Chapter 20: Inflation
In 1887 there was a bar and grill owner in San
Francisco named George Inflation. One day he failed
to receive a shipment of his finest whiskeys and brandy
from the East.
Since the demand for booze was great, George
Inflation decided to charge 15c for a shot of whiskey,
instead of the standard 10c. He also made the shot
glass smaller.
This did not stop his customers from buying booze, so he
raised the price to 20c, then 25c.
The other bars in San Francisco raised their prices accordingly
and when their customers complained, the other bar and grill
owners would say, “Blame it on Inflation”. Thus, inflation soon
became part of the English Language.
Source: Posted in Gazette (Montreal), 1969 in the insights column
Learning Outcomes
• Define inflation
• Describe how inflation is measured.
• Distinguish between the different measures of inflation
• Explain why inflation is regarded as a problem.
• Distinguish between three approaches to explaining what causes
inflation:
• Discuss the different policies that can be used to combat inflation
• Explain demand-pull and cost-push inflation
• Mention policies that can be used to combat inflation.
KFC
prices
1976
KFC prices 2018
20.1 Inflation
• "Public enemy number one"
• Inflation reduces the power of money
▫ Lets your salary looks bigger, but you buy less and less
with it
• Inflation: a continuous and considerable rise in prices
in general, but the quality of the product remains the
same.
• Four aspects need to be emphasised with this
definition:
• Neutral – allows for all possible causes of inflation to
be taken into account, and provides a sounder basis for
anti-inflation policy.
• Process – continuous increase in prices, not a once-off
price increase
• A considerable increase in prices.
• Prices in general, not an increase in the price of a
particular good.
20.2 Measuring inflation
Consumer
Price
Index
(CPI)
Three main
measures
of inflation
The
implicit
GDP
deflator
Producer
Price
Index
(PPI)
20.2 Consumer Price Index (CPI)
• Most commonly used indicator of the general price level
• Reflect the cost of a representative basket of consumer goods and services
• Reported each month since inflation is a continuous process
• Expressed as an annual rate (always in %)
• How do we measure inflation for a particular year?
• Since its measured monthly meaning each year = 12 figures (not restricted to
calendar years; any 12 month average may be compared with the previous 12
month average)
• When we say that the inflation rate is 10%, this means that prices are
increasing at a rate of 10% per year.
Table 20-1
Method 1: Month on the same
month of the previous year:
• Compare the index of the
corresponding month in the previous
year.
• To calculate inflation for December
2013
CPI 2013  CPI 2012
 100
CPI 2012
105.4  100.0
100
100.0
= 5.4% (subject to fluctuations)
Table 20-1
Method 2: Inflation annual
average:
• Calculate the average of all the
monthly index values,
• Compare it with the corresponding
average of the previous year.
Avg2013  Avg2012
 100
Avg2012
103.4  97.8
97.8
= 5.7 % (not subject to fluctuations)
Class activity
The South African Reserve Bank has released the following CPI figures for 2016 in
their first Monetary Policy Review.
Using the information in the table below, calculate the current inflation rate.
Answer
CPI inflation rate2016 = [(CPI2016 - CPI2015)/CPI2015] x100%
= [(106.9 – 102.3)/102.3] x 100%
= 4.5%
20.2 Producer Price Index (PPI)
• Also important price index but differs from CPI
• Associated with the cost of production
• Basket consists of capital & intermediate goods
• Measures change in wholesale prices, i.e. prices of production
Table 20-2
20.2 GDP Deflator
• Implicit index – used as another measure to calculate the inflation rate. Side
effect of the calculation of economic growth
• The GDP deflator shows the difference between nominal and real GDP in a
particular year:
o GDP at current prices: Nominal GDP (current price level)
o GDP at constant prices: Real GDP (true value, adjusting for the effects of
inflation)
• The transformation of GDP at current prices (nominal) to constant prices (real –
adjusting for the effect of inflation) measures economic growth, but also yields
an inflation measure.
Calculating inflation using the GDP deflator
method
 Nom.GDPYearB 
 *100
Defl.YearB  
 Re al.GDPYearB 
 Nom.GDPYearA 
 *100
Defl.YearA  
 Re al.GDPYearA 
 Defl.YearB  Defl.YearA 
 *100
 YearB  
Defl.YearA


Exercise
Consider the following information provided by Statistics South Africa:
Calculate the inflation rate for 2016
Year
2014
2015
2016
GDP at current
GDP at 2000 constant
prices
prices
888 057
624379
982 944
642 038
1098 714
661 147
Answer
Year
2014
2015
2016
GDP at current
GDP at 2000 constant
prices
prices
888 057
624379
982 944
642 038
1098 714
661 147
• GDP deflator 2016 = (1098714 / 661147) x 100 = 166.2
• GDP deflator 2015 = (982944 / 642038) x 100 = 153.1
• Inflation 2016 = (166.2-153.1)/153.1 x 100 = 8.6%
Study guide: pg. 97
The causes of inflation
• We can explain some elements of the inflation process by
examining three approaches to diagnosing inflation.
• The approaches are:
o The demand-pull and cost-push approach
o The structural approach
o The conflict approach
20.4 Demand-Pull Inflation
• AD increase while AS remains unchanged.
• “Too much money chasing too few goods”
• This is associated with an increase in money stock (M)
• REMEMBER: AD = C + I + G + X – Z
• THUS an increase in AD is caused by an increase in C,I,G,X
•  (C): credit
•  (I): lower interest rates/profits expectation
•  (G): combat unemployment/better services
•  (X) earnings: Improved economic conditions
Fig 20.1 Demand-pull inflation
 AD ↑ lead to ↑ in P & increase in
production and income (Y) (see AD1 &
AD2)
 + impact on employment, production
and income provided that there's still
unemployed resources.
 At full employment (economy), increases
in AD will simply lead to increases in
price only.
 Indicated by the shift from AD3 to AD4.
 How do we fix?
• Monetary Policy ... i .... M
• Fiscal Policy ... t ... G
20.4 Cost-Push Inflation
• Prices are pushed up by increases in costs
of production
• Higher cost leads to lower supply
• AS shifts to the left
• 5 main causes:
• Increase in wages and salaries
• Increase in imported capital &
intermediate goods
• Increase in profit margins
• Decrease in productivity
• Natural disasters
20.4 Cost-Push Inflation
• Cost-push inflation has a negative impact on
production, income and employment.
• Stagflation occurs, because increasing prices (inflation)
are accompanied by increased unemployment.
• Cost-push inflation can be combat with an income
policy (see chapter 21)
• Monetary policy & Fiscal policy cannot combat costpush inflation.
Fig 20.2 Cost-push inflation
 An increase in production cost
results in an increase in the
price and a decrease in the
total production (stagflation).
 This has a negative impact on
employment, income and
production.
20.4 Structuralist Approach
• Retains the distinction between demand-pull and cost-push, but in a
broader context.
• The inflation process is the result of the interaction between three
interrelated sets of factors:
▫ The underlying factors
 which provide the background against which the inflation process
occurs (provides an indication of the vulnerability of economy to
inflation).
 For instance, a lack of fiscal discipline, the size of the public sector.
▫ The initiating factors
 which triggers or intensify a particular inflation process.
 Classified into three broad factors (demand pull factors, Cost push
and other price/cost increases). For instance, natural disasters.
20.4 Structuralist Approach
▫ The propagating factors
 which explains the transmission to the rest of the economy in
sustaining inflation
 Generate the process of rising inflation
 Three sets of propagating factors
 For instance, inflationary expectations
• The sustained process of inflation can occur if all the three factors
are present
• Take note of Table 20-4
Conflict approach to inflation
• Inflation is a symptom of disharmony/imbalance in society (among
various social groups like trade unions, large firms, politicians etc.)
• Everyone tries to claim a bigger share of the national income; claiming
more than what is available – triggering inflation
• Hence - according to this approach, inflation is a symptom of the lack
of effective economic and/or political mechanisms to reconcile
reported income levels
20.3 The costs/effects of inflation
Distribution
Expected
inflation
Economic
Social and
political
Economic effects
Distribution effects
• No equal impact on individuals and
groups
• Debtors (borrowers) tend to gain at
the expense of creditors (real value
of their repayments is reduced over
time)
• Government (biggest debtor in the
country) tends to gain at expense of
private sector.
• Government also gains via the
progressive tax system (individuals
will pay a higher tax rate even when
they are not better off) – bracket
creep
• Redistributes income and wealth from
the elderly to the young
• Affects poor households
•
impact on employment and growth
•
productive activity neglected
•
Saving (e.g. fixed deposit) discouraged
•
exports may suffer (if inflation in SA is
higher than that of main trading
partners)
•
imports may be stimulated
Social and political effects
•
Creates a climate of conflict that is not
conducive to economic progress
•
Gives rise to social and political unrests
•
Makes people unhappy
Expected inflation
•
inflation may result in the expectation of
further inflation
•
self-fulfilling prophesy
•
may give rise to hyperinflation
20.5 Anti-inflation policy
• Demand-pull inflation
• Use restrictive monetary and fiscal policy by  the tax &
interest rates and  government spending.
• Discourage spending
• Such an approach would reduce inflation or even lead to
reduced price levels.
20.5 Anti-inflation policy
• Cost-push inflation
• Cannot use restrictive monetary and fiscal policy (Cost push is
already accompanied by a decline in production/income)
• Restrictive policy would increase unemployment further and
push the economy deeper into a recession
• Increasing supply is therefore ideal, despite increased costs
• Difficult in practice
20.5 Anti-inflation policy
• Indexation
• Prices, wages and so on are linked to price indices like the CPI to
eliminate the distributional effects of inflation.
• Inflation rate should be 100% or more (only used in emergency
conditions)
• Inflation targeting
• An economic policy in which a central bank estimates and makes a
public projected, or "target", inflation rate and then attempts to steer
actual inflation towards the target through the use of interest
rate changes and other monetary tools
• The key features are:
• The announcement of quantitative targets
• The primary of price stability as the objective of monetary policy
(in addition, the central bank should be operationally independent)
• A broad-based, pragmatic approach to the analysis of inflation
(use a wide range of variables to decide on the suitable setting of the
policy instrument (repo rate))
• Transparency (central bank should regularly inform the public and
markets about its plans, decisions and objectives).
• Accountability (central bank should be held accountable to the
parliament or public at large for achieving its main objectives)
• Advantages and disadvantages (textbook page 397[441])
Inflation Targeting in South
Africa
• Announced inflation targeting
framework in 2000
• Inflation target range: 3 – 6%
• Uses repo rate as monetary policy
instrument to control inflation
• Repo rate set by Governor of
Reserve Bank in consultation with
Monetary Policy Committee
• MPC meetings six times during the
year
21.5) Unemployment and inflation
The Phillips curve
Table 21-2: Aggregate demand, production, prices and
unemployment (Textbook page 405)
 Inverse relationship
between inflation and
unemployment
 Lower unemployment levels
are associated with higher
rate of increase in general
price level, vice versa
 Trade-off  Inflation can be
reduced to 0 only if the
unemployment rate is
allowed to increase to 5%
The Phillips
curve
21.5.1) Stagflation in the Phillips curve
 1970s:  Inflation + 
unemployment
 Illustrated by a rightward shift of
short-run Phillips curve
 Causes of stagflation?
Occurs due to factors such as higher
rate of increase in import prices,
wages due to trade union pressure
or higher profit margins
 Associated with a supply shock
(↓AS↑P)
Fig. 21-3
A simultaneous increase in inflation and
unemployment
 P1 is the worse position for the
economy  solution is an income
policy
21.6) Supply side Policies
Income policy
 Three – way agreement to allow the income policy to work
 Government
 Employers (firms)
 Workers (unions)
 Policy directed at the control of inflation
 Refers to some form of government intervention in the determination of
wages and prices (usually by limiting increases)
 Usually requires workers (and unions) to limit their demands for nominal
wage increases
 Firms are required to limit their profit margins
Cont…
 If prices can be kept constant, relative share of profits and wages remains
constant
 Difficult to implement – Refer to box 21-3
 Uncertainties as to whether parties involved will keep to the agreement
 Unrealistic to expect all sectors to grant uniform increases in wages
 Also prevents the working of the market mechanism at the microeconomic level
 Industries will not attract labour through higher wages
 As a result, they will not grow/expand – same profit margin throughout
 If implemented, income policies generally do not last long, particularly in
market oriented economies
 U.S (1971 – 74); UK (1972 – 74); Canada (1975 – 78)
 Further reading in textbook page 407- 408
Other important concepts
Hyperinflation
• very high inflation which tends to escalate out of control
Deflation
• continuous fall in prices in general
• falling prices even more damaging than rising prices
Disinflation
• falling inflation rate
• prices still increase but at a declining rate
Stagflation
• High inflation accompanied by high unemployment rate (explained in
Chapter 21)
Test Your Knowledge
Question 1
Consider the following information provided by Statistics South Africa:
Calculate the inflation rate for 2017
Year
Nominal GDP
Real GDP
2013
3 561 238
3 027 654
2014
4 155 965
3 390 972
2015
4 795984
3 730 069
2016
5 130 703
4 028 475
2017
5 643 773
4 391 038
Answer
GDP deflator = Nominal GDP/Real GDP *100
• Deflator 2016 = 5 130 703/4 028 475 x100 = 127.36
• Deflator 2017 = 5 643 773/4 391 038 x 100 = 128.53
Inflation rate 2017 = deflator current year - deflator previous
year/deflator previous year *100
Inflation rate 2017 = 128.53-127.36/127.36 x 100 =
0.92%
Question 2
Complete the following table by calculating the rate of inflation for each
given month of 2002
Month
CPI 2001
CPI 2002
January
103.8
109.0
February
104.1
110.2
March
104.8
111.3
April
105.3
113.1
Answers
Complete the following table by calculating the rate of inflation for each given
month of 2002
CPI
CPI
Month
Rate of inflation
2001
2002
January
103.8
109.0
5.0
February
104.1
110.2
5.9
March
104.8
111.3
6.2
April
105.3
113.1
7.4
Recap
• Inflation: a continuous increase
in the general price level
• Measured through three
different methods
• 2 Main causes/approaches of
inflation? Other two
approaches?
• Effects/costs of inflation.
• SA’s inflation target.
• Watch video on eFundi
‘chapter videos’ – ‘chapter 20’
Thank you