Principles of Economics II

School of Economics,
UNIVERSITY OF CAPE COAST
INFLATION
 INFLATION
• This refers to the sustained increase in the general price level of
a basket of goods and services and factors of production in an
economy over a period of time leading to a fall in the value of
money.

• The process in which the price level rises and money loses
value/purchasing power of currency reduces.

• Inflation is fundamentally a monetary phenomenon.

• The average level of prices is rising.

 TYPES OF INFLATION
• Suppressed Inflation:
Existing inflation disguised by government price controls or other
interferences in the economy such as subsidies or wage control. Such
suppression, nevertheless, can only be temporary because no
governmental measure can completely contain accelerating inflation
in the long run. Also called repressed inflation.

• Creeping Inflation :
Situation where inflation increases gradually, but continually, over
time. The relatively small effect of creeping inflation, when viewed
long-term, actually adds up to a pretty significant increase in the
cost of living. Fairly stable inflation with an average of 5% or less per
annum.
 TYPES OF INFLATION
• Strato-Inflation:
High inflation ranges between 10% to several hundred %.
• Hyper-Inflation / Galloping Inflation:
Several 100% to several 1000% per day. Eg: 1923 Germany hyper-
inflation.
Occur in a political crisis when a weak government loses control of
the economy and turns to printing money to pay its debts. Eg:
Zimbabwe.
• Stagflation:
When high rates of inflation grows with high unemployment.
Stagflation means “inflation and stagnation in output”. Eg: UK in late
1970s and early 1980s.
 CAUSES OF INFLATION
Grouped into 3:
• Demand-pull inflation.
• Cost push inflation
• Imported inflation
 DEMAND-PULL INFLATION
• Demand-pull inflation is inflation that results from an initial increase in
aggregate demand.
• A demand pull inflation can result from any influence that increases
aggregate demand.
• In a demand-pull inflation, initially
aggregate demand increases,
real GDP increases above potential GDP and the price level rises,
money wages rise.
• the price level rises further and real GDP decreases toward potential
GDP.
 DEMAND-PULL INFLATION
• A one-time increase in aggregate demand raises the price level
but does not always start a demand-pull inflation.
• For demand pull inflation to occur, aggregate demand must
persistently increase.
 Real GDP increases and the price level
rises. Now real GDP exceeds potential GDP.
Price
Demand pull inflation
SAS1

P2

P1
AD2

AD1

0 Q1 Q2 Output
 Real GDP increases and the price level
rises. Now real GDP exceeds potential GDP.
Price SAS2
LAS
Demand pull inflation
SAS1

There is an inflationary gap. The money

P3 wage rate begins to rise. And the SAS
P2 curve shifts leftward.

P1
AD2

Real GDP decreases toward potential GDP. AD1

The price level rises further

0 Q1 Q2 Output
Price SAS2
LAS
SAS1

SAS0
P3
P2

P1
AD2

AD1

AD0
0 Q1 Q2 Output
CAUSES OF DEMAND-PULLED INFLATION
➢Monetarist explanation:
Expansion in MS eg: to finance budget deficits.
➢Higher exports over imports:
Leading to: reduction of goods in domestic market.
increase the income of producer of exported goods.
➢Natural disaster:
Like: Earthquake, Floods etc increasing AD.
➢War:
AD exceeds AS of consumer goods putting pressure on prices.
➢Rapid Industrialisation and Growth:
 SOLUTIONS TO DEMAND PULL
➢Monetary policies

➢Fiscal policies
 COST PUSH INFLATION
Cost-push inflation: results from an initial increase in costs.
Inflation arising from reduction in AS. Also known as SUPPLY-SIDE
inflation.

The two main sources of cost-push inflation are:

• an increase in the money wage rate (cost of labour).
• an increase in the money prices of raw materials (production raw
materials).
 COST PUSH INFLATION

In a cost-push inflation, initially

• short-run aggregate supply decreases
• real GDP decreases below potential GDP and the price level rises
• the economy could become stuck in this stagflation situation for
some time.
Price SAS2

SAS1

P2

P1

AD1

0 Q2 Q1 Output
 FACTORS
➢Increased cost of inputs.

➢Fiscal policies.
Increase in taxes.
SOLUTIONS TO COST PUSH INFLATION
➢Wage freeze.

➢Persuasions and exhortations of labour unions.

➢Increasing efficiency in production.

➢Fiscal policies:
Subsidies or tax holidays.
 IMPORTED INFLATION
Imported inflation is associated to countries that are import
dependent (foreign trade).

• Arises when the price paid to the factors of production in the

country from which the importing country receives goods generally
rise.

• Arises when the currency of the importing country continually

depreciates.
Eg: Ghana and most developing countries.
 EFFECTS OF INFLATION
• Regardless of whether its origin is demand-pull or cost-push,
inflation imposes costs.

• The costs depend on whether the inflation is anticipated or

unanticipated.
EFFECTS OF ANTICIPATED INFLATION
• Fall in the Purchasing Power of consumers.
➢Inflation at 4% would mean workers would know that nominal wage
increases of 4% were not real wage increases, and
➢Investors earning a 7% rate of interest on bonds would know that their real
return would be 3% after adjusting for inflation.
• Menu costs: the actual physical costs of changing prices.
• Shoe-leather costs: additional wear and tear necessary to hold less
cash.
• Anticipating inflation also avoids:
• the redistribution of income and wealth.
• errors in investment and saving decisions.
EFFECTS OF UNANTICIPATED INFLATION
Unanticipated inflation can cause the following problems:
• redistribute income between firms and workers
• move real GDP away from potential GDP
• redistribute wealth between borrowers and lenders
• result in too much or too little saving and investment
 EFFECTS OF INFLATION
➢Distributional Effects:
Pensioners on fixed income.
Borrower-Lender syndrome – reduction in purchasing power of
lenders.
➢Distortion of regular economic behaviour due to expectations:
➢Money becomes dysfunctional
➢Shoe lather and menu cost
➢Due to its effects on interest rates , it may affect investment and
the allocation of resources.