CHAPTER 20
INFLATION
Objectives
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Define Inflation
Describe how inflation is measured
Distinguish between different measures of Inflation
Explain why inflation is regarded as a problem
Distinguish between the approaches to explaining Inflation
Explain demand–pull and cost-push inflation
Mention policies that can be used to combat inflation
Inflation
• Inflation is the continuous and considerable rise/increase in general price level.
• Note: Inflation is not just a once off increase in price but a continuous process. It is a general
increase and not an increase of price of a particular good/service.
The measurement of inflation.
• Inflation is measured in 3 different ways:
 Consumer price Index (CPI) – the most commonly used indicator (measure) of inflation .
Remember we looked at the CPI in chapter 13.
 The unadjusted CPI for all urban areas is referred to as Headline CPI.
 Be able to calculate Inflation rate, month on month and annual average on annual
average as we did in chapter 13.
The Producer Price Index (PPI) – PPI measure prices
at the level of first significant commercial transaction
(e.g. Price at the factory, at the farm or a country’s
boarder)
Look at table 20-2 Pg 383 for the differences
between CPI and PPI.
The Implicit GDP inflator – GDP at current Price
(nominal GDP) and GDP at constant price (Real GDP)
is used to measure inflation.
 GDP deflator = nominal GDP X 100%
Real GDP
The effects of inflation
We will look at 3 sets of effect of inflation as well as expected inflation: distribution,
economic, social and political effects of inflation as well as expected inflation.
Distribution effect of inflation – Inflation affects the distribution of income and
wealth among participants of the economy.
• Inflation benefits debtors (borrowers) at the expense of creditors (lenders), if
Real interest rate is lower than inflation. Real interest is interest after adjusting
for inflation.
• Inflation redistributes income and wealth from the elderly to the young, because
young people are usually net borrowers and the old have fixed nominal income.
• Inflation redistributes income from private sector to the government through tax
and government borrowing.
Economic effects of inflation includes lower economic growth and higher
unemployment as a result of:
• Investors/ private sector anticipating inflation rather than seek profitable new
production opportunities.
• Inflation Stimulating speculative practices.
• Inflation discouraging saving in its traditional form.
• Balance of payment problems – inflation affects a country’s international
competitiveness due higher domestic prices.
 Social and political effects of inflation – Increase in general price leads to increase
in cost of living.
• Social and political unrest.
• Uncertainty and despair among the society
• All these does not provide a conducive environment for economic progress.
 Expected inflation – Problem with inflation is the inflation it causes.
What is hyperinflation?
Causes of inflation
The theories/approaches that explains the causes of inflation are:
Demand pull Inflation.
Cost push inflation
Structuralist approach
The conflict approach
Demand Pull Inflation: This occurs when aggregate (total) demand (AD) for goods
and services increases while Aggregate (total) Supply (AS) remains unchanged.
This excess demand then pulls up prices.
See fig. 20-1 for illustration Pg. 389. At E3 there is full employment and therefore
no excess resources to increase production. Beyond E3, prices increase while
production and income remains constant at Yf - referred to as stagflation.
Causes of inflation conts:
Demand pull inflation is caused by :
Increase in consumption spending by households (C).
Increase in investment spending by firms (I).
Increase in government spending (G).
Increase in export earning (X).
Demand pull inflation can be combated by:
Applying a restrictive monetary policy – involves increasing interest
rates and reducing money supply.
Applying a restrictive Fiscal policy – involves reducing government
spending and increasing tax.
These 2 policies would reduce aggregate demand (AD) and therefore price.
However it may also have negative effect on production, income and
employment.
Causes of inflation conts:
Cost Push Inflation – is triggered by increase in the costs of
production. This type of inflation is therefore caused by factors
which push up the costs of production
Sources/ causes of cost push inflation are:
Increase in wages and salaries.
Cost of imported capital and intermediated goods.
Increase in profit margins.
Decreased productivity.
Natural disasters – floods, drought, earth quakes etc.
See fig 20-2 Pg. 390 for the illustration of the cost push inflation.
Causes of inflation contd
Policies to combat cost push inflation: To avoid cost push inflation,
measures should be taken to avoid increases in costs of production. For
example
Increases in wages, salaries and profits have to be kept in control ( i.e.
applying an income policy). Income policy is a form of government
intervention in determining wages, salaries and prices.
Increase productivity of the FOP.
Structuralist approach to inflation: Inflation process is the result of the
interaction between 3 interrelated sets of factors:
The underlying factors
 The initiating factors
The propagating factors
See table 20-4 Pg. 391 for more information.
Causes of inflation conts:
The conflict approach of inflation. Inflation is a symptom of
fundamental disharmony in society which results in a continuous
imbalance between the rate of growth in the real national income
and rate of growth of the total effective claims on this income. See
Pg. 394 for details.
Both the structuralist and conflict approach suggest income
policy to combat inflation.
NOTE: The policy that is applied to combat inflation will depend
on the type or the cause of the inflation.
Look at inflation targeting, its advantages and disadvantages.