INFLATION

What is inflation?

Inflation is a sustained/persistent increase in the general price level leading to a fall

in the purchasing power of money.

The rate of inflation is measured by the annual percentage change in consumer

prices. The consumer price index (CPI) seeks to calculate the changes in the price
of a very ‘shopping basket’ of the products, bought by consumers.

Constructing a CPI

1. Selecting a base year

A base year is a standard year in which there were no drastic changes. It is given a
figure of 100 and the price level in other years is compared to this figure.

2. Selecting a basket of commodities

It is important to know how people spend their money. This will include all those
goods that are mostly consumed by the overall population. To find out the
spending patterns of people, government officials carry out surveys of household
expenditure.

3. Assign weights

Weights reflect the relative importance of the selected goods.

4. Constructing a weighted price index

The final stage is to multiply the weights by the new price index for each category
of products and to calculate the change in the general price level.

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Example:

An average population receives rs25000 as income. Rs10000 is spent on food,

Rs2500 on housing, rs6250 on transport and the rest rs6250 on entertainment.

Assign weights:

 Food: (10000/25000)
 Housing: (2500/25000)
 Transport: (6250/25000)
 Entertainment: (6250/25000)

Category Weights Price Index Weighted Price Index

Food 4/10 110 (0.4*110) 44
Housing 1/10 95 (0.1*95) 9.5
Transport 1/4 100 (1/4*100) 25.0
Entertainment 1/4 108 (1/4*108) 27.0
44+9.5+25.0+27.0=105.5

Therefore, change in the general price level= *100

= *100

=5.5%

A 5.5% change indicates a 5.5% rise in the general price level.

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Causes of inflation

I. Demand-pull inflation

Demand pull inflation occurs when aggregate demand is growing at an

unsustainable rate leading to increased pressure on scarce resources.

When there is excess demand, producers can raise their prices and achieve bigger
profit margins. If aggregate supply may not be able to rise in line with aggregate
demand, then demand pull inflation occurs. Demand-pull inflation is likely when
there is full employment of resources and SRAS is inelastic.

Reasons for increase in AD

1. A depreciation of the exchange rate increases the price of imports and

reduces the foreign price of a country's exports. If consumers buy fewer
imports, while exports grow, AD in will rise.

2. A change in fiscal policy for instance, lowers direct or indirect taxes or

higher government spending. If direct taxes are reduced, consumers have
more disposable income causing demand to rise. Higher government
spending and increased borrowing creates extra demand.

3. A change in monetary policy to the economy: A fall in interest rates may

stimulate too much demand – for example in raising demand for loans.
Monetarist economists believe that inflation is caused by “too much money
chasing too few goods" and that governments can lose control of inflation if
they allow the financial system to expand the money supply too quickly.

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A rise in AD will cause the AD curve to shift to the right, pulling up prices.

II. Cost-push inflation

Cost-push inflation occurs when the price level is pushed up by the increases in
the costs of production. That is, firms respond to rising costs by increasing prices
in order to protect their profit margins.

There are many reasons why costs might rise:

1. Component costs: e.g. an increase in the prices of raw materials and other
components. This might be because of a rise in commodity prices such as
oil, copper and agricultural products used in food processing. A recent
example has been a surge in the world price of wheat.

2. Rising labour costs - caused by wage increases, which are greater than
improvements in productivity. Wage costs often rise when unemployment is
low because skilled workers become scarce and this can drive pay levels
higher. Wages might increase when people expect higher inflation so they
ask for more pay in order to protect their real incomes. Trade unions may

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 use their bargaining power to bid for and achieve increasing wages, this
could be a cause of cost-push inflation
3. Higher indirect taxes – for example a rise in the duty on alcohol, fuels and
cigarettes, or a rise in Value Added Tax. Depending on the price elasticity of
demand and supply for their products, suppliers may choose to pass on the
burden of the tax onto consumers.

4. A fall in the exchange rate – this can cause cost push inflation because it
leads to an increase in the prices of imported products such as essential raw
materials, components and finished products.

Higher costs of production shift the aggregate supply curve to the left and
this movement forces up the price level.

III. Monetary inflation

This is caused by an excessive growth in the money supply. It is argued that an

increase in money supply will cause an increase in expenditure of goods and
services and this will lead to an increase in prices.

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Consequences of inflation

Many governments have set their central banks a target for a low but positive
rate of inflation. They believe that persistently high inflation can have damaging
economic and social consequences.

1. Income redistribution: inflation redistributes income in an unplanned way.

Some people gain from it, while others lose. Workers with strong bargaining
power tend to gain, as their income usually rises more than the inflation rate.
During inflation, borrowers gain and savers lose.

2. Falling real incomes: With millions of people facing a cut in their wages,
rising inflation leads to a fall in real incomes.

3. Menu and shoe-leather costs: Menu costs are the costs involved in
changing prices in catalogues, price lists etc…shoe-leather costs are those
costs involved in moving money around to gain higher interest rates.

4. Cost of borrowing: High inflation may also lead to higher borrowing costs
for businesses and people needing loans. There is also pressure on the
government to increase the value of the state pension and unemployment
benefits and other welfare payments as the cost of living goes higher.

5. Fall in international competitiveness: If one country has a much higher

rate of inflation than others for a considerable period of time, this will make
its exports less price competitive in world markets. Eventually this may
show through in reduced export orders, lower profits and fewer jobs, and
also in a worsening of a country’s trade balance. A fall in exports can trigger
negative multiplier and accelerator effects on national income and
employment.

6. Business uncertainty: High and changing inflation is not good for business
confidence partly because they cannot be sure of what their costs and prices
are likely to be. This uncertainty might lead to a lower level of capital
investment spending.

Overall, a high and unstable rate of inflation is widely considered to be damaging

for an economy that trades in international markets as it brings:

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  Uncertainty / fall in business and consumer confidence
 A fall in competitiveness of producers in international markets
 A negative effect on the real standard of living
 A negative impact on levels of income inequality

Note: Inflation can be positive as it encourages firms to expand. A low and

stable level of demand pull inflation may make entrepreneurs optimistic about
future sales.

SOURCE: TUTOR2U

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Policies to control inflation
Inflation can be reduced by policies that slow down the growth of AD and/or boost
the rate of growth of aggregate supply (AS).

Fiscal policy:

1. Controlling aggregate demand is important if inflation is to be controlled. If

the government believes that AD is too high, it may choose to ‘tighten fiscal
policy’ by reducing its own spending on public and merit goods or welfare
payments.

2. It can choose to raise direct taxes, leading to a reduction in real disposable

income.

3. The consequence may be that demand and output are lower which has a
negative effect on jobs and real economic growth in the short-term.

Monetary policy:

1. A ‘tightening of monetary policy’ involves the central bank introducing a

period of higher interest rates to reduce consumer and investment spending.

2. Higher interest rates may cause the exchange rate to appreciate in value
bringing about a fall in the cost of imported goods and services and also a
fall in demand for exports (X).

Supply side economic policies:

Supply side policies seek to increase productivity, competition and innovation – all
of which can maintain lower prices. These are ways of controlling inflation by
using supply side policies, and they are:

1. A reduction in company taxes to encourage greater investment.

2. A reduction in taxes which increases risk-taking and incentives to work – a
cut in income taxes can be considered both a fiscal and a supply-side policy.
3. Providing training and skills to employees in order to increase efficiency and
thus productivity.

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Rising productivity will cause an outward shift of aggregate supply which can be
shown in the figure below:

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 DEFLATION
What is price deflation?

Deflation happens when the rate of inflation becomes negative, that is a

sustained fall in the general price level.

Causes of deflation

Deflation may result from the supply-side or the demand side of the economy.

 The fall in aggregate demand triggers a decline in the prices of goods

and services. Some factors leading to a decline in aggregate demand are:
a. Fall in the money supply

A central bank may use a tighter monetary policy by increasing interest rates.
Thus, people, instead of spending their money immediately, prefer to save more of
it. In addition, increasing interest rates lead to higher borrowing costs, which also
discourage spending in the economy.

b. Decline in confidence

Negative events in the economy, such as recession, may also cause a fall in
aggregate demand. For example, during a recession, people can become more
pessimistic about the future of the economy. Subsequently, they prefer to increase
their savings and reduce current spending.

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  An increase in aggregate supply is another trigger for deflation.

Subsequently, producers will face fiercer competition and be forced to lower

prices. The growth in aggregate supply can be caused by the following factors:

a. Lower production costs

A decline in price for key production inputs (e.g., oil) will lower production costs.
Producers will be able to increase production output, which will lead to an
oversupply in the economy. If demand remains unchanged, producers will need to
lower their prices on goods to keep people buying them.

b. Technological advances

Advances in technology or rapid application of new technologies in production can

cause an increase in aggregate supply. Technological advances will allow
producers to lower costs. Thus, the prices of products will likely go down.

A rise in AS causes a lower price level.

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Consequences of deflation

1. Holding back on spending: Consumers may postpone demand if they expect

prices to fall in the future.

2. Debts increase: The real value of debt rises with deflation and higher real
debts can be a big drag on consumer confidence. This is a situation which
represents that borrowers lose, lenders gain.

3. The real cost of borrowing increases: Real interest rates will rise if nominal
rates of interest do not fall in line with prices.

4. Lower profit margins: Lower prices can mean reduced revenues & profits
for businesses - this can then lead to higher unemployment as firms seek to
reduce costs by shedding labour.

5. Deflation can make exporters more competitive eventually – but this often
comes at a cost i.e. higher unemployment in short term.

6. Deflation can reduce a current account deficit or increase a current account

surplus if demand for exports and imports is elastic.

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Policies to control deflation
1. Fiscal Policy:

Fiscal policy through increase in public expenditure and reduction in taxes tends to
raise national income, employment, output, and prices. An increase in public
expenditure during deflation increases the aggregate demand for goods and
services and leads to a large increase in income via the multiplier process, while a
reduction in taxes has the effect of raising disposable income thereby increasing
consumption and investment expenditures of the people.

The government should increase its expenditure through deficit budgeting and
reduction in taxes. The public expenditure includes expenditure on such public
works as roads, canals, dams, parks, schools, hospitals and other buildings, etc. and
on such relief measures as unemployment insurance, pensions, etc.

2. Monetary Policy:

To control deflation, the central bank can increase the money supply in the
economy. They can also reduce the interest rate. As a result, their ability to extend
credit facilities to borrowers increases.

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