INFLATION

This refers to the persistent increase in the general/ average price level of goods and services
over a given period of time.

Inflationary rate

This refers to the percentage increase in the general price level.

MEASUREMENT OF INFLATION

The following are the methods used to calculate inflation.

1. Use of price index.

Under this method, inflation rate is calculated as follows;
Pt −Pt −1
×100
Pt −1
Where Pt is the price of the current year
Pt-1 is the price of the previous year
2. Use of GDP deflator
Under this method, inflation rate is calculated as follows
GDP of current year
× 100
GDP of base year
OR
Nominal GDP
×100
Real GDP

STATE OF INFLATION
This is the speed at which the general price level is increasing in the economy and its
categorized according to different types of inflation and includes the following;
1. Creeping/ mild inflation
This refers to an increase in the general/ average price level at a slow rate usually less than
10% per annum. This state of inflation is desirable.
2. Moderate/ running inflation
This is one whereby the persistent increase in the general price level proceeds at a high rate
usually above 10% per annum. Such inflation adversely/ negatively affects the poor and the
middle class groups hence it requires strong monetary and fiscal policies or else it leads to
hyper inflation.
3. Hyper/ galloping/ runaway inflation
This refers to inflation where the general price level increases at a very high rate, the increase
taking place within hours, days or weeks and the percentage point increase per annum is over
20%.
THEORIES OF INFLATION
There are many theories of inflation and these include;
♫ Cost push inflation
♫ Demand pull inflation
♫ Structural inflation
♫ Imported inflation
♫ Monetarist inflation
♫ Speculative inflation
♫ Wage – wage inflation
♫ Wage – price inflation
♫ Price – wage inflation
COST PUSH INFLATION
This refers to a persistent increase in the general/ average price level due to rising cost of
production.
Causes of cost push inflation
♫ Rising costs of raw materials
♫ Rising wages and salaries
♫ Rising costs of energy/ fuel
♫ Rising rates of rent
♫ Rising costs of borrowing
♫ Rising rates of indirect taxes
♫ Rising transport costs
♫ Rising costs of improving working conditions due to trade union pressure.

Solutions to cost push inflation

♫ Reduce bank rate/ lending rates by the central bank.

♫ Improving infrastructures like roads to reduce on transport costs
♫ Reducing indirect taxes
♫ Offering subsidies to producers to reduce the cost of production.
♫ Wage control measures/ controlled trade union influence

DEMAND PULL INFLATION

This refers to a persistent increase in the general/ average price level due to aggregate demand
being greater than aggregate supply at full employment situation of national income/ resources.
Causes of demand pull inflation
♫ Increase in wage levels hence increased purchasing power
♫ Increase in population size
♫ Excessive issuance of currency which increases aggregate demand in the economy without
corresponding increase in output.
♫ Reduced importation of essential goods that are highly demanded in the local market.
♫ Excessive exportation o f essential goods which reduces domestic supply.
♫ Excessive government supply.
♫ Natural factors/ industrial unrests/ breakdowns which lead to a fall in production levels.
♫ Excessive inflows of income from abroad.
♫ Uncontrolled creation of credit by commercial banks.
♫ Reduced direct taxation which increases purchasing power of the people.

Measures to reduce demand pull inflation

♫ Reduce government expenditure especially on provision of non-essential products.

♫ Increase direct taxes to reduce disposable income.
♫ Control export of essential goods.
♫ Encourage importation of essential goods that are highly demanded in the local market
especially from cheaper sources.
♫ Undertake restrictive monetary policy to reduce the amount of money in circulation e.g.
increase the bank rate.
♫ Wage control measures/ controlled trade union influence
♫ Control population growth rates.

STRUCTURAL INFLATION

This refers to a persistent increase in the general price level due to supply rigidities and structural
bottlenecks in the sectors of the economy leading to a decline in the supply of essential goods.

OR

Is one caused by supply rigidities in the economy.

Causes of bottleneck inflation

♫ Breakdown of infrastructures such as bridges, roads causing difficulty in transporting

commodities form areas of plenty to areas of scarcity.
♫ Natural calamities/ hazards such as floods, droughts, etc causing drastic reduction in supply
of agricultural commodities.
♫ Political instabilities. These discourage productive activities causing shortage of goods and
services leading to increase in prices.
♫ Scarcity/ exhaustion of raw-materials/ inputs.
♫ Breakdown of major industries hence causing shortage of goods in the economy leading to
increase in prices.
♫ Shortage of foreign exchange.
♫ Speculation by businessmen.
♫ Hoarding of goods by traders.

Solutions to structural inflation

♫ Improve infrastructures e.g. roads

♫ Improve political climate
♫ Agricultural modernization to reduce dependence on nature e.g. undertaking irrigation to
overcome the problems of natural calamities like drought.
♫ Importation of raw-materials/ inputs from other countries hence ensuring continued
production thereby overcoming problems of scarcity of goods.
♫ Encourage private, local and foreign investors/ further liberalization of the economy.
♫ Rehabilitation and establishment of industries.
♫ Diversification of production.

IMPORTED INFLATION

Is one where the persistent increase in the general price level is as a result of a country importing
from another country prone to inflation/ experiencing inflation leading to price increment in the
domestic economy.

Possible solutions

♫ Encourage importation from cheaper and friendly sources.

♫ Reducing on import tariffs and subsidizing importers of essential goods.
♫ Undertake import substitution industrial strategy to produce goods that were formerly
imported.
MONETARIST INFLATION
This is one whereby persistent increase in the general price level is due to excessive money
supply in the economy without corresponding increase in the value of output.
SPECULATIVE INFLATION
This is one which arises due to anticipation of future increase in prices that eventually leads to
increase in demand forcing the producers to increase prices of goods and services.
WAGE – WAGE INFLATION
This occurs due to inter-sectoral comparisons among workers whereby workers with the same
type of employment demand for a high wage when workers in similar occupations are also
earning a high wage elsewhere forcing the employers to increase prices so as to effect those
wages.
WAGE PRICE INFLATION
This is one where workers demand for increased pay without corresponding increase in output
forcing employers to increase prices of final goods in order to increase workers’ wages and also
maintain their profit margins.
 PRICE WAGE INFLATION (INFLATIONARY SPIRAL)
This is one that arises due to continuous increase in prices which increases the cost of living
forcing workers to continuously demand for higher wages forcing the employers to increase
prices of goods and services so as to increase wages for the workers
OR
This is a situation where the increase in the price level in the economy forces the workers to
demand for higher wages leading to increase in the cost of production and thus firms (producers)
are forced to increase prices of goods and services which again forces workers to demand for
higher wages.
GENERAL CAUSES OF INFLATION
1. Breakdown of infrastructures. Infrastructures such as roads, bridges and railways are ever
breaking down making it very expensive and difficult to transport raw-materials to
production centres and finished goods to markets. This results into low levels of production
causing shortage of commodities in the economy leading to inflation.
2. Excessive/ uncontrolled credit creation by commercial banks. Commercial banks in the
country are lending money to willing borrowers excessively so as to earn more profits by
charging interest on them and this is putting too much money in circulation causing excessive
aggregate demand over aggregate supply leading to inflation.
3. Excessive issuance of currency by the central bank. The central bank is excessively
issuing a lot of currency without corresponding increase in the level of output being produced
in the country thereby causing excessive aggregate demand over aggregate supply causing
demand pull inflation.
4. Excessive inflow of funds from abroad. LDCSs are receiving a lot of income from abroad
in form of donations, grants, loans, income of nationals abroad and income from the
country’s investments abroad. This results into excessive money supply in the economy
causing excessive aggregate demand leading to demand pull inflation.
5. Excessive government expenditure. Government is spending excessively on issues like
elections, infrastructure, wages, compensations etc thereby leading to excessive money
supply in the economy leading to excessive aggregate demand over aggregate supply
causing inflation.
6. Excessive exportation of essential goods. Excessive exportation of essential goods such as
sugar and other food stuffs to neighbouring countries like Kenya, Rwanda and southern
Sudan leads to shortage of goods in the domestic economy yet their demand is high hence
leading to inflation.
7. Decline in the value of the local currency relative to other currencies. The value of the
local currency has been persistently falling in relation to foreign currencies therefore
importation of raw-materials and other essential commodities becomes very expensive
leading to price increase in the domestic economy.
8. Rising costs of production e.g. rising wages, interest rates, fuel prices, etc. These costs
force the producers to increase the prices of final goods and services in order to cover such
costs and at the same time maintain their profit margins hence leading to cost push inflation.
9. Importation of goods from countries experiencing inflation. LDCs over rely on imports
but some of these imports are bought from countries that are prone to inflation and therefore
they are sold in the domestic market at high prices thereby causing imported inflation.
10. Greed for profits by traders. Some traders want to obtain a lot of profits therefore cause
artificial shortages of goods by hoarding them so as to increase prices hence causing inflation
in the economy.
11. Speculation by traders and consumers. As consumers anticipate future price increases,
they increase their demand for the available goods on the market whose price is expected to
increase. Such increase in demand forces the producers to increase prices of goods and
services causing inflation.
12. Natural hazards/ calamities such as drought, landslides, floods. These lead to drastic fall
in supply from agricultural sector yet demand for such commodities is increasing pushing
prices upwards.
13. Political instability/ unfavourable political climate in some parts of the country. This
leads to destruction of productive infrastructure leading to low levels of output in the
economy in relation to demand hence causing inflation.
NOTE
Emphasis on explanations should address issues/ factors that lead to scarcity of goods
relative to their demand forcing prices upwards.
OR
Factors that put too much money in circulation leading to excessive aggregate demand
without corresponding increase in output pushing prices upwards.

ASSIGNMENT
To what extent is inflation in developing countries caused by rising costs of production?
SOLUTION
To a minor extent, inflation in developing countries is caused by rising costs of production
such as;
- Rising costs of raw materials
- Rising wages and salaries
- Rising costs of energy/ fuel
- Rising rates of rent
- Rising costs of borrowing
- Rising rates of indirect taxes
- Rising transport costs
- Rising costs of improving working conditions due to trade union pressure.

To a larger extent, inflation in developing countries is caused by other factors other than
rising costs of production as explained below;

- Breakdown of infrastructures.
- Excessive/ uncontrolled credit creation by commercial banks.
- Excessive issuance of currency by the central bank
- Excessive inflow of funds from abroad.
- Excessive government expenditure.
- Excessive exportation of essential goods.
- Decline in the value of the local currency relative to other currencies
- Importation of goods from countries experiencing inflation
- Greed for profits by traders
- Speculation by traders and consumers.
- Natural hazards/ calamities such as drought, landslides, floods.
 - Political instability/ unfavourable political climate in some parts of the country.

EFFECTS OF INFLATION ON AN ECONOMY

POSITIVE EFFECTS
1. Mild inflation helps the economy to recover from a recession/ depression. This is because
the increasing prices being experienced in the economy promote more investments and lead
to increase in the supply of goods due to increased profits thereby pulling the economy out of
a recession.
2. It stimulates peoples’ effort. This is because they have to work harder to meet the rising cost of
living as prices of goods and services increase thereby helping the country to increase its productive
capacity.
3. Increased prices stimulate investments since they increase the profits of the producers and
such investments lead to increased production (output) leading to high economic growth rate.
4. Employment opportunities may be generated. This is due to the fact that as prices
increase, entrepreneurs are encouraged to work harder and increase their scale of production
which necessitates employment of more workers.
5. It may encourage adoption of import substitution strategy. Imported inflation encourages
the country to adopt import substitution industrialization strategy so as to produce internally
formerly imported industrial goods as a way of reducing importation of highly priced
industrial goods hence leading to increased industrial development in the economy.
6. Government revenue increases. This is mainly through increasing direct taxes on incomes
of the rich so as to reduce their purchasing power. The revenue collected through taxation is
used to meet government expenditure needs.
7. It encourages forced savings. This is because the funds that would have been spent are
saved to be used later on when the inflation rates are low because as prices increase, the
purchasing power of money reduces.
8. It encourages innovativeness and creativity in the economy. This is arises due to the need
for producers to obtain higher profits and survive the hard times when inflation rates are
high. Producers increase research and improve their production techniques so as to continue
surviving in business leading to improved quality and quantity of output produced in the
economy.
9. Borrowers/ debtors stand to gain. This is because they borrow money when its purchasing
is high due to low prices of goods but pay back or return the money when inflationary rates
are high implying that by the time they pay back this money, its purchasing power is low.
10. It encourages labour mobility. As prices persistently increase, it forces labour especially
skilled labour to move to different areas hence being able to utilize such skilled labour for
production hence promoting growth of such areas.

NEGATIVE EFFECTS

1. Discourages local and foreign investors due to persistent increase in the production costs
and also increased prices of goods and services leads to reduced demand for goods and
services making producers to make losses.
2. Worsens BOP position. This is because of the heavy expenditure required by the country to
import goods to supplement domestic output hence worsening the country’s BOP position.
3. It leads to loss of confidence in the country’s currency. This is because as prices
persistently increase, the value of money falls continuously making people not to trust the
country’s currency as a medium of exchange.
4. Leads to uneven distribution of income. High rates of inflation negatively affect the poor
and middle class groups as compared to the high income earners hence leading to income
inequalities.
5. It makes planning difficult. Planning on the side of producers, government and consumers
becomes very difficult since prices are not stable therefore being unable to know how much
to save and how much to spend.
6. Leads to industrial unrests especially strikes. This is because workers continuously
demand for higher wages to meet the rising cost of living and this disrupts the production
process leading to less output being produced by the industries.
7. Leads to brain drain. Inflation makes the economy and the country’s highly skilled
manpower to move to other countries where there is economic stability and better paying
opportunities leaving the country with limited supply of skilled manpower hence retarding
economic growth and development.
8. People are strained because they have to work extremely hard, forego leisure and work
under poor working conditions in an attempt to cope with the rising cost of living.
9. Government becomes unpopular. This is because the population blames the government
for their suffering due to its failure to curb inflation resulting into demonstrations, riots and
sometimes political instabilities.
10. Lending is discouraged as creditors stand to lose. This is because whenever prices
increase, the value of money declines therefore lenders receive back their money with a low
purchasing power than when they lent it out before the price increase.
11. Leads to production and consumption of poor quality goods. This is because production
becomes less affordable due to high costs involved.
12. It encourages illegal activities such as corruption, smuggling which makes the
government to lose a lot of revenue that would otherwise be realized through taxation.
13. Discourages savings. This is because the funds that would have been saved are used to
purchase goods and services at higher prices thereby limiting the level of capital
accumulation in the country.
14. Leads to collapse of some firms. High costs of production incurred by firms during periods
of high inflation rates such as high costs of raw-materials , fuel, rent force some firms to
close down leading to reduced output and retarded economic growth.
15. Leads to unemployment. This is because some firms are forced to close down as production
costs increase and others substitute labour with machines to increase on resource exploitation
and also cut down the costs of supporting existing labour.
16. Fixed income earners suffer. This is because as prices increase, the purchasing power of
these people reduces since their income remains the same yet the cost of living is rising. This
lowers their standards of living.
ASSIGNMENT
Why does government control inflation in your country?
NOTE
A student should be well versed with negative effects of inflation if they are to attempt this
question.
Answers should address the intention/ objectives.
SOLUTION
- To attract local and foreign investors
- To reduce capital outflow
 - To avoid loss of confidence in the country’s currency.
- To reduce uneven distribution of income.
- To ease planning
- To reduce industrial unrests arising due to demand for higher wages
- To reduce brain drain
- In order to avoid straining the people which arises as the cost of living rises.
- To make government more popular
- To encourage lending by creditors
- To discourage production and consumption of poor quality goods/ to promote production
of better quality products
- To avoid/ overcome illegal activities such as corruption, smuggling arising out of hyper
inflation.
- To encourage savings
- To encourage resource exploitation/ to accelerate economic growth.

MEASURES THAT SHOULD BE TAKEN TO CONTROL INFLATION IN LDCs/

UGANDA
1. Reduce government expenditure especially on provision of non essential goods. This
helps to reduce the amount of money in circulation thereby reducing aggregate demand in the
economy leading to a fall in prices of goods and services.
2. Further liberalize the economy. Liberalization of the economy involves removing
unnecessary restrictions on economic activities hence giving people liberty to carry out
economy activities without unnecessary government interference. This increases the level of
output in the economy and competition among producers and traders leading to a fall in
prices of goods and services.
3. Improve the investment climate. This is achieved through providing tax holidays, free land
for investment, subsidies to reduce production costs and attract more investors which help to
increase output in the economy hence leading to a decline in the prices of goods and services.
4. Development of infrastructure such as roads, bridges, railways. These infrastructures
facilitate fast and cheap movement of raw materials to production centres and finished
 products to markets thereby leading to increased production/ supply of goods and services
hence controlling structural inflation.
5. Undertaking a contractionary/ restrictive monetary policy for example increased bank
rate, sale of government securities. Such a policy reduces the capacity of commercial banks
to create credit thereby reducing the amount of money in circulation hence controlling
aggregate demand leading to a decline in prices of goods and services.
6. Control issuance of currency by the central bank. The central bank should control
issuance of currency especially that which is not in line with the level of economic activities
in the country so as to reduce excessive money supply in the economy which helps to reduce
aggregate demand thereby controlling demand pull inflation.
7. Modernization of agriculture. This should transformed form subsistence to commercial
high yielding production through use of methods such as irrigation, land reforms, improving
of infrastructures, use demonstration farms, etc. This helps to increase the supply of
agricultural commodities hence leading to a fall in prices.
8. Carrying out further privatization of state owned enterprises i.e. transferring of
ownership of state owned enterprises to private individuals. This is increases efficiency
in the running of the enterprises and the scale of production also expands thereby increasing
production of goods and services in those enterprises hence controlling structural inflation.
9. Improve political climate/ atmosphere, through negotiating for peace talks with rebels and
other discounted groups in the country hence promoting production of more goods and
services and also attract more investors thus increasing the productive capacity of the country
leading to a fall in prices of goods and services.
10. Reduce indirect taxes especially on essential goods such as petroleum products, soap,
sugar, etc so as to reduce production costs which eventually leads to a fall in prices of goods
and services.
11. Control export of some goods produced in the country e.g. sugar, meat and other food
stuffs. Their exportation should be controlled so as to ensure adequate supply of such goods
in the local market hence overcoming the problem of scarcity leading to a decline in prices.
12. Undertake import substitution industrial strategy, whereby goods that were formerly
imported are produced internally thus enabling the country to overcome imported inflation
which arises due to importation of goods from countries experiencing inflation.
13. Increase direct taxes especially on high income earners so as to reduce their disposable
income which reduces their purchasing power hence controlling the level of aggregate
demand in the economy leading to a fall in prices of goods and services.
14. Encourage the use of instruments of credit such as cheques, bank drafts, promissory
notes. This helps people to move with such written documents instead of moving with big
sums of money that encourage them to spend thereby controlling aggregate demand leading
to a fall in prices.
15. Use of price controls, especially maximum price legislation i.e. a policy where prices are
fixed below equilibrium price such that even when there is excess demand, prices cannot be
increased.
16. wage control measures/ controlled trade union influence
17. Compulsory saving schemes e.g. NSSF.

ASSIGNMENT
Why may an increase in money supply not necessarily lead to inflation in your country?
SOLUTION
An increase in money supply may not necessarily lead to inflation in my country because
there may be an increase in money supply but when…
- There is price controls especially maximum price legislation i.e. a policy where prices are
fixed below equilibrium price such that even when there is excess demand, prices cannot
be increased.
- The marginal propensity to save is high such that the percentage of additional incomes is
saved but not consumed.
- The increase in money supply is accompanied by an increase in output.
- The increase in money supply is accompanied by higher direct taxes on peoples’ income
which reduces their disposable income thereby controlling the purchasing power of
consumers.
- There is an increase in the rate of interest.
- An increase in money supply is channeled to production of capital goods.
- An increase in money supply is followed by a reduction in the volume exports.
- An increase in money supply is followed by an increase in the volume of imports
 - The economy is undergoing an economic recession characterized by low investments,
low incomes, high poverty levels etc hence an increase in money supply only helps to
stimulate economic activities through increased purchasing power of consumers.
- The increase in money supply aims at exploiting idle resources such that as exploitation
of resources increases, the volume of goods and services also increases hence not leading
to inflation.
OTHER CONCEPTS
1. DEFLATION
Refers to a persistent decrease in the general price level of goods and services mainly due to
a fall in aggregate demand
Causes of deflation
♫ Reduced government expenditure especially on provision of essential goods.
♫ Use of restrictive monetary policy e.g. increased bank rate.
♫ Increased direct taxes on peoples’ income.
♫ Reduced incomes/ wages.
♫ Reduced inflow of incomes from abroad.
♫ Reduced exportation of goods causing excessive supply of goods in the local market.

Effects of deflation

♫ Leads to high unemployment levels. This is because as prices fall, even profits reduce
and many firms close down because they are unable to cover the average cost of
production.
♫ Leads to decline in government revenue because some firms reduce output.
♫ High income earners suffer. This because large scale traders/ industrialists and real estate
developments are faced with falling prices of their products which reduces their profit
margins.
♫ Discourages investments since low prices scare both local and foreign investors.
♫ Leads to slow economic growth rate since low prices lead to declining output.
♫ It makes people gain more confidence in the currency because as prices reduce, the value
of money increases.
 ♫ Creditors gain as debtors lose. This is because creditors receive back their money when it
has more purchasing power than when it was lent out.
♫ It leads to low resource exploitation due to decline in profit margins as price falls hence
leading to resource wastage.
2. STAGFLATION
Is a situation in which high inflation rates co-exist with high levels of unemployment.
Effects of stagflation
♫ Leads to brain drain
♫ Results into low government revenue
♫ It results into low production
♫ Increases income and wealth inequalities.
♫ Leads to low aggregate demand for goods and services.
♫ Leads to decline in savings.
♫ It makes the government unpopular.
♫ Etc.
Measures for reducing stagflation
♫ Reduce direct taxes to increase disposable income which increases consumption hence
encouraging investments.
♫ Subsidize producers to reduce production costs.
♫ Use of expansionary monetary policy e.g. reducing the bank rate which leads to provision
of cheap/ affordable loans for investments.
♫ Increase government expenditure especially on productive ventures hence increasing the
level of production thereby increasing employment opportunities and reducing inflation
through increased output.
3. STAGNATION
This refers to an economic period of static economic activities characterized by low levels of
investments, low levels of employment and constant economic growth rates.
Causes
♫ low income levels
♫ reduced government expenditure
♫ high indirect taxes
 ♫ unfavourable political climate/ political instability

Measures to curb stagnation

♫ Use of expansionary monetary policy e.g. reducing the bank rate.

♫ Increasing government expenditure especially on provision of essential goods.
♫ Reduction of direct taxes. This helps to increase disposable incomes of consumers
thereby stimulating investment, employment and output.
♫ Giving incentives to investors such as tax holidays, subsidies, etc. Such incentives lead to
increased investment, employment creation and output hence helping the economy to
overcome stagnation.
♫ Improve the political climate. This helps to promote economic activities and attract more
investors thereby leading to increase in incomes, investment, output and employment
opportunities.
♫ Develop infrastructure.
♫ Etc.
4. REFLATION (REFLATIONARY POLICY)
This refers to the deliberate government policy of forcing prices upwards so as to recover
from an economic recession.
Instruments of reflationary policy
♫ Tax reduction
♫ Expansionary monetary policy.
♫ Increase in government expenditure/ subsidization
♫ Increasing wages
♫ Encouraging exports
5. OPEN INFLATION
This is one where the persistent increase in the general price level is as a result of operation
of a free market system whereby resource allocation is done by market forces of demand and
supply with limited or no government intervention.
6. SUPPRESSED INFLATION
Is a situation where demand exceeds supply but the effect of this on prices is minimized by
price controls and rationing.
 Effects
♫ Leads to misallocation of resources whereby producers shift their resources/ capital from
commodities that are rationed and have price controls to commodities that have no such
controls.
♫ It reduces incentives of producers to work hard. This is because putting of price controls
and rationing reduces the producers’ profit margins hence reducing their scale of
production.
♫ It results into trade malpractices such as smuggling, black marketing so as to sell
commodities at a higher price hence government losing a lot of revenue that would have
been got from taxes.
♫ It increases employment problems. This is because some firms are forced to close down
while others substitute labour with machines as a way of cutting down labour costs.
♫ Leads to exploitation of consumers especially on commodities where there are no price
controls by government hence leading to low standards of living.
7. HEADLINE INFLATION
This is where persistent increase in the general price level in the economy includes the prices
of foodstuffs.
8. UNDERLYING INFLATION
This is whereby the persistent increase in the general price level in the economy includes all
commodities in the country but excludes prices of foodstuffs.