CHAPTER 20 INFLATION

INTRODUCTION
In this chapter, we focus on inflation, which has often been described as “Public Enemy
Number One”
20.1 DEFINITION OF INFLATION
Inflation is defined as a continuous and considerable rise in prices in general, but the quality of the
product remains the same

Four aspects of this definition have to be emphasised:

 Neutral: allows for all possible causes of inflation to be taken into account, and
provides a sounder basis for anti-inflation policy.
 Process: continuous increase in prices, not a once-and-for-all increase.
 Considerable: continuous rise in prices- not just a once off rise.
 General: not an increase in the price of a particular good, but goods in general

THE MEASUREMENT OF INFLATION

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20.1 Consumer Price Index (CPI)

Reflect the cost of a representative basket of consumer goods and services

 Most commonly used indicator of the general price level

 Reported each month since inflation is a continuous process
 Expressed as an annual rate (always in %)
 How do we measure inflation for a particular year?
 Since its measured monthly meaning each year = 12 figures (not restricted to calendar
years; any 12 month average may be compared with the previous 12 month average)
 When we say that the inflation rate is 10%, this means that prices are increasing at a
rate of 10% per year.
Method 1: Month on the same month of the previous year

 Compare the index of the corresponding month in the previous year.

To calculate inflation for December 2013:

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Method 2:

 Calculate the average of all the monthly index values,

 Compare it with the corresponding average of the previous year.

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Practical example 1:
The South African Reserve Bank has released the following CPI figures for 2019 in their first
Monetary Policy Review. Using the information in the table below, calculate the current
inflation rate.

YEAR CPI
2016 92.2
2017 105.7
2018 102.3
2019 106.9

CPI inflation rate 2019= [CPI2019-CPI2018)/CPI2018] *100%

= [106.9-102.3/102.3] *100%
=4.5%

20.2 PRODUCER PRICE INDEX

Measures prices at the level of the first significant commercial transaction (entry into the
market).

Important features of the PPI

 Also important price index but differs from CPI
 Associated with the cost of production
 Basket consists of capital & intermediate goods
 Measures change in wholesale prices, i.e. prices of production
 PPI measures the cost of production and not cost of living.

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Table 20.2 Main differences between CPI and PPI

20.2 GDP DEFLATOR

Implicit index – used as another measure to calculate the inflation rate. Side effect of the
calculation of economic growth
The GDP deflator shows the difference between nominal and real GDP in a particular year:
o GDP at current prices: Nominal GDP (current price level)
o GDP at constant prices: Real GDP (true value, adjusting for the effects of inflation)
The transformation of GDP at current prices (nominal) to constant prices (real – adjusting for
the effect of inflation) measures economic growth, but also yields an inflation measure.

Calculating inflation using the GDP deflator method:

 Nom.GDPYearB 
Defl.YearB  
 Re al.GDP 
 *100
 YearB 

 Nom.GDPYearA 
Defl.YearA    *100
 Re al.GDPYearA 
 Defl.YearB  Defl.YearA 
 YearB    *100
 Defl.YearA 

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Practical example 2
Consider the following information provided by Statistics South Africa:

Calculate the inflation rate for 2017.

GDP deflator = Nominal GDP/Real GDP *100
Deflator 2016 = 5 130 703/4 028 475 x100 = 127.36
Deflator 2017 = 5 643 773/4 391 038 x 100 = 128.53
Inflation rate 2017 = deflator current year - deflator previous year/deflator previous year
*100
Inflation rate 2017 = 128.53-127.36/127.36 x 100 = 0.92%

20.3 THE EFFECTS OF INFLATION

The costs of inflation are not immediately obvious, and certainly, everyone is perturbed by
inflation, but does it hurt everyone?
Three sets of inflation effects are as follows:
Distribution effects: Inflation affects the distribution of income and wealth amongst the
various participants in the economy. The first significant distribution effect is the
relationship between creditors and debtors, where some individuals or groups lose while
others benefit.
who lose and who win?
 Debtors (borrowers) tend to gain at the expense of creditors (the real value of their
repayments is reduced over time)
 Government (biggest debtor in the country) tends to gain at expense of private
sector.
 Government also gains via the progressive tax system (individuals will pay a higher
tax rate even when they are not better off) – bracket creep
 Affects poor households more than those who are better off financially.

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Costs/effects of inflation

Distribution effects
 No equal impact on individuals and groups
 Debtors (borrowers) tend to gain at the expense of creditors (real value of their
repayments is reduced over time)
 Government (biggest debtor in the country) tends to gain at expense of private
sector.
 Government also gains via the progressive tax system (individuals will pay a higher
tax rate even when they are not better off) – bracket creep
 Redistributes income and wealth from the elderly to the young
 Affects poor households
Economic effects
 impact on employment and growth
 productive activity neglected
 Saving (e.g. fixed deposit) discouraged
 exports may suffer (if inflation in SA is higher than that of main trading partners)
 imports may be stimulated
Social and political costs
 Creates a climate of conflict that is not conducive to economic progress
 Gives rise to social and political unrests
 Makes people unhappy
Expected inflation
 inflation may result in the expectation of further inflation
 self-fulfilling prophesy
 may give rise to hyperinflation

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20.4 THE CAUSES OF INFLATION
The causes of inflation are not difficult to find, hence why we can explain some elements of
the inflation process by examining four approaches to diagnosing inflation. These approaches
are:
 The demand-pull and cost-push approach
 The structural approach
 The conflict approach
The demand –pull
 Aggregate demand increasing while aggregate supply remains unchanged.
 “Too much money chasing too few goods”
 REMEMBER: AD = C + I + G + X – Z
 THUS an increase in AD is caused by an increase in C,I,G,X-Z

 This is associated with an increase in money stock (M)

To combat demand-pull inflation, the authorities have to keep the aggregate demand for
goods and services in check. This can be done by applying restrictive monetary and fiscal
policies. Restrictive monetary policy entails raising interest rates and limiting the increase of
the stock of money MP ... i .... M , whilst restrictive fiscal policy entails a reduction in
government spending and/or increased taxation FP ... T ... G.

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Figure 20.1 Demand pull inflation

Demand-pull inflation occurs when the aggregate demand for goods and services increases. This is
illustrated by the rightward shift of the AD curve from AD1 to AD2, AD3 and AD4. As long as there is
still excess capacity in the economy, the increase in the price level will be accompanied by increase
in production and income. However, when full employment is reached, further shifts in the AD
curve (from AD3 to AD4) lead to price increases only.

Cost-push inflation

Cost-push inflation is triggered by an increase in the cost of production, which push up the
price level

 Higher cost leads to lower supply

 AS shifts to the left
5 main causes of cost-push inflation:
 Increase in wages and salaries
 Increase in imported capital & intermediate goods
 Increase in profit margins
 Decrease in productivity
 Natural disasters

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Figure 20.2 cost-push inflation

Cost-push inflation occurs when the cost of producing each level of total productivity Y increases.
This is illustrated by an upward (leftward) shift of the AS curve from AS1 to AS2. Increase in the
price level are accompanied by reductions in aggregate production or income Y (and therefore also
by increase in unemployment). In the diagram, the price label increase from P1 to P2 and the level
of income falls from Y1 to Y2.

o Cost-push inflation has a negative impact on production, income and employment.

o Stagflation occurs, because increasing prices (inflation) are accompanied by
increased unemployment
o Cost-push inflation can be combat with an income policy.
o Monetary policy & Fiscal policy cannot combat cost-push inflation.

The structuralist approach

Retains the distinction between demand-pull and cost-push, but in a broader context. The
inflation process is the result of the interaction between three interrelated sets of factors:
The underlying factors
 Which provide the background against which the inflation process occurs (provides an
indication of the vulnerability of economy to inflation).
 For instance, a lack of fiscal discipline, the size of the public sector.
The initiating factors
 Which triggers or intensify a particular inflation process.
 Classified into three broad factors (demand pull factors, Cost push and other
price/cost increases). For instance, natural disasters.

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Propagating factors
 Which explains the transmission to the rest of the economy in sustaining inflation
 Generate the process of rising inflation
 For instance, inflationary expectations

Conflict approach to inflation

Inflation is a symptom of disharmony/imbalance in society (among various social groups like
trade unions, large firms, politicians etc.)
Everyone tries to claim a bigger share of the national income; claiming more than what is
available
Hence - according to this approach, inflation is a symptom of the lack of effective economic
and/or political mechanisms to reconcile reported income levels

20.5 Anti-inflationary policy

Demand-pull inflation
 Use restrictive monetary and fiscal policy by  the tax & interest rates and 
government spending.
 Discourage spending
 Such an approach would reduce inflation or even lead to reduced price levels.

Cost-push inflation
 Cannot use restrictive monetary and fiscal policy (Cost push is already accompanied
by a decline in production/income)
 Restrictive policy would increase unemployment further and push the economy
deeper into a recession
 Increasing supply is therefore ideal, despite increased costs
 Difficult in practice

Indexation

Prices, wages and so on are linked to price indices like the CPI to eliminate the distributional effects
of inflation.

Inflation rate should be 100% or more (only used in emergency conditions).

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Inflation targeting

An economic policy in which a central bank estimates and makes a public projected, or
"target", inflation rate and then attempts to steer actual inflation towards the target through the
use of interest rate changes and other monetary tools.

The key features of inflation targeting:

 The announcement of quantitative targets
 The primary of price stability as the objective of monetary policy (in addition, the
central bank should be operationally independent)
 A broad-based, pragmatic approach to the analysis of inflation (use a wide range of
variables to decide on the suitable setting of the policy instrument (repo rate))
 Transparency (central bank should regularly inform the public and markets about its
plans, decisions and objectives).
 Accountability (central bank should be held accountable to the parliament or public
at large for achieving its main objectives)
**See Advantages and disadvantages of inflation targeting in textbook on page 396-397**

Inflation targeting in South Africa

 Announced inflation targeting framework in 2000.

 Inflation target range: 3 – 6%.
 Uses repo rate as monetary policy instrument to control inflation.
 Repo rate set by Governor of Reserve Bank in consultation with Monetary Policy
Committee.
 MPC meetings six times during the year.

Source: Mohr & Fourie. Economics for South African Student, 5th Edition

VERY IMPORTANT! Complete eFundi quiz and homework 1

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