This Photo by Unknown author is licensed under CC BY-NC-ND.
INFLATION
This Photo by Unknown author is licensed under CC BY-NC.
Inflation can be defined as a general and continuing rise
in prices.
If the prices of goods and services are going up generally
in the economy over a period, inflation is said to exist.
Inflation
Inflation continuously reduces the purchasing power of
money.
A short term (Temporarily) increase in general price level
cannot be considered as inflation. Also, increase price of
all goods & services are not expected during inflation.
Deflation can be
defined as a general
and continuous fall in
prices.
Deflation
Deflation may
slowdown the
economy.
Consumer
price Index
(CPI)
• Inflation is measured using consumer price
index.
• It is the measure of the general price level.
• This examines the weighted average prices
of a basket of consumer goods and services
such as transportation, food, and medical
care. It is calculated by taking price changes
for each item in the predetermined basket of
goods and averaging them.
• This average is then converted into an index
number. This allows comparison to be made
between different periods.
• Demand pull inflation caused by too much in the
economy.
Demand-pull
Inflation
• “Increase in the pieces of the real output, when an
economy tries to spend more than the expenditure
bearable to the production capacity of the economy
(Due to the surplus aggregate demand)”
• “Inflation exists due to too much money chasing after
too little number of goods.”
• The main factor which causes inflation is the excess
aggregate demand. - Any factor which increases the
aggregate demand (AD) of an economy (Private
consumption, investment, public consumption, and net
exports) may lead to a demand-pull inflation
• Reasons for demand pull Inflation.
Demand-pull
Inflation
Expansion of money supply
Decrease in interest rate.
Increase in disposable income.
Expansion of the ownership of assets, wealth,
and property Decrease in demand for money.
• Inflation expectation.
• Changes in the business cycle (Inflationary gap)
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•
•
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Cost-push
Inflation
Inflation caused by rising business
cost is known as “cost-push
inflation”.
When businesses are faced with
rising cost, they put up their prices
to protect their profit margins. As
a result, inflation is caused.
Cost-push Inflation
• Reasons for cost push inflation,
• Imposing or increasing the indirect taxes by the government.
• Increasing in prices of production factors.
• E.g.-Increase in salary according to wage policies or due to actions of trade unions,
increasing profits by monopoly and oligopoly firms, increasing the inflation rate under a
rigid monetary policy etc.
• Increase in price of domestic raw materials.
• Increase in profit of oikology firms.
• Collapsing the production due to natural reasons, civil disputes etc.
• Increase the price of products (produced using imported raw materials) due to increase in price
of imported raw materials or due to the depreciation of foreign exchange rate.
• There is a strong link between inflation and growth in the
money supply. -
• The money supply is the stock of notes and coins, bank
deposits and other financial assets in the economy.
Relationship
between
inflation and
Interest rates
• Inflation may be caused when households, firms and the
government borrow more money from banks to fund extra
spending.
• This adds to the money supply because there are now
more bank deposits.
• The extra money lent by the banks creates more demand
and prices are driven up. This type of inflation is more likely
to happen if interest rates are low. This is because
borrowing is likely to increase when interest rates are low.
• So, government can raise the interest rates to bring down
the inflation by falling money supply
Impacts of
inflation.
• Prices – Prices tend to rise in inflation. So, inflation
reduces the purchasing power of money. This
means that people cannot buy as much with their
income.
• Wages- when prices are rising, workers need to
increase their wages to compensate for the loss in
purchasing power.
• Exports- if inflation is higher at home than in other
countries, firms may find difficult to sell in
overseas markets. This is because the prices of
exports rise. As a result, the demand for exports is
likely to fall which means balance of payments is
affected negatively.
Impacts of inflation.
• Unemployment- high level of inflations mainly caused due to increase in aggregate
demand. As a result, firms will keen to increase output since the prices of goods is
increasing. This means firms will need to recruit more workers, which reduces
unemployment.
• Menu cost- if inflation is rapid, firms will have to increase their prices frequently,
therefore new broachers need to print, websites update etc. this will incur an
additional cost.
• Shoe leather cost- when prices are increasing, cost to firms and consumers of
searching for new suppliers tend to be high. This is known as “shoe leather cost”.
• Investment- inflation often results in decline in business investment. This is
because the uncertainty of future returns of the investments