NATIONAL INCOME ANALYSIS

1. MEANING

National Income is a measure of the money value of goods and services becoming available to a nation from
economic activities. It can also be defined as the total money value of all final goods and services produced by
the nationals of a country during some specific period of time – usually a year – and to the total of all incomes
earned over the same period of time by the nationals.

2. DIFFERENT CONCEPTS OF NATIONAL INCOME

Gross Domestic Product

The money value of all goods and services produced within the country but excluding net income from
abroad.

Gross National Product

The sum of the values of all final goods and services produced by the nationals or citizens of a country during
the year, both within and outside the country.

Net National Product

The money value of the total volume of production (that is, the gross national product) after allowance has
been made for depreciation (capital consumption allowance).

Nominal Gross National Product

The value, at current market prices, of all final goods and services produced within some period by a nation
without any deduction for depreciation of capital goods.

Real Gross National Product

This is the national output valued at the prices during some base year or nominal GNP corrected for inflation.

3. NATIONAL INCOME ACCOUNTING

This refers to the measuring of the total flow of output (goods and services) and of the total flow of inputs
(factors of production) that pass through all of the markets in the economy during the same period.

To see exactly what national income includes, how it is measured, and what it can tell us, we start with
economic models: By economic models we mean:

A simplification of a real world or a practical situation aimed at explaining that situation

within a set of assumptions.

The Circular Flow of Income and Expenditure

This is an economic model illustrating the flow of payments and receipts between domestic firms and

1
 domestic households. The households supply factor services to the firms. In return, they get factor
incomes. With factor incomes, they buy goods and services from the firms. These flows can be illustrated
diagrammatically as follows for a two sector economy:

Two Sector economy = Household + Firms

Y = C + I

The points at which flows from one sector meets the other sector and generate other flows are called critical
points. In the above diagram, the critical points are A, B and C. At A, the flow of factor services from the
households sector meets the firm sector and generates the flow of factors incomes from the firms to the
households. At B, the flow of factor incomes meets the household sector and generates the flow of consumer
spending. At C, the flow of consumer spending meets the firms sector and generates the flow of goods and
services.

2
3
CIRCULAR FLOW OF INCOME FOR A THREE SECTOR ECONOMY

Three Sector economy = Household + Firms + Governemt

Y = C + I + G
CIRCULAR FLOW OF INCOME FOR A FOUR SECTOR ECONOMY

Four Sector economy = Household + Firms + Government + Exports - Imports

Y = C + I + G + X - I

4
5
4. APPROACHES TO MEASURING NATIONAL INCOME

The compilation of national income statistics is a very laborious task. The total wealth of a nation has to be
added up and there are millions of nationals. Moreover, in order to double check and triple check the statistics,
the national income statistician has to work out the figures out in three different ways, each way being based on
a different aspect. The three aspects are:

a. The national output: - The creation of wealth by the nation’s industries. This is valued at factor cost, so it
must be the same as b) below.

b. The national income: - The incomes of all the citizens.

c. The national expenditure because whatever we receive we spend, or lend to the banks to invest it, so that
the addition of all the expenditure should come to the same as the other two figures.

Put in its simplest form we can express this as an identity:

National output  National Income  National Expenditure.

(i) Using Total Expenditure for Calculating National Income

The expenditure approach centres on the components of final demand which generate production. It thus
measures GDP as the total sum of expenditure on final goods and services produced in an economy. It
includes

• All consumers’ expenditure on goods and services, except for the purchase of new houses which is
included in gross fixed capital formulation.
• All general government final consumption. (all current expenditure by central and local government on
goods and services, including wages and salaries of government employees.)
• gross fixed capital formation or expenditure on fixed assets (buildings, machinery, vehicles etc) either
for replacing or adding to the stock of existing fixed assets. This is the major part of the investment which
takes place in the economy.
• value of physical increases in the stocks, or inventories, during the course of the year. The total of all
this gives us Total domestic expenditure (TDE).
• expenditure on exports to the TDE and arrive at a measure known as Total Final Expenditure. It is so
called because it represents the total of all spending on final goods.
• the final expenditure is on imported goods and we therefore subtract spending on imports.

Having done this we arrive at a measure known as gross domestic product at market prices.

To gross domestic product at market price we

• subtract the taxes on expenditure levied by the government and add on the amount of subsidy.

When this has been done we arrive at Gross Domestic Product at factor cost.

National Income however is affected by rent, profit interest and dividends paid to, or received from,
overseas. This is added to GDP as net property income from abroad.

6
 This figure may be either positive or negative. When this has been taken into account we arrive at the gross
national product at factor cost.

As production takes place, the capital stock of a country wears out. Part of the gross fixed capital formation is
therefore, to replace worn out capital and is referred to as Capital Consumption.

When this has been subtracted we arrive at a figure known as the net national product. Thus, summarising
the above, we can say:

Y = C + I + G + (X – M)

(ii) Using Factor Incomes for Calculating National Income

A second method is to sum up all the incomes to individuals in the form of wages, rents, interests and profits
to get domestic incomes.
• This is because each time something is produced and sold someone obtains income from producing it.
• It follows that if we add up all incomes we should get the value of total expenditure, or output.
• Incomes earned for purposes other than rewards for producing goods and services are ignored.
• Such incomes are gifts, unemployment or relief benefits, lottery, pensions, grants for students etc.
• These payments are known as transfer income (payments) and including them will lead to double
counting.
• The test for inclusion in the national income calculation is therefore that there should be a “quid pro quo”
that the money should have been paid against the exchange of a good or service.
• Alternatively, we can say that there should be a “real” flow in the opposite direction to the money flow. We
must also include income obtained from subsistence output.
• This is the opposite case from transfer payments since there is a flow of real goods and services, but no
corresponding money flow.
• It becomes necessary to “impute’’ values for the income that would have been received. Similarly workers
may, in addition to cash income, receive income in kind; if employees are provided with rent free housing,
the rent which they would have to pay for those houses on the open market should, in principle, be
“imputed” as part of their income from employment. The sum of these incomes gives gross domestic
product GDP.
• This includes incomes earned by foreigners at home and excludes incomes earned by nationals abroad. Thus,
to Gross Domestic Income we add Net property Income from abroad.
• This gives Gross National Income.
• From this we deduct depreciation to give Net National Income.

(iii) Using the National Output for Calculating National Income

A final method which is more direct is the “output method” or the value added approach.
• This involves adding up the total contributions made by the various sectors of the economy.
• “Value Added” is the value added by each industry to the raw materials or processed products that it
has bought from other industries before passing on the product to the next stage in the production
process.
• This approach therefore centres on final products.

7
 • Final products will include capital goods as well as consumer goods since while intermediate goods are
used up during the period in producing other goods, capital goods are not used up (apart from “wear and
tear” or depreciation) during the period and may be thought of as consumer goods “stored up” for future
periods. Final output will include “subsistence output”, which is simply the output produced and
consumed by households themselves.
• Because subsistence output is not sold in the market, some assumption has to be made to value them at some
price.
• We also take into account the final output of government, which provides services such as education,
medical care and general administrative services.
• However, since state education and other governmental services are not sold on the market we shall not have
market prices at which to value them.
• The only obvious means of doing this is to value public services at what it costs the government to supply
them that is, by the wages bill spent on teachers, doctors, and the like.
• When calculating the GDP in this matter it is necessary to avoid double counting.

5. SOME DIFFICULTIES IN MEASURING NATIONAL INCOME

National Income Accounting is beset with several difficulties. These are:

a. What goods and services to include

Although the general principle is to take into account only those products which change hands for money,
the application of this principle involves some arbitrary decisions and distortions. For example, unpaid
services such as those performed by a housewife are not included but the same services if provided by a
paid housekeeper would be.

Many farmers regularly consume part of their produce with no money changing hands. An imputed value is
usually assigned to this income. Many durable consumer goods render services over a period of time. It
would be impossible to estimate this value and hence these goods are included when they are first bought
and subsequent services ignored. Furthermore, there are a number of governmental services such as
medical care and education, which are provided either 'free' or for a small charge. All these provide a
service and are included in the national income at cost. Finally, there are many illegal activities, which are
ordinary business and produce goods and services that are sold on the market and generate factor incomes.

b. Danger of Double Counting

The problem of double counting arises because of the inter-relationships between industries and sectors.
Thus we find that the output of one sector is the input of another. If the values of the outputs of all the
sectors were added, some would be added more than once, giving an erroneously large figure of national
income. This may be avoided either by only including the value of the final product or alternatively by
summing the values added at each stage which will give the same result.

Some incomes such as social security benefits are received without any corresponding contribution to
production. These are transfer payments from the taxpayer to the recipient and are not included. Taxes and
subsidies on goods will distort the true value of goods. To give the correct figure, the former should not be
counted as an increase in national income for it does not represent any growth in real output.

c. Inadequate Information
The sources from which information is obtained are not designed specifically to enable national income to
be calculated. Income tax returns are likely to err on the side of understatement. There are also some

8
 incomes that have to be estimated. Also, some income is not recorded, as for example when a joiner,
electrician or plumber does a job in his spare time for a friend or neighbour. Also information on foreign
payments or receipts may not all be recorded.

Factors affecting the size of a National Income

The size of a nation’s income depends upon the quantity and quality of the factor endowments at its disposal.
A nation will be rich if its endowments of natural resources are large, its people are skilled, and it has a useful
accumulation of capital assets. The following points are of interest:

a) Natural Resources
These include the minerals of the earth; the timber, shrubs and pasturage available; the agricultural potential
(fertile soil, regular rainfall, temperature or tropical climate); the fauna and flora; the fish; crustacea etc of
the rivers and sea; the energy resources, including oil, gas, hydro-electric, geothermal, wind and wave power.

b) Human Resources
A country is likely to prosper if it has a large population; literate and numerate sophisticated and
knowledgeable about wealth creating processes. It should be well educated and skilled, with a nice mixture
of theory and practice. It should show enterprise, being inventive, energetic and determined in the pursuit
of a better standard of living.

c) Capital Resources
A nation must create and then conserve capital resources. This includes not only tools, plant and
machinery, factories, mines, domestic dwellings, schools, colleges, etc, but a widespread infrastructure of
roads, railways, airports and ports. Transport creates the utility of space. It makes remote resources
accessible and high-cost goods into low-cost goods by opening up remote areas and bringing them into
production.

d) Self-sufficiency
A nation cannot enjoy a large national income if its citizens are not mainly self-supporting. If the majority
of the enterprises are foreign –owned there will be a withdrawal of wealth in the form of profits or goods
transferred to the investing nation.

e) Political Stability

6. USES OF NATIONAL INCOME FIGURES

• We need national income statistics to measure the size of the "National cake' of goods and services
available for competing uses of private consumers, government, capital formation and exports (less
imports).

• National Income statistics are also used in comparing the standard of living of a country over time

• And also the standards of living between countries.

• National Income Statistics provide information on the stability of performance of the economy over
time e.g. a steadily increasing income would be indicative of increasing national income.

9
 • If National Income Statistics are disaggregated it would enable us to assess the relative importance of the
various sectors in the economy. This is done by considering the contribution of the various sectors to
Gross National Product over time. Such information is crucial for planning purposes for it reveals to
planners where constraints to economic development lie. It therefore becomes possible to design a
development strategy that eventually would overcome these problems. This central contribution could be
in the form of employment or the production of goods and services.

• By assessing exports and imports as a percentage of Gross national Product i.e. using national statistics, it
is possible to determine the extent to which a country depends on external trade.

• National Income Statistics also help in estimating the saving potential and hence investment
potential of a country.

Real Vs Nominal GNP: “Deflating” by a price Index

One of the problems that confront economists when measuring GNP is that they have to use money as the
measuring rod. These days however, inflation sends the general price level up and up clearly this means that the
yardstick stretches in their hands every day.

Economists repair most of the damage wrought by the elastic yardstick by using a price index. The price index
used to remove inflation (or “deflate’’ the GNP) is called the GNP deflator. The GNP deflator is defined as the
ratio of nominal GNP to real GNP. It is constructed as follows:

GNP Deflator = Nominal GNP

Real GNP

Real GNP = Value at current Price

CPI

Where CPI is Consumer Price Index

The GNP deflator is useful because it includes prices on all goods and services in GNP.

PER CAPITA INCOME

By National Income is meant the value of outputs produced within a year. Income per capita is simply the
National Income divided by the population of the country in a year.

INCOME PER CAPITA = National Income

Population

It shows the standard of living a country can afford for its people. The level of income per capita is
determined by the size of a country’s population. The higher is the rate of growth of population; the lower
is the rate of growth of income per capita.

Per capita income is a theoretical rather than a factual concept. It shows what the share of each individual’s
National Income would be if all citizens were treated as equal. In a real world situation there exists considerable
inequality in the distribution of income especially in the third world countries.

10
NATIONAL INCOME AND WELFARE
The relationship between National Income and Welfare is best explained in terms of economic growth
(By economic growth is meant capacity expansion). The effect of economic growth is an increase in
the National Income. This increase in National Income has several effects on a country’s citizens.

1) Assuming a fair distribution of income, the average citizen would be in a position to enjoy a higher living
standard.

2) The ordinary households or persons could be able to afford luxury commodities. NB: luxury differs in its
definition from one country to another and the determining factor being the level of income. e.g. clothing
can be a luxury for some people.

3) It enables the ordinary household to afford leisure which may be regarded as luxury i.e. reducing working
hours.

Points 1, 2 and 3 are based on assumption that there exists a fair distribution of the National cake. This
may not be the case in fact it is disastrous to rely on GNP, its growth rate and GNP per capita as indicators of
economic well being.

GNP per capita e.g. gives no indication of how National Income is actually distributed and who is
benefiting most from the growth of production. A rising level of absolute and per capita GNP may camouflage
the fact that the poor are not better than before. In fact the calculation of GNP, and especially its rate of
growth is in reality largely a calculation of the rate of growth, of the incomes of upper 20% who receive a
disproportionately large share of the National Product. It is, therefore, unrealistic to use GNP growth rates as
an index of improved economic welfare for the general public.

Example: Assuming a 10 people economy and assuming 9 of them had no income and the 10 th person receives
100 units of income the GNP for this economy would be 100 units of income and per capita income would be
10 units. Suppose everyone’s income increases by 20% so that GNP rises to 120 units per capita income would
rise to 12 units. However for the 9 people without income before and currently such a rise in per capita income
provides no cause for rejoicing since the one rich individual still has the income. In this case we observe that
GNP instead of being a welfare index of a society as a whole is merely increasing the welfare of a single
individual.

This exchange though an extreme case is indicative of what happens in the real life situation where incomes are
very unequally distributed.

NATIONAL INCOME AND STANDARDS OF LIVING

Standard of living refers to the quantity of goods and services enjoyed by a person. These goods may be
provided publicly, such as in the case of health care or education or they may be acquired by direct purchase. It
also includes the less easily quantifiable aspects of living such as terms and conditions of employment and general
living environment.

National Income figures can be used to measure the standard of living at a particular point of time and over time.
This is done by working out the per capita income of the country. By per capita income we mean: the value of
goods and services received by the average man. Per capita income is obtained by dividing the National
Income by the Total population. If the per capita income is high, it can be deduced that the standard of living is
high.

11
 PROBLEMS OF USING PER CAPITA INCOME TO COMPARE STANDARD OF LIVING OVER
TIME

1) The composition of output may change. e.g. more defence-related goods may be produced and less spent
on social services, more producer goods may be made and less consumer goods, and there may be a surplus
of exports over imports representing investment overseas. Standards of living depend on the quantity of
consumer goods enjoyed.

2) Over time prices will change. The index of retail prices may be used to express the GNP in real terms but
there are well known problems in the use of such methods.

3) National Income may grow but this says nothing about the distribution of that income. A small group
may be much better off. Other groups may have a static standard of living or be worse off.

4) Any increase in GNP per capita may be accompanied by a decline in the general quality of life.
Working conditions may have deteriorated. The environment may have suffered from various forms of
pollution. These non-monetary aspects are not taken into account in the estimates of the GNP.

5) Finally the national income increases when people pay for services which they previously carried out
themselves. If a housewife takes an office job and pays someone to do her housework, national income will
increase to the extent of both persons' wages. Similarly a reduction in national income would occur if a man
painted his house rather than paying a professional painter to do the same. Changes of the above type mean
that changes in the GNP per capita will only imperfectly reflect changes in the standard of living.

PER CAPITA INCOME AND INTERNATIONAL COMPARISONS

Per capita income figures can also be used to compare the standards of living of different countries. Thus if the per
capita income of one country is higher than that of another country, the living standard in the first country can be
said to be higher. Such comparisons are made by aid giving international agencies like the United Nations and they
indicate the relevant aid requirements of different countries.

But there are major problems in using real income per head (per capita income) to measure the standard of living
in different countries. First there is the whole set of statistical problems and, secondly, there are a number of
difficult conceptual problems or problems of interpretation.

i. Inaccurate estimates of population: The first statistical problem in calculating income per head particularly
in less developed countries is that we do not have very accurate population figures with which to divide total
income.

ii. Specific items which are difficult to estimate: Another data problem, as already mentioned, is that data
for depreciation and for net factor income from abroad are generally unreliable. Hence although we should
prefer figures for “the’ national income, we are likely to fall back on GDP, which is much less meaningful
figure for measuring income per head. Inventory investment and work-in-progress are also difficult items to
calculate.

iii. Non-marketed subsistence output and output of government: some output like subsistence farming and
output of government are not sold in the market. These are measured by taking the cost of the inputs. In
one country, however, salary of doctors for instance, might be higher and their quality low compared to

12
 another country. Although the medical wage bill will be high, the "real consumption” of medical care in the
former might be lower. Since “public consumption” is an important element in national income, this could
affect comparisons considerably.

Also in making international comparisons it is assumed that the complied national income figures of the
countries being compared are equally accurate. This is not necessarily the case. If, for example, in one country
there is a large subsistence sector, a lot of estimates have to be made for self-provided commodities. The
national figures of such a country will, therefore, be less accurate than those of a country whose economy is
largely monetary or cash economy.

iv. Different degrees of income distribution: If the income of one country is evenly distributed, the per capita
income of such a country may be higher than that of another country with a more evenly distributed income,
but this does not necessarily mean that most of its people are at a higher living standard.

v. Different Types of Production: If one country devotes a large proportion of its resources in producing
non-consumer goods e.g. military hardware, its per capita income may be higher than that of another country
producing largely consumer goods, but the standard of living of its people will not necessarily be higher.

vi. Different forms of Published National Income figures: The per capita income figures used in
international comparisons are calculated using the published figures of national income and population by
each country. For meaningful comparisons, both sets of national income figures should be in the same form
i.e. both in real terms or both in money terms, the latter may give higher per capita income figures due to
inflation, and thus give the wrong picture of a higher living standard. On the other hand, if both sets are in
money terms the countries being compared should have the same level of inflation. In practice, this is not
necessarily the case.

vii. Exchange Rates: Every country records its national income figures in its own currency. To make
international comparisons, therefore, the national income figures of different countries must have been
converted into one uniform currency. Using the official exchange rates does this. Strictly speaking, these
apply to internationally traded commodities, which normally form a small proportion of the national
production. The difficulty is that these values may not be equivalent in terms of the goods they buy in their
respective commodities i.e. the purchasing power of the currencies may not be the same as those reflected in
the exchange rate.

viii. Difference in Price Structures: Differences in the relative prices of different kinds of goods, due to
differences in their availability, mean that people can increase their welfare if they are willing to alter their
consumption in the direction of cheaper goods. The people in poor countries probably are not nearly as
badly off as national income statistics would suggest, because the basic foodstuffs, which form an important
part of their total consumption, are actually priced very low.

ix. Income in relation to Effort: The first conceptual problem in calculating income per head is to look at
goods and services produced in relation to the human effort that has gone into producing them.
Obviously if people work harder, they will be able to get more goods; but they may prefer the extra leisure.
Indeed, the amount of leisure that people want depends in part on their level of income. Strictly,
therefore, we should take income per unit of labour applied. It is largely because this would be statistically
awkward that economists prefer to take real income per head.

x. Differences in size: A problem which is both conceptual and statistical is due to the transport factor. If
two countries are of different sizes, the large country may devote a large proportion of its resources in

13
 developing transport and communication facilities to connect the different parts of the country. This will
be reflected in its national income, but the standard of living of its people will not necessarily be higher
than that of smaller country, which does not need these facilities to the same extent.

xi. Differences in Taste: Another formidable difficulty is that tastes are not the same in all countries. Also
in different countries the society and the culture may be completely different thus complicating
comparisons of material welfare in two countries. Expensive tastes are to some extent artificial and their
absence in poor countries need not mean a corresponding lack of welfare. Tastes also differ as regards the
emphasis on leisure as against the employment of the fruit of labour: if in some societies people prefer
leisure and contemplation, who is to say this reduces their welfare as compared to those involved in the
hurly-burly of life and labour in modern industry?

xii. Different climatic zones: If one country is in a cold climate, it will devote a substantial proportion of its
resources to providing warming facilities, e.g. warm clothing and central heating. These will be reflected in
its national income, but this does not necessarily mean that its people are better off than those in a country
with a warm climate.

xiii. Income per head as index of economic welfare: We cannot measure material welfare on an arithmetic
scale in the same way as we measure real income per head. For instance, if per capita income increases,
material welfare will increase; but we cannot say by how much it has increased, and certainly that it has
increased in proportion.

14
 INFLATION
Meaning

The word inflation has at least four meanings.

• A persistent rise in the general level of prices, or alternatively a persistent falls in the value of
money.

• Any increase in the quantity of money, however small can be regarded as inflationary.

• Inflation can also be regarded to refer to a situation where the volume of purchasing power is
persistently running ahead of the output of goods and services, so that there is a continuous
tendency of prices – both of commodities and factors of production – to rise because the supply of
goods and services and factors of production fails to keep pace with demand for them. This type
of inflation can, therefore, be described as persistent/creeping inflation.

• Finally inflation can also mean runaway inflation or hyper-inflation or galloping inflation where a
persistent inflation gets out of control and the value of money declines rapidly to a tiny fraction of
its former value and eventually to almost nothing, so that a new currency has to be adopted.

Measurement of Inflation
The rate of inflation is measured using the Retail Price Index. A retail Price Index aims to measure
the change in the average price of a basket of goods and services that represents the consumption
pattern of a typical household. It estimates the change in the cost to consumers of a range of
commodities that they typically buy. It is usually prepared for different classes of consumers and for
different areas. The index is measured as follows:

n
∑ P1 iQoi
i=1
1=
n
∑ 1 PoiQoi
i

Where: I is the cost of living index

n is the number of commodities in the representative basket.

P1i is the price of the commodity in the basket in the current period
Qoi is the weight of the commodity in the consumer’s basket.
Poi is the price of the commodity I in the base period

The calculation of the index requires:

• Selection of commodities to be included in the consumers basket
• Selection of the base period weights for each commodity
• Date on prices of the commodities in the current period and in the base period
Such an index then estimates the cost of living or the purchasing power of incomes. If the index
increases by 10% in a given period, wages would need to rise by 10% for purchasing power to
remain constant. It is in this regard that trade unions and workers demand that wages should
increase pari-passu with the cost of living index.

15
TYPES AND CAUSES OF INFLATION

Types of Inflation
• Moderate or Mild Inflation
One way of classifying inflation is in terms of the rate at which the general level of price
increases. Here the price level rises slowly. Increase is generally single digit. It does not cause
much concern as it is seen as good for business.

• Galloping Inflation
Refers to a rapid increase in the general level of prices. The one percentage rate of increase is
in terms of tens and hundreds

• Hyper Inflation or Run-way inflation

This refers to a situation where the rate of increase in general level of prices is extremely high
and uncontrollable. The only solution is to establish a new currency e.g in Germany in 1923,
Hungary after WW2, Zimbabwe etc.

Inflation can also be classified in terms of its causes.

Causes of Inflation

At present three main explanations are put forward: cost-push, demand-pull, and monetary.

Cost-push inflation
This occurs when he increasing costs of production push up the general level of prices. It is therefore
inflation from the supply side of the economy. It occurs as a result of increase in:

• Wage costs: Powerful trade unions will demand higher wages without corresponding
increases in productivity. Since wages are usually one of the most important costs of
production, this has an important effect upon the price. The employers generally accede to
these demands and pass the increased wage cost on to the consumer in terms of higher prices.

• Import prices: A country carrying out foreign trade with another is likely to import the
inflation of that country in the form of intermediate goods.

• Exchange rates: It is estimated that each time a country devalues it’s currency by 4 per cent,
this will lead to a rise of 1 per cent in domestic inflation.

• Mark-up pricing: Many large firms fix their prices on unit cost plus profit basis. This makes
prices more sensitive to supply than to demand influences and can mean that they tend to go up
automatically with rising costs, whatever the state of economy.

• Structural rigidity: The theory assumes that resources do not move quickly from one use to
another and that wages and prices can increase but not decrease. Given these conditions, when
patterns of demand and cost change, real adjustments occur only very slowly. Shortages
appear in potentially expanding sectors and prices rise because slow movement of resources
prevent the sector and prices rise because of slow sectors keep factors of production on part-
time employment or even full time employment because mobility is low in the economy.
Because their prices are rigid, there is no deflation in these potentially contracting sectors.
Thus the process of expanding sectors leads to price rises, and prices in contracting sectors stay
16
 the same. On average, therefore, prices rise.

• Expectation theory: This depends on a general set of expectations of price and wage increases.
Such expectations may have been generated by continuing demand inflation. Wage contracts
may be made on a cost plus basis.

Demand-pull inflation
This is when aggregate demand exceeds the value of output (measured in constant prices) at full
employment. The excess demand of goods and services cannot be met in real terms and therefore is
met by rises in the prices of goods. Demand-pull inflation could be caused by:

• Increases in general level of demand of goods and services. A rise in aggregate demand in a
situation of nearly full employment will create excess demand in may individual markets, and
prices will be bid upward. The rise in demand for goods and services will cause a rise in demand
for factors and their prices will be bid upward as will. Thus, inflation in the pries of both
consumer goods and factors of production is caused by a rise in aggregate demand.

• General shortage of goods and services. If there is a general shortage of commodities e.g. in
times of disasters like earthquakes, floods or wars, the general level of prices will rise because of
excess demand over supply.

• Government spending: Hyper-inflation certainly rises as a result of government action.

Government may finance spending though budget deficits; either resorting to the printing press to
print money with which to pay bills or, what amounts to the same thing, borrowing from the
central bank for this purpose. Many economists believe that all inflation is caused by increases in
money supply.

Monetarist economists believe that “inflation is always and everywhere a monetary phenomenon in
the sense that it can only be produced by a more rapid increase in the quantity of money than in
output” as Friedman wrote in 1970.

THE IMPACT OF INFLATION AND ITS CONTROL MEASURES

Inflation has different effects on different economic activities on both micro and macro levels. Some
of these problems are considered below:

i. During inflation money loses value. This implies that in the lending-borrowing process, lenders
will be losing and borrowers will be gaining, at least to the extent of the time value of money.
Cost of capital/credit will increase and the demand for funds is discouraged in the economy,
limiting the availability of investable funds. Moreover, the limited funds available will be
invested in physical facilities which appreciate in value over time. It’s also impossible the
diversion of investment portfolio into speculative activities away from directly productive
ventures.

ii. Other things constant, during inflation more disposable incomes will be allocated to consumption
since prices will be high and real incomes very low. In this way, marginal propensity to save will
decline culminating in inadequate saved funds. This hinders the process of capital formation and

17
 thus the economic prosperity to the country.

iii. The effects of inflation on economic growth have inconclusive evidence. Some scholars and
researchers have contended that inflation leads to an expansion in economic growth while others
associate inflation to economic stagnation. Such kind of inflation if mild, will act as an incentive
to producers to expand output and if the reverse happened, there will be a fall in production
resulting into stagflation i.e. a situation where there is inflation and stagnation in production
activities.

iv. When inflation implies that domestic commodity prices are higher than the world market prices, a
country’s exports fall while the import bill expands. This basically due to the increased domestic
demand for imports much more than the foreign demand for domestic produced goods (exports).
The effect is a deficit in international trade account causing balance of payment problems for the
country that suffers inflation.

v. During inflation, income distribution in a country worsens. The low income strata get more
affected especially where the basic line sustaining commodities’ prices rise persistently. In fact
such persistence accelerates the loss of purchasing power and the vicious cycle of poverty.

vi. Increased production

It is argued that if inflation is of the demand-pull type, this can lead to increased production if the
high demand stimulates further investment. This is a positive effect of inflation as it will lead to
increased employment.

vii. Political instability

When inflation progresses to hyper-inflation, the unit of currency is destroyed and with it basis of
a free contractual society.

viii. Inflation and Unemployment

For many years, it was believed that there was a trade-off between inflation and unemployment
i.e. reducing inflation would cause more unemployment and vice versa.

Measures to control inflation

An inflationary situation can effectively be addressed/tackled if the cause is first and foremost
identified. Governments have basically three policy measures to adopt in order to control inflation,
namely:

Fiscal Policy: This policy is based on demand management in terms of either raising or lowering the
level of aggregate demand. The government could attempt to influence one of the components C + I
+ G (X – M) of the aggregate demand by reducing government expenditure and raising taxes. This
policy is effective only against demand-pull inflation.

Monetary Policy: For many years monetary policy was seen as only supplementary to fiscal policy.
Neo-Keynesians contend that monetary policy works through the rate of interest while monetarists’
viewpoint is to control money supply through setting targets for monetary growth. This could be
achieved through what is known s medium term financial strategy (MTFs) which aims to gradually
reducing the growth of money in line with the growth of real economy – the use of monetary policy
instruments such as the bank rate, open market operations (OMO) and variable reserve requirement
(cash & liquidity ratios).

18
Direct Intervention: Prices and incomes policy: Direct intervention involves fixing wages and prices
to ensure there is almost equal rise in wages and other incomes alongside the improvements in
productivity in the economy. Nevertheless, these policies become successful for a short period as
they end up storing trouble further, once relaxed will lead to frequent price rises and wage
fluctuations. Like direct intervention, fiscal and monetary policies may fail if they are relied upon as
the only method of controlling inflation, and what is needed is a combination of policies.

19