Resource Person: Ms. Chamari
Lakshika
2281_ECONOMICS
INFLATION &
DEFLATION
Grade 10
Inflation
Inflation is a sustained rise in the general price level in an economy over time. This does not
mean that the price of every good and service increases, but that on average the prices are
rising.
Governments aim to control inflation because it reduces the value of money and the spending
power of households, governments and firms.
Top 5 countries with the highest inflation Rates in the world , 2019
Source: CEOWORLD Magazine
Rank
Country
Inflation Rate
1
Venezuela
282,972.8%
2
Zimbabwe
175.66%
3
South Sudan
56.1%
4
North Korea
55%
5
Argentina
54.4%
How to measure inflation?
The consumer price index /Price Indices
The consumer price index (CPI) is a common method used to calculate the inflation rate. It
shows the changes in general price level in percentage terms over time.
It measures price changes of a representative basket of goods and services (those consumed
by an average household) in the country. For example, items such as staple food products,
clothing, petrol and transportation are likely to be included.
There are two main types of price indices, namely:
•
Retail Price Index (RPI)
•
Consumer Price Index (CPI)
Their coverage is very similar with relatively small differences only.
For instance, RPI includes mortgage interest payments while the CPI does not. On the other
hand CPI includes university accommodation fees.
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Resource Person: Chamari Lakshika
Constructing a Price Index
There are a number of stages in constructing a Price Index. These include selecting a base year,
finding out how households spend their money, attaching new weights to items of expenditure,
finding out price changes from a range of trade outlets and then constructing a weighted price
index.
1. Selecting a base year
Government statisticians try to select, a relatively standard year in which there were no dramatic
changes, as a base year. The base year is then given a figure of 100 and the price levels in other
years are compared to this figure.
Example
If the base year is 2007, it would mean that if the price index in 2010 is 123, the general price
level had been risen by ......................... between 2007 and 2010.
2. Finding out how households spend their money
In calculating the average rise in prices, it is important to know how people spend their money.
This is because a price changes in an item, that people spend a large proportion of their total
expenditure on, will have more impact on the cost of living than on an item on which they spend
relatively small proportion.
For example, if the typical household in a country spent 15 per cent of its income on food, then
15 per cent of the weights in the index would be assigned to food. Therefore, items of
expenditure that take a greater proportion of the typical household's spending are assigned a
larger weighting.
3. Constructing a weighted price index
Example: Consumers may spend $40 on food, $ 10 on housing, $ 25 on transport and $25 on
entertainment. This gives a total expenditure of $100. The price of food may have risen by 10%,
the price of housing has fallen by 5%, the price of transport may not have changed, and the price
for entertainment has risen by 8%.
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Resource Person: Chamari Lakshika
Calculate the weighted price Index.
Category
Weight
Price Index
Weighted Price
Index
The change in the price level could also have been calculated rather more directly by using the
weighted price change as shown below.
Category
Weight
Price Index
Weighted Price
Index
The causes of inflation
Inflation is not a one-off increase in the general price level. While examining the causes of
inflation, therefore it is necessary to consider the reasons for a rise in the price level over a
period of time. Economists divide the causes in to four main categories.
They are :
1. Cost- Push Inflation
2. Demand – Pull Inflation
3. Monetary Inflation
4. Imported inflation
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1. Cost- Push Inflation
Cost push inflation occurs when the price level is pushed up by increases in the costs of
production. If firms face higher costs , they will usually raise their prices to maintain their profit
margins.
There are number of reasons for an increase in costs:
•
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•
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Graph:
2. Demand–Pull Inflation
Demand-pull inflation occurs when the price level is pulled up by an excess demand.
Aggregate demand for a country’s products can increase due to higher consumption, higher
investment, higher government spending or higher net exports.
Such an increase in Aggregate Demand will not necessarily cause inflation, if aggregate supply
can extend to match it. For instance, when the economy has the plenty of spare capacity, with
unemployed workers and unused machines, higher aggregate demand will result in higher
output but no increase in output.
If the economy is experiencing shortage of some resources , for example –skilled workers, then
aggregate supply may not able to rise in line with aggregate demand and inflation occurs. In
situation of full employment resources it would not be possible to produce anymore output.
Graph:
3. Monetary Inflation
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Monetary Inflation is a form of demand-pull inflation. In this case , excess demand is created
by an excessive growth of money supply.
A group of economists called, Monetarists believe that the only cause of inflation is the
money supply increasing faster than output. They argue that if the money supply increases,
people will spend more and this will lead to an increase in prices.
In explaining their view, monetarists examine the relationship between the money supply and
the velocity of circulation on one hand and the price level and output on the other.
4. Imported inflation
This occurs due to higher import prices, forcing up costs of production and therefore causing
domestic inflation.
The consequences of Inflation
Most of the consequences of inflation are thought to be harmful but some may actually prove
to be beneficial. Inflation can complicate planning and decision making for households, firms
and governments, with many consequences as outlined below.
The harmful effects of Inflation
1. The purchasing power of consumers goes down when there is inflation - there is a fall
in their real income because money is worth less than before. Therefore, as the cost of
living increases, consumers need more money to buy the same amount of goods and
services.
2. The existence of inflation imposes extra costs on firms
•
Menu costs - Inflation impacts on the prices charged by firms. Catalogues, price lists
and menus have to be updated regularly and this is costly to businesses.
•
Shoe leather costs - Inflation causes fluctuations in price levels, so customers spend
more time searching for the best deals. This might be done by physically visiting
different firms to find the cheapest supplier or searching on line. Shoe leather costs
represent an opportunity cost for customers.
3. Inflation redistributes income in an unplanned way.
•
Savers lose out from inflation, assuming there is no change in interest rates for
savings. This is because the money they have saved is worth less than before.
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Resource Person: Chamari Lakshika
•
Lenders lose from inflation. This is because the money lent out to borrowers
becomes worth less than before due to inflation.
•
By contrast, borrowers tend to gain from inflation as the money they need to repay
is worth Jess than when they initially borrowed it - in other words, the real value
of their debt declines due to inflation.
4. Inflation can harm the country’s Balance of payments position.
If a country’s inflation rate is above that of its rivals, its products will become less price
competitive.
5. Inflation can cause a fiscal drag
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The beneficial effects of inflation
1. Inflation may encourage firms to expand.
2. Inflation reduces the real burden of any debt that households and firms have built up
3. Inflation can prevent some workers being made redundant in a declining industry or
region ( this is because whilst workers are likely to resist any cut in their money wages,
they may accept their money wages rising by less than inflation)
Deflation
While the prices of goods and services tend to rise, the prices of some products actually fall
over time. This is perhaps due to technological progress or a fall in consumer demand for the
product, both of which can cause prices to fall.
Deflation is defined as a persistent fall in the general price level of goods and services in the
economy - in other words, the inflation rate is negative
A fall in the rate of inflation (known as disinflation) means that prices are still rising, only
at a slower rate.
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Resource Person: Chamari Lakshika
Deflation rates around the world 2013
Country
Deflation rate(%)
Somalia
-15.35
Chad
-4.90
Labia
-3.60
Japan
-0.30
The causes of deflation
The causes of deflation can be categorised as either demand or supply factors. Deflation is a
concern if it is caused by falling aggregate demand for goods and services (often associated
with an economic recession and rising levels of unemployment).
➢ Deflation caused by supply factors
Deflation can be caused by higher levels of aggregate supply, increasing the productive capacity
of the economy. This drives down the general price level of goods and services while increasing
national income. Such deflation is called benign deflation (non-threatening deflation).
For example, supply-side policies such as investment in education and infrastructure higher
productivity, improved managerial practices, technological advances and government subsidies
for major industries all help to raise national income in the long run.
Graph
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Resource Person: Chamari Lakshika
➢ Deflation caused by demand factors Deflation can also be caused by lower levels of
aggregate demand in the economy, driving down the general price level of goods and
services due to excess capacity in the economy. This causes what is known as malign
deflation (deflation that is harmful to the economy). For example, during an economic
recession, household consumption of goods and services falls due to lower GDP per
capita and higher levels of unemployment.
Graph:
The consequences of deflation
The consequences of deflation depend on whether we are considering benign deflation or
malign deflation. The consequences of benign deflation are positive as the economy is able to
produce more, thus boosting national income and employment, without causing an increase in
the general price level. This therefore boosts the international competitiveness of the country.
However, malign deflation is generally harmful to the economy.
The consequences of malign deflation include the following:
• Unemployment - As deflation usually occurs due to a fall in aggregate demand in the
economy, this causes a fall in the demand for labour - that is, deflation causes job losses in the
economy.
• Bankruptcies - During periods of deflation, consumers spend less so firms tend to have lower
sales revenues and profits. This makes it more difficult for firms to repay their costs and
liabilities (money owed to others, such as outstanding loans and mortgages). Thus, deflation
can cause a large number of bankruptcies in the economy.
• Wealth effect -As the profits of firms fall, so does the value of their shares during times of
deflation. This means that dividends and the capital returns on holding shares fall, thus reducing
the wealth of shareholders.
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Resource Person: Chamari Lakshika
• Debt effect - The real cost of debts (borrowing) increases when there is deflation. This is
because real interest rates rise when the price level falls. For example, if interest rates average
1.0 per cent but the inflation rate is - 1.5 per cent, then the real interest rate is 2.5 per cent
(imagine the situation of falling house prices while having to pay interest on mortgages taken
out when prices were higher). Thus, with deflation and the subsequent rising real value of debts,
both consumer and business confidence levels fall, further adding to the economic problems in
the country.
Hyperinflation in Zimbabwe
Major economic problems in Zimbabwe caused the country to
suffer from extremely high rates of inflation – known as
hyperinflation – between 2003 and 2009.
In June2006, the Central Bank introduced a new 100000
Zimbabwean dollar banknote (less than USS1 back then).
However, by July 2008, inflation had reached a whopping
231,000,000 percent! People carried large bundles of cash to buy
their groceries.
Several
months
later
in
January2009,the
Zimbabwean
government launched the 100 trillion Zimbabwean dollar
banknote (ZWD100000000000000) This meant the currency became worthless, and it was
eventually abandoned.
Today, Zimbabwe still does not have its own official currency, with many preferring to use the
US dollar. With GDP per capita at S487 (about $ l .33 per day), around 80 percent of the country's
12.6 million people live in extreme poverty.
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Resource Person: Chamari Lakshika
Hyperinflation in Venezuela
Currency instability in Venezuela, began,
in
2016
during
the
country's
ongoing
socioeconomic and political crisis. Venezuela began experiencing continuous and uninterrupted
inflation in 1983, with double-digit annual inflation rates. From 2006 to 2012, the government of
Hugo Chávez reported decreasing inflation rates during the entire period. Inflation rates
increased again in 2013 under Nicolás Maduro, and
continued to increase in the following years, with
inflation exceeding 1,000,000% by 2018..
In 2014, the annual inflation rate reached 69%, the
highest in the world.
In 2015, the inflation rate was 181%, again the
highest in the world and the highest in the
country's history at the time. The rate reached
800% in 2016,over 4,000% in 2017,and about
1,700,000% in 2018, with Venezuela spiraling into hyperinflation.
The Central Bank of Venezuela (BCV) officially estimates that the inflation rate increased to
53,798,500% between 2016 and April 2019.
According to experts, Venezuela's economy began to experience hyperinflation during the first
year of Nicolás Maduro's presidency
Potential causes of the hyperinflation include heavy money-printing and deficit spending..
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Resource Person: Chamari Lakshika