INFLATION

Inflation can be defined as a situation where the general prices of a basket of goods and
services in a country or region are rising. It occurs when there is an upward trend in prices
of all commodities and not in prices of just a few. Inflation leads to a reduction in the value
of money and its purchasing power. i.e. during inflation, a given amount of money buys
less of a commodity than before the inflation set in.

Inflation is measured using the consumer price index (CPI). An index number helps in
measuring the relative change of a variable where the actual measurement of its change
would otherwise be difficult. CPI therefore measures and allows comparison of prices of
goods and services for two different periods. It also measures the changes in the purchasing
power of the consumers in the said periods. CPI is measured using two methods:

Simple average method

CPI = ΣP1 × 100
ΣP0
Weighted average method
CPI= ΣP1W × 100
ΣP0W
TYPES OF INFLATION
a) Moderate / creeping/ mild inflation
Refers to a type of inflation in which the general prices increase slowly. The
percentage rate of price increase is usually less than 10. It can be beneficial to both the
business people as well as the debtors. It benefits the business people in that they buy
goods when the prices are low and sell them later when prices have risen. Similarly the
debtors benefit because they would buy goods at the current price and pay for them in
the future at the same old price and not the high price the commodity would be selling
at that time.
b) Galloping /rapid inflation
Describes a situation where the general price levels increase rapidly at a percentage of
tens or hundreds.
c) Hyper-inflation /run away inflation
Describes a situation where the rise in price levels is extremely high. In this situation
the inflation rates can be in thousands or even in millions per cent per annum. Under
hyper-inflation people lose confidence in money as a medium of exchange and as a store
of value. In such a situation consumers use a lot of money to buy few goods and
services. This type of inflation would appear unlikely to happen. It however happened
in Germany in 1923 and the country had to do away with its currency system to restore
its monetary confidence.
Causes of Inflation
Inflation may be caused by either an increase in demand thereby forcing prices upwards or
by factors on the supply side that bring about increase in prices. The cause of inflation can
thus be classified into two broad categories; demand pull inflation and cost push inflation.

Demand-pull inflation

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This type of inflation comes about where there is excessive demand for goods and services in
the economy causing a rise in prices. The rise in demand pulls prices upwards, hence the
term “demand pull:. In this situation, there is: too much money chasing too few goods: The
following are some of the factors that cause demand pull inflation.
i. Increase in government expenditure
The government finances its activities from the revenue it collects mainly from
taxes, levies and fines. In situation where the government is not able to raise
enough money from its main sources, it can resort to borrowing from the central
Bank or in the very extreme cases, it may print more money.
When the government spends the money, it in effect makes more money available
to people thus increasing aggregate demand, which in turn may lead to upward
pressure on the prices of goods and services.
ii. Effects of credit creation by the commercial banks
Credit creation is the process through which banks lend out money to individuals
and businesses. Through this process, commercial banks can lend out more money
that the deposits they hold. This process increases the money supply, which in turn
leads to an increase in consumers purchasing ability. The increased consumer’s
ability to purchase more goods and services increases the aggregate demand which
eventually leads to inflation.
iii. Increase in money incomes
If money incomes increase due to reasons such an increase in export earnings, or
increase in wage earnings, the people’s purchasing power will increase. This will
have upward pressure on prices as demands for goods and services increase.
iv. General shortages of goods and services
Shortages of commodities supplied may bring about demand pull inflation in that
the demand would be higher than supply. The high demand hence pulls the prices
of the commodities upwards. Shortages may be caused by factors such as, adverse
climatic conditions, hoarding, and smuggling, withdrawal of firms from the industry
and decline in levels of technology.
AS
Price level

P2
AD2
P1
AD1

O
Y1 Y2 Real national income

With an increase in aggregate demand from AD1 to AD2, there has taken place an increase
in real national income from Y1 to Y2 and an increase in the price level from P1 to P2.

Cost-Push Inflation

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An increase in the total production costs of goods and services may lead to an increase in
prices of the commodities. These increases in prices may result into a type of inflation
referred to as cost-push-inflation. The term “cost-push inflation” is used because it is the
cost of production that pushes up the prices. The following are some of the factors that
may bring about cost push inflation.
i. Rise in wages and salaries
An increase in wages and salaries may increase the cost of labor. Such increase
may be brought about by pressure from workers and trade unions for better pay.
The increased cost of labor may be reflected in the increased prices of commodities
which in turn would cause inflation.
ii. Increase in taxes
Increase in indirect taxes, such as VAT, can increase the cost of production and
cause firms to raise their prices.
iii. Increase in profit margin
A desire by management or shareholders to raise profit margin, can lead to an
increase in price. This is possible especially where there’s no price control.
iv. Increase in cost of inputs other than labour
Cost-push inflation may arise from increase in cost of inputs other than labour such
as raw materials and capital. These inputs can either be locally available or
imported inflation. This can in turn, increase the prices of locally produced goods.
For example, an increase in prices of imported oil may lead to inflation as imported
oil is used in the manufacture of many products.
v. Reduction in subsides
The government may reduce subsides for a commodity. The removal of a subsidy
implies that a producer would have to meet that part of cost which the government
was paying through subsidization. This would eventually be reflected in the
increase in the price of the commodity.

AS2 AS1
Price level

P2
P1
AD

O
Y2 Y1 Real national income

In the diagram above, an increase in the costs of production results in an upward shift of
aggregate supply curve from AS1 to AS2. This results in a reduction in real national income
from Y1 to Y2 and an increase in the price level from P1 to P2.

Effects of Inflation in an Economy

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Inflation has a number of effects on businesses, demand and consumer confidence. These
effects can either be positive or negative as discussed below:
a. Positive effects of inflation
i. Benefit to debtors
Inflation may benefit debtors’ in that they end up paying less in real terms. This is because
the debtors pay for the commodities in the future at the old low prices and not at the high
prices which the commodity would be selling.
ii. Benefit to the sellers
Sellers may benefit from inflation in that they buy commodities when prices are low and
sell them later when prices are high thereby making more profits.
iii. Motivation to work
Inflation may have some motivating effect to work as people try to cope with effects of
inflation by working harder. As prices of commodities go up people may find that they are
not able to buy the amount of commodities they were buying before the inflation set in. In
an effort to maintain their standards of living, they may work harder in order to earn more.
b. Negative effects of Inflation
i. Reduction in profits
A rise in prices of commodities may lead to reduced sales volume for firms. This in turn
may reduce the firm’s profits.
ii. Wastage of time
Inflation can be wasteful in that individuals and firms may waste a lot of time shopping around
for reasonable prices. The time so wasted can be an extra cost to the individual or firm.
Similarly, firms may waster a lot of time adjusting their price list to reflect new prices.
iii. Increases in wages and salaries
During inflation, firms are usually pressurized by employees and trade unions to raise
employees’ wages and salaries to cope with inflation. A conflict may arise between the
parties concerned, regarding the level of increase that is adequate.
iv. Decline in standards of living
During inflation, consumers’ purchasing power decreases. This is so especially for people
who earn fixed incomes such as pensioners. The reduction in purchasing power brings abut
a decrease in standard of living.
v. Loss to creditors
Creditors lend out when the value of money is high. At the time of payment, the creditors
receive less in real money terms. Since its value has been eroded by inflation.
vi. Retardation of economic growth
Inflation may create a situation where business people are not willing to take risks, invest in
new ventures, expand production or hire more workers. This would be more than the
exports resulting into unfavorable balance of payment.
vii. Adverse effects on the balance of payments
Inflation may have adverse effects on the balance of payments. If inflation is high in the
domestic economy, exports become more expensive leading to a fall in their demand.
On the other hand, the imports from countries not experiencing inflation become relatively
cheap thus increasing their demand. This implies that the imports would be more than the
exports resulting into unfavorable balance of payment.
viii. Loss of confidence in the monetary system

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High levels of inflation may lead to loss of confidence in money both as a medium of
exchange and a store of value. This may lead to a collapse of the monetary system.
Controlling Inflation (Anti-inflationary measures)
Inflation is not desirable and for this reason the government may adopt policies meant to
reduce or control it to a manageable level. The anti- inflationary policies are divided into
three categories:
 Monetary policies
 Fiscal policies.
 Non- monetary policies
a) Monetary policies (Control of Money Supply)
In most cases inflation will occur when the amount of money in circulation is greater that
the available goods and services. The government should ensure that increase in money
supply is matched with increase in goods and services. Monetary policy influences the
economy through changes in the money supply and available credit. The central bank uses
the following monetary policy instruments to control money supply/ to remove inflation:
1. Bank rate policy. During inflation, the bank rate is raised. In view of this
commercial banks also increase the interest rates/lending rates thus discouraging
borrowing hence a reduction in the amount of money in circulation.
2. Open market operation. During inflation, the central bank sells government
securities such as treasury bills and government bonds through open market
operations (OMO). This reduces the excess money in circulation.
3. Reserve requirements. During inflation, the central bank increases the reserve
requirements. This reduces the amount of money at the disposal of commercial banks
for lending purposes. This helps to control the amount of money in circulation
4. Rationing of credit. All commercial banks get loans from the central bank up to a
specific limit. During inflation, this limit is reduced.
5. Margin requirements. Margin requirement is the difference between the value of
the security and the amount of the loan advanced against that security. During
inflation, the margin requirement is raised.
6. Consumers selective credit control. Here the central bank discourages the
purchase of commodities on instalment basis to check inflation.
7. Restricting terms of hire purchase agreement and credit sales in order to reduce
demand for commodities sold. This can be done by:
 Increasing the rate of interest.
 Reducing the repayment period.
 Increasing the amount required as down payment.
b) Fiscal policies.
Fiscal policy refers to the deliberate change in either government spending or taxes to
stimulate or slow down the economy. It is the budgetary of the government relating to
taxes, public expenditure, public borrowing and deficit financing. Fiscal policy is based
on demand management i.e raising or lowering the level of aggregate demand by
controlling government expenditure, consumption expenditure and investment
expenditure. The main fiscal policy measures are:
1. Public expenditure. During inflation the government reduces its expenditure
leading to a reduction in the amount of money in circulation and a fall in prices.

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 2. Changes in taxation. Changes in tax rates can help in the stabilization of the economy.
For example, a decrease in tax rates increases disposable income in relation to national
income. Hence consumption rises at every level of national income. With increase in
aggregate demand for goods, employment increases. A rise in tax rates causes a
decrease in disposable income, creates a larger budget deficit and reduces inflation. Also
high inflation reduces individual’s purchasing power and a fall in prices.
3. Changes in government expenditure. If inflation is at or above the level of full
employment in the economy, the government can reduce prices by restricting its own
unproductive expenditure.
4. Public borrowing. Public borrowing reduces aggregate demand for goods hence
reducing the price level. If the government borrows money from individuals and spends
it on more productive purposes, the production of goods increases and prices tend to fall.
5. Balanced budget changes. A balanced budget decrease has a mild contractionary
effect on national income and hence bringing down the price level.
6. Control of deficit financing. If the government resorts to deficit financing e.g bank
borrowing and printing of notes to finance the budget deficit, money supply in the
country increases and this pushes prices upwards. Deficit financing should be avoided.
c) Non-monetary measures
1. Wage Adjustment. Wages must be raised at regular intervals to enable the individuals
to maintain their purchasing power at the same level.
2. Output Adjustment. The government must take steps to increase the production of
goods, so that the rise in price level is checked.
3. Price control. The government fixes prices or imposes direct controls on prices of
essential/basic commodities.
4. Rationing. Here the purchase of specific commodities is controlled. The individuals
can purchase a specific quantity only during a specific period.
d) Cost controls
Cost push inflation can be controlled by controlling the factors that contribute to rise in
cost. These factors include:
 Increase in wages and salaries-To curb inflation brought by increase in wages and
salaries the government may restrict such increase. Alternatively, if unions are
believed to be pushing for excessive pay increase, then direct attempts can be made to
curb their powers.
 Reducing taxes- taxes such as VAT are believed to be behind the cost-push
inflation, the government cab reduce such taxes in order to control inflation.
 Restricting imports-Where inflation is caused by increase in prices of imports, the
importing country can control the inflation by reducing the quantities of such
imports. This can be done by looking for alternative sources of supply.
DEFLATION
Deflation is a situation where there is a fall in the general level of prices and as a result
thereof, the value of money increases. It is that state of the economy where the value of
money is rising or prices are falling. Deflation, in fact is a situation where falling prices are
accompanied by falling levels of employment, output and income.
Causes of deflation
 A fall in private investment

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  A persistent unfavourable balance of payments
 Continued government budgetary surpluses
 A sudden increase in total output
 Action of the central bank to raise the interest rate.
 Action of the central bank by selling securities such as treasury bills and
government bonds
Effect of deflation on different sections of the society
1. Over production. When prices are falling, the producers buy materials and other inputs at
higher prices and are forced to sell the products at lower prices. This results in over
production of commodities.
2. Traders lose. During deflation, the traders purchase their goods at higher prices and
have to sell them later at lower prices due to the deflationary trend.
3. Investing class. During deflation, the equity holders lose and debenture holders gain
when prices fall.
4. Fixed income groups. During deflation , the pensioners, wage earners gain as the wages
and pensions do not decrease with the fall in prices.
5. Consumers. When prices of commodities fall, the consumers whose income is fixed, gain.
6. Creditors and debtors. During deflation, the creditors to gain and the debtors tend to lose.
7. Tax payers. The tax payers lose during deflation as the value of money rises.
8. Private sector units. The private sector units when the prices of their goods fall.
9. Industrial unrest. During deflation, there are industrial disputes and unrests in the
industrial sector.
10. Pace of economic growth. During deflation, the pace of economic growth slows
down. The reduction in output and increase in unemployment retards economic growth.

THE RELATIONSHIP BETWEEN INFLATION AND

UNEMPLOYMENT
The relationship between inflation and unemployment is explained by using the phillip’s
curve.
THE PHILLIPS CURVE
This is a curve which depicts the inverse relationship between the unemployment rate and
the rate of money wage inflation. There is a trade-ff between inflation and unemployment
such that lower unemployment tends to be associated with higher inflation, and lower
inflation with higher unemployment. Both the demand-pull inflation theory (inflation
caused by excess aggregate demand when the economy is at, or close to, full employment)
and the cost-push inflation theory (inflation caused by rising production costs) are
consistent with the argument that the closer the economy is to full employment, the greater
the inflationary pressure; the greater the rate of unemployment, the less the inflationary
pressure. Keynes argued that with unemployed resources, money wages would be more or
less constant, but at low levels of unemployment (resources becoming employed), money
wages would start to rise as bottlenecks occurred in the labour market. As full employment
was reached, money wages would rise rapidly as employers competed vigorously with each
other for existing workers. All this suggests that there may be a trade-off (or inverse

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relationship) between the rate of unemployment (U) and the rate of money wage inflation.
(W)

Inflation %

(W)

Unemployment % (U)
Revision Questions
1. Explain the following terms
a) Mild inflation d) Hyper inflation
b) Demand pull inflation e) Cost push inflation
c) Imported inflation
2. Explain how inflation may lead to unemployment.
3. State the various ways in which businesses may be affected by inflation.
4. Highlight the factors that may contribute to demand pull inflation.
5. What is a price index number? How is it constructed?
6. What is a weighted index number? How is it constructed?
7. Define inflation. Discuss the types and causes of inflation. How is inflation harmful to
the society?
8. Define deflation. Discuss the effects of deflation on the society
9. Discuss the various anti-inflationary measures/ Explain how inflation may be controlled.