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Inflation Inflation refers to the persistent increase in the general price level of goods and services. It is the percentage rate of change in the average price level over a specified period of time. Thus it is measured by the inflation rate, which is the percentage change in a price index. This does not mean that all prices increase the same, nor that all prices necessarily increase. Some prices might increase a lot, others a little, and still other prices decrease or remain unchanged. Inflation results when the average of these assorted prices follows an upward trend. Inflation leads to continual erosion of consumers’ purchasing power.
Inflation can also be defined as a decline in the value or purchasing power of a currency. If the supply of money rises faster than the supply of goods and services in the country, one would expect a decline in the value of the currency. Inflation is the most common phenomenon associated with the price level. Two related phenomena are deflation, a decrease in the price level, and disinflation, a decrease in the inflation rate.
Measurement of inflation: The most common measures of inflation are derived from the Consumer Price Index (CPI), Producer Price index (PPI) and the GDP price deflator. The CPI is the most widely known of the three.
1. Consumer Price Index: The Consumer Price Index (CPI) is a measure of the average prices of a fixed basket of goods and services purchased by urban consumers. This index, compiled and published monthly by the Bureau of Statistics (Uganda’s case), provides a relatively accurate indication of the average price level in the economy. The CPI is based on a market basket of goods and services that are identified in an extensive survey of urban consumers. It is then assumed that urban consumers repurchase this market basket each month. The CPI compares the total expenditures on this market basket from month to month. If expenditures rise, then prices, on average, increase.
The CPI is defined to equal 100 for the base period. Constructing the CPI involves three stages: selecting the CPI basket; conducting the monthly price survey; calculating the CPI.
Cost of CPI basket at current period prices CPI = X100. Cost of CPI basket at base period prices
Using 2016 as the base year, calculate the inflation rate between 2015 and 2017
Year Price of bread Quantity of bread Price of Apple Quantity of Apples
DIY Exercise : Compute the CPI for the three years
Measuring Inflation
Use the CPIs to compute the inflation rate and interpret
The inflation rate is the percentage change in the price level from one year to the next.
(CPI in current year – CPI in previous year) The inflation rate = *100. CPI in previous year
When the price level rises rapidly, the inflation rate is high. When the price level rises slowly, the inflation rate is low.
2. GDP Price Deflator: The GDP price deflator is an index of prices calculated as a ratio of nominal gross domestic product to real gross domestic product. This index provides the best overall indicator of the average price level because it is based on gross domestic product. It includes the prices of all final goods and services, not just those purchased by urban consumers. It is also based on prices of business investment in capital, government purchases, and exports to the foreign sector.
Students should compute real and nominal GDP
Formula:
3. The Producer Price Index (PPI) This measures the average change in selling prices received by domestic producers of goods and services over time. PPIs measure price change from the perspective of the seller. The target set of goods and services included in the PPIs is the entire marketed output of a country’s producers. The set includes both goods and services purchased by other producers as inputs to their operations or as capital investment, as well as goods and services purchased by consumers either directly from the service producer or indirectly from a retailer.
Classification of inflation according to composition of CPI
1. Headline inflation is a measure of the total inflation within an economy. However, some products have volatile prices for example food and energy, and as a result headline inflation may not present the actual state of the economy. 2. Core inflation also known as underlying is a measure of inflation that excludes certain items that face volatile price movements. It excludes products that have temporary price shocks such as food and energy costs because these shocks can diverge from the overall trend and give a false measure of inflation.
Policies to reduce demand pull inflation
a. Restrictive monetary policy should be used to reduce money in circulation. Policies such as increasing the bank rate, moral suasion, increase of the legal reserve requirement. b. Restrictive fiscal Policy
Government can reduce its expenditure such as reducing on the wage bill and increase spending on other productive sectors. Government can also impose higher direct taxes (causing a fall in disposable income)
c. Adoption of price such as fixing prices of goods and services.
2. Cost-Push Inflation: This is inflation attributable to decreases in aggregate supply, primarily due to increases in the cost of production. This type of inflation results when the cost of inputs increases. In effect, the cost of producing output on the supply side of the aggregate market "pushes" the price level higher because increased costs are passed on to consumers, causing a rise in the general price level.
Types of cost push inflation include profit-push, wage-push inflation and supply shock inflation.
i. Wage Push Inflation – It is a type of inflation which is caused due to increase in wages of labor more than increase in their productivity in work. Since the producers have to pay more to workers they will increase the price of goods and hence increasing inflation. Usually this type of inflation occurs when there are strong labor unions. ii. Profit Push Inflation – This type of inflation is caused when entrepreneurs or producers in their drive for greater profits raise prices of goods and services than required and hence inflation. iii. Supply Shock Inflation – A supply shock implies a drastic reduction in the supply of goods for example failure of crops due to bad weather or reduction in the supply of oil by OPEC (organization of petroleum exporting countries) etc… which leads to shortage in quantities of goods and services and hence increase the prices leading to inflation.
Measures to reduce cost push inflation Increase the level of output a. Government can encourage both local and foreign investors in order to break monopoly power and create competition. b. Improvement of infrastructures to reduce the cost of production. c. Adoption of an income policy for example by fixing wages. d. Investing in alternative energy sources to avoid the increasing prices and fluctuating supply of imported oil.
3. Structural inflation This is inflation that is part of an economic system so that a complete change in economic policy would be needed in order to get rid of it. According to the structuralists, this type of inflation is common in developing countries.
Causes of structural inflation: i. Population growth. ii. Low productive capacity of the economy for example limited fixed capital stock. iii. Foreign exchange bottle necks. iv. Technological backwardness. v. Limited entrepreneurial skills. vi. Inputs shortage of capital, fuel and oil. vii. Infrastructural bottlenecks with respect to electricity, transport and communication, and telecommunication. viii. Political insecurity.
Policy measures to control structural inflation i. Govt. to offer incentives to attract private investment for example credit facilities, tax holidays to increase the level of investment. ii. Improve sectors that are failing for example the agricultural sector by setting up irrigation schemes, storage systems, electricity and other relevant support. iii. Improvement of infrastructures. iv. Land reforms for equitable allocation of land. v. Population control.
4. Imported inflation This is a type of inflation experienced through importation of goods and services from countries already experiencing inflation. Sometimes it is simply a result of importing in highly priced goods.
Policy measures to control imported inflation: i. Import restrictions especially on imports from countries with inflation for as long as there are other available alternatives. ii. Subsidization of imports. iii. Import substitution strategy.
Effects of inflation:
1. Uncertainty: Unpredictable inflation creates uncertainty especially when it fluctuates widely from time to time. Because most individuals are risk averse, if they know that prices will be increasing for example by 10 percent, then they can adjust plans accordingly. However, unexpected inflation creates uncertainty, making long-term planning difficult.
Phillips found that wages tend to rise when unemployment is low and the vice versa. This is because workers tend to press less strongly for higher wages when fewer alternative jobs are available and in addition firms would resist wage demands when profits are low.
Exploiting the Phillips curve
It became accepted that policy-makers could exploit the trade -off between unemployment and inflation
- a little more unemployment meant a little less inflation. The accepted explanation was that a fiscal or monetary stimulus, and increase in aggregate demand would trigger the following sequence of responses:
- An increase in the demand for labor since government spending generates growth.
- Unemployment will fall.
- Workers have greater bargaining power to seek out increases in nominal wages and firms must compete for fewer workers by raising nominal wages.
- Wage costs will rise.
- Faced with rising wage costs, firms pass on these cost increases to consumers in form of higher prices.
- Inflation will increase.
Illustration of the short-run Phillips curve (SRPC)
From the diagram, as you move leftward on the curve, unemployment reduces and the rate of inflation increases and vice versa.
The long run Phillips curve A long run Phillips curve is a vertical line passing through the non-accelerating inflation rate of unemployment (NAIRU). This refers to a specific level of unemployment that exists in an economy at which inflation is stable.
The short run Phillips curve was criticized that there is no permanent trade-off between inflation and unemployment because inflation expectations will catch up with reality and unemployment will remain at the NAIRU.
The idea is that inflation will accelerate only if the unemployment rate falls below the NAIRU level. The NAIRU often represents equilibrium between the state of the economy and the labor market.
If government increases aggregate demand through a monetary or fiscal stimulus, unemployment in the economy will fall. Workers will have more bargaining power and they will ask for higher wages. Firms will also compete for the fewer workers leading to a rise in the nominal wage. This will increase the cost of production and in turn, firms will pass on this cost to consumers in form of higher prices. This will raise the inflation rate. Workers on the other hand are slow to adjust their perceptions of prices in general and the increase in their money wages will be seen as an increase in their real wages. However, they will reduce labor supply after realizing that their real wages have not significantly changed.
Illustration of the long-run Phillips curve:
Let us assume that the economy starts from equilibrium position at point A, with inflation currently at 3% and the unemployment at the natural rate of say 6%. Given the concern by the public with unemployment, if government attempts to expand the economy so that aggregate demand increases and unemployment falls, the economy will initially move to point B and there is a fall in unemployment but a corresponding increase in inflation. Consequently, inflation erodes any gains by workers and firms. Real spending and output return to their previous levels but at a higher inflation rate at point C.
The above process will continue to occur every time government tries to reduce unemployment. In the long run the Phillips curve is thus a vertical straight line passing through NAIRU.
Note: Stagflation is a period of slow economic growth, high unemployment (stagnation) and inflation resulting in an increase in input cost. This is reflected by the shift in the short run Phillips curve to the right.
