CHAPTER 4

INFLATION
Inflation is the Inflation is a general and sustained increase in the price
general and
level. In times of inflation, the nominal measurements will
sustained increase in
the price. be higher than the real measurements.

REAL AND NOMINAL MEASUREMENTS

Measurements made using prices that are current at the
time a transaction takes place are known as measurements
of nominal values. When prices are rising, these nominal
Nominal values
overstate the extent
measurements will always overstate the extent to which an
to which an economic economic variable is growing through time.
variable grows
overtime which is Clearly, to analyze performance, economists will be more
why it is important to interested in ‘real’ values – that is, the quantities produced
use Real Values.
after having removed the effects of price changes. One way
in which these real measures can be obtained is by taking
the volumes produced in each year and valuing these
quantities at the prices that prevailed in some base year.
This then enables allowance to be made for the changes in
prices that take place, permitting a focus on the real values.
These can be thought of as being measured at constant
prices.

For example, suppose that last year you bought a good for
$2, but that inflation has been 10%, so that this year you
had to pay $2.20 for the same good. Your real consumption
of the item has not changed, but your spending has
increased. If you were to use the value of your spending to
measure changes in consumption through time, it would be

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 misleading, as you know that your real consumption has
not changed at all (so it is still $2), although its nominal
value has increased to $2.20.

HOW TO MEASURE INFLATION

An important macroeconomic measure by the government
is the general price level, which is the recognized measure
of the cost of living, at any point in time. Changes in the
To measure inflation
a general price index general price level, on a year-by-year basis, are a measure
can be used. A of the rate of inflation in an economy. The general price
typical basket of
level is calculated periodically, by using some forms of the
goods is defined to
reflect the spending consumer price index.
pattern of a
representative CONSUMER PRICE INDEX (CPI)
household. The cost
of this bundle is The most important general price index in the UK is the
calculated in the base consumer price index (CPI). This index is based on the
year and then in the
prices of a bundle of goods and services measured at
subsequent years.
different points in time. 180 000 individual price quotes on
680 different products are collected each month, by visits
to shops, and using the telephone and internet. Data on
spending is used to compile the weights for the items
included in the index. These weights are updated each
year, as changes in the consumption patterns of
households need to be accommodated if the index is to
remain representative.

The calculation of the CPI is a major statistical task,

involving three main stages:

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 1. A survey to find out what families buy and how much
they spend on particular items – this provides the
weights.

2. Recording how much the prices of some 680 selected

items have changed – this information is collected from
all main types of retail outlet, as well as from gas, water,
electricity and transport suppliers at a base date.

3. The percentage change in price for each item is then

multiplied by its weight – from this the average change in
the CPI is determined.

Here is a simple example that shows how the calculation is

done:

Step 1: Find the percentage change in prices for each item

Food: 25%

Fuel: 8.3%

Housing: 10%

Step 2: Find the weighted average for each item

Food: 25% x 60% = 15%

Fuel: 8.3% x 30% = 2.49%

Housing: 10% x 10% = 1%

Index in Base
Item Base Year Price Weights Price in Year 1
Year
Food $2 100 60% $2.5
Fuel $3 100 30% $3.25
Housing $5 100 10% $5.5

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Step 3: Find in value of index in Year 1 and rate of inflation

Rate of inflation in Year 1 = 15% + 2.49% + 1% = 18.49%

Index in Year 1 = 100+18.49 = 118.49

Now for example if the value of index in Year to rises from

118.49 to 120, the rate of inflation for Year 2 will be:

Rate of inflation = 1.27%

This would mean rate of inflation has fallen from 18.49% to

1.27%

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 DEGREES OF INFLATION

Percentage change
Outcome
per annum

Very mild inflation which can actually aid

<5
competitiveness.

Mild inflation which must be kept under

5-9
control to avoid future difficulties.

Inflationary pressures build up which increase

wage demands and high interest rates;
10-19
savings begin to be affected. Strict policies
are essential if the problem is to be resolved.

Serious inflation. Economic relationships are in

20-50 real danger of breaking down. Confidence in
money is seriously eroded.

Signs of hyperinflation. Depending on

severity, domestic economic structures
50 and above
collapse and currency becomes worthless on
foreign exchange markets and also internally.

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PROBLEMS OF MEASURING INFLATION
1. The basket used in any country represents the purchasing
habits of a “typical” household, but this will not be
applicable to all people. The purchasing habits of
different people will clearly vary greatly. For example, the
“basket” of a family with children will be very different
from that of an elderly couple or a single person with no
children.

2. The weights used to construct the average price level are

fixed. As a result, the effect on the inflation rate of an
increase in the price of a particular good is
overestimated. Even though consumers will switch away
from it and purchase other cheaper substitutes, its
significance (its weight) in the construction of the average
will be the same.

3. New products are not immediately taken into account in

the construction of the average price level. It took a few
years for the price of mobile phone services to enter the
typical basket of goods and services in many countries.

4. Improved quality of goods and services may not be

properly accounted for in the construction of the average
price level. A better version of a product may be 10%
more expensive but may last 50% more than the older
version, rendering it effectively cheaper. Again, the
official inflation rate may overestimate true inflation.

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5. There may be large statistical errors in the collection and
tabulation of data that limit the accuracy of the final
results. Some examples of such issues are sampling
errors, time lags, wrong range of outlets selected and
invalid statistics due to calculation error.

6. The base year selection has to be done carefully. A base

year which is not stable with fluctuating prices may not
be a true measure of the cost of living of an economy.

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CAUSES OF INFLATION
Demand Pull Inflation

An increase in any component of AD may prove

responsible for demand-pull inflation. An increase in
aggregate demand leads to a rise in prices, especially if the
SRAS curve becomes so steep in the long run as to become
vertical, i.e. the economy does not have the spare capacity
to meet the increased demand.

FIGURE 4.1 Demand Pull Inflation

Demand-pull inflationary pressure may originate from a

rapid increase in consumption and investment expenditures
caused by excessively optimistic and confident households
and firms. Surging exports may also exert upward pressure
on prices. Export growth may accelerate, as a result of an

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 undervalued or depreciating currency or faster growth
abroad. Governments are sometimes responsible for
demand-pull inflation when they incur very high spending.

Cost-Push Inflation

Cost-push inflation is associated with continuing rises in

costs and hence continuing leftward (upward) shifts in the
SRAS curve. Such shifts occur when costs of production rise
independently of aggregate demand.

FIGURE 4.2 Cost Push Inflation

If firms face a rise in costs, they will respond partly by

raising prices and passing the costs on to the consumer,
and partly by cutting back on production. This is illustrated
in the figure above. There is a leftward shift in the

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aggregate supply curve: from SRAS0 to SRAS1. This causes
the price level to rise to P1 and the level of output to fall to
Q3.

Rises in costs may originate from a number of different

sources. As a result, we can distinguish various types of
cost-push inflation:

• Wage-push inflation: This is where trade unions push

up wages independently of the demand for labor.

• Profit-push inflation: This is where firms use their

monopoly power to make bigger profits by pushing up
prices independently of consumer demand.

• Import-price-push inflation: This is where import prices

rise independently of the level of aggregate demand.

• Tax-push inflation: This is where increased taxation

adds to the cost of living. Here, the government causes
the inflation to occur.

Inflationary expectations themselves are a common cause

of continuing inflation. If prices are expected to continue
climbing then firms and workers with pricing power will
increase their prices and wages to keep ahead of the game,
adding to the inflationary spiral.

Targeting inflation, whether explicitly or implicitly, is said to

be beneficial as it results in a reduction in inflationary
expectations. The target acts as an anchor, holding down
inflationary pressure. If they do not expect higher inflation

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then they will not make demands for increases in wages any
higher than the expected rate of inflation and this will keep
the costs of labour from rising excessively. This suppresses
cost-push inflationary pressure.

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COST OF INFLATION
Reducing inflation is an important macroeconomic priority
because the government considers stable prices as an
important indicator of the economy’s performance, which is
crucial in creating an environment in which investment and
economic growth can be encouraged. A sustained rise in
price level is considered a problem for many reasons:

1. Shoe Leather Cost: High rates of inflation also mean that

people and companies may lose considerable purchasing
power if they keep money lying idle and not earning
interest. Economists refer to this as shoe leather costs.
These are the costs involved in moving money from one
financial asset to another in search of the highest rate of
interest. The term can also be applied to firms and
consumers spending more time searching for the lowest
prices.

2. Menu Cost: Menu costs are the costs involved in

changing prices. Menu costs affect firms, for example
catalogues, price tags, bar codes and advertisements
have to be changed. Changing prices involves staff time
and is unpopular with customers.

3. Redistribution Cost: Inflation redistributes income away

from those on fixed incomes and those in a weak
bargaining position, to those who can use their economic
power to gain large pay, rent or profit increases. It
redistributes wealth to those with assets (e.g. property)

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 that rise in value particularly rapidly during periods of
inflation, and away from those with types of savings that
pay rates of interest below the rate of inflation and hence
whose value is eroded by inflation. Pensioners may be
particularly badly hit by rapid inflation.

4. Uncertainty and lack of investment: Inflation tends to

cause uncertainty among the business community,
especially when the rate of inflation fluctuates. (Generally,
the higher the rate of inflation, the more it fluctuates.) If it
is difficult for firms to predict their costs and revenues,
they may be discouraged from investing. This will reduce
the rate of economic growth.

5. Balance of Payment: Inflation is likely to worsen the

balance of payments. If a country suffers from relatively
high inflation, its exports will become less competitive in
world markets. At the same time, imports will become
relatively cheaper than home-produced goods. Thus
exports will fall and imports will rise. As a result, the
balance of payments will deteriorate and the GDP will
decline.

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Factors affecting the consequences of inflation
The effects of inflation depend on:

1. The cause of inflation. Demand-pull inflation is likely to

be less harmful than cost-push inflation. This is because
demand-pull inflation is associated with rising output
whereas cost-push inflation is associated with falling
output.

2. The rate of inflation. A high rate of inflation is likely to

cause more damage than a low rate especially if the high
rate develops into hyperinflation. Indeed, hyperinflation
can lead to households and firms losing faith in the
currency and may bring down a government.

3. Whether the rate of inflation is accelerating or stable. An

accelerating inflation rate, and even a fluctuating
(constantly changing) inflation rate, will cause uncertainty
and may discourage firms from investing. The need to
devote more time and effort to estimating future inflation
rates will increase costs.

4. Whether the inflation rate is the one that has been

expected. Unanticipated inflation, which occurs when the
inflation rate was different from that expected, can also
create uncertainty and so can discourage some
consumer expenditure and investment. In contrast, if
households, firms and the government have correctly
anticipated inflation, they can take measures to adapt to
it and so avoid some of its potentially harmful effects.

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 For instance, firms may have adjusted their prices,
money interest rates may have been changed to
maintain real interest rates and the government may
have adjusted tax brackets, raised pensions and public
sector wages in line with inflation.

5. How the inflation rate compares with the rate of other

countries. It is possible for a country to have a relatively
high rate of inflation, but if it is below that of competing
countries its products may become more internationally
competitive.

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 DEFLATION
Deflation is defined as a persistent fall in the average level
of prices in the economy. If deflation comes about from
improvements in the supply side of the economy and/or
increased productivity it may not be bad.

FIGURE 4.3 Deflation

However, if deflation or falling prices is due to a lack of

demand in an economy then it could have serious
implications.

1. Consumer Confidence: With falling prices, consumer

confidence tends to be low; consumers are concerned

54
 about the future, and know that if they do not buy today,
they might be able to buy at a cheaper price tomorrow.

2. Investment: A lack of consumer confidence then feeds

into a lack of business confidence and lower investment
as businesses expect to make less profit, or make losses.
This has negative implications for future economic
growth.

3. Unemployment: With falling demand and investment,

businesses are likely to lay off workers. This would result
in further fall in incomes and a reduction in demand
causing a deflationary spiral, as an economy may go into
deep recession.

4. Costs to borrowers: Anyone who has taken a loan

suffers as a result of deflation because the value of their
debt rises as a result of deflation. If profits are low, this
may make it too difficult for businesses to pay back their
loans and there may be many bankruptcies. This will
further worsen business confidence.

There are benefits of falling price level to some economic

groups. People on fixed income, like pensioners, and
creditors will benefit. Also export prices will fall and import
prices will rise, and given they are price elastic, their value
will also rise, ultimately resulting in the balance of payment
to improve.

However, the depressing effect on demand of deflation is

the key reason why economists suggest that the ideal rate

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of inflation is a positive 1-2%. Very low inflation means that
the costs of inflation are low. At the same time, very mild
inflation is associated with economic growth and increasing
prosperity

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