13.

INFLATION

1. Explain the meaning of inflation

2. Describe demand pull-inflation
3. Describe cost-push inflation
4. Distinguish between demand pull and cost-push inflation

Inflation is a sustained or continuous rise in the general or average price level as

reflected in changes in the consumer price index (CPI). The term aggregate demand
refers to the total demand of a good or service in the whole economy.This means there
is an increase in the cost of living.

Price Stability is when the changes in the average price level are small and don’t have
adverse effects on the economy. The acceptable level of inflation rate is referred to as
creeping inflation .

Levels of inflation
1. creeping inflation [1 – 15% per year]
2.high inflation [10 – 100% per year]
3. Hyperinflation [100 – 400% per year] e.g. Israel 1980s, Germany 1920s, Zimbabwe
2008.

Types/Causes of Inflation

Demand pull inflation

It is caused by continuing rises in aggregate demand(AD).It result from the existence of

excess demand over supply or when aggregate demand exceeds aggregate
supply(AS) ,thereby driving prices upwards. All the economic agents (households, firms
and government) collectively buy more goods and services than the country can
produce.It is called demand pull because an increase in demand pulls prices upwards if
the economy does not have spare capacity to meet these increased needs. Firms
respond to a rise in demand partly by raising prices and partly by increasing output, and
this depends on the availability of spare capacity.This is the type of inflation people are
talking about when they say that inflation is w
‘ hen too much money is chasing too few
goods’.

Fig.1:Demand-pull inflation
The diagram illustrates the effects of changes in AD when the economy is close tofull
employment (unable to increase output to match AD situation). Changes in AD from AD1
to AD2 result to a small increase in prices from P1 to P2 because the economy is close
to full employment or is in the intermediate range. At output Y2 an increase in AD from
AD2 to AD3 caused the prices to increase by a greater margin. At output Y3, the
economy is now at full employment(no longer able to increase output using available
resources) and any further increase in AD would only cause the prices to increase and
not output
The diagram above illustrates the monetarist view to demand pull inflation. They
assume the long run aggregate supply to be perfectly inelastic i.e. the economy is at full
employment at Y1. An increase in AD from AD1 to AD2 will cause the prices to increase
from P1 to P2

Causes of demand pull inflation

 Transfer payments

Transfer payments are payments by government for reasons other than the provision of
goods and services. Large increases in transfer payments since independence, such as
payments to the disabled, war victims led to increases in demand for goods.

An increase in one or more of the components of AD e.g. C, I, G, X-M. AD can increase

as a result of the following
A depreciation of the exchange rate which makes exports more competitive in
overseas markets leading to an injection of fresh demand into the circular flow and a
rise in national and demand for factor resources – there may also be a positive
multiplier effect on the level of demand and output arising from the initial boost to
export sales.
Higher demand from a government (fiscal) stimulus e.g. via a reduction in direct or
indirect taxation or higher government spending and borrowing. If direct taxes are
reduced, consumers will have more disposable income causing demand to rise. Higher
government spending and increased borrowing feeds through directly into extra
demand in the circular flow.

Faster economic growth in other countries – providing a boost to country’s exports

overseas.
Improved business confidence which prompts firms to raise levels of investment
An increase in the money supply. Economists who believe this aremonetarists . (Note:
not all economists believe this theory).
Monetary stimulus to the economy- A fall in interest rates may stimulate too much
demand

 Increase in government expenditure

 Increase in money supply

 Increase in wages/income

Cost push inflation

Cost-push inflation is a situation where the increases in the price level are caused by
increases in the cost of production. Increases in wages, electricity or transport costs
can raise the costs of production for firms, hence continuing leftward (upward) shifts in
the Aggregate Supply curve i.e. decrease in supply. Such shifts occur when costs of
production rise independently of aggregate demand. 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 can be illustrated as follows;
The diagram above illustrates that cost-push inflation occurs when there is an increase in
the cost of production not associated with AD. If a firm‘s costs increase they will react by
increasing their prices and reducing production. This is represented by a shift to the left in
the AS1 TO AS2 curve and results in an increase in the price level, P1 to P2, and a reduction
in output from Q1 to Q2.

There are many reasons why costs might rise these includes:

Component costs: e.g. an increase in the prices of raw materials and components.
This might be because of a rise in global commodity prices such as oil, gas copper and
agricultural products used in food processing – a good recent example is the surge in
the world price of wheat.
Rising labour costs (wage push inflation) - caused by wage increases that exceed
improvements in productivity. Wage and salary costs often rise when unemployment is
low (creating labour shortages) and when people expect inflation so they bid for higher
pay in order to protect their real incomes this result to firms charging higher prices. This
increase in prices is likely to lead to further wage claims and this could result in what is
known as thewage-price spiral .
 Higher indirect taxes imposed by the government (tax push inflation) – for example a
rise in the duty on alcohol, cigarettes and petrol/diesel or a rise in the standard rate of
Value Added Tax. Depending on the price elasticity of demand and supply, suppliers
may pass on the burden of the tax onto consumers.
Depreciation of currency - A rise in import prices can be an important contributor to
inflation. Imports may become expensive if the domestic currency depreciate, this
result to higher prices being charged. This is called imported inflation

Profiteering-This is perhaps less important than an increase in wage costs. There could
be a situation where firms use their monopoly power to increase prices in order to
increase profit margins. In this situation the increase in the price of the product is not
associated with an increase in consumer demand.
Increase in Import prices-A rise in import prices can be an important contributor to
inflation. Imports may become expensive if the domestic currency depreciate, this
result to higher prices being charged. This is called imported inflation.

An increase in cost of production such as:

 Increase in wages

 Increase in raw material prices

 Increase in rentals

 Increase in interest rates

Suppliers or producers would pass over this cost to the final consumer in the form of
high prices. This leads to cost push inflation

Other factors

 Drought

 Lack of investment

 Foreign currency shortages

EFFECTS OF INFLATION

1. Explain how consumers are affected by inflation,

2. Describe the effects of inflation on producers,
3. Illustrate how the government would be affected by inflation
4. Explain the effects of inflation on the functions of money.

Negatives effects
On consumers

Erosion of peoples purchasing power

When the value falls, the spending power of consumers decreases. Consumers will buy
less of goods and services using the money they have. If previously consumers would
buy 4 loaves of bread using $2, they can now afford to buy only 2 loaves of bread using
the same amount. Therefore , consumers will not be able to buy the same quantities of
goods as before using a certain amount of money, reducing the purchasing power of
consumers.

Real income falls

Inflation results in the fall of the realincome of consumers because money will have
less value than before. Real income refers to the value of money when it is adjusted for
inflation. As inflation increases, the real value of money will be falling. This negatively
affects groups of people who receive fixed sums of money such as pensioners.

It becomes difficult for consumers to plan

When the value of money keeps on falling, it becomes difficult for consumers to plan
how to spend their money. As a result, consumers may become unwilling to spend their
money resulting in low level of consumption in the economy.

Consumers will spend valuable time searching for cheaper commodities.

During periods of inflation, prices will be very unstable. Consumers are forced to move
around in search of cheaper alternative products. Before buying a certain product, a
consumer may compare the price of the product in a number of shops, say five. So this
process of window shopping will be time consuming. The time spent window shopping
has an opportunity cost, which is usually referred to as shoe leather cost.

Leads to a decadence in peoples living standards

Inflation may result in less variety of products being accessible to the consumers. The
cause of the lack of variety is reduction of production by many firms in the economy.
Some products will no longer be produced. Imported goods will also be expensive. Lack
of variety in an economy will lower peoples standards of living.

Effects of inflation on producers.

Inflation increases the cost of production.

Increase in costs of production makes it hard for producers to produce more goods and
services.
Cost of production reduces competitiveness of domestic products in the international
market because an increase in the costs of production results in an increase in
exports.This makes consumers to opt for imports which become cheaper.

Inflation results in an increase in menu costs.

Menu costs are the expenses that firms experience when adjusting and reprinting the
price tags
of their products since prices keep on changing within a short period. This is because
firms require new catalogues, barcodes, and price tags. They will also need to advertise
the new prices of goods and services.

It increases the cost of borrowing money.

o This is because during a period of inflation, lenders tend to charge high rate of
interest to prevent loss of real income. So, the producers will tend to refrain from
borrowing leading to less investment in the economy.

Erosion of profits

Inflation causes a fall in profits of producers who sell their goods on credit.When the
amount of money is paid after a certain period of time, it would have lost its value if it
was not adjusted for inflation. When the inflation rate is higher than the interest rate,
there is reduction in savings.The firm’s income which is saved for reinvestment will be
eroded by inflation.

Planning becomes very difficult

Firms will be unable to forecast on their costs and revenues due to constant changes in
prices.

Lower business confidence

Inflations results in lower business confidence. As firms expect the inflation rate to
continue rising, they lose confidence in the future viability of businesses. They may end
up reducing the scale of production.

Fall in investor confidence

Due to low investor confidence in an economy with high levels of inflation, firms will not
be willing to borrow money for investment. For the firms that have been saving, their
savings will lose value, thereby inhibiting them to invest more.

Shortage of basics on the market

High inflation levels may result in shortages of commodities in the economy. The
shortages may be caused by individuals and businesses that hoard products in
anticipation of further increases in prices. Shortages of basic commodities will promote
black markets.

Wage price spiral, as wages are increased prices also increase

Due to inflation, workers will demand higher wages resulting in the increase in the costs
of production.this will reduce profit levels of the firm. Imported raw materials will be
expensive and also increase the cost of production. Firms will shift the costs to
consumers in form of high prices which will reduce workers real income and hence
demand higher wages again leading to wage – price – spiral problem.

How the government is affected by inflation

Low economic growth.

Cost push inflation will result in low economic growth. When the cost of production
increases, firms will reduce output of goods and services resulting in the leftward
(inward) shift of the PPC . Thus reduction of both consumer and capital goods
produced by firms in an economy.Production of goods is reduced from PPC1 to PPC2,
which results in negative growth.

Rise in the rate of unemployment

Negative economic growth is associated with many problems which include increase in
unemployment and lower standard of living due to closure of companies..Increased
unemployment increase government expenditure in trying to cater for the unemployed.
Government may incur additional costs trying to provide goods and services that are
short in supply.

Low supply of merit and public goods

Inflation affects the the ability of the government to supply public and merit goods. It
will also be expensive for the government to supply essential services such as
education, defense and healthcare. As a result, it may be forced to suspend some
infrastructural projects such as road construction.

Civil servants will constantly demand cost of living adjustment and salary increases.

As real wages are eroded by inflation, workers would need wages and salary
adjustments. The increase in remunerations of civil servants will result in an increase in
wage bills which requires budgetary adjustment. At times, high salary hikes result in
budget deficits.
OTHER EFFECTS

 Corruption becomes rampant (order of the day)

 General macro economic and political instability

 Brain drain

 Can lead to the eruption of anti social behaviour

The effects of inflation on functions of money.

medium of exchange ;

 Lose its role

 No longer acceptable

 People resort to barter

as a store of wealth;

 Abandoned as a means to store wealth

 Wealth in form of money loses value

 Savings will not be possible

 Wealth will be stored in form of assets other than money

standard for deferred payments

 Goods will be sold on cash basis

 No credit transactions

 Debtors will benefit/creditors will lose

 Demand of goods decrease

Inflation and unit of account.

Due to an increase in inflation, it becomes hard to compare values of different products

in an economy

Positive effects
  It leads to redistribution of income

Income is redistributed from lenders to borrowers. Income is redistributed from the rich
(lenders) to the poor (borrowers).Borrowers will return the money to lenders whn its real
value has decreased. Therefore borrowers would gain whilst lenders will lose,

Real wage bills of firms may fall.

Firms may reduce their real wage bills if they keep their wages constant or raise wages
at a rate lower than the inflation rate. This may prevent firms from laying off workers,
thereby maintaining high employment levels in the country, despite inflation.

Inflation reduces debt burden of individuals or firms

Nominal interests do not usually rise at the same rate as inflation. When the rate of
inflation is higher than the rate of interest, the debt burden will fall. For example, the real
money value of loan repayments will fall, giving a debt relief to borrowers. When the
debt burden of consumer falls, their expenditure on consumer goods will rise leading to
higher output of goods and services in the economy.

May create confidence in business

A low level of inflation arising from an increase in aggregate demand in a stable

economy, will make businesses and investors to become optimistic, thereby willing to
increase output and investment. On the other hand if the margin of rise is higher than
the margin of increase in cost of production, firms will earn profit which can be
reinvested in the business.

Other effects

 Inflation unites conflicting parties

 It forces policy makers to be wide awake and implement sound policies

 Profiteering by firms

Measurement of inflation
1. calculate rate of inflation using Consumer Price Index (CPI) and Retail Price Index
(RPI)
2. identify the current rate of inflation in Zimbabwe
3. compare rates of inflation for different periods in Zimbabwe
4. explain the monetary and fiscal policy tools used to curb inflation

Measuring Inflation

It is useful to have a general understanding of how inflation is measured. The most

common measure of inflation is the ‘inflation rate CPI.

Constructing consumer price index (CPI)

Key terms:

Price index : is a measure of the average level of prices in one period as a percentage of
their level in an earlier period (e.g. the previous year).

Price level: is the average level of prices as measured by a price index.

Regimen/Basket of goods: a sample of goods or services used in calculation of the

price index.

Base year: the year chosen as the first year of measurement. It is given the value 100.

Weighting: a value given to a good/service to indicate its importance in a regimen as

indicated by expenditure on the item compared to other good/service.

Steps followed in constructing consumer price index

Step 1 A regimen is chosen/Basket of goods. This can be done by a survey of

households. Prices are gathered for all the items. In Zimbabwe the prices are obtained
from a survey carried out.
Step 2 The price of items in the basket in the base year is noted. The base year is the
year in which it is assumed that there were no chronic economic problems, that is, there
is no inflation
Step 3 The price of goods in the basket is recorded in the current year and compared
with base year prices as a percentage (index) using the equation:-

(i) Consumer price index (CPI)

CPI is a measure that examines the weighted average of prices of a basket of consumer
goods and services, such as transportation, food and medical care. It is calculated by
taking price changes for each item in the predetermined basket of goods and averaging
them. Changes in the CPI are used to assess price changes associated with the cost of
living. The CPI is one of the most frequently used statistics for identifying periods of
inflation or deflation. Most countries use CPI as a measure of inflation providing a cost
of living index. The average price of the consumer basket in the first year of calculation
is 100.The first year is termed the base year. If on average, the goods and services in
the basket rise in price by 30%, the price index will be 130%.

 Steps followed in constructing consumer price index

  Step 1 A Basket of goods is chosen. This can be done by a survey of households.
Prices are gathered for all the items. In Zimbabwe the prices are obtained from a
survey carried out.
 Step 2 The price of items in the basket in the base year is noted. The base year is
the year in which it is assumed that there were no chronic economic problems,
that is, there is no inflation
 Step 3 The price of goods in the basket is recorded in the current year and
compared with base year prices as a percentage (index) using the equation:-

Example

 Prices of commodities ,2022 and 2023

GOOD 2022 Price($) 2023 Price($)

Food 10 15
Clothing 3 4
Shelter 20 21
Medical care 5 6

Calculation of a price index

GOOD 2022 Price($) Index 2023 Index

Price($)
Food 10 100 15 150
Clothing 3 100 4 133
Shelter 20 100 21 105
Medical care 5 100 6 120
TOTAL 400/4 508/4

Inflation rate 127 -100 X 100

100

= 27%

(ii) Retail price index (RPI)

Retail Price Index (RPI) is a measure of inflation published monthly by the ZIMSTATS
office.RPI measures the change in the cost of a representative sample of retail goods
and services. Many employers also use it as a starting point in wage negotiation.

The RPI includes an element of housing costs, for example Council tax, mortgage
interest payments, house depreciation, buildings insurance, ground rent, solar PV feed
in tariffs and other house purchase costs such as estate agents' and conveyance fees.
How to calculate RPI
A base year is chosen.A list of items bought by an average family is drawn up which
makes a consumer basket.A set of weights are calculated, showing the relative
importance of the items in the average family budget.The greater the share of the
average household bill, the greater the weight.The price of each item is multiplied by
the weight given to the item, so that the contribution of the item's price is in proportion
to its importance.

The price of each item must be found in both the base year and the year of
comparison (or month).This enables the percentage change to be calculated over the
desired time period.
For example, let’s assume that an economy has only 4 products . Also, imagine that,
over a year, food increase in price by 20%, clothing increase by 10%; shelter fall by 10%
and medical care fall by 20%.

You would think that these cancel each other out so that inflation is zero.But, what if
consumers do not allocate their incomes evenly between the four goods?The burden of
inflation might actually be ‘positive’ or ‘negative’ rather than neutral.For example,
households might choose to spend 40% of their income on food, 30% of their income on
clothing, 20% of their income on shelter and only 10% of their income on medical care.
We can put this information into a table:

Good % income Price Index Weight Weighte

spent change d index
Food 40 +20% 120 4 480
Clothing 30 +10% 110 3 330
Shelter 20 -10% 90 2 180
Medical care 10 -20% 80 1 80
Total 100 10 1070/10

 Which gives an inflation index of 107, and an inflation rate of 7%.

CONTROL OF INFLATION
How inflation is controlled in an economy depends on the causes and the type of
inflation economy is experiencing.

Fiscal Policy
 Increase taxes
 Decrease in government expenditure
 Decline in government transfer payments

Monetary Policy
Monetary policy is that part of macroeconomic policy which regulates the changes in
money supply in order to maintain price stability. Tools of monetary policy are changing
discount rate (d); changing required reserve ratio (rr) reduces the extent to which
commercial banks create credit hence reduces money supply. When the discount rate is
increased short term interest rates increase and this discourages borrowing to finance
investment spending. This invariably reduces aggregate demand. Central bank selling of its
own government securities to the general public reduces money supply which reduces
aggregate demand. Generally, there will be contractionary monetary policy.
The following diagram illustrates how monetary and fiscal policies shift the aggregate
demand curve.

– reducing money supply

 Increase interest rates to discourage borrowing.

 Central bank selling government securities to the public

 Changing required reserve ratio

Income and Price Policy

 Wage freeze
 Maximum prices
Income Policy measures may take the form of wage freeze, linking wage increases to
increase in productivity. Price Policy may also be used. Maximum prices are used in this
case. These prices are the highest possible legal prices for scarce goods. However,
these prices may lead to queues, rationing and black marketing in scarce products.

Supply Side Policies

 Subsidies
 Increasing productivity in all sectors of the economy. Increases in productivity
may increase output, which will subsequently increase supply. This may be
achieved by the retraining of labour, improving technology, removing all structural
rigidities e.g. land tenure system, poor road infrastructure e.t.c.

SUMMARY OF SOULUTIONS

Demand Pull Inflation

 Government can implement demand side policies

 Increase PAYE

 Increase corporate tax

 Income policy e.g. wage freeze

 Aligning fiscus to budgeted levels

 Reducing government expenditure through retrenching the civil service

Cost Push Inflation

 Government can employ supply side policies

 Granting subsidies

 Price controls

 Increasing productivity through training

 Reducing interest rates

 Reducing VAT

Imported Inflation

 Embargoes

 Increasing import tarrifs

 Import substitution
  Trade licences

Monetary Inflation

 Matching money supply growth with GDP growth

 Avoid printing money unnecessarily

 Devaluation

 Open market operations