LESSON 12- INFLATION
Main Lecture:
1.What is Inflation?
Inflation refers to a general and sustained rise in the level of prices of goods
and services. That is, prices of the vast majority of goods and services on
sale to consumers just keep on rising and rising! Prices change over time so
inflation is always given per period of time - per month or per year. For
example the inflation rate in Pakistan in 2009-2010 was 10.15 % . That is,
on average the prices of all goods and services rose by 10.15 paisa in every
rupee over that year.
2. How does the government calculate Inflation?
An index of consumer prices, the retail price index (RPI), shows the change
in the general price level in percentage terms over time. It seeks to calculate,
the changes in the price of a very large 'shopping basket' of the products
bought by consumers. There are a number of stages in constructing a price
index. Firstly, a base year has to be selected. Government statisticians try to
select a relatively standard base year in which there were no dramatic
changes, in other years are compared to this figure. Then, the spending
patterns of house holds are observed by carrying out surveys of house hold
expenditure from a sample of representative house holds. From the
information obtained, the main commodities being bought by households are
identified and weights are assigned to each commodity which reflect the
proportion of expenditure on that commodity. Each month government
officials find out information about prices of these commodities and estimate
the change in prices. Having assigned weights to different items included in
the index and measured price for each category, and then sum up the
weighted index of each category to obtain the Retail Price Index.
For Example
Commodity
Food
Housing
Transport
Entertainment
Weights
x
Price Index
=
0.4
0.1
0.3
0.2
1.0
x
x
x
x
130
120
105
90
=
=
=
=
Weighted Price
Index
52
12
31.5
18
RPI = 113.5
Hence using data from the above table, it can be said that relative to the base
year, prices have increased by 13.5% (113.5 - 100)
3. Causes of Inflation
(i) Government policies:
Some economists argue that governments only have themselves to blame for
the high inflation rates. This is because some governments try to boost
demand to reduce unemployment in the economy in periods when labour
unemployment is high and rising. For a time the increase in demand will
reduce unemployment as firms take on more resources to produce more
goods and services. However, inflation soon begins to rise as aggregate
demand increases faster than output. Eventually the high inflation reduces
the purchasing power of people's incomes and demand for goods and
services begins to rise.
The government also aims for economic growth. However, it is a known fact
that economic growth also results in inflation.
(ii) Demand-pull Inflation:
Inflation caused by an increase in aggregate demand is called demand-pull
inflation. Aggregate demand in an economy will rise if spending by
governments, consumers and/or firms increases. Consumers will be able to
spend more of their incomes if they reduce saving or if a government cuts
income taxes. An increase in aggregate demand will cause prices to increase
and inflation to rise if firms are unable to increase supply of goods and
services at the same rate.
(iii) Cost-push Inflation
Inflation caused by higher costs feeding into higher prices is called cost-push
inflation. The cost of producing goods and services can rise because workers
demand increases in wages or cost of raw material rises etc. Firms may pass
these higher costs on to consumers as higher prices so that they do not have
to suffer a cut in their profits. A rise in costs is likely to cause a fall in
supply. As supply falls, prices will rise (keeping other factors constant).
(iv) Imported Inflation
Many materials and finished goods and services are imported from overseas.
An increase in their prices will also boost inflation in Pakistan. This
imported inflation can occur if the value of the Pakistani Rupees falls against
foreign currencies like the US dollar or Euro. As the value of Rs falls the
price paid for imported products will rise even if the prices of those goods in
US dollars, Euros or other foreign currencies have not changed. The reverse
is also true: if the value of the Rs rises the price paid for imported products
will fall.
4. Costs of Inflation:(i) Personal Costs
Rising prices reduce the purchasing power of people's incomes. That is, their
real income, in terms of what it can buy, falls. For example pensioners and
students who are on fixed incomes decided by the Government, face a stern
challenge by the rising prices while their incomes remain stagnant. Thus
their purchasing power falls. However professional people and workers in
strong trade unions may be able to ask for wage and salary increases. For
them, inflation wouldn't hurt that much!
People who save or lend money may also be hurt by inflation. If they find
the interest rate received on money they have saved or lent is lower than the
inflation rate the real value of their money will fall. They will be worse off.
On the other hand, people who borrow money will benefit by repaying less
in real terms than they borrowed.
(ii) Cost to the society
Some economists argue that inflation causes unemployment. As prices rises,
people cannot afford to buy so many goods and services and so demand
falls. In addition, some people save more in times of high inflation to protect
the real value of their savings. This again means less spending on goods and
services. As a result firms may cut their output and make resources,
including labour, unemployed.
If the Pak rate of inflation is higher than the rate of price inflation in other
countries it becomes more and more difficult for Pak firms to sell their
increasingly expensive goods and services abroad. In addition, Pak
consumers may increase their spending on cheaper imports and buy fewer
domestic products.
QUESTION/ANSWERS SESSION
Q1. How might inflation affect a person's spending, saving and borrowing?
[10]
Ans. Inflation erodes the value of money reducing the purchasing power of
consumers. This implies that a person needs to spend more in nominal terms
to consume the same amount of goods and services, for instance, if a pair of
jeans costed Rs.500 in year 1. At an annual average rate of inflation of, say
10%, the person would have to spend Rs.550 to buy the same pair of jeans in
year 2. So inflation might increase a person's spending, at least in money
terms. However, as goods and services become expensive due to inflation,
quantity demanded is likely to fall, according to the law of demand. Thus,
with unchanged money income levels, a person's real spending might fall,
but his basic necessities before he decides to save a part of his income. As
real incomes decline due to inflation, savings are likely to fall. This is
because money saved today will have less purchasing power in the future so
a person might prefer to spend today to avoid the loss of purchasing power
in the future. However , it depends on the purpose of saving and the
expected rate of future inflation. Unlike savings, inflation might increase a
person's borrowing. This is because the person would have to repay less
than the borrowed amount in real terms, as money would lose value over
time so borrowers are likely to gain during a period of inflation. Also,
increased borrowing may be required to maintain current spending, if money
incomes do not increase in line with the rate of inflation. However, the effect
on a particular person will depend on that person's particular circumstances,
the prevailing rate of inflation, and the person's expectations regarding
future incomes and prices.