By the end of this chapter, you will be able to

(i) define inflation and deflation.
(ii) explain the causes of inflation and deflation.
(iii) explain the costs of inflation and deflation.

  1. Inflation is that the persistent rise within the level of costs throughout the country. the speed of Inflation is that the proportion increase within the level of value (usually consumerprice index however alternative value indices are used) over a twelve month amount.
  2. Commonly measured victimization the buyer index (CPI). In India the a lot of common live is that the Wholesale index (WPI) whereas in GB, the Retail index (RPI) is employed.
  3. CPI could be a live supported a basket of products and services consumed by a typical unit.
  4. Let the CPI be one hundred in 2005. If the CPI in Gregorian calendar month 2007 was 103.3 and grew to 106.7 in Gregorian calendar month 2008 then the speed of inflation in 2007 was [(106.7 /103.3) x 100 percent] - one hundred nothing = a pair of.61 nothing --------------------( * ) If the CPI in Gregorian calendar month 2007 was 103.3 then compared to year 2005 there was Associate in Nursing rate of inflation of 103.3 -100 = 3.3 (or 3.3%) from 2005 to 2007. Having aforesaid therefore, most economists and policy manufacturers are a lot of fascinated by the speed of inflation from a year past (i.e. year-on-year basis, the calculation victimization formula ( * ) above).
  5. The rule of seventy is often accustomed estimate what percentage years can it take before the speed doubles for a given rate. Associate in Nursing approximation: 70/2.61 = 26.8 years. If the rate of inflation is a pair of.61 nothing p.a. then in regarding twenty seven years, the value level can double. A chocolate ice-cream that prices HKD ten currently can value HKD twenty in twenty seven years from currently if the rate of inflation is a pair of.61 you look after each year.
  6. Similarly, deflation is that the persistent decline within the level of costs throughout the country. the speed of deflation is that the proportion decrease within the level of value (usually shopper index however alternative value indices are used) over a twelve month amount.
  7. Diagram 1. Inflation rate of Hong Kong from 1982 to 2007 measured with composite CPI.


    Discussion A.

    (a) Identify a period or periods of rising price levels.

    (b) Identify a period or periods of rising inflation rate.

    (c) Identify a period or periods of falling inflation rate. Economists refer to falling inflation rate as disinflation.

    (d) Identify a period of falling price levels.


    Box 1. Problems in Measuring Inflation rate. (HL)

    (i) Definition of typical household.
    Which basket of goods should be used? What goods and services should be included? Who consume what? Here the problem lies with how the governmental statistical department define the "average" household and its typical consumption of goods and services. Governments are actually aware of this problem. The Hong Kong government actually calculates CPI for low, middle and high monthly income households using their respective consumption patterns as well as composite CPI. Many governments revise the composition of the basket of goods and services regularly to reflect the typical consumption pattern in the economy.

    CPI may understate the inflation for groups in the population who spend unusually large portions of their income of goods and services that increased most in prices.
    Although housing and food accounts for more than 62 per cent of CPI(A) for low income households in Hong Kong, this proportion is less than 57 per cent in the composite CPI. Some Hong Kong households may spend more than 62 per cent of their incomes on housing and food. When food prices and rents increase substantially as from 2007 in Hong Kong, the inflation for low income households that spent more than 62% of their incomes on housing and food will be a lot higher than stated by CPI(A) or composite CPI.

    (ii) Quality of goods and services.
    CPI does not take into consideration of quality of goods and services. If quality is generally improving then the cost of living has not risen as much as suggested by an increasing CPI. Some economists estimate that improvement is technology and quality is about 3% a year.

    (iii) Discounts.
    The CPI measure does not take into consideration of discounts that sellers may offer to buyers. Although the market price of a bottle of A&B Shampoo is Euro 2 but a consumer can buy 2 and get 1 free offer from seller for the same good. In this case, our consumer is only paying a Euro 1.33 per bottle of shampoo. Again CPI has overstate the actual inflation in the economy.

    (iV) Buyer-response / substitution effect.
    CPI does not take into consideration that consumers will change their consumption pattern with a change in relative prices. The CPI assumes consumers will buy the same brands and amount of goods and services as prices increase. In reality this is not the case. When petrol (gasoline) becomes more expensive, consumers can switch to public transportation and cut back on long-distance traveling to cut back on gasoline. If brand A marmalade becomes expensive then cost-conscious consumers can switch to a brand with a lower price. Thus, CPI tends to overstate the inflation rate.

    (v) Underground economy.
    If the economy has official price controls on goods that lead to shortages then consumers will be forced to buy the same goods in the black market at higher prices. In this case, the CPI measure understate the actual inflation in the economy.

    (vi) Non-transaction activities. (housekeeping, painting your own room, etc.)
    These activities improves the living standard of a person without incurring extra expenses for consumers. For instance, a CPI may include the price of haircut and consumers can reduce their monthly expenditure by cutting their own hair at home.

Cost of Inflation

If people can correctly anticipate the rate of inflation and fully adjust prices and income accordingly then the cost of inflation is minor. The inconvenience for consumers is to mentally adjust the notion of "fair prices" when they go shopping and for firms they will have to adjust price tags, price catalogues and menu to reflect price rise. Economists call the costs associated to the adjustment of price lists as Menu Costs of Inflation. However, people often make mistakes with this anticipation and do not fully adjust prices and income. This creates problems beyond the costs of inflation and these burdens are heavier when the rate of inflation is higher and fluctuations become more frequent.

  1. Redistributive effects. Inflation distributes financial gain aloof from folks that earn mounted incomes and don't have any dialogue power. Pensioners, mounted financial gain employees, and other people World Health Organization couldn't talk over their rents suffer from inflation. Depositors World Health Organization attained negative real interest rates additionally loss as a result of they loss getting power for his or her savings. {people World Health Organization|people that|folks that|those that|those who} have property and also the power to boost rents profit additionally as borrowers who like lower real rate of interest like inflation.
  2. Uncertainty and lack of investment. Generally, the upper rate of inflation, the a lot of it fluctuates. so investors have a tougher time in anticipating future profits and returns to their investments. This reduces the motivation to speculate and successively reduce the quantity of injection into the economy.
  3. Output effects. Aggregate Demand (AD) won't shifts out the maximum amount because it may and reduces the expansion of the economy. This shift in AD will manifest itself from a lower investment level within the economy (see purpose b above).
  4. Effects after all of payment. Balance of Payment, roughly place, is Associate in Nursing accounting live that tracks total outlay on foreign product and services + capital outflows, and total incomes from exports + capital influx. High rate of inflation ends up in native exports being less competitive within the world market. Export can fall. At identical time, foreign product become cheaper compared to native product and imports increase. The balance of payment can deteriorate and/or rate of exchange can depreciate against foreign currency. we'll investigate the matter caused by a deterioration of balance of payment on the economy later.
  5. Decision-making errors. When rate of inflation is high and fluctuates oftentimes, customers can got to estimate rate of inflation when making a decision their consumption and saving patterns. whether or not or not, an individual can keep most of his cash in liquidity forms depends on what she expect the important rate of interest in future. Government additionally has got to take inflation into thought when making a decision what rates to supply for its bills and bonds. The expected returns to Associate in Nursing investment can depend upon the anticipated inflation rates on prices and revenue. a lot of mistakes square measure a lot of doubtless once rate of inflation is each high and fluctuates oftentimes. once mistakes occur in creating economic selections, the economy run less with efficiency as some resources are often erroneously dedicated to Associate in Nursing investment that evidenced unprofitable once actual rate of inflation exceeds the anticipated rate of inflation.
  6. Hyperinflation happens once costs rise by many hundred per cent or perhaps thousands per cent in a very year. corporations can have very little incentive to speculate during this condition. corporations can got to raise costs perpetually and worry regarding increase in prices of production. employees can perpetually demand for salary increase to stay earlier than inflation. this could cause wage-price spiral wherever wages and costs chase one another leading to AD perpetually shifting to the proper and AS perpetually shifting to the left. individuals won't would like to avoid wasting cash and can pay the money all some tangible product as presently as doable. the products will then later be used for bartering later. Hyperinflation adds to the mental burden of all economic agents as most are preoccupied by the persistent increase in indicator, the falling getting power of cash, and also the securing of products. Hyperinflation is commonly caused by excessive financial growth in Associate in Nursing economy during which cash chases when product and services.
  7. Political instability is probably going once individuals expertise high and increasing rate of inflation. The classical example was Deutschland when warfare one during which the annual inflation was 7000 billion p.c by season 1923. individuals were pissed off and gave rise to Hitler's fascist party in Deutschland. The recent case of hyperinflation was Republic of Zimbabwe that finally resulted in Gregorian calendar month 2009. in line with Associate in Nursing freelance estimate, the annnual rate of inflation in Republic of Zimbabwe exceeded one million p.c in might 2008 (The state capital Globe, twenty one might 2008).
Costs of Deflation
  1. Put businesses struggling to scale back prices by all means that to stay competitive. this could cause employment insecurity.
  2. Pressure to chop prices might erode the assembly base of the economy. Less funds for innovation resulting in poorer internal control and possibly higher state. Less investment as a result of anticipated deflation reduces the speed of returns to investment and profits.
  3. It may create it troublesome to scale back real worth of debt burdens. Borrowers suffer beneath this condition.
  4. Consumers might expect costs to fall more and can remit purchase. This adds to a lot of deflationary pressure for costs to fall more. Note: you'll modify the on top of list on "costs of deflation" into the "benefits of modest level of inflation." Thus, modest level of inflation permits corporations to boost their costs and profits. Inflation reduces the worth of debt.

Costs of Deflation

  1. Put businesses under pressure to reduce costs by all means to remain competitive. This may lead to employment insecurity.
  2. Pressure to cut costs may erode the production base of the economy. Less funds for innovation leading to poorer quality control and probably higher unemployment. Less investment because anticipated deflation reduces the rate of returns to investment and profits.
  3. It may make it difficult to reduce real value of debt burdens. Borrowers suffer under this condition.
  4. Consumers may expect prices to fall further and will postpone purchase. This adds to more deflationary pressure for prices to fall further.

Note: You can modify the above list on "costs of deflation" into the "benefits of modest level of inflation." Thus, modest level of inflation allows firms to raise their prices and profits. Inflation reduces the value of debt.

Causes Of Inflation

  1. Demand-Pull (demand-side) Inflation is the inflation caused by persistent rises in aggregate demand (see diagram 2 below). AD can increase with an increase in consumption, an expansionary monetary and fiscal policies from the government, and inflow of capital from abroad. As AD shifts from AD1 to AD2 as in diagram 2, say due to an increased consumption, firms will respond by increasing outputs and prices. The increase in price level depends on the steepness of AS. If AD stops at AD1 then an increase in injection will cause an inflation as price level adjusts from p1 to p2 as in diagram 2. Once this short-run inflation has occurred, inflation will stop. For inflation to persist there must be a continuous shift in AD to the left from say AD1 to AD2 then to AD3 and so on. In this process, real national income rises with inflation rate. However, the rise in national income will diminish for every increase in inflation rate when the slack in the economy lessens, i.e. the AS becomes more vertical. If AS becomes vertical where the economy is operating at full potential then any shift in the AD has no effect on real national output but only causes an increase in price level. That is excess demand bids up the prices of the fixed real output. "Too much money chasing after too few goods and services." A demand-pull inflation can cause a runaway inflation especially reinforced by wage-price spiral. A demand-pull inflation is typically associated with a booming economy and is the counterpart of demand-deficient unemployment.

  2. Diagram 2. Demand-pull inflation.

    Diagram 3. Cost-push inflation.


  3. Cost-push (supply-side inflation) is the inflation caused by persistent increase in the costs of production. It explains rising prices in terms of factors which raise per unit production cost. Cost-push inflation tends to be self-limiting. The amount of increase in price level depends on the steepness of AS curve.

(i) Wage-push inflation:Theoretically sound because labor costs usually take up 2/3 of production costs. Labour Unions demand wage hike independent of the demand for labour and successful negotiations lead to increase in wage rates. Costs of production increase and AS shifts to the left as in diagram 3 above. Price level increases and real national income/output decreases as in diagram 3. However, the power of labour union is waning in many countries.

(ii) Supply shock variant: "cost-push" due to unanticipated increase in the costs of raw materials or energy inputs. AS shifts to the left. E.g. 1973-74, 1979-80 and the recent (2007/8-) oil shocks. Inflation due to the persistent increase in the price of imported oil can be termed import-price-push inflation.

Exhaustion of natural resources lead to AS shifting to the left and causes inflation. A temporary inflation can also happen when faced by a bad harvest of grains and natural disasters that destroyed production capacities. Theoretically, a temporary deflation can happen with a bumper harvest. However, the latter case is more unlikely because prices tend to be sticky.

(iii) Profit-push inflation in which firms use their monopoly powers to push up prices independent of demand.

(iv) Tax-push inflation due to an increase say VAT.

In the globe it's usually troublesome to differentiate Demand-pull from Cost-push inflation. In fact, in most cases they occur along and act with one another (see diagram four below). Say a rise in AD from AD1 to AD2 ends up in a movement on the AS1 curve and ends up in higher indicator and output. Inflation will lead employees to demand a salary increase and AS shifts to the left from AS1 to AS2. there's a movement on the new AD2 and ends up in higher indicator and a fall in output. individuals with a lot of financial gain can more shifts AD from AD2 to AD3 that increase indicator and output. This started another spherical of wage demand and AS shifts to the left once more. Inflation rises once more however output might not have modification such a lot type the initial level.

Diagram 4. Interaction between demand-pull inflation and cost-push inflation.

Structural (demand-shift) Inflation is inflation caused by the structural modification within the pattern of demand or provide in Associate in Nursing economy. The previous 2 kinds of inflation square measure short development whereas structural inflation are often a lot of permanent. A structural modification within the pattern of demand will cause bound industries or industries targeted in a very bound region going out of business. If costs Associate in Nursingd wages square measure sticky down within the catching industries and costs and wages rise within the increasing industries then the economy can still expertise an over all increase in indicator. the speed of inflation can rise more if the catching industries cause a discount in mixture provide and AS shifts to the left as in diagram three on top of. folks that lives in a very region during which a catching industries accustomed dominate can suffer from each structural state and structural inflation. Expectations and Inflation. Inflation is influenced by people's expectation of future inflation the maximum amount as by shift in AS and/or AD curves. If individuals expects inflation to be high in future then their action can cause the next rate of inflation. for instance, if customers expects inflation to rise in close to future then they're going to get currently before the particular increase. One simple thanks to model this expectation is to use reconciling expectation during which information from these days or now's accustomed predict rate tomorrow. as an example, if the rate of inflation is three-d this month then we have a tendency to expect next month's inflation is three-d beneath reconciling expectation. in a different way to model expectation is to use rational expectation wherever all offered data is employed to predict rate tomorrow.

Measures to deal with Inflation

  1. Fiscal Policy.
    1. To combat Demand-pull inflation (where AS is vertical), a government can use deflationary or contractionary policy to reduce the rate of growth of aggregate demand. This can be done by increase income tax and cutting government spending.
    2. Cost-push inflation, government can lower corporate tax, lower income tax, and lower government spending (reduces the crowding out effect) to encourage investment and higher productivity.
      In order to reduce the rate of increase in costs of production, a government can also use supply side policy of restraining the bargaining power of labour union, and to provide incentives, grants, and subsidies for firms to increase productivity. These programmes can involve encouraging R&D, subsidies and tax break for investing in productivity enhancing technology, and training schemes for workers. If inflation is fueled by increase in food prices such as rice due to poor and inadequate supply then government can increase subsidise to the cultivation of rice as happen in Malaysia. The effect of supply-side is not immediate. Furthermore, subsidies and grants may actually increase AD that adds to demand-pull inflation.
  2. Monetary Policy that reduces money supply and increases interest rates.
  3. Income Policy – inflation adjustment index. Allow a Cost of Living Adjustment (COLA) index be built into employment contract so to reduce the inflation burden on fixed income earners. This COLA index will also improve efficiency as it does away with the need of labour unions negotiating for a wage increase substantially above the inflation rate that may cause further cost-push inflation.
  4. Exchange rate policies – pegging, exchange rate regime. If inflation is caused by an inflow of hot money from abroad that raises AD then government can stop this flow of hot money by placing restriction on the movement of speculative money, say into the stock markets. Local currency becomes not freely convertible in the foreign currency market.
  5. Targets- expectation : Inflation Target: the rationale here is that when public knows the objective of inflation target then the public can anticipate policy actions. If public is convinced of the efficacy of government target then it will be easier for this target to be met and inflation be kept within target.
  6. Hyperinflation case: A government in this case has to modify public's expectation and build public confidence in local currency. A change in government and/or monetary authority that is committed to fight inflation can be helpful to modify public's expectation. A commitment to tight monetary policy is reflected by a controlled government spending, immediate stop to a policy of excess monetary growth, a new currency with smaller denominations, and transparency in fighting inflation. Transparency can means reporting the statistical figures of money supply, government spending and inflation regularly to public. Sometimes, a country experiencing an hyperinflation will need to switch and adopt the use of hard currencies like US dollar to stop the hyperinflation from spiralling up.

  7. Exercises

    1. Why are price controls ineffective in controlling Inflation?
    2. What are the different types of Inflation and measures to control them? Use appropriate diagrams in you answer.
    3. What are the costs of inflation?
    4. What are the arguments for and against a 0% inflation target?
    5. Evaluate the effectiveness of demand-side policies in dealing with cost-push inflation.
    6. "The impact of monetary growth of India and excess demand for nontradable goods and assets (especially real estate) is already being felt. Wholesale price inflation of India began rising in May 2006 (from slightly above 4%), reaching an annualized rate of 6.0% in the third week of January 2007. Consumer price inflation is higher still. While this was initially driven by booming international energy prices, and by still-ascendant food price inflation, recent figures show that burgeoning manufactured goods price inflation is now contributing as much as food and fuel prices combined.

      Given tight manufacturing and supporting infrastructure capacity, and the significant time lags involved in augmenting it to meet rising demand, manufacturing is overheating. Faced with demand-led inflation, the Reserve Bank of India (RBI) needs to dampen expenditures. However, in doing so, it will be important not to reduce the credit available for expanding manufacturing capacity more than is necessary to contain inflation." Adapted from Asian Development Outlook 2007.
      1. Define damand-led inflation.
      2. Use an appropriate diagram to explain the demand-led inflation experienced by India.
      3. What can India do to "dampen expenditure" ?
      4. Evaluate the adequacy of implementing only policies to "dampen expenditure" to fight this demand-led inflation.


    7. Study the figures below and answer the following questions.
      Figure 1. Inflation

      . HK GDP

      1. Distinguish deflation from decreasing inflation rate with reference to figure 1 above.
      2. Distinguish GDP at current market prices and GDP at chained (2005) dollars in figure 2 above.
      3. Use an AS -AD diagram to explain the change in Hong Kong inflation rate in 1999.
                                            -  THE END-

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