Inflation
Topic Twenty-Eight

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Inflation

Inflation is defined as the general increase in the price of goods and services in an economy.   Over time, as the cost of goods and services increase, the value of a dollar will decline because a  consumer will not be able to purchase as much with that same dollar as he/she previously could have.  The consumer price index (CPI) is an index that measures the average price of a basket of consumer goods and services purchased by households. The percentage change in the CPI is a measure of inflation.

Causes of inflation or Types of Inflation

Demand Pull Inflation – this type of inflation results from an increase in demand for goods and services in the economy.  This may be as a result of an increase in the money supply.  For example, when the Central Bank reduces the reserve requirement ratio or prints more money to meet demand or repurchase bonds that they previously issued, demand will increase and so too will prices. 

Cost Push Inflation – this type of inflation occurs when there are increases in the cost of production or in the cost of factors of production that are used to produce other goods and services. 

Imported Inflation – this is when the general price levels locally are determined by the price levels of different countries.  This will mean that when we import goods with already inflated prices, these are passed on to the local consumers. 

Monetary Inflation – this is inflation that results from an increase in the money supply especially when the economy is at full employment level. 

Measuring Inflation

Inflation is usually measured by the Consumer Price Index which measures prices of a basket of goods and services purchased by a typical consumer. The inflation rate is the percentage rate of change of a price index over time.  For example, if in January 2007, the Consumer Price Index was 202.416, and in January 2008 it was 211.080. Using the CPI formula, the price change for the year can be calculated as follows: 

Figure 1

The resulting inflation rate for this one year period is 4.28 percent, meaning the general level of prices for typical consumers rose by approximately four percent in 2007.

The effects of inflation

Some of the effects of inflation are as follows:

Redistribution of real income - nominal income is the number of dollars a person receives. Real income is what can be bought with that money. Inflation causes a decline in the purchasing power of income that is fixed or does not increase as high as the rate of inflation. Inflation does not affect the purchasing power of those whose income is variable and increases as prices go up.   This amounts to a redistribution of real income from those on fixed income to those on variable income ultimately leading to a fall in the standard of living of these people on fixed income and an increase in poverty.

Redistribution of real wealth - during a period of unanticipated inflation, creditors and savers lose while borrowers benefit. As the purchasing power of a dollar decreases, creditors and savers are paid back with dollars which are worth less than before.  This affects the return on the money that they would have lent.  On the other hand, borrowers benefit in the sense that the amount of installments that they repay remain fixed while prices increase. 

The balance of payments – whenever there is inflation, this means that our goods and services become more expensive for foreigners.  This is because the cost of producing these goods and services would have risen and so the price of the final goods and services will have to be higher in order for sellers to earn a profit.  This will mean that our exports can fall which can create a deficit on our balance of payments.

Deflation

Deflation is defined as a fall in the general price level. It is a negative rate of inflation.  Deflation means that the value of money increases rather than decreases.  Deflation can discourage spending in the present period  because things will be cheaper in the future. Deflation can also increase real debt burdens – reducing the spending power of firms and consumers.

Problems with Deflation

Discourages consumer spending – with falling prices, people may delay purchases because goods and services will be cheaper in the future.  Therefore, deflation brings with it declines in spending which can cause a recession or a downturn in the economy.

Real wage unemployment – deflation causes a rise in the purchasing power.  When this happens, real wage will be above equilibrium wage and will cause a fall in the demand for labour which leads to unemployment.

Increase real value of debt - deflation increases the real value of money and the real value of debt. Deflation makes it more difficult for debtors or borrowers to pay off their loans.   Therefore, consumers and firms have to spend a bigger percentage of disposable income on meeting loan and debt repayments.

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