Inflation
Definition
Inflation is the consistent and persistent rise
in the general price level of most of the goods and services in a country
leading to a fall in the value of money and purchasing power.
Types of
Inflation
There are three types of Inflation:
1) Creeping Inflation:
Creeping inflation is when the rise in price
level is very low usually 1% to 6% per year. This type of inflation is good for
the economy. Creeping Inflation usually means that the country is experiencing
economic growth.
2) Galloping/Hyper/Runaway Inflation:
This is a very high increase in the general price
level, even more than 100% causing a huge fall in the value of money. During
this type of inflation people lose confidence in money.
3) Suppressed Inflation:
This type of inflation occurs when the aggregate
(total) demand in the economy is more than the aggregate supply causing a rise
in the general price level. This type of inflation can be controlled by the
government by imposing maximum price control and through rationing.
Causes of Inflation:
There are mainly four causes for Inflation:
1)
Demand-pull Inflation
2)
Cost-push Inflation
3) Increase
in money supply Inflation
4) Imported
Inflation
Demand-pull
inflation
Demand pull inflation occurs when the aggregate
demand is more than the aggregate supply, pulling up the price level of most
goods and services.
*full employment is when the country uses up
all its resources and can no longer produce any more. The supply of all the
country will be perfectly inelastic in the long run.
Reasons for
demand-pull inflation:
• War
time condition:
Every country has limited resources and basically
the goods that every country produce are categorized into consumer goods and
capital goods and during war time military goods, and if the country has to
produce more of one good then they have to forgo the productions of other
goods.
• More exports:
If a country exports more goods, income of the
people increases as well as the supply of goods available to use in the home
country becomes less.
• Economic growth:
In order for the country to economically grow
they need to produce more of capital goods which means consumer goods would be
produced less resulting in a shortage (AD greater than AS) leading to rise in
the general price level.
• Increase
in Government spending:
When government spending increase especially at
full employment level, it would increase the aggregate demand of the people and
the government, which would result in an increase in the general price level
since at full employment level country cannot produce further goods to meet the
demand since supply would be perfectly inelastic.
Cost-Push
Inflation:
When prices of factors of production like (wages,
rent, raw materials…etc.) increases it increases the cost of production, which
means it is more costlier for the producer to produce goods now so it reduces
the aggregate supply pushing up the general price level.
Diagram
When cost of
production increases the aggregate supply decreases from AS to AS1 causing the
general price level to increase from P1 to P2 resulting in a decrease in
national input/output.
Reasons for
cost-push inflation:
Increase in wage rate:
When wage rate increase more than the increase in
productivity, it would increase the cost of production since wage is one of the
major cost of production. This would decrease aggregate supply hence,
increasing the price level.
Increase in the price of raw material:
When prices of raw materials increase it increases
the cost of production causing aggregate supply to decrease increasing the
general price level.
Indirect tax:
Indirect taxes are taxes which are directly added
to the prices of goods and services like VAT. When indirect tax increases it
naturally increases the general price level.
Increase in money
supply Inflation
If the money supply in the economy is more than
the output of goods and services, this would increase the general price level.
When money supply increases it means everybody has more money with them to
spend causing an increase in aggregate demand leading to inflation.
Imported Inflation
If the country is depending mainly on imports for
its raw materials and other goods and services, and if the price of imported
goods increase this will cause the general price level to rise, because the
cost of producing these goods would increase raising the prices leading to
imported inflation.
Effects of
Inflation
Inflation might have an effect on the following:
• Effect on different
income group
• Effect in
production
• Effect on
borrowers and lenders
• Effect on
balance of payment.
Effect on different income group
Basically the income group is divided into three
types which are fixed income group, business class, and the varied income
group. And all these three types are affected differently during inflation:
• Fixed income group:These are those people whose incomes are fixed
(like pensioners and salaried employees) and would not change with the change
in prices. During inflation these people would be affected most since their
purchasing power falls with the rise in price level
• Business class: These are
the people who run the businesses, that is, people who sell the goods and
services. During inflation these people would be most benefited since their
income increases with the inflation.
• Varied income group: In
some sectors in the economy the worker’s salaries get an automatic increase in
their wages or salaries and in some industries the trade union are strong
enough to persuade the employer to raise the wages during inflation. So varied
income group is the group which is least affected during inflation.
Effect on production
Inflation
affects the production depending on the cause of inflation.
Demand pull
inflation: Production will increase to earn more profit
(If the inflation is caused by demand pull inflation and if the
country is operating below full employment level, the production will increase
in order to meet with the demand and also to earn more profit, since the
aggregate demand has pulled up the price level which means producers can earn
more revenue if they increase supply.)
Cost Push Inflation: The production will decrease
as production cost is more
(On the other hand if the cause of inflation is cost-push, then
production would decrease. Because in cost-push inflation the prices of factors
of production increases increasing the cost of production, which means it is
now more costlier for the producers to produce so they reduce the supply. In
short, during a demand-pull inflation the production will increase if it’s not
operating at full employment level and during a cost-push inflation production
will decrease.)
Effect on borrowers and lenders
Borrowers are people who take loans and lenders
are people who give out loans. During inflation borrowers gain and lenders
lose. When borrowers borrow money to pay back at a later time, they actually
gain during inflation, because the amount they pay at a later date has less
value than the amount that they have borrowed.
(For example Mr. A borrowed Rf 5000 in December 2006 from Mr. B to be
paid back on December 2007. But during 2007 the country experienced an
inflation rate of 20% which means by the time Mr. A returns money the value of
that Rf 5000 has gone down since now we can’t buy the same amount of goods and
services that we were able to buy before inflation, in other words the
purchasing power has gone down. So Mr. A is actually gaining here since he is
now paying a Rf 5000 which is less in value, but Mr. B will lose since he is
receiving his money with a less value.)
Effect on Balance of payment Balance of payment is the difference
between exports and imports. If export is greater than imports then the country
would have a surplus balance of payment (since export means country receiving
money while import means expense to the country) and if the imports are greater
than export then the country would have a deficit balance of payment. One of
the main economic objectives of the government of every country is to have a
surplus balance of payment.
During inflation exports becomes more expensive
because inflation means rise in the general price level so when prices of our
goods increases, exports would decrease since other countries would not demand
out goods because of higher prices, and on the other hand during inflation it
is cheaper to import goods from other countries since our own good’s prices are
expensive. This will result in high imports and less exports resulting in a
deficit balance of payment which is not good for the country since it means the
country’s expenses are more than the country’s income.
Measuring Inflation
Inflation is measured in order to find the rate of inflation. Rate
of inflation means the percentage change (increase or decrease) in general
price level in a country over a period of time.
In
the UK, there are two widely used measures of the price level; Retail Price
Index (RPI) and Consumer Price Index (CPI).
The
retail price index (RPI) measures the changes in prices of a
fixed basket of goods and services commonly consumed by the majority of
households. There are two ways of calculating the RPI, namely:
1) Simple index number
2) Weighted index number
There are some key terms that need to be focused, which are as
follows:
Family expenditure survey:
The survey asks about a sample of 7000 ‘typical’ households to record their
expenditure on over 650 categories of goods and services known as the ‘basket
of goods’ and surveys over the period of a fortnight.
• Basket of goods: large number of commonly used goods
would be taken. Basket of goods shows the true representative of household
purchases.
• Base year: the year from which the index begins. In the
base year the index will always be 100 so that we can compare it with the
current year.
• Current year: the year for which inflation is calculated.
• Index value: index value is the percentage change in the
price compared to the base year. In the base year index value would be 100.
Index value = current year’s price / base year’s price × 100
• Weight: the importance given to each product. Goods which
household spend more would be given a high weight.
Simple Index Method
Ø In simple index method we take a basket of goods and measure the
changes in price level by calculating index value.
Ø To calculate index value we divide the current price by
base year’s price and multiply it by 100.
Ø Then we find the average price index by adding all the
index value and dividing it by the total number of commodities so that it can
be compared to the base year’s average.
And this difference is the change in inflation rate which would be
stated as a percentage. This can be explained with a numerical example:
(Average price index current year = 200+80+110
= 390/3 = 130)
(Average price index
base year = 100+100+100= 300/3 = 100)
(Therefore, change in
price index (% rise in price level) = 130 – 100 = 30%)
Weighted Index Method
In Weighted Index
Method we give each product a weight depending on the usage of the product by
the people of the country. The higher the weight of an item the more it will be
consumed
Ø Sometimes
when calculating RPI in the simple index method the real inflation rate might
not be shown since we are not giving a weight to the good.
Ø People
spend more on commodities like food, housing, clothing, electricity…etc. than
on luxury items. So if inflation rate is calculated based on the consumer usage
of the good then it will show a true inflation rate.
Ø That
is the reason why in most countries RPI is calculated by the weighted index
method.
How to
calculate
Ø In
weighted index method we take a basket of goods, give them a weight according
to the usage and measure the changes in price level by calculating weighted
index value.
Ø To
calculate the weighted index value we divide the current price by base year’s price,
multiply it by 100 and multiply the answer by the weight given.
In other words, calculate the index value same as in
Simple Index Method, then multiply the index by the given weight to get the weighted
index.
Ø Then we
find the average price index by adding all the weighted index value and
dividing it by the total weight given to the commodities so that it can be
compared to the base year.
Ø And the
difference between average weighted index of base year and average weighted
index of current year is the change in inflation rate which would be stated as
a percentage.
This can be explained with a help of a numerical
example:
Average price index current year = 200+160+330 = 690/6
= 115
Average price index base year = 100+200+200= 600/6 =
100
Therefore, change in price index (% rise in price
level) = 115 – 100 = 15%
Consumer
price Index (CPI)
CPI is the measure of
the price level used across European Union (EU) and used by the Bank of England
to measure inflation against its target since 2003. The CPI has only been
calculated in the UK since 1996.
There are variety of
differences between CPI and RPI.
CPI excludes a number
of items relating to housing, whereas these are included in RPI. Excluded from
the CPI is Council tax, mortgage interest payments, house depreciation,
building insurance, and estate agents’ conveyance fees
Although the price of a good or
service may rise, this may be accompanied by an improvement in quality of the
good. It is hard to make price comparisons of, for example, electrical goods
over the last 20 years because new audio-visual equipment is so different from
its predecessors. In this respect, the CPI may over-estimate inflation. The CPI
is slow to respond to the emergence of new products and services.
‘Policies
to deal with inflation’
Following measures can be taken
to reduce the inflation…..
1)
Monetary policy
Inflation occurs when too much
money chases too few goods. To control the inflation, Central Bank can take the
following measures……
a)
Increase the bank rate.
b)
Increase the (CRR) commercial reserve ratio of
commercial banks.
c)
Sell bonds and securities.
All this measures reduce the
money supply in the economy which will reduce the inflation.
2)
Fiscal policy
Fiscal policy refers to the
regulation of government expenditure and taxation in order to control the level
of spending in the economy. To control the inflation, government can
a)
Increase income tax and corporation tax.
b)
Reduce government spending
All this measures reduce the consumer
income and inflation.
3)
Income policy
Income policy refers to
application of control on the factor rewards such as wages. This policy will
help reduce cost of production and thereby inflation.
4)
Supply side policy
Increase in supply overcomes the
problem of excess demand. Government can take following measures to increase
supply.
a)
Training and retraining workers to make them
more productive.
b)
Provide subsidies and grants to enhance
investments.
c)
Improving telecommunication, transportation
network in the country.
d)
Promote horizontal integration.
All this measures may help in
increase in supply and reduce demand pull inflation.
5)
Price control
Government sometimes directly controls the price to reduce
inflation….