Inflation

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• An economic situation when there is a sustained increase in the general price level
  • General price level: all prices, not the price of one good
  • Sustained increase: Continuous, not a one-time increase
• Inflation is defined as a persistent and appreciable rise in the general level of prices (noticeable price increases that occur over time, and across a range of goods)

Measuring Inflation

• Inflation refers to the rate of change of the general price level (GPL).
• The inflation rate over a period of time is measured by the percentage rate of change using a given price index
• Rate of inflation is basically the rate of change
• That is, $\frac{x_2-x_1}{x_1}\times 100\%$
• Types of price indices
  • Consumer Price Index (CPI)
  • Retail Price Index (RPI)
  • Wholesale Price Index (WPI)
  • Producer Price Index (PPI)

Consumer Price Index (CPI)

• The CPI is a measure that examines the weighted average of prices of a basket of consumer goods and services
• It is calculated by taking price changes for each item in the predetermined basket of goods/services and averaging them
• The goods are weighted according to their importance
• Inflation refers to the rate of change of GPL
• The inflation rate between any two periods of time is measured by the percentage rate of change in the relevant price index

Causes of Inflation

Demand-Pull Inflation

• Demand-pull inflation occurs when aggregate demand (AD) rises at a rate that is not matched by the output of goods and services (Aggregate Supply)
• What causes an increase in AD leading to rightward shift of AD curve?
  • AD = C + I + G + (X – M)
  • Rise in consumption expenditure by households
  • Rise in firms’ investment expenditure
  • Rise in demand for country’s exports
  • Excessive speculative spending
  • Rise in government expenditure or decrease tax
  • Expansionary fiscal or monetary policy

Cost-Pull Inflation

• Cost Push Inflation occurs when rising production costs (cost of production) are passed on to consumers who then pay higher prices for final goods and services.
• Costs reflect the prices paid for productive inputs.
• Periods of cost push inflation can be attributed to increases in prices of significant productive inputs. (for example, crude oil, wheat, labour, etc.)
• Wage Pull Inflation
  • Caused by persistent rise in wages without corresponding rise in labour productivity
• Import Price- Push Inflation
  • Caused by rising import prices resulting in rise in imported consumer goods & raw materials
• Profit Push Inflation
  • Caused by firms making use of their market power to make higher profits by raising prices
• Tax Push Inflation
  • Caused by increase in taxation
• Exhaustion of Natural Resources
  • Caused by depletion of major natural resources for example due to natural disasters

In Summary

Type of Inflation	Demand-pull Inflation	Cost-pull Inflation
Causes of inflation	Caused by persistent increases in AD not matched by output of G&S (AS)	Caused by persistent rises in costs of production, independent of AD

Effects of inflation

Loss of Confidence in Currency

• As GPL rises, purchasing power of money falls, ceteris paribus.
• Domestic currency will have lower purchasing power $\to$ undermine people’s confidence in the currency $\to$ less willing to hold money.
• Internal value of money falls $\to$ people will preserve wealth by buying assets or foreign currencies
• Domestic currency depreciates (due to lower demand) and assets further increase in price

Redistribution of Income

• If GPL increases, purchasing power decreases
• Debtor
  • Real value of their debt falls.
  • Encourages borrowing
• Creditor
  • Real value of their loans fall when loans are repaid.
  • Discourages lending.
• Variable Income Earner
  • Income is linked to GPL.
  • As GPL rises, nominal income also rises. Real value of income remains constant
  • Better off
• Fixed Income Earner
  • As GPL rises, real value of their incomes falls
  • Worse off
• Inflation erodes the purchasing power of savings
• Inflation discourages savings as the real value of savings is eroded
  • But those saving for specific purposes (eg. for retirement or children’s education) will have to save more to compensate for the fall in real value of savings.
• Those who save in terms of real assets (eg. jewellery, real estate) gain as the value of these assets tend to rise with rising prices.
• In summary, those who save in cash are worse off, and those who save in assets are better off

Effects on Production

• Mild Inflation: Input costs rise slower than product price
  • Pros: Stimulates production due to high expected returns leads to a rise in I which leads to an increase in employment & productive capacity, leading to a rise in Y
  • Cons: Prices increase, profits increase, thus complacency increases and efficiency deceases; thus there is no incentive to conduct R & D (research and development)
• Creeping / Hyperinflation: Input costs rise faster than product price
  • Cons: Businesses operate at a loss, leading to them closing down, and a decrease in production
  • Pros: Surviving firms forced to be more efficient in order to remain in business

Effects on Investment

• Inflation can be unpredictable,
• High inflation rates are often associated with uncertainty about the future.
• This makes planning difficult, as it has an adverse effect on planned capital investments, that is, the cost of production could be significantly different than predicted.
• This creates a negative effect on economic growth and productive capacity

Effects on Government Finance

• During mild inflation, GPL rises, leading to an increase in incomes and profits, leading to a rise in tax receipts, leading to an increase in government revenue.
• If government revenue rise faster than government expenditure, leading to a budget surplus
• In the longer run, benefits cannot offset the cost of inflation on society and the economy.

Is inflation necessarily bad?

• The effects of inflation can be good or bad. It ultimately depends on:
  • Anticipated vs Unanticipated inflation
  • the rate of inflation: mild, creeping, hyperinflation • duration of inflation: short or prolonged
  • whether productivity or efficiency rises with an increase in price levels.