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INFLATION
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Objectives
• Definition of inflation, disinflation and deflation
• Types of inflation and their causes
• Consequences of inflation
• Deflation and its consequences
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• In addition to maintaining a low level of unemployment, national
governments and central banks also focus their policies on the
average price level of goods and services in a nation.
• Maintaining price level stability is considered a fundamental objective
of macroeconomic policy, since price level instability can have
negative impacts on a nation’s economic health.
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THE CLASSICAL THEORY OF INFLATION
• Inflation is an increase in the overall level of prices. It causes the value
of money to decrease.
• Hyperinflation is an extraordinarily high rate of inflation.
• Disinflation is a decrease in the rate at which the average price level is
rising. Specifically, it is a slowing in the rate of inflation. It is used to
describe instances when the inflation rate has reduced marginally
over the short term.
• Deflation is the decrease in general price level throughout the
economy. A fall in prices results in an increase in the value of money.
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Inflation
• Inflation is one of the important topics of discussion in economics.
• It is defined as an increase in the average price level of goods and
services in a nation over time.
• A tool to collect inflation data is price index.
• There are a few price indexes that are commonly used to portray the
general price level and one that is frequently used is the consumer
price index (CPI).
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Consumer Price Index (CPI)
• A measurer to track changes in prices of goods and services purchased by
households, ie of the consumer basket.
• It measures the prices of consumer goods and services and is widely used
by governments to measure changes in the price level of the products that
a typical household may buy in a particular period.
• The composition of goods in the consumer basket is fixed based on
consumer spending patterns.
• The main component in the consumer basket for a Malaysian CPI is FOOD.
• A price index is found by dividing the price of a basket of goods in one
period by the period of the identical basket of goods in a base period and
multiplying by 100.
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Calculate the Cost of CPI Consumer Basket at Based Year Price
• Let’s work an example of the
CPI calculation.
• In a simple economy, people
consume only oranges and
haircuts.
• The CPI basket is 10 oranges
and 5 haircuts.
• The table also shows the
prices in the base period.
Table a
(a) The cost of the CPI basket at base-period prices:
2016
CPI basket
Item
Quantit
y
Price
Cost of
CPI Basket
Oranges
10
$1.00
$10
Haircuts
5
$8.00
$40
Cost of CPI basket at base-period
prices
$50
• The cost of the CPI basket in
the base period was $50.
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Calculate the Cost of CPI Consumer Basket at Current Year Price
Table a and b
• Table b shows the
fixed CPI basket of
goods.
(a) The cost of the CPI basket at base-period prices: 2016
• It also shows the
prices in the current
period.
Oranges
10
$1.00
$10
Haircuts
5
$8.00
$40
• The cost of the CPI
basket at currentperiod prices is $70.
(b) The cost of the CPI basket at current-period prices: 2017
CPI basket
Item
Quantity
Price
Cost of CPI basket at base-period prices
Cost of
CPI Basket
$50
CPI basket
Item
Quantity
Price
Cost of
CPI Basket
Oranges
10
$2.00
$20
Haircuts
5
$10.00
$50
Cost of CPI basket at current-period prices
$70
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Calculate the CPI for Based Year and Current Year
• After calculating the cost of the CPI basket at base year price and current
year price, the next step would be to calculate the CPI for both years.
CPI =
𝑪𝒐𝒔𝒕 𝒐𝒇 𝑪𝑷𝑰 𝒃𝒂𝒔𝒌𝒆𝒕 𝒂𝒕 𝒄𝒖𝒓𝒓𝒆𝒏𝒕 𝒚𝒆𝒂𝒓 𝒑𝒓𝒊𝒄𝒆
𝑪𝒐𝒔𝒕 𝒐𝒇 𝑪𝑷𝑰 𝒃𝒂𝒔𝒌𝒆𝒕 𝒂𝒕 𝒃𝒂𝒔𝒆 𝒚𝒆𝒂𝒓 𝒑𝒓𝒊𝒄𝒆
𝒙 𝟏𝟎𝟎
• Using the numbers for the simple example:
CPI for year 2016= ($50 ÷ $50) × 100 = 100.
CPI for year 2017= ($70 ÷ $50) × 100 = 140.
• The CPI is 40 percent higher in the current period than it was in the base
period.
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Calculating the Inflation Rate
• The major purpose of the CPI is to measure inflation.
• Inflation rate is one of the important guides in the economy. It is used
by various parties to evaluate the price changes in a country.
• The inflation rate is the percentage change in the price level from one
year to the next.
• The inflation formula is:
Inflation rate =
(𝑵𝒆𝒘 𝑪𝑷𝑰 −𝑶𝒍𝒅 𝑪𝑷𝑰)
𝑶𝒍𝒅 𝑪𝑷𝑰
𝒙 𝟏𝟎𝟎
• What is the inflation rate if the CPI is 100 in the year of 2017 but 94 in
2016?
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Weighting of Categories in the CPI
• To account for the different proportions of a typical household’s disposal
income that goes towards the purchase of different types of goods,
governments assign weights (% total income spent) to categories of goods
measured in the CPI.
• The weight reflects its relative importance to the purchasing households
and the total weights of all categories must add up to 100%.
• The purpose of weighting categories in a CPI is to ensure that when a
particular category of good experiences large fluctuations in price over
time, the overall CPI does not fluctuate wildly. It simply adjusts in a manner
that reflects the relative impact that price changes in that category have on
the typical consumer’s cost of living.
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Weighting of Categories in the CPI
• Assuming a price index has three categories, A, B and C, the weighted
price of the basket of goods is:
(PA x weightA) + (Pb x weightB) + (Pc x weightC)
• Based on the category weights, we can estimate the effect a
change in the price of one good will have on the overall CPI
(not inflation) – refer practice question set.
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Weighting of Categories in the CPI-example
Good
Banana
Haircut
Taxi ride
Average price
(2016)
2
11
8
Average price
(2017)
1.50
10
10
% of income spent
on each good
25
30
45
Weighted price in 2016 = ____________
Price index for 2016 = _______________
Weighted price in 2017 = _____________
Price index for 2017 = _______________
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Price Level, Inflation, and Deflation
Figure shows the relationship
between the price level and the
inflation rate.
The inflation rate is:
• High when the price level is
rising rapidly and
• Low when the price level is
rising slowly.
• Negative when the price level
is falling
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Factors that Cause Inflation
• Inflation is an increase in the average price level of a nation’s goods
and services over time.
• The AS/AD diagram shows the average price level of a nation on its yaxis; therefore, any factor that changes the equilibrium price level in a
nation causes inflation or deflation.
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Types and Factors that Cause Inflation
1.
2.
3.
4.
Demand pull/excess demand
Increase in costs
Supply shock
Adaptive expectations
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Demand-Pull Inflation
• An inflation that starts because aggregate demand increases is called
demand-pull inflation.
• Defined as an increase in prices arising from the increased overall demand
for a nation’s output when consumption, investment, government
spending or net exports rise without a corresponding increase in the level
of AS.
• Demand-pull inflation can begin with any factor that increases aggregate
demand.
‒ Examples are a cut in the interest rate, an increase in the quantity of money, an
increase in government expenditure, a tax cut, an increase in exports, or an increase
in investment stimulated by an increase in expected future profits.
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Demand-Pull Inflation
Initial Effect of an Increase in
Aggregate Demand
• Figure illustrates the start of a
demand-pull inflation.
• Starting from full
employment, an increase in
aggregate demand shifts the
AD curve rightward.
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Demand-Pull Inflation
• The price level rises, real
GDP increases, and an
inflationary gap arises.
• The rising price level is the
first step in the demand-pull
inflation.
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Demand-Pull Inflation
• Money Wage Rate Response
• The money wage rate rises
and the SAS curve shifts
leftward.
• The price level rises and real
GDP decreases back to
potential GDP.
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Cost-Push Inflation
• An inflation that starts with an increase in costs is called costpush inflation.
• Primary determinants of the SRAS are the productivity of the
nation’s resources and the costs of production of the nation’s
firms. Anything that decreases productivity or increases costs of
production will shift a nation’s SRAS to the left and drive up costs
of production.
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Cost-Push Inflation
• An unexpected decrease in AS is known as negative supply shock and
may arise as a result of the following.
•
•
•
•
•
An increase in oil prices
An increase in the nominal wage rate
Depreciation of the nation’s currency
Natural disaster of war
Higher taxes on firms
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Cost-Push Inflation
Initial Effect of a Decrease in
Aggregate Supply
• Figure illustrates the start of
cost-push inflation.
• A rise in the price of oil
decreases short-run aggregate
supply and shifts the SAS curve
leftward.
• Real GDP decreases and the
price level rises.
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Cost-Push Inflation
A Cost-Push Inflation Process
• If the oil producers raise the price of oil
to try to keep its relative price higher,
unemployment rises..
• There is an outcry of concern and a call
for action to restore full employment and
the Fed responds by increasing the
quantity of money (eg by cutting interest
rate), so AD increases. AD shifts rightward
and full employment is restored..
• The oil producers now see the prices of
everything they buy increasing, so oil
producers increase the price of oil again
to restore its new high relative price…a
process of cost-push inflation continues.
• The combination of a rising price level
and a decreasing real GDP is called
stagflation.
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Cost-Push Inflation
• Leads to an increase in both inflation and unemployment.
• The only way a nation experiencing cost-push inflation can bring price
levels down without driving up unemployment rates is by increasing
its SAS through policies that lower costs to firms that have
experienced unexpected cost increases due to one of the reasons
above.
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Factors that Cause Inflation
• Inflation may happen if consumers expect it to happen.
• This psychological factor is an important factor in the field of social
science.
• If people expect prices to go up, they will purchase goods before the
price increases.
• Increase in demand causes prices to go up and inflation to occur.
Inflation due to this psychological factor is called adaptive
expectation inflation.
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The Costs of Inflation
• Loss of purchasing power
• As a nation’s price level rises, households’ real income decreases.
• Lower real interest rates for savers
• Real interest rate earned on savings falls as inflation rises.
• Real interest rate = nominal interest rate – inflation rate
• Higher nominal interest rates for borrowers
• Lenders charge higher interest rate if inflation is expected in the
near future.
• Reduction of international competitiveness
• High inflation at home makes domestic output less attractive to
foreigners, and imports more attractive to domestic consumers –
reduce AD and lead to a loss of jobs in export industries.
Deflation and Its Consequences
• Despite the negative effects of inflation, mild inflation is
desirable and evidence of a healthy, growing economy.
• Deflation, a decrease in the average price level is a major threat
to a nation’s economy and can plunge an economy into a
steadily worsening recession.
• During a period of deflation, the inflation rate is negative.
• There are two basic causes of deflation – deflation due to a fall
in AD (undesirable) or an increase in productivity of the nation’s
resources or lower costs of production to firms (desirable).
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Deflation and Its Consequences
• The costs of deflation can be summarized as follows:
• Rising unemployment
• Falling consumption and increased savings
• Falling investment
• Increased debt burden on households
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Deflation – Group Discussion
• When is deflation desirable?
• In what ways does deflation present a bigger challenge to
macroeconomic policymakers than inflation?
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