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Chapter 20:
Inflation
Definition of inflation
“the continuous and considerable
increase in prices in general.”
Study section 20.1 in the prescribed
textbook.
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Note the following:
The definition is neutral, as it does not seek to
attribute inflation to any specific causes;
The definition also makes it clear that the
increase in prices must be continuous;
The rise in prices must be a significant
amount. It is debatable whether a 1 or 2 %
increase in prices over one year can be
considered inflation;
The increase in prices must be for goods and
services in general. A rise in the price of a
specific good (while all other goods and
services remain at a constant price) does not
constitute inflation.
The Measurement of Inflation
The Consumer Price Index
• The most frequently used measurement or
indicator of inflation.
• The CPI is an index of the prices of a representative
“basket” of consumer goods and services.
The CPI thus represents the cost of the “shopping
basket” of goods and services of a typical or average
South African household.
Study section 20.2 in the prescribed textbook.
Constructing the CPI
Stats SA
Selects the goods and services to be
included in the basket;
Assigns a weight to each good or service to
indicate its relative importance;
Decides on a base year for calculating the
CPI;
Decides on a formula for calculating the
CPI;
Collects price each month to calculate the
value of the CPI for that month.
STATS SA
• set of CPI values,
• calculate the rate of inflation by calculating the percentage
change in the CPI values.
• The inflation rate, expressed as a percentage, is per year.
• The CPI is measured and expressed on a monthly basis,
therefore in any given year you will have twelve values – one
for each month.
Table 20-1 on p. 383.
The measurement of inflation
• The consumer price index
– Month on the same month during the previous year
– Annual average on annual average
Table 20-1 The consumer price
index and inflation in South
Africa 2012–2013
(Textbook page 383)
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Formula to calculate the inflation rate
CPI(t) – CPI(t−1)
Inflation rate(t) =
x 100
CPI(t−1)
Where:
Inflation rate(t) = inflation rate for the current year;
CPI(t)
= CPI of the current year
CPI(t-1)
= CPI of the previous year.
Month on the Same Month during the Previous Year
The most common practice in South Africa is to compare
the CPI in January 2013 for example, with the same month
in 2012.
The result of this comparison is then given as a percentage.
Activity
Refer to Table 20-1 on p. 383 of the prescribed textbook.
Using the formula, calculate the inflation rate (%) in
December 2013 (compared to December 2012)
Annual Average on Annual Average
• another means of expressing inflation.
• the average of the monthly inflation rates is important.
The production price index
CPI measures the cost of a representative basket of goods
and services to the consumer,
Example:
1. the prices of imported goods are measured at the point where
they enter the country and not where they are sold to
consumers.
PPI measures prices at the level of the first significant
commercial transaction.
Example:
1. manufactured goods are priced when they leave the factory, not
when they are sold to consumers.
Important features of PPI
• PPI includes capital and intermediate goods, but
excludes services (which account for 45% of the CPI
basket).
• A significant change in its rate of increase is usually an
indication that there will be a change in the rate of
increase in the CPI some months later.
• PPI also draws a distinction between goods produced in
South Africa and imported goods. This makes it possible
to determine to what extent the cost pressures are
emanating from the domestic economy or from the
country’s economic links with the rest of the world
CPI and PPI
Are explicit indices that are specifically designed to
measure price increases
The implicit GDP deflator
To eliminate the effects of inflation: Statistics South Africa and
the SARB transform the GDP at current prices (or nominal GDP)
to GDP at constant prices (or real GDP).
Real GDP: measures GDP in terms of the prices ruling in a
certain base year (i.e. at constant prices). This provides the
basis for calculating economic growth.
Implicit GDP deflator: another index that can be used to
calculate an inflation rate. (The difference between nominal
GDP and real GDP indicates what happened to prices). It is an
implicit index since it is a side effect of the calculation of
economic growth.
The measurement of inflation
• The producer price index
Table 20-2 Main differences between the CPI and PPI
(Textbook page 383)
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The measurement of inflation
The producer price index
Table 20-3 Annual
rates of increase in
CPI and PPI, 2013
(Textbook page 384)
• The implicit GDP
deflator
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The effects of inflation
The overall effects of inflation may be divided into three
(3) categories:
• Distribution effects
• Economic effects
• Social and political effects
Box 20-1 The destructive power of inflation (Textbook page 386)
Box 20-2 Falling prices: a consumer’s heaven? (Textbook page 387)
• Expected inflation
Box 20-3 Hyperinflation (Textbook page 387)
Study section 20.3 in the prescribed textbook.
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Distribution effects
•Re-distribution between creditors and debtors
Basic rule: inflation benefits debtors (borrowers) at the expense of creditors
(lenders)
Real interest rate is the difference between nominal interest rate and
inflation rate.
Nominal interest rate lower than inflation rate = negative real interest rate
The lender is prejudiced in 2 ways:
-Real value of his wealth declines
- interest income he receives is not sufficient to compensate him for inflation
Positive real interest rate: distribution of income falls away and only wealth
is redistributed.
This redistribution of wealth applies to all assets whose nominal value is
fixed, eg money, government securities, bonds, certain insurance policies
and certain pensions
Inflation tends to redistribute income and wealth from the elderly to the
young
Distribution effects
•Redistribution from private sector to the government
Government is always a debtor
During inflation government gains at the expense of the holders of public
debt (eg holders of government stocks)
•Government also gains from tax systems
The higher the income the greater the % of income tax paid
When there is inflation the individual's nominal income rise, even if their
real income don’t.
Bracket Creep: Individuals have to pay higher tax even though they are no
better than before. Bracket creep results from a combination of inflation and
a progressive income tax.
Fiscal dividend: increased government spending from taxation through
inflation
•Inflation also tends to affect the poor households more, especially with
increasing prices of necessities. They have to spend all their income to
survive
Economic effects
May result in low economic growth and higher unemployment
•Private sector: decision makers tend to be more concerned
with anticipating inflation than with seeking out profitable new
production opportunities
•Inflation also stimulates speculative practices
People try to outwit each other by speculating in shares,
property, foreign currencies, antiques, art etc
•Reducing the value of existing savings also discourages savings
(eg. fixed deposits, pension fund contributions)
Economic effects
•Inflation can produce balance of payments
Inflation increases the costs of export industries and importcompeting industries
If inflation in SA is higher than in the economies of major
trading partners and international competitors, results will be
loss of international competiveness.
Social and political effects
•Price increases make people unhappy
•People from different group in society start blaming
one another for increases in the cost of living
•Inflation creates a climate of conflict and tension
The Causes of Inflation
Study “demand-pull inflation” and “cost-push inflation” in
section 20.4 in the prescribed textbook.
Demand-Pull Inflation
This happens when aggregate demand increases and there
is no appropriate increase in aggregate supply.
As a direct result of AD rising and AS remaining unchanged,
prices start to rise – the excess demand “pulls up” the
prices.
Factors that influence an increase in AD:
A rise in consumption spending by the households;
A rise in investment spending by the firms;
A rise in government spending;
An increase in exports to the foreign market.
The above indicates a demand for money
This results in an increase in supply of money (supply of
money is demand determined)
The causes of inflation
• Demand-pull and cost-push inflation
– Demand-pull inflation
Figure 20-1 Demand-pull inflation (Textbook page 389)
Demand –pull inflation occurs when
aggregate demand for goods and
services increases. This is illustrated by
the rightward shift of the AD curve from
AD1 to AD2, AD3, AD4.
As long as there is till excess capacity in
the economy, the increases in the price
level will be accompanied by increases
in production and income.
When full employment is reached,
further shifts in the AD curve (from AD3
to AD4. ) lead to price increases only.
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Measures that may be taken to prevent demand-pull
inflation
Restrictive monetary policy, which entails raising interest
rates and limiting the increase in the money supply. This raises
the cost of credit and also reduces the availability of credit to
the various sectors of the economy;
Restrictive fiscal policy entails a reduction in government
spending and/ or increased taxation.
Trying to prevent results in a trade-off between inflation and
unemployment.
Restrictive monetary and/ or restrictive fiscal policy will lead
to a reduction in the general price level (in reality, a slowing of
the inflation rate),
But lower levels of output will result in greater levels of
unemployment.
Cost-Push Inflation
This inflation is caused by an increase in the costs of
production.
The rising costs of manufacturing “push-up” the price
level.
There are generally five (5) main causes of cost-push
inflation:
Increase in wages and salaries;
The cost of imported goods and services;
Increase in profit margins;
Decreased productivity;
Natural disasters.
How cost-push inflation may be combatted
Measures must be taken to avoid increases in the costs of
production.
Increases in wages and salaries and profits have to be kept
under control (incomes policy);
Increases in productivity can also help to avoid or combat
cost-push inflation.
The causes of inflation
Demand-pull and cost-push inflation
– Cost-push inflation
Figure 20-2 Cost-push inflation (Textbook page 390)
Cost–push inflation occurs when cost of
producing each level of total production
Y increases. This is illustrated by an
upward/ leftward shift of the AS curve
from AS1 to AS2.
Increases in the price level are
accompanied by reductions in
aggregate production or income Y (and
therefore also by increases in
unemployment).
In diagram the price level increases
from P1 to P2 and the level of income
from Y1 to Y2
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Anti-inflation policy
• The costs of anti-inflation policy
• Indexation
• Inflation targeting
– What is inflation targeting?
– The case for inflation targeting
– Inflation targeting in South Africa
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Important concepts
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Inflation
Consumer price index
Headline inflation
Producer price index
GDP deflator
Distribution effects
Real interest rate
Bracket creep
Fiscal dividend
Economic effects
Social and political effects
Hyperinflation
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Deflation
Demand-pull inflation
Cost-push inflation
Stagflation
Incomes policy
Underlying factors
Initiating factors
Propagating factors
Conflict approach
Effective claims
Indexation
Inflation targeting
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