Principles of

Monetary and Finance

Chapter 2: Inflation
 Chapter introduction

• 2.1 Definition and Types of Inflation

• 2.2 Causes of Inflation
• 2.3 Effects of Inflation
• 2.4 Inflation and Economic Growth in Vietnam
2.1 Definition of Inflation

• Inflation is an increase in the overall level of

prices.
• Inflation is not an increase in the price of a
specific good or service relative to the prices of
other goods and services.
 2.1.Types of Inflation
1. Creeping inflation: inflation index is less than 10
percent per year
+ Creeping inflation: inflation index is 3 percent
per year or less
+ Walking Inflation: inflation is between 3-10
percent a year
2. Galloping Inflation: inflation index rises from 10
percent up to 200 percent per year
3. Hyperinflation: inflation index rises more than
200 percent per year
Hyperinflation in Germany 1923
• Prices ran out of control (eg. a loaf of bread, which
cost 250 marks in January 1923 had risen to
200,000 million marks in November)
1923. German's currency became worthless.
Hyperinflation in Zimbabwe 2008
• Zimbabwe had the second highest incidence of
hyperinflation on record. The estimated inflation rate
for Nov 2008 was 79,600,000,000%
• That is effectively a daily inflation rate of 98.0.
Roughly every day, prices would double
 Inflation in Vietnam

• Galloping inflation 1976 to 1994: most of inflation

indexes in this period are 2 numbers, ~50% - 90%

• Hyperinflation 1986-1987-1988: inflation peaking

in 1987 at 776%.
2.2 Causes of Inflation

• Quantity theory – too much money in the

economy causes inflation
2.2 Causes of Inflation

• Demand-pull Theory – when demand for

goods/services exceeds existing supplies

• Cost push theory – when producers raise

prices to meet increased costs, leads to wage
price spiral.
Demand-pull Theory
• Price levels rise because of an imbalance in the
aggregate supply and demand. When the
aggregate demand in an economy strongly
outweighs the aggregate supply, prices go up.
Economists describe demand-pull inflation as a
result of too many dollars chasing too few goods.
Causes of Demand-Pull Inflation
• A growing economy: When consumers feel confident, they will spend
more, take on more debt by borrowing more. This leads to a steady
increase in demand, which means higher prices.
• Asset inflation: a sudden rise in exports, which translates to an
undervaluation of the involved currencies
• Government spending: when the government opens up its
pocketbooks, it drives up prices. Military spending prices may go up
when the government starts to buy more military equipment.
• Inflation expectations: forecasts and expectations of inflation, where
companies increase their prices to go with the flow of the expected
rise
• More money in the system: demand-pull inflation is produced by an
excess in monetary growth or an expansion of the money supply. Too
much money in an economic system with too few goods makes prices
increase.
Example of Demand-Pull Inflation
• When oil refineries work at full capacity, they cause demand-pull
inflation. Environmental concerns cause regulatory problems for
refineries. Because of prohibitive factors by the government, supply
created by oil refineries is also limited. Rather than a lack of oil or the
lack of companies to produce oil, restrictive legislation prevents the
market from providing optimum efficiency in producing goods with
high demand. The oil industry, then, is one of the biggest contributors
of demand-supply inflation.
• During the U.S. economic downturn and the eurozone debt crisis,
concerned investors turned to gold, buying the precious metal as a
hedge against a collapse in the U.S. dollar and the euro, increasing
demand for the commodity.
Cost push theory
• Cost push theory – when producers raise prices to
meet increased costs, leads to wage price spiral.
• Cost-push inflation is a situation in which the
overall price levels go up (inflation) due to increases in
the cost of wages and raw materials.
• Cost-push inflation develops because the higher costs of
production factors decreases in aggregate supply (the
amount of total production) in the economy. Since there
are fewer goods being produced (supply weakens) and
demand for these goods remains consistent, the prices
of finished goods increase (inflation).
Cost push theory
• The most common cause of cost-push inflation starts with an
increase in the cost of production, which may be unexpected. This
can be related to an increase in the cost of raw materials,
unexpected damage or shutdown to a production facility (such as
one caused by a fire of natural disaster), or mandatory wage
increases for production employees, including instances where a
rise in minimum wage automatically increases the compensation of
employees who were being paid below the new standard.
• For cost-push inflation to take place, demand for the affected
product must remain constant during the time the production cost
changes are occurring. To compensate for the increased cost of
production, producers raise the price to the consumer to maintain
profit levels while keeping pace with expected demand.
Unexpected Causes of Cost-Push Inflation

• One common unexpected cause is a natural disaster. This

can include floods, earthquakes, tornadoes or any other
large disaster that disrupts any portion of the production
chain and leads to increased production costs. Not all
natural disasters may qualify, as not all of them result in
higher production costs.
• Other activities may qualify if they lead to higher
production costs. This can include a worker strike, such
as one relating to contract negotiations, or a sudden
change in government (more often seen in developing
nations) that affects the country’s ability to maintain
previous output.
Example of Cost-Push Inflation
• In the early 1970s, the Organization of the
Petroleum Exporting Countries (OPEC) wanted a
monopoly over oil prices and tried to decrease the
global oil supply by raising prices. The group's
attempt to raise the price resulted in a supply shock.
This is a good example of cost-push inflation, as
there was no increase in demand for the
commodity.
Expected Causes of Cost-Push Inflation

• While a sudden change in government may be

considered unexpected, changes in current laws
and regulations may be anticipated even though
there may be no reasonable way to compensate for
the increased costs associated with them.
Wage-Price Spiral

• The wage-price spiral is a macroeconomic theory used to explain

the cause-and-effect relationship between rising wages and rising
prices, or inflation. The wage-price spiral suggests that rising
wages increase disposable income raising the demand for goods
and causing prices to rise. Rising prices increase demand for
higher wages, which leads to higher production costs and further
upward pressure on prices creating a conceptual spiral.
Wage-Price Spiral
• The wage-price spiral is an economic term that describes how prices
increase when wages increase. It is a phenomenon that
occasionally occurs when the general prices for goods and services
increase causing workers to demand a wage hike. The wage
increase effectively increases general business expenses that are
passed on to the consumer in the form of higher prices. It is
essentially a loop or cycle that perpetuates itself through consistent
price increases.
• The wage-price spiral reflects the causes and consequences of
inflation and it is, therefore, characteristic of Keynesian economic
theory. It is also known as the "cost-push" origin of inflation. Another
cause of inflation is known as "demand-pull" inflation, which
monetary theorists believe originates with the money supply.
 How a Wage-price Spiral Begins
• A wage-price spiral is caused by the effect of supply and demand on
aggregate prices. People who earn more than the cost of
living typically decide on an allocation mix between savings
and consumer spending. As wages increase, so too does a
consumer's propensity to both save and consume.
• If the minimum wage of an economy increased, for example, it would
cause consumers within the economy to purchase more product,
increasing demand. The rise in aggregate demand and the increased
wage burden causes businesses to increase the prices of products
and services. Although wages are higher, the increase in prices
causes workers to naturally demand even higher wages. If higher
wages are granted, a spiral where prices subsequently increase may
occur repeating the cycle until wage levels can no longer be
supported.
Stopping a Wage-price Spiral
• Governments and economies favor stable inflation — or price
increases. A wage-price spiral often makes inflation higher than is
ideal. Governments have the option of stopping this inflationary
environment through the actions of the Federal Reserve or central
bank. A country's central bank can use monetary policy, the interest
rate, reserve requirements or open market operations, to curb the
wage-price spiral.
• However, the United States has done this in the past and actually
caused a recession. The 1970s was a time of oil price increases
by OPEC that resulted in increased domestic inflation. The Federal
Reserve responded by raising interest rates to control inflation,
stopping the spiral in the short-term but acting as the catalyst for a
recession in the early 1980s.
 2.3 Effects of Inflation

• Creeping inflation stimulate the

economic development.
• High inflation has negative effects on
the economy.
2.3 Effects of Inflation
Negative impacts of high inflation
• to the business
• to the commodity circulation
• to money and credit
• to the state budget
• to consumption and living of people
 Strategies for tackling inflation

Temporary solution
- Monetary and credit measures: The purpose
of this measure is to reduce the amount of
cash in circulation and to control the flow of
money. Therefore, the central bank and
commercial banks should take the following
measures:
 Strategies for tackling inflation

+ Tightening money supply: the central bank does

not issue more money to the circulation in any
form.
+ To manage and minimize the possibility of
"creating money" by commercial banks by raising
the compulsory reserve ratio, tightening credit, …
+ Raising interest rates: The central bank has an
impact on the mobilizing and lending interest rates
of commercial banks.
+ Commercial banks must diversify forms of
mobilizing money in the public.
 Strategies for tackling inflation

- Budget management measures:

+Cutting down expenditures of state budget.
+ Strengthening and improving the efficiency of the
state budget by: reforming tax policies towards
expanding and raising incomes
- Other measures:
+ Price control of some essential commodities
+ Encouraging free trade
+ Stabilizing the prices of gold and foreign currencies
in order to stabilize the prices of other commodities in
the market.
Strategies for tackling inflation

Strategic solution
- To make master plan on development of
production and circulation of goods of the
national economy
- To adjust the economic structure to develop
goods industry for export.
- Enhancing the effectiveness of state
management
2.4 Inflation and Economic Growth in
Vietnam

• Inflation in period of 1975-1991

• Inflation in the period 1985-1988
• Inflation in period of 2004-2014
• Inflation in the period 2008-2013