A cost-push inflation is caused by rising wages and other
production costs. Firms will raise their prices to cover these
additional costs
There are a number of reasons for an increase in costs.:
wages increasing more than labor productivity
increase in indirect taxes
increase in cost of raw materials
increase in higher cost of capital goods
Cost-push inflation
The Consequences of Inflation
Most of the Consequences of inflation are thought be
harmful but some may actually prove to be beneficial
The effect that inflation has, depends on a number of
factors:
the interest rate, stability of this rate
its rate relative to the inflation rates of other countries
the reaction of the government
The Harmful Effects
Inflation causes a fall in the value of money
• If prices are rising, each unit of money will buy fewer products.
The purchasing power of consumers goes down when there is
inflation. There is a fall in their real income because money is
worth less than before. Therefore, as the cost of living increases,
consumers need more money to buy the same amount of goods
and services.
• In a situation of hyperinflation, the value of money may be falling
rapidly
The Harmful Effects
Inflation redistributes income in an unplanned way
• Some people gain from it, while others lose. Lenders lose
money from inflation because the money lent out to borrowers
worth less than before. However, borrowers tend to gain as the
money they need to repay is worth less than when they initially
borrowed it.
• Index-linking: changing payments in line with changes in the
inflation rate.
The Harmful Effects
Inflation may reduce business confidence level.
Inflation causes a lower expected real rates of return on investment
The existence of inflation imposes extra costs on firms.
• Menu costs: the costs involved in changing price in catalogues and price
lists etc.
• Shoe leather costs: costs involved in moving money around to gain high
interest rate.
• Hence, firms may be discouraged from investing which will be harmful for
the economy
The Harmful Effects
Inflation can harm the country’s balance of payments position
If a country’s inflation rate is above that its rival, its products
will become less price competitive. This may result in fall in
export revenue and a rise in import expenditure
The fall in demand for the country’s products may also result
in a rise in unemployment
The Beneficial Effects of Inflation
If the inflation is of a demand-pull, low and stable nature and is below
that of rival countries, the possible beneficial effects of inflation include:
Encourage firms to expand, it may make entrepreneurs optimistic about
future sales
A reduction in debt, inflation reduces the real burden of any debt that
households and firms have built up
A reduction of unemployment, workers are likely to resist any cut in their
money wages, they may accept their money wages rising less than
inflation
The Causes of Deflation
A sustained fall in the general price level
Deflation may result from the supply-side or demand-side of the
economy
The economy may become more internationally competitive as a result
of advances in technology and increases in labor productivity
In contrast, deflation resulting from a decline in AD is likely to be harmful
Consumers expect prices to be lower in the future
Firms are likely to reduce their output and employment
The Consequences of Deflation
The effect of deflation will be influenced by whether it is 'good
deflation'(caused by an increase in AS) or 'bad deflation'(caused
by a decrease in AD)
Good deflation may reduce a current account deficit or increase
a current account surplus if demand for exports and imports is
elastic
Good deflation can be associated with increases in output and
employment
The Consequences of Bad Deflation
Unemployment
As deflation usually occurs due to a fall in aggregate demand
in the economy, this causes a fall in the demand for labour
Bankruptcies:
During periods of deflation, consumers spend less so firms
tend to have lower sales revenues and profits, This makes it
more difficult for firms to repay their costs and liabilities
The Consequences of Bad Deflation
Government debt:
With more bankruptcies, unemployment and lower levels
of economic activity, tax revenues fall while the amount of
government spending rises. This creates a budget deficit for
the government, meaning that it needs to borrow money
even though the real cost of borrowing rises with deflation
The Consequences of Bad Deflation
Consumer confidence:
Deflation usually causes a fall in consumer confidence
levels, as consumers fear that things will get worse for the
economy. Thus, they may delay their spending, especially
on consumers durable goods such as cars and furniture, as
they expect prices to fall even further in the future
