British Council Economics Notes

Chapter How the Macroeconomy Works:
8 Economic Problems - Inflation

CONTENT OUTLINE
1. Definition and Measurement of Inflation

1.1 Definition of inflation
1.2 Measurement of Inflation
1.3 Degrees of Inflation
2. Types & Causes of Inflation

2.1. Demand-Pull Inflation
2.1.1. Causes of Demand-Pull Inflation
2.1.2. Process leading to Demand-Pull Inflation
2.2. Cost-Push Inflation
2.2.1. Sources of Cost-Push Inflation
2.2.1.1. Wage-Push Inflation
2.2.1.2. Import Price-Push Inflation
2.2.1.3. Tax-Push Inflation
2.2.2. Process leading to Cost-Push Inflation
2.2.3. Cost-Push Inflation due to Exhaustion of Natural Resources
3. Wage-Price Spiral
4. General Effects of Inflation

4.1. Internal Effects
4.2. External Effects
5. Remedies for Inflation

5.1. Demand-Pull Inflation
5.1.1. Fiscal Policy (FP)`
5.1.1.1. Shortcomings of FP in dealing with Demand-Pull Inflation
5.1.2. Monetary Policy centred on Interest Rates (MP)
5.1.2.1. Shortcomings of MP in dealing with Demand-Pull Inflation
5.1.3. Monetary Policy centred on Exchange Rates/Exchange Rate Policy (ERP)
5.1.3.1. Shortcomings of ERP in dealing with Demand-Pull Inflation
5.1.4. Incomes and Price Policy (IPP)
5.1.4.1. Shortcomings of IPP in dealing with Demand-Pull Inflation
5.2. Cost-Push Inflation
5.2.1. Short-Term Supply-Side Policies
5.2.1.1. Fiscal Policy (FP)
5.2.1.1.1. Shortcomings of FP in dealing with Cost-Push Inflation
5.2.1.2. Exchange Rate Policy (ERP)
5.2.1.2.1. Shortcomings of ERP in dealing with Cost-Push Inflation
5.2.1.3. Incomes and Price Policy (IPP)
5.2.1.3.1. Shortcomings of IPP in dealing with Cost-Push Inflation
6.2.2 Long-term Supply-Side Policies
6. Deflation
REFERENCES
1. Sloman, Economics Chapter 21
2. Miller, Economics Today Chapter 7
3. Lipsey, Steiner & Purvis, Economics 10th Edition Chapter 32
4. Mceachern, Economics Chapter 7
Nanyang Junior College (2019 H2 Economics Lecture Notes)

Chapter 8: Economic Problems - Inflation Page 8 - 1
1. DEFINITION AND MEASURE OF INFLATION
Have you heard your parents or grandparents lamenting on how a bowl of

noodles use to cost $1, or perhaps even 50 cents when they were young? Why
did the prices rise? Who does it affect? Why are we concerned about the rising
prices? What can be done to minimise the negative impact of price rises?
In this chapter, we will examine the definition of inflation, its causes and the
different policies that can be used to rectify the problems associated with it.
1.1 Definition of Inflation
Inflation is defined as an economic situation where there is a sustained

increase in the general price level of an economy.
It implies a reduction in the purchasing power of money (i.e. the amount of goods
and services that money can buy) as the price level is higher in general. However,
this does not mean that prices of all goods and services are raised by the same
percentage.
Most people think that inflation is bad. But, the truth is that inflation affects
different people differently, and whether it is anticipated or unanticipated.
 Anticipated inflation: The inflation that the majority of individuals foresee will
occur. When it does, we are in a situation of fully anticipated inflation.
 Unanticipated inflation: The inflation that comes as a surprise to economic

agents, either higher or lower than the rate forecasted. It is more of a concern
than anticipated inflation as economic agents are not prepared.
1.2 Measuring Inflation
The general price level is measured using the Consumer Price Index (CPI).
However, inflation refers to the rate of change of the general price level. Thus,
the area of focus should be the change in CPI, and not the level of CPI itself
An index number is set for the level of prices at a particular time. For example, a
base year is first chosen and the price level in that base year is assigned the
value 100. If the GPL in the next year is 110, this value is 10% higher than the
value of 100 for the base year. Thus we can conclude from the index numbers
that the GPL has increased by 10% from the previous year.
The inflation rate between any two periods of time is measured by the percentage
change in the relevant price index.

Numerical Illustration
2010 2016 2017 2018

(Base Year)
Consumer Price Index 100 110 120 115
Rate of Inflation = Percentage Change of Price Index
Price Index in Year 2 – Price Index in Year 1 x 100%

Price Index in Year 1
Suppose in a country, the base year was 2010 and the consumer price index in
Dec 2016 was 110. The inflation rate between 2010 and 2016 would be:
Inflation Rate = [(110-100)/100] x 100% = 0.10 x 100%  10%
In another words, the country experienced a 10% inflation rate in 2016.
Suppose by Dec 2017, the consumer price index had risen to 120. The inflation
rate in 2017 would be:
Inflation Rate = [(120-110)/110] x 100% = 0.09 x 100%  9%
The inflation rate in 2017 was 9%, 1% lower than that of 2016. However, this
should not be misinterpreted as a fall in prices in 2017. Since the inflation rate in
2017 was still positive (9%), prices had increased in 2017 but the rate of increase
had slowed down.
In general, so long as the inflation rate is positive:

 a rise in inflation rate means a faster rate of price increases;
 a fall in inflation rate (i.e. disinflation) means a slower rate of price increases.
1.3 Degrees of Inflation
Many economists consider mild inflation desirable but hyperinflation extremely

detrimental to the economy. Thus, it is important to distinguish between the
degrees of inflation to study their different effects on the economy.
Mild inflation: The price level rises slowly (usually less than 2%). Most
economists feel that a low rate of inflation may stimulate economic expansion.
Hyperinflation (also known as galloping/runaway inflation): This is a situation

where prices rise at a phenomenal rate. Prices are rising so fast that money
ceases to be a medium of exchange or a store of value and normal economic
activity may break down. Usually the GPL rises by more than 100%.
Hyperinflation is frequently associated with social instability and leads to
disruptions in the economy.
[Note: When inflation is between ‘mild’ (which is generally desirable) and ‘hyper’
(which is generally undesirable), it is sometimes described as creeping inflation.]

2. TYPES & CAUSES OF INFLATION
The source or cause of inflation will determine the type of inflation. Inflation can
be classified as either demand-pull or cost-push, which are caused by demand
and supply factors in the economy respectively. This can be explained with the
aggregate demand (AD) and aggregate supply (AS) curves.
But in reality, there is no single source of inflation, as what started as a demand-

side problem may in time be compounded by inflation from the supply-side.
2.1 Demand-Pull Inflation
Demand-pull inflation occurs when there are persistent rises in aggregate

demand (AD) in the economy that are not matched by the output of goods and
services (AS). (i.e. the rising AD is not matched by AS)
Excessive AD occurs near or at full employment level of national output.
2.1.1 Causes of Demand-Pull Inflation
Recall that AD = C + I + G + (X-M). Hence, increases in AD may be due to an

increase in consumer expenditure for goods and services (C), investment
expenditure by firms (I), government expenditure (G), or foreigners' expenditure
for the country's exports (X), or any combination of the four.
The causes of demand-pull inflation are the determinants of C, I and X. For

example, AD could increase due to an increase in I that is caused by positive
business expectations. This increase in AD will lead to demand-pull inflation.
[Note: For the determinants of C, I and X, please refer to Chapter 6]
2.1.2 Process Leading to Demand-Pull Inflation
In Figure 1, when AD rises along the intermediate range of AS from AD0 to AD1,
resources are becoming increasingly limited and shortages of certain resources
arise. In order to increase their production and meet the rising AD, firms have to
compete for these resources by offering a higher price. They will, in turn, demand
a higher price for their products. Thus, demand-pull inflation occurs as GPL starts
to rise slowly from P0 to P1. Real national income also increases from Y0 to Y1.
GPL AD2 AS
AD1
AD Figure 1:
P2 0
Demand-Pull Inflation
P1
P0
O Real National Income

Y0 Y1 YF

As AD continues to increase from AD1 to AD2 and the economy moves towards
full employment of resources, the magnitude of demand-pull inflation increases
as firms compete more intensely for resources. At the full employment level,
which corresponds to the classical range of AS, productive capacity is fully
utilised. The economy is producing the maximum output (full employment output)
of OYF. A further increase in AD to beyond AD2 will not result in a higher real
national income, only an escalation of prices.
2.2 Cost-Push Inflation
Cost-push inflation occurs when there are persistent rises in costs of

production (e.g. increase in wages, rents, interest, etc.), independent of
aggregate demand. Hence cost-push inflation is a supply-side phenomenon.
2.2.1 Sources of Cost-Push Inflation
The rise in costs of production may originate from a number of different sources.
As a result, we can distinguish between various sources of cost-push inflation.
2.2.1.1 Wage-Push Inflation
Wages is one of the most important components of a firm's costs. Therefore,

wage increases have an important effect on prices. Powerful trade unions may
have the ability to coerce firms to increase wages without corresponding
increases in labour productivity.
2.2.1.2 Import Price-Push Inflation
The domestic rate of inflation is directly affected by the price of imported factors
of production. Import prices may rise as a result of inflation in other countries or
when the currency of the domestic country depreciates or devalues (i.e. becomes
weaker vis-à-vis other currencies).
The extent to which domestic inflation is affected by "imported inflation" depends

on the quantity and nature of imports consumed. An example of import
price-push inflation happened in 1973-74, when the OPEC countries quadrupled
the price of oil, which resulted in many oil-importing countries experiencing import
price-push inflation.
2.2.1.3 Tax-Push Inflation
This is where an increase in indirect taxation adds to the cost of living. For
instance, the increase in the goods and services tax (GST) in 2007 from 5% to
7% caused prices to rise.

2.2.2 Process Leading to Cost-Push Inflation
If firms face a rise in costs, they will respond by cutting back on production to
raise prices so that the higher costs could be passed on to consumers. This is
shown in Figure 2. An increase in the cost of production causes the aggregate
supply curve to shift from AS0 to AS2. There is a shortage of goods at the original
price level of P0 as firms now require a higher price level to produce the same
amount. There is upward pressure on prices and the aggregate demand of goods
decreases as prices increase. As a result, cost-push inflation occurs as the
general price level rises from P0 to P2. Real national income falls from Y0 to Y2.
GPL
AD
AS2 0
P2
P1 AS1
P0
AS0
0 Real National
Y2 Y1 Y0 YF Income
Figure 2: Cost-Push Inflation
2.2.3 Cost-Push Inflation due to Exhaustion of Natural Resources
In the 3 types of cost-push inflation above, the AS curve will shift upwards. Cost
of production has increased without a change in the potential output. However,
cost-push inflation may also be due to consistent depletion of natural resources.
As shown in Figure 3, the depletion of natural resources reduces the potential

output, resulting in the leftward shift of the AS curve. As the natural resources
become scarcer, the industries that use these natural resources will face a higher
cost of production, as they need to pay more to secure the dwindling resources.
For example, the pollution of the seas may mean higher prices and a decline in
incomes for nations with large fishing and marine industries (consider the
radioactive wastewater released from the Fukushima nuclear plant in the
aftermath of the Japan 2011 earthquake and tsunami).
GPL AS1 AS0
P1
P0
AD0
Real National
0 Income
Y1 Y0 YF
Figure 3: Cost-Push Inflation due to Depletion of Natural Resources

3. WAGE-PRICE SPIRAL
Regardless of the initial type of inflation, inflation can breed more inflation.
In a situation where a country is already experiencing demand-pull inflation (say,

due to rising export revenue), a wage-price spiral may result.
 Step 1: From Figure 4, a rise in AD from AD0 to AD1, results in an increase in

GPL from P0 to P1. Persistent rises in AD will lead to inflation in the economy,
leading to a higher cost of living.
 Step 2: This may result in trade unions demanding higher wages for
members to offset rising costs of living. The higher wages raises cost of
production for firms. As a result, production is reduced. AS curve will shift
from AS0 to AS1 (Yf remaining unchanged). The fall in production causes a fall
in national income from Y1 to Y2. The shortage due to the falling AS also
raises GPL further from P1 to P2.
 Step 3: Once again, trade unions may demand higher prices to offset the
rising cost of living for its members. The action by the trade union again
raises the production cost of firms, who again reduces production. AS curve
will again fall from AS1 to AS2 (Yf remaining unchanged). The fall in production
causes a fall in national income from Y2 to Y3. The shortage due to the falling
AS also raises GPL further from P2 to P3.
This spiralling process will continue as trade unions again ask for higher wages to
offset the increase in GPL from P2 to P3. As trade unions continue to demand for
higher wages, it leads to higher GPL. This is known as the wage-price spiral.
GPL
P3
P2
P1
AS2
Step 3
P0 AD1
Step 1
AS1 Step 2
AD0
AS0
0
Y0 Y1 YF Real National
Y3 Income
Y2
Figure 4: Wage Price Spiral worsening inflation that was sparked
by a demand-pull inflation

Similarly the actions of trade unions can also spark off a wage-price spiral if there
was cost-push inflation (e.g. due to rising oil prices). The action of demanding
higher wages drives up the costs of production of firms and the AS curve keeps
shifting upwards from AS0 to AS1 to AS2 as shown in Figure 4.
The causes of inflation can be brought on by demand-side as well as supply-side

causes and tend to overlap. Once started, inflation inevitably gathers momentum.
Thus inflation, when not checked, can breed further inflation.
4. GENERAL EFFECTS OF INFLATION
When considering the effects of inflation you need to keep in mind the various
degrees of inflation. The extent of the effect on the economy could be internal or
external and is dependent on: the rate at which prices are rising, the root cause
and whether the inflation is anticipated or unanticipated.
4.1 Internal Effects
These effects are relevant for both demand-pull and cost-push inflation. In
explaining the effects of inflation, it is necessary to examine the causes of the
price increase first before explaining how various sectors are affected.
Assuming that the economy is not at full employment, the rise in prices is due to
rising aggregate demand, its inflation tends to be a mild one! However if rising
prices are due to rising costs ie cost-push factors, then inflation tends to be
higher and effects more adverse.
a) Effects on Production
The impact of inflation on production and productivity would vary, depending on

the rate at which general price levels rise.
In the case of mild demand-pull inflation, producers may experience higher profit
margins amid the rising prices since factor costs are unlikely to rise in the short
term due to contracts agreed upon earlier. This would encourage both investment
and growth, leading, in the long-run to an increase in productive capacity.
For producers, if raw material prices rise faster than end-product prices, they
would earn lower profits or may even operate at a loss. Businesses that earn a
lower profit may choose to either produce less or even close down. If so, overall
production levels may fall together with investments, employment and growth
levels. However, one positive effect for producers would be that the rising costs
may force firms to become more efficient and innovative in order to survive.
If end-product prices rise faster than raw material prices, greater production and
investment may be encouraged due to higher expected returns. This would lead
to a higher level of investment and employment resulting in productive capacity
rising, thus generating higher incomes and economic growth. But inflation may
also reduce efficiency in production as even inefficient firms can survive because
of the high product prices, much to the disadvantage of the consumers.
Prices play an important role in the efficient allocation of resources. A higher

price signals producers to allocate more resources into producing that good or
service. However, in periods of high inflation, producers cannot differentiate

between a price change due to inflationary pressures or an increase in genuine
demand. If this occurs, it may lead to misallocation of resources in the economy.
b) Effects on Investment
High rates of inflation resulting from any cause are often associated with
uncertainty. Thus, firms may have difficulty estimating their future costs and
profits accurately. This may have an adverse effect on the level of planned capital
investment of the firms.
To encourage them to undertake higher risks arising from such uncertainty, firms
may demand a higher nominal rate of return on planned investment projects
before they proceed with the capital spending. These higher rates may cause
projects to be cancelled or postponed until the economic conditions improve. A
low rate of new capital investment may result in damages to long-run economic
growth, employment and productivity.
[Note that a low rate of inflation can have a positive effect on the level of
investment as low inflation indicates a healthy economy with rising economic
activity. This implies that there are more investment opportunities.]
c) Loss of Confidence in Currency
When GPL is rising, the real value of money and incomes would fall, ceteris
paribus. This could undermine people’s confidence in the currency, making them
less willing to want to hold cash as its value declines over time and its the effect
can be very significant. Instead of holding money, households may choose to
hold and conduct transactions in real assets instead. This leads to a meltdown of
the market mechanism as money and prices would no longer be the sole medium
of exchange. In addition, with households holding more real assets, they will also
save less in terms of deposits in the banks. This reduces the amount of funds
available to the banks for its lending to firms or other components of the
economic system.
d) Effects on Government Finance
Government tax revenues would increase as incomes and prices rise as taxes
paid by households and firms are based on a percentage of incomes
earned/profits made. Budget surpluses could result if government revenue rises
faster than government expenditure. However these benefits may be short-lived
and cannot outweigh the costs imposed by inflation on society and the economy.
If so, the government has to take anti-inflationary measures to bring inflation
under control.
Inflation would reduce the real cost of borrowing by the government as the value
of the amount borrowed is higher than the value of the amount paid at the
maturity date due to the situation of high inflation. When the government borrows
from the public by selling government bonds, the interest on the bond is fixed at
the time of issue. However with especially high inflation, the real cost of paying
the interest by the government would fall. ‘Lenders’ to the government would thus
tend to loose out when they surrender their bonds upon maturity as the value of
their principle sum plus interest paid out may be lower than at the time of lending.
This would be so if the inflation rate is higher than the interest rate to be paid out
for the bond.

e) Redistribution of Income
Inflation thus causes a redistribution of income! Certain groups of people would

benefit whilst others would suffer due to inflation. There will thus be ‘gainers’ and
‘losers’.
 Debtors (borrowers) vs creditors (lenders): Creditors charge an interest on

loans made by the debtor. If this interest rate charged is lower than the
inflation rate, debtors would gain because the real value of their debts would
have fallen. Creditors lose out because at the time the loans are repaid, the
real value would have fallen. Ceteris paribus, inflation encourages borrowing
and discourages lending.
 Fixed income earners vs variable income earners: Fixed income earners

are people who earn a constant amount of wages each month. Examples of
fixed income earners include pensioners and salaried workers receiving fixed
pension payments or salaries, and holders of fixed interest government bonds.
As GPL rises, the standard of living of fixed income earners would be lowered
as they would experience a fall in their real incomes as their purchasing
power is reduced by the higher prices. [Note that in some cases pension
payments are inflation-indexed, such that pension payments rise with inflation
and their real value is not reduced.]
Variable income earners are people whose incomes are linked to price
movements. Their real incomes would tend to remain relatively stable.
Inflation favours those who are paid in the form of variable fees and
commissions. Some examples are property agents and lawyers where their
fees are based on a fixed percentage of the selling price.
 Businessmen vs labour: Other things being constant, when prices are rising,
costs usually lag behind because it takes time for trade unions to demand for
higher wages and for prices of raw materials to rise. Moreover in the short-run,
some costs are fixed due to contracts that had been signed over a period of
time. Hence, profits for businessmen will be rising faster than costs as prices
rise faster than costs. The businessmen would gain at the expense of the
labour as well as creditors and others whose incomes are fixed. There could
be a situation where businessmen profiteer and take advantage of the
situation of rising prices to further increase the prices of their product beyond
the current inflation rate.
 Real savings vs nominal savings: Inflation discourages savings because

the real value of savings is eroded as prices continue to rise. In fact, real
interest rates may even be negative if nominal interest rates are below the
inflation rate. People tend to spend and not hold cash to avoid suffering
further losses (i.e. consumption rises and savings fall). However, it can be
argued that for those who save for specific purposes (e.g. for children’s
education or to finance retirement), inflation makes them want to save more
so as to compensate for the fall in the real value of their savings in the future.
Conversely, people who save in terms of real assets such as jewellery and
real estate will gain as the value of these assets would tend to rise with rising
prices.

4.2 External Effects
a) Effects on the Balance of Trade (Current Balance)
During inflation, prices of domestic goods rise thus making domestic goods to be
more expensive in their foreign markets. Export prices would then increase,
ceteris paribus, quantity demanded for exports will fall. At the same time, foreign
goods are now relatively cheaper in the home market compared to locally
produced goods. Imports are now cheaper substitutes, and ceteris paribus,
demand for imports will rise. Assuming the demand for exports is price elastic,
the trade balance will deteriorate as net export revenue now falls. This could
reduce a trade surplus, change a trade surplus to a deficit or worsen a trade
deficit.
b) Effects on the Capital Balance
An increase in the inflation rate will push the nominal interest rates up. Other
things remaining unchanged, this would mean that the domestic interest rate will
be higher relative to that of other countries. This may lead to foreigners wanting
to transfer more funds into the country to take advantage of the relatively higher
interest rates, leading to larger short-term capital inflows. Ceteris paribus, this will
improve the capital account position.
However, a country with an inflation rate that is much higher than that of other
countries, would be seen as relatively less attractive and economically unstable
to foreign investors. This may also lead to long-term capital outflow due to a fall in
foreign direct investment and its other consequential adverse effects.
c) Effects on the Balance of Payments and External Value of the Currency
During inflation, the purchasing power of money within the economy falls, and the
internal value of the currency falls. At the same time, because of Sections 4.2(a)
and 4.2(b), more currency flows out of the economy than into the economy. This
leads to deterioration in the balance of payments and a fall in the external value
of the currency. Thus inflation leads to a fall in the internal and external value of
the currency.
5 REMEDIES FOR INFLATION
5.1 Demand-Pull Inflation
Contractionary demand-side policies are used to deal with demand-pull inflation.

It focuses on lowering AD to reduce the general price levels as seen in Figure 5.
GPL AS
AD0
AD1 Figure 5: Falling AD to Solve
Po Demand-Pull Inflation
P1
0 Y1 Y0 Real National Income

5.1.1 Fiscal Policy (FP)
Contractionary fiscal policy can be used to solve demand-pull inflation by

lowering government spending and/or raising taxes. The purpose is to reduce
purchasing power and hence aggregate demand in order to relieve inflationary
pressures in the economy.
a) Lowering Government Expenditure
Deliberate reduction in government expenditure on goods and services and on

transfer payments will contract the economy via reductions in AD.
 Lowering government expenditure on goods and services: Reducing

government expenditure (e.g. in the areas of defence, education, healthcare
etc.) will lower the ‘G’ component of AD and cause the AD curve to shift
leftwards. This could result in falling GPL, reducing demand-pull inflation.
 Lowering government expenditure on transfer payments: Reducing

transfer payments to citizens (e.g. unemployment benefits) will cause a
reduction in consumption expenditure, while lowering transfer payments to
firms such as wage subsidies reduces profitability and hence investment
expenditure. Both a fall in the ‘C’ and ‘I’ components will reduce AD.
b) Adjusting Tax Rates
 Raising income tax rates (direct tax): When the government wants to
reduce the consumption component of AD, personal income tax rates will be
raised. The rising tax rates will result in falling disposable income, hence
causing purchasing power to fall.
 Raising corporate tax rates (direct tax): Corporate taxes are levied on the
profits of firms. Raising corporate income tax rates will lower post-tax profits
and hence cause a reduction in the investment component of AD.
[Note that to reduce AD, only direct tax rates should be increased as indirect
tax rates will cause GPL to increase further. This is because raising indirect
taxes results in prices of goods being more expensive (recall that indirect
taxes are levied on goods and services)].
 Lowering import taxes / tariffs (indirect tax): Lowering of import tax rates
will result in increased demand for foreign goods at the expense of domestic
goods. This will cause a fall in the AD curve and hence help ease prices.
5.1.1.1 Shortcomings of FP in Dealing with Demand-Pull inflation
a) Size of Multiplier
The effectiveness of fiscal policy is contingent on the size of the multiplier. If it is

small, fiscal policy may be of limited use in altering AD. For example, a
government’s decision to withdraw an infrastructure development project might
only lead to a small multiplied decrease in AD, which may be ineffective at fully
dealing with demand-pull inflation.

In reality, most countries would not have a large multiplier effect. The multiplier
effect is low when the leakages from the circular flow (in the form of savings,
taxes and spending on imports) are high. For example, the strong culture of
saving in Asian countries would mean that they have a small multiplier. On the
other hand, European countries tend to have a low multiplier due to high tax rates.
b) Rigidity or Inflexibility of Government Spending
Public works are carried out to promote the welfare of the country’s residents. It is
sometimes impossible to postpone government expenditure on certain projects
as they are tied to population growth and the expectations of the people. The
construction of schools, hospitals and infrastructure like transportation systems
are sometimes impossible to delay. Hence such projects may be carried out even
in periods of inflation, thereby aggravating the existing inflationary situation.
Furthermore, long-term projects cannot be stopped abruptly and must continue

even though there is inflation. In addition, in helping households who are affected
by falling real income, the government may even have to spend more to help the
lower income groups adversely affected by inflation.
c) Time Lag
Contractionary fiscal policy encounters the problem of time lags. Firstly, there is a
decision lag. Demand-pull inflation must be identified, studied and appropriate
action decided upon. Once a decision has been made to reduce government
expenditure and raise the rates of direct taxes, there may still be an execution lag
as it takes time for the measures to be implemented.
Even when the measures are implemented, there will be a time lag before these
measures begin to exert their effects on the economy. By that time, however,
conditions may have worsened so much that the remedies are no longer
adequate or worse still, the demand-pull inflation may have already been
resolved, and the policy may end up creating deflation instead.
d) Political Consideration or Acceptability
In periods of inflation, direct taxes are usually raised in order to restrict the
demand for goods and services. However, increase in taxes is always a politically
unpopular measure especially in an election year as it may lead to loss of votes.
Hence political considerations may not favour significant rises in tax rates.
Furthermore it is difficult to raise taxes after cutting them.
e) Other Factors
Other factors like accuracy and availability of information, inaccurate projections

or forecast and policy conflicts with unemployment would affect the effectiveness
of contractionary fiscal policy in dealing with demand-pull inflation.

5.1.2 Monetary Policy centred on Interest Rates (MP)
The main feature of monetary policy is to adjust money supply such that interest
rates are affected. When tackling demand-pull inflation, contractionary monetary
policy is used to reduce money supply so as to increase interest rates. Higher
interest rates tend to curb consumption and investment expenditure.
i/r M1 M0 i/r
R1 R1
R0
R0 MEI
LP
0 0
Qty of money I1 I0 Investment
GPL AS
AD0
AD1
Po
P1
0 Y0 Real National Income

Y1
Figure 6: Contractionary MP and Keynesian Transmission Mechanism
The money supply in an economy can be reduced by raising the cash ratio and
selling government bonds. This fall in money supply from M0 to M1 raises the
interest rates from R0 to R1 as seen in Figure 6.
With higher interest rates, cost of borrowing rises and this reduces expected
profitability on investment, resulting in a fall in investment expenditure (I) from I0
to I1. Furthermore, higher interest rates discourage consumption (C) as cost of
borrowing to purchase on credit is higher and savings becomes more attractive.
The fall in ‘I’ and ‘C’ will cause a fall in AD from AD0 to AD1, reducing the
equilibrium level of national income from Y0 to Y1. The contractionary monetary
policy also tends to lower the general price level from P0 to P1, thereby
addressing demand-pull inflation.
5.1.2.1 Shortcomings of MP in Dealing with Demand-Pull Inflation
a) Effectiveness of MP Tools
Details on the effectiveness of MP tools are similar to those described in Chapter

6 on Economic Growth, Section 6.1.2.2(a).

b) Interest Elasticity of Investments and Consumption
For contractionary MP to be effective, it must be able to reduce the AD. The

extent to which contractionary MP works to reduce AD by raising interest rates
depends on the responsiveness of investments and consumption to the change
in interest rates.
Interest
rates Figure 7: Interest Rates and the
R1 Interest Elasticity of MEI
R0
MEI2
MEI1
0 I2 I1 I0 Investments
If investments are insensitive to higher interest rates, the fall in AD will be minimal
and hence GPL may not be reduced by much. The less responsive the level of
investments is to a change in interest rates, the steeper the MEI curve. In such
cases, investments are said to be interest inelastic.
This is seen in Figure 7, where given a rise in interest rates from R0 to R1, a
relatively steep MEI curve, MEI1, would result in a smaller fall in investments,
from I0 to I1, as compared to a gently sloped MEI curve, MEI2, where investments
fall from I0 to I2.
The smaller the fall in the investments, the more insignificant would be the fall in
AD and hence the lower fall in GPL. Thus the effectiveness of MP depends on
the steepness of the MEI curve (i.e. the sensitivity of investments to a change in
interest rates).
If investors regard interest rates as a major factor influencing investments, the

MEI curve would be gently sloped. For example, if interest payments make up a
large portion of a firm’s costs, the rising interest rates will significantly increase
their costs and hence lower their profits. In this case, investments will be interest
rate sensitive. However, if they regard other factors as being more crucial in
making investment decisions, the MEI curve would be steeply sloped. For
example, should firms expect the economy to be robust in the future, they would
not react much to the rising interest rates.
c) Other Factors
Other factors include accuracy and availability of information, time lag, political
acceptability, size of multiplier and policy conflicts with unemployment.

5.1.3 Monetary Policy centred on Exchange Rates / Exchange Rate
Policy (ERP)
In trying to address demand-pull inflation, a country can attempt to appreciate its

currency. By buying its currency in the international foreign exchange market (i.e.
selling foreign currency), there will be an increase in the demand of the country’s
currency in the ER market. The country’s ER appreciates as seen in Figure 8.
Price of domestic
currency in foreign
currency
SSdomestic currency
$F1
$F0
DD1 domestic currency
DDdomestic currency
Qty of domestic currency

0 Q0 Q1
Figure 8: Appreciating the Exchange Rate of a Country’s Currency
The appreciation in the country’s ER makes the price of the goods that the
country exports higher in terms of the foreign currency and the price of the goods
that the country purchases from other countries (its imports) lower in terms of its
domestic currency. Assuming that demand for imports is price elastic, this will
lead to a fall in AD and hence inflation is contained.
5.1.3.1 Shortcoming of ERP in Dealing with Demand-Pull Inflation
a) PED of Imports
Appreciating the ER to reduce inflation will work only if the PED of imports is
greater than 1. Recall that if the demand for a good is price elastic, a fall in its
price leads to a more than proportionate increase in its quantity demanded and
hence an increase in the expenditure (revenue) on that good and vice versa.
Similarly, if the demand for a good is price inelastic, a fall in its price leads to a
less than proportionate increase in its quantity demanded and hence a fall in the
expenditure (revenue) on that good and vice versa.
Hence if the government appreciates its domestic ER, foreign goods would now
seem less expensive in terms of the domestic currency. If the PED for imports is
greater than 1, this would lead to a rise in its import expenditure. Simultaneously,
a rise in the domestic ER would now make the domestic country’s exports more
expensive in terms of foreign currency. As price of exports in terms of domestic
currency remains unchanged, demand for exports would decrease and this would
lead to fall in export revenue. The net effect would be a fall in the country’s net
exports (value of exports – value of imports), leading to a fall in AD and hence a
fall in general price level.

b) Availability of Foreign Exchange
In altering the ER, there is a need for the government to have a sizeable amount
of funds for exchange. For example, if the government intends to appreciate the
domestic ER, it will need to demand the domestic currency by supplying foreign
currency in the foreign exchange market. In other words, it must first have
sufficient foreign currency reserves should it want to appreciate its ER.
5.1.4 Incomes and Price Policy (IPP)
The key point in dealing with demand-pull inflation is to reduce AD. This can be
achieved by lowering the disposable income of households. One way to do this in
the case of Singapore is to raise the employee’s CPF contribution rate. This
causes an increase in savings, and thus, a decrease in disposable income, which
reduces consumption expenditure, and hence lowers AD.
Alternatively, voluntary and statutory restraints on wage increases can help to

contain inflation. The government can provide guidelines on permitted rates of
wage rises (e.g. wage ceiling/controls). Legislation to restrict the power of trade
unions or persuasion of unions to practice a wage restraint policy can prevent
excessive wage increases.
5.1.4.1 Shortcomings of IPP in Dealing with Demand-Pull Inflation
a) Increased Borrowing
Although an increase in employee CPF contribution rates may reduce the

purchasing power of employees, it does not reduce their access to funds. If high
inflation expectations are unchanged, lower disposable income may simply be
replaced with borrowing. In this case, employees will continue to spend as before,
rendering the measure ineffective.
b) Decrease in Standard of Living
As inflation also lowers real income, the increase in the employee’s CPF rates
would further reduce real disposable income and this may adversely affect the
standard of living in the country (especially for fixed income earners).
c) Poor Response to Wage Guidelines
Trade unions and employers may not be keen to cut wages as demand-pull
inflation is usually associated with a tight labour market (due to the strong
demand in the economy). Employers may in fact be more willing to provide higher
wages to woo the scarce labour.
5.2 Cost-Push Inflation
Cost-push inflation mostly arises because of rising cost of production. To dampen

the inflationary effects caused by cost-push inflation, supply-side policies are
aimed at reducing cost of production so as to increase AS.

There are long-term and short-term supply-side policies. The long-term policy
affects the productive capacity of the economy via increasing the quantity and
quality of factors of production (this is mostly to ensure potential economic growth)
while the short-term policy affects the cost of production while leaving productive
capacity unchanged.
5.2.1 Short-Run Supply-Side Policy
These policies refer to any form of direct/indirect intervention into wage or price
determination so as to eliminate cost-push inflationary pressures. It sets limits to
or controls the returns to factor inputs.
Figure 9: Short-Run Supply-Side

Policies to Lower Cost of Production
Such policies attempt to reduce costs of production without changing the

productivity and efficiency of firms. Hence, AS increases and the AS curve shifts
downwards from AS0 to AS1. The general price level falls from P0 to P1.
5.2.1.1 Fiscal Policy (FP)
Details of using fiscal policy as a short-run supply-side policy to deal with cost-
push inflation are similar to those described in Chapter 6 on Economic Growth,
Section 6.2.1.
5.2.1.1.1 Shortcomings of FP in Dealing with Cost-Push Inflation
The issues with using fiscal policy as a short-run supply-side policy to deal with
cost-push inflation are similar to those described in Chapter 6 on Economic
Growth, Section 6.2.1.1.
5.2.1.2 Exchange Rate Policy (ERP)
One way to reduce cost of production would be to appreciate domestic currency

[see Section 5.1.3 on demand-pull inflation to understand how this can be done].
With a stronger currency, the country is able to purchase imported raw materials
at a lower price in terms of the domestic currency. This translates to lower cost of
production and hence reduces price.

5.2.1.2.1 Shortcomings of ERP in Dealing with Cost-Push Inflation
The issues with using exchange rate policy as a short-run supply-side policy to
deal with cost-push inflation are similar to those described in Chapter 6 on
Economic Growth, Section 6.2.1.2.
5.2.1.3 Incomes and Price Policy (IPP)
Details of using incomes and price as a short-run supply-side policy to deal with
cost-push inflation are similar to those described in Chapter 6 on Economic
Growth, Section 6.2.1.3.
5.2.1.3.1 Shortcomings of IPP in Dealing with Cost-Push Inflation
The issues with using incomes and price policy as a short-run supply-side policy
to deal with cost-push inflation are similar to those described in Chapter 6 on
Economic Growth, Section 6.2.1.3.1.
5.2.2 Long-Run Supply-Side Policy
This policy raises the productive capacity of the country (i.e. it increases the full
employment level of national income) by improving the productivity and efficiency
of firms as well as increasing the quality and quantity of factors of production.
This results in a rightward shift of the long-run aggregate supply (LRAS) curve
There will be an increase in the productive capacity of the economy. The GPL
thus falls while the national income rises. Hence inflation is reduced and income
is increased.
6. DEFLATION
Deflation is defined as a persistent (sustained) decrease in general price levels

of an economy. It could result from a decrease in AD, or an increase in AS.
a) Decrease in AD
 Tight MP in response to inflationary pressures: As a result of inflation,

central banks in many countries may tighten their monetary policies
(i.e. cut money supply). Thus with less liquidity in the economy, there will be
less ‘money chasing after goods’ resulting in excess supply and falling prices.
 Increased savings: Greater incentive to save for various purposes and for
retirement or for the future will lead to lower demand for goods and services
thus leading to lower prices.
b) Increase in AS
 Improvements in technology: Technological advancement could lead to

lower production costs resulting in an increase in the aggregate supply.
Graphically, this could lead to both a rightward and a downward shift of the
AS curve. It leads to a decrease in GPL.

 Deregulation of industries: Deregulation and the gradual opening of
markets all around the world has led to greater and more aggressive
competition among producers. This may enable greater increase in import
expenditure, particularly in developed economies importing from developing
economies, resulting in falling AD and hence falling prices. In addition,
imported resources may be more easily and cheaply obtained which can
cause the aggregate supply to rise and hence reducing general price levels.
In general, deflation caused by an increase in AS could be perceived as positive

as it increases the real national income of the economy. On the other hand,
deflation caused by a decrease in AD would be a potential problem for
economies as it implies that there will be a decrease in real national income.


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Chapter How the Macroeconomy Works:

8 Economic Problems - Inflation

1. Definition and Measurement of Inflation

2. Types & Causes of Inflation

4. General Effects of Inflation

5. Remedies for Inflation

Nanyang Junior College (2019 H2 Economics Lecture Notes)

Have you heard your parents or grandparents lamenting on how a bowl of

1.1 Definition of Inflation

Inflation is defined as an economic situation where there is a sustained

 Unanticipated inflation: The inflation that comes as a surprise to economic

1.2 Measuring Inflation

Nanyang Junior College (2019 H2 Economics Lecture Notes)

2010 2016 2017 2018

Consumer Price Index 100 110 120 115

Rate of Inflation = Percentage Change of Price Index

Price Index in Year 2 – Price Index in Year 1 x 100%

Inflation Rate = [(110-100)/100] x 100% = 0.10 x 100%  10%

In another words, the country experienced a 10% inflation rate in 2016.

Inflation Rate = [(120-110)/110] x 100% = 0.09 x 100%  9%

In general, so long as the inflation rate is positive:

1.3 Degrees of Inflation

Many economists consider mild inflation desirable but hyperinflation extremely

Hyperinflation (also known as galloping/runaway inflation): This is a situation

Nanyang Junior College (2019 H2 Economics Lecture Notes)

But in reality, there is no single source of inflation, as what started as a demand-

2.1 Demand-Pull Inflation

Demand-pull inflation occurs when there are persistent rises in aggregate

Excessive AD occurs near or at full employment level of national output.

2.1.1 Causes of Demand-Pull Inflation

Recall that AD = C + I + G + (X-M). Hence, increases in AD may be due to an

The causes of demand-pull inflation are the determinants of C, I and X. For

[Note: For the determinants of C, I and X, please refer to Chapter 6]

2.1.2 Process Leading to Demand-Pull Inflation

O Real National Income

Nanyang Junior College (2019 H2 Economics Lecture Notes)

2.2 Cost-Push Inflation

Cost-push inflation occurs when there are persistent rises in costs of

2.2.1 Sources of Cost-Push Inflation

2.2.1.1 Wage-Push Inflation

Wages is one of the most important components of a firm's costs. Therefore,

2.2.1.2 Import Price-Push Inflation

The extent to which domestic inflation is affected by "imported inflation" depends

2.2.1.3 Tax-Push Inflation

Nanyang Junior College (2019 H2 Economics Lecture Notes)

2.2.3 Cost-Push Inflation due to Exhaustion of Natural Resources

As shown in Figure 3, the depletion of natural resources reduces the potential

GPL AS1 AS0

Nanyang Junior College (2019 H2 Economics Lecture Notes)

In a situation where a country is already experiencing demand-pull inflation (say,

 Step 1: From Figure 4, a rise in AD from AD0 to AD1, results in an increase in

Nanyang Junior College (2019 H2 Economics Lecture Notes)

The causes of inflation can be brought on by demand-side as well as supply-side

4. GENERAL EFFECTS OF INFLATION

4.1 Internal Effects

The impact of inflation on production and productivity would vary, depending on

Prices play an important role in the efficient allocation of resources. A higher

Nanyang Junior College (2019 H2 Economics Lecture Notes)

c) Loss of Confidence in Currency

d) Effects on Government Finance

Nanyang Junior College (2019 H2 Economics Lecture Notes)

Inflation thus causes a redistribution of income! Certain groups of people would

 Debtors (borrowers) vs creditors (lenders): Creditors charge an interest on