INFLATION

Inflation is a persistent rise in the general price level

It is a persistent and appreciable rise in the general price level
When there is inflation the prices of all goods and services show an upward trend
Disinflation a reduction in the rate of inflation.
Deflation a decline in the economy’s price level.
Degrees of Inflation
Creeping Inflation : a low rise in the price level, say, 1 to 2 % a year.
Galloping Inflation : a moderate rise in the price level, say, 5 to 6 % a year.
Hyperinflation : an extremely rapid rise in the price level, for example, over 20 % a year.

Types and causes of inflation

Demand-pull inflation

Demand pull inflation occurs when people have lot of money which increases AD and production of goods
cannot match the increase in Ms. It occurs when the economy is at full employment. Remember that
Keynesians assume that the long run aggregate supply (LRAS) curve is horizontal, upward sloping and then
vertical. Assume that the current level of aggregate demand is AD 1. The price level is P1 and the level of real
output is Y1. There is a lot of spare capacity in the economy. The level of output is nowhere near the full
employment level YFE. An increase in aggregate demand (AD from now on) to AD 2 in this situation, due to a rise
in government spending, for example, will cause in increase in real output (to Y 2) with no penalty in terms of
rising prices.
Further increases in government spending would start to be inflationary. A shift in the AD curve from AD 2 to
AD3 will increase real output (from Y2 to Y3) but the price level will also rise (from P1 to P2). The result is similar
if AD rises to AD4. At this stage, the economy is approaching the full employment level of real output, so some
industries still have some spare capacity but others will be at full capacity, resulting in price rises in some
industries, and so a rise in the average price level when AD rises.

A further increase in AD when the economy is at full employment (AD level AD 4) will simply result in a price
rise with no increase in the level of real output.

The diagram shows that increases in the level of demand in an economy cause inflation. The rising level of
demand is 'pulling' the price level up, hence the name 'demand-pull' inflation. This effect can also be shown on
the 45-degree diagram, where a level of demand above that which gives a full employment equilibrium results
in an inflationary gap. The best example of this happening in the UK economy was the consumer boom of the
late 80s. Excessive demand in the economy forced the inflation rate up to 10%.

Cost-push inflation

This cause of inflation is associated with rises in the costs of an industry, or the economy generally. The main
reasons why costs might rise are (i) increases in wages and salaries (the biggest cost of production economy
wide); (ii) increases in the cost of raw materials; (iii) increases in the price of imported goods (either as finished
goods, semi-finished manufactures or raw materials) due to a fall in the value of the Zim $ or price rises in the
country of origin; (iv) increases in indirect taxes (or reductions in government subsidies). Any of these factors
will have the inflationary effects

Short run aggregate supply (SRAS) curves have been used, but the analysis could be applied to LRAS curves.
Quite simply, an increase in the costs of an economy will shift the SRAS curve to the left (from SRAS 1 to SRAS2)
causing the price level to rise to P2 and the level of real output to fall to Y2.

MEASURES OF INFLATION
1. Cost of living Index (COLI)
also called the retail price index or consumer price index. This is the most frequently used measure and is
based on observations of prices of a ‘basket’ of goods selected as a representative of the spending patterns of
consumers within some specified range of incomes.
2. Wholesale price index
is the index which measures prices of commodities commonly bought and sold by wholesalers. This index has
an advantage over the consumer price index in that it gives an earlier warning of an upsurge in prices than a
retail index. It takes time for a rise to work its way through to the shops and markets.
3. The GNP deflator
This is derived from comparisons of GNP estimates in current prices and in constant prices. Prices of consumer
goods, capital goods etc. are taken into consideration when compiling this.

The Retail Price Index (RPI)

This was virtually the only measure available until the early 80s. The index has no units. It is just a set of
numbers that show the monthly change in the (weighted) average of a 'basket' of goods and services. The
choice of goods and services that make up this 'basket' has to reflect a typical household. An annual Family
Expenditure Survey that is used to find which goods and services to include in the 'basket' and which are the
most important, can be done. Housing and food costs, for example, will be more important (because they
make up a larger proportion of a typical household's monthly expenditure) than, say, tobacco.The inflation
figure, therefore, is the annual percentage change in this index, from the most recent month compared with
the same month in the previous year. It is often referred to as the headline rate of inflation.

Construction of the Retail Price Index

Worked example

Inflation = 20%

Weaknesses of the RPI

 The number of goods included in the same basket is far from a complete inventory of the economy.
 The accuracy of the index can vary with the effectiveness of the data collection, the construction and
coverage of the index and the extent to which it is updated.
 The index does not account for the changes in the quality of goods. An increase in prices may be the
result of an improvement in quality and therefore should not be counted as an increase in the price
level only. It is somehow an increase in the cost of living.
 The same basket is fixed and does not take into account that people may make substitution toward
the lower-priced goods instead.
 The C. P. I. has an upward and downward bias. It overstates or understates the rate of change in price.
Negative effects of inflation
• Effect on those on fixed incomes in particular. Inflation penalizes people on ‘fixed’ incomes and favours
those whose money incomes adjust quickly to price changes. The former group includes pensioners, University
students, and many salary earners, while most wage and profit earners fall into the latter category.
•Savers can be worse off if inflation is greater than the rate of interest Inflation favours borrowers and
penalizes lenders as long as it is unanticipated. Thus, if interest rates are fixed, in money terms in the
anticipation that the level of prices will remain constant (or the rate of inflation will remain constant), an
increase in the prices will reduce the real cost of borrowing. Savers are key to future investment, growth and
development.
•Inflation impairs the efficiency of the price mechanism and raises the cost of buying and selling because
money becomes less reliable as a standard of value.
•A continuing higher rate of domestic inflation than experienced in other economies can lead to increased
imports and reduced exports and can lead to create potential problems for stable exchange rates
•Given a system of un-indexed taxes, namely one where taxes are fixed in money terms rather than real terms,
inflation will redistribute income from the private to the public sector.
•A country’s exports can become less price-competitive in world markets (the actual effect will depend on
inflation rates in different countries).
•Industrial disputes may occur if workers are unable to secure wage increases to restore their standard of
living.
• Low worker morale, which affects productivity, quality and the supply of goods and services
• lenders of money can be worse off (again, depending on the interest rate)
• Widespread uncertainty, which makes forward business planning difficult
• Speculative activities, which divert resources from productive activities
• Strain on the country’s foreign exchange due to increased import demand
• reduction in purchasing power of a given sum of money
• can be linked with unemployment (stagflation)
• decline in real income
• may undermine confidence in the currency
Possible benefits:
• It can act as an incentive to firms to produce
• It could stimulate economic growth
• It leads to higher wage increases
• Borrowers of money may gain.
• could lead to higher profits for firms
•The government finds that people earn more and so pay more income tax, inflation pushes income earners
into higher tax brackets (where tax system is progressive). This may however defeat the economic policy of
reaching full employment because total spending decreases automatically.
Solutions
 Contractionary monetary policy and other monetary policy measures
 Contractionary fiscal policy
 Increasing productivity – matching an increase in Ms with an increase in production of goods and services
 Freezing wages and salaries mainly used to control cost push inflation. It is an unpopular policy with
employees
 Introduction of price controls, effective if coupled with other inflation control polices, however, may result
in shortages, black markets, conflicts with retailers and an increase in price after the price control period
 Indexing, matching increases in prices with matching increases in wages and salaries
 Moral suasion
Inflation vs expectations
DEFLATION
Definition: The term refers to a sustained decrease in the average price level. Deflation exists if prices, overall,
decrease in the economy. (note that disinflation refers to a decrease of inflation; this means that during a
disinflationary period prices continue to rise but at a slower rate; if, for example, the inflation rate has
decreased from 8.7% to 5.5% and then to 2.1%, then the price level continues to rise but at a decreasing rate.
If though the inflation rate was 1.3% in, say, 2002, and -0.6% in 2003, then the economy was experiencing
deflation as the price level was decreasing (prices were falling) in 2003.
Japan has been suffering by deflation in the past few years. In January 2006, the latest figure for the % change
in Japan of consumer prices on year earlier was -0.8%. This means that the average consumer price level has
decreased by 0.8% compared to January 2005 (The Economist, January 21-27 2006, page 96)
Costs of deflation
Deflation is very costly and difficult to cure. Some costs of deflation include:
 The real value of debt increases à this makes indebted consumers hesitant (lower consumer confidence)
to make purchases and indebted firms hesitant (as revenues are also falling) to make investments AD thus
decreases even more
 Borrowers are worse off while lenders are better off (they will be owed more in real terms) thus creating
disincentive to borrow
 Falling prices (“companies cut prices to win over customers”) squeeze firms’ profit margins also firms are
forced cut down on costs thus, wages fall and / or layoffs follow (unemployment rises) with AD falling
further
 Consumers delay purchases since they are concerned with their own job and financial outlook. They also
come to expect further price decreases hence AD falls further
 Monetary policy may become totally ineffective (entering a ‘liqudity trap’ according to Keynes).
 Nominal interest rates cannot become negative any extra liquidity (money) will be kept as cash as
incentive to borrow diminishes
 Fiscal policy (extra spending by the government and/or lower taxes) may prove equally ineffective as
households prefer to save (hoard the extra cash) and postpone spending financial institutions accumulate
“bad” loans (loans that aren’t repaid); risk of banking crisis with repercussions on the real economy.

Representative basket for Zimbabwe and weights 2012