Inflation
Definition of Inflation
inflation occurs when prices rise throughout the economy. When
overall prices rise, our budget is affected; we can buy less with our
income.
Now imagine that prices double every day. This was the situation in
Zimbabwe in 2008 when the inflation rate reached almost 80 billion
percent per month! The Zimbabwe situation is an example of
hyperinflation, an extremely high rate of inflation that completely
stymies economic activity.
Deflation occurs when overall prices fall; it is negative inflation.
Stagflation occurs when inflation rises during times of recession. (The
term is a combination of the words “stagnation” and “inflation.”)
Measuring inflation accurately requires great care. First, prices don’t
all move together; some prices fall even when most others rise.
Second, some prices affect consumers more than others.
Before we arrive at a useful measure of inflation, we have to agree on
what prices to monitor and how much weight we’ll give to each price.
In the United States, the Bureau of Labor Statistics (BLS) measures
and reports inflation data.
The BLS estimates the overall price level. The price level (P) is a
measure of the average prices of goods and services throughout an
economy.
CPI
the most common price level used to compute inflation is CPI.
The consumer price index (CPI) is a measure of the price level based
on the consumption patterns of a typical consumer.
The CPI reflects the overall rise in prices for consumers on average.
For computing CPI, The BLS estimates prices on everything. In
addition to inputting price information, the BLS surveyors estimate
how each good and service affects a typical consumer’s budget. Once
they do this, they attach a weight to the price of each good in the
consumer’s “basket” so that the things people spend more money on
are counted more heavily.
Measuring Inflation Rates
Once the CPI is computed, economists use it to measure the inflation
rate. The inflation rate (i) is calculated as the percentage change in
the price level (P).
Using the CPI as the price level, the inflation rate from period 1 to
period 2 is:
Assume the CPI rises from 100 to 125 in one year. The inflation for that
year would be 25%,
What problems does inflation bring?
Inflation causes uncertainty about future price levels and
can lead to a redistribution of wealth.
Inflation can also impact how much people save. Inflation erodes
purchasing power over time, so you need to save more to meet
savings targets.
Types of inflation
What Is Demand-Pull Inflation?
Demand-pull inflation is the upward pressure on prices that follows a
shortage in supply. Economists describe it as "too many dollars
chasing too few goods."
Demand-pull inflation is a tenet of Keynesian economics that
describes the effects of an imbalance in aggregate supply and
demand. When the aggregate demand in an economy strongly
outweighs the aggregate supply, prices go up.
This is the most common cause of inflation.
Demand pull inflation
According to Keynesians, aggregate
demand may rise due to a rise in
consumer demand or investment
demand or government expenditure or
net exports or the combination of these
four components of aggregate demand.
Given full employment, such increase in
aggregate demand leads to an upward
pressure in prices. Such a situation is
called DPI.
However, how much price level will rise
following an increase in aggregate
demand depends on the slope of the AS
curve.
The essence of this type of inflation is
that “too much spending chasing too
few goods.”
Demand pull
additional
inflation
demand
Increased Increase in
income price level
Cost-Push Inflation
Cost-push inflation occurs when we experience rising prices due to
higher costs of production and higher costs of raw materials. Cost-
push inflation is determined by supply-side factors, such as higher
wages and higher oil prices.
Cost-push inflation is different to demand-pull inflation which occurs
when aggregate demand grows faster than aggregate supply.
Cost-push inflation can lead to lower economic growth and often
causes a fall in living standards, though it often proves to be
temporary.
Cost-Push Inflation
AS1 is the initial aggregate supply curve.
Below the full employment stage this AS
curve is positive sloping and at full em
ployment stage it becomes perfectly inelastic.
Intersection point (E1) of AD1 and AS1 curves
determine the price level (OP1). Now there is a
leftward shift of aggregate supply curve to
AS2. With no change in aggregate demand,
this causes price level to rise to OP 2 and
output to fall to OY2. With the reduction in
output, employment in the economy declines
or unemployment rises. Further shift in AS
curve to AS3 results in a higher price level
(OP3) and a lower volume of aggregate output
(OY3). Thus, CPI may arise even below the full
employment (YF) stage.
Causes of demand pull inflation
Increase in disposable income
Increase in money supply and bank credit
Increase in export earning
Decrease in import
Increase in population
Increase in speculative hoarding
Increase in govt. expenditure
Increase in foreign demand for domestic good
Money earned by illegal activities
Causes of cost push inflation
Increase the price of raw materials
Increase in wage rate
Higher taxes
Inefficiency, corruption, mismanagement of the economy
Expectations of increasing price level
A fall in the exchange rate
Stagflation
Definition of stagflation
Stagflation is a period of rising inflation but falling output and rising
unemployment.
Stagflaton is often a period of falling real incomes as wages struggle to
keep up with rising prices.
Stagflation is often caused by a rise in the price of commodities, such as oil.
Stagflation occurred in the 1970s following the tripling in the price of oil.
A degree of stagflation occurred in 2008, following the rise in the price of oil
and the start of the global recession.
Stagflation is difficult for policy makers. For example, the Central Bank can
increase interest rates to reduce inflation or cut interest rates to reduce
unemployment. But, they can’t tackle both inflation and unemployment at
the same time.
Diagram stagflation
Causes of stagflation
Oil price rise Stagflation is often caused by a supply-side shock. For example, rising
commodity prices, such as oil prices, will cause a rise in business costs (transport
more expensive) and short-run aggregate supply will shift to the left. This causes a
higher inflation rate and lower GDP.
Powerful trade unions. If trade unions have strong bargaining power – they may be
able to bargain for higher wages, even in periods of lower economic growth. Higher
wages are a significant cause of inflation.
Falling productivity. If an economy experiences falling productivity – workers
becoming more inefficient; costs will rise and output fall.
Rise in structural unemployment. If there is a decline in traditional industries, we
may get more structural unemployment and lower output. Thus we can get higher
unemployment – even if inflation is also increasing.
Supply shocks. If there is disruption to supply chains, there prices will start rising.
The supply shock will also cause decrease in unemployment. For example, in 2021,
UK supply shocks caused moderate degree of stagflation.
Solutions to stagflation
There are no easy solutions to stagflation.
Monetary policy can generally try to reduce inflation (higher interest
rates) or increase economic growth (cut interest rates). Monetary policy
cannot solve both inflation and recession at the same time.
One solution to make the economy less vulnerable to stagflation is to
reduce the economies dependency on oil. Rising oil prices are the major
cause of stagflation.
The only real solution is supply-side policies to increase productivity,
this enables higher growth without inflation. See:
Solutions to Stagflation
In 2010/11, the Central Bank decided to keep interest rates low (at
0.5%) because they felt low growth was a bigger problem than some
temporary cost-push inflation.
2022 – A return to Stagflation
In 2022, we are seeing a rise in global inflation due to supply side
shocks, rising oil prices and supply chains adjusting to Covid shocks.
However, with high inflation, we are also seeing rapid growth (e.g. UK
grew 7.1% in 2021) as it recovered from Covid slump.
However, the economic growth figures are slightly misleading. Most
consumers don’t feel there is ‘growth’ of 7.1% because real wages
have been squeezed by rising prices. Therefore, it may feel like
stagflation to many consumers even it economic stats don’t show
classic stagflation.
Link: [Link]
Methods to control inflation
Monetary
policy
Fiscal policy
Physical or
non monetary
policy
Monetary policy
In a period of rapid economic growth, demand in the economy could be growing faster
than its capacity to meet it. This leads to inflationary pressures as firms respond to
shortages by putting up the price. We can term this demand-pull inflation. Therefore,
reducing the growth of aggregate demand (AD) should reduce inflationary pressures.
The Central bank could increase interest rates. Higher rates make borrowing more
expensive and saving more attractive. This should lead to lower growth in consumer
spending and investment.
A higher interest rate should also lead to a higher exchange rate, which helps to reduce
inflationary pressure by:
1. Making imports cheaper. (lower price of imported goods)
2. Reducing demand for exports.
3. Increasing incentive for exporters to cut costs.
Fiscal policy
Monetary policy alone is incapable of controlling inflation. It should,
therefore, be supplemented by fiscal measures. Fiscal measures are
highly effective for controlling government expenditure, personal
consumption expenditure, and private and public investment.
The principal fiscal measures are the following:
1. Reduction in unnecessary expenditure
2. Increase in taxes
Non monetary or others policy
1. To increase production: One of the foremost measures to control
inflation is to increase the production of essential consumer goods like
food, clothing, kerosene oil, sugar, vegetable oils, etc.
2. Rational Wage Policy: Another important measure is to adopt a
rational wage and income policy. Under hyperinflation, there is a wage-
price spiral. To control this, the government should freeze wages,
incomes, profits, dividends, bonus, etc.
3. Price Control: Price control and rationing is another measure of
direct control to check inflation. Price control means fixing an upper
limit for the prices of essential consumer goods.
4. Rationing : It is meant to stabilize the prices of necessaries and assure
distributive justice. But it is very inconvenient for consumers because it
leads to queues, artificial shortages, corruption and black marketing.
Wish you good luck.
Thank you
