UNIT 6

Inflation
 LECTURE OUTLINE

Define inflation

Demand-pull inflation

Cost-push inflation

Problems with demand-pull and cost-push inflation

 INFLATION
Inflation is often described as “public enemy number one.”

Inflation is defined as a continuous and considerable rise in prices in general.

Take note of the four aspects of the definition.

It is a neutral definition which does not attempt to define inflation in terms of specific causes. Inflation is often
defined in the media as “too much money chasing too few goods” or as “excessive increases in the money stock”.

Such definitions highlight a particular cause of inflation and therefore exclude all other possible causes. These are
called causal definitions.
 INFLATION
One of the drawbacks of causal definitions is that they can result in the formulation of inappropriate policies for
fighting inflation.

A neutral definition, on the other hand, allows for all possible causes of inflation to be taken into account. It also
provides a sounder basis for anti-inflation policy.
Another important element of the definition is that it describes inflation as a process. Inflation does not refer to a once-and-for-
all increase in prices.

What is an issue here is a continuous increase in prices.

Inflation refers to a process in which the prices of most goods and services are increasing from year to year (or even from month
to month).
 INFLATION

Inflation is concerned with a considerable increase in prices.

If prices are, on average, increasing by only 1 or 2 per cent per year, it is

questionable whether this should be described as inflation.

Such price rises could, for example, have resulted from increases in the quality of
the goods and services concerned, in which case it would be wrong to describe
them as inflation.
 INFLATION
Inflation refers to an increase in prices in general.

An increase in the price of a particular good (eg meat or petrol) is not inflation.

Even when the overall level of prices remains constant some prices will increase while others will decrease in
response to changes in supply and demand.

There is inflation only when the prices of most goods and services in the economy are increasing.

Economists therefore often refer to inflation as increases in the general (or average) price level.
 INFLATION
It is measured using an indicator known as the consumer price index (CPI).
The CPI reflects the cost of a representative basket of goods and services. Inflation is calculated by taking the
percentage change in the CPI over a period of time (not less than a year).

Inflation rate is the % change in CPI from one period to another.

It is always expressed as an annual rate

Is Inflation a Problem?
Unpredictable changes in the inflation rate are a problem because they redistribute income in arbitrary ways between employers
and workers and between borrowers and lenders.

A high inflation rate is a problem because it diverts resources from productive activities to inflation forecasting.

Eradicating inflation is costly because it brings a period of greater than average unemployment.
 INFLATION
The Causes of Inflation
• Inflation is a complex, dynamic process which cannot be ascribed to a single cause.

• To avoid pointing a finger at any one party (such as the government or the trade unions), it is best to look at approaches
used to explain this process.

• There are four approaches identified and each provides a framework for formulating policies that can be used to combat
inflation.
• Approaches to examine causes:
• Monetarist Approach
• Demand-pull Inflation
• Cost-push Inflation
• Structuralist Approach
• The Conflict approach
 INFLATION
The Monetarist Approach
• Regards inflation as a purely monetary phenomenon.

• Sustained high rates of monetary growth cause high inflation, while low rates of monetary growth will
eventually produce low inflation.

• Shortcomings of this approach – It assumes that changes in the quantity of money does not affect real
variables such as output and employment.

• Demand-pull inflation occurs when the aggregate demand for goods and services increases while aggregate
supply remains unchanged – “too much money chasing too few goods.”
 DEMAND-PULL INFLATION
The excess demand pulls up the prices of goods and services Could be as a result of:
• Increased consumption spending by households (C)
• E.g. as a result of availability of credit or cheaper credit

• Increased investment spending by firms (I )

• E.g. as a result of lower interest rates or increased business confidence

• Increased government spending (G)

• E.g. as a result of an attempt to reduce unemployment or to provide more or better services

• increased export earnings (X)

• E.g. as a result of improved economic conditions in the rest of the world or increased prices of
exports.
 DEMAND-PULL INFLATION

Cost-push inflation is triggered by increases in the cost of production. Increases in

production costs push up the price level.
COST-PUSH INFLATION
 COST-PUSH INFLATION
The first source is increases in wages and salaries.

A second source is the cost of imported capital and intermediate goods.

A third source is increases in profit margins.

A fourth source is decreased productivity.

A fifth source is natural disasters, such as droughts or floods, which occur periodically.
 COST-PUSH INFLATION
The first source is increases in wages and salaries:
• Wages and salaries are the largest single cost item in any economy – in South Africa the remuneration of
labour constitutes about 50 per cent of the cost of producing the gross domestic product.
• Increases in wages and salaries are therefore an important potential source of cost-push inflation.
A second source is the cost of imported capital and intermediate goods.
• These goods are essential to the functioning of the domestic economy, particularly the manufacturing sector.
• When the prices of imported goods such as oil, machinery and equipment increase, the domestic costs of
production are raised.
• The increases in import prices could be the result of price increases in the rest of the world or of a
depreciation of the domestic currency against the currencies of the exporting countries.
 COST-PUSH INFLATION
A third source is increases in profit margins:
• Like wages, interest and rent, profit is also included in the cost of production.
• When firms push up their profit margins they are therefore raising the cost of production (and the prices that consumers
have to pay).

A fourth source is decreased productivity.

If the various factors of production become less productive while still receiving the same
remuneration, the costs of producing each unit of output increases.

A fifth source is natural disasters, such as droughts or floods, which occur

periodically.
• They raise the costs of production and the prices of agricultural and other related products.
 PROBLEMS WITH DEMAND-PULL AND COST-PUSH INFLATION
The major problem with demand-pull and cost-push inflation is that both become intertwined in the inflation
process and it is difficult to distinguish between the two in practice.

Neither one of the two can take place without some increase in the money supply….and then there is time lag, the
effect of the velocity of money and other factors (discussed below) that affect the outcome.
Take this situation as an example: Let us say oil prices rise dramatically because of a war in the Middle East.

A country such as South Africa that imports its oil, now has to pay more – petrol prices rise and so do the prices of
all goods that are affected by it – though it is said that we have “imported inflation” this is not strictly true, since it is
a once off price shock and if the money supply stayed constant, expenditure will shift to other products (people will
buy less) which will cause the prices of the those products to drop in the same relation as the rise in prices caused
by the increase in the oil price so the general price levels (inflation) would theoretically stay constant.
 THE STRUCTURALIST APPROACH
According to this approach, inflation is the result of the interaction between three interrelated
sets of factors:

• Underlying factors – provides the background against which the inflation process occurs;

• Initiating factors – trigger or intensify a particular inflation process; and

• Propagating factors – transmits the initiating impulse(s) through the economy and over time,
and, in so doing, generates/sustains the process of rising prices.
 THE STRUCTURALIST APPROACH
Underlying factors – provides the background against which the inflation process occurs;
• The underlying factors, also called the structural factors (hence the term “structuralist approach”),
lie at the root of the inflation process.
• They provide the background against which the process occurs.
• An examination of the underlying factors gives an indication of how vulnerable an economy is to
inflation.
• For example, the greater the degree of class or race conflict in society, the greater the chances
that high inflation will occur.
• Not surprisingly, therefore, the highest inflation rates tend to occur during wars or civil wars.
• On the other hand, the greater the degree of social and political cohesion, the greater the chances
will be that disputes about the distribution of income and wealth can be settled without generating
a process of inflation.
 THE STRUCTURALIST APPROACH
Underlying factors
• Traditions, values and norms of society
• Degree of conflict (or cohesion) between different groups in society
• Political strength and bargaining power of trade unions
• Degree of competition in the goods market
• Degree of protection from international competition
• Extent of administered pricing
• Extent of formal and informal indexation
• Size of the public sector
• Degree of fiscal discipline
• Degree of independence of the monetary authorities
• Openness of the economy
• Exchange rate regime
 THE STRUCTURALIST APPROACH
Initiating factors – trigger or intensify a particular inflation process;
• Although the underlying factors are important, they cannot explain why the inflation rate is what it is, why it sometimes falls and
why it sometimes accelerates.
• Against the background of the underlying factors, specific cost and/or price increases are required to initiate or aggravate a
particular inflationary episode.
• The immediate causes of such increases are called the initiating factors.

Initiating factors – trigger or intensify a particular inflation process;

• These factors can be classified into three broad categories: demand-pull factors, cost-push factors and “other”
price or cost increases.
• The demand-pull factors and cost-push factors are the same as those already discussed in the section on demand-
pull and cost-push inflation. The distinction between demand pull and cost push is thus retained, but in a much
narrower context.
• The demand-pull and cost-push factors set the process in motion but do not in themselves explain the whole
process.
 THE STRUCTURALIST APPROACH
Initiating factors – trigger or intensify a particular inflation process;
• Towards the end of 2001, for example, the rand depreciated sharply against the major
international currencies.
• As a result, the prices of imported capital, intermediate and consumer goods increased sharply.
Such increases, however, are in themselves insufficient to explain a process of inflation.
• They have to be transmitted through the economy and over time by the propagating factors.
Initiating factors – trigger or intensify a particular inflation process;
• Demand-pull factors (eg exogenous increases in C, I, G or X)
• Cost-push factors (eg exogenous increases in wages, profits or import prices)
• Other price increases (eg as a result f natural disasters or increases in indirect taxes)
 THE STRUCTURALIST APPROACH
Propagating factors – transmits the initiating impulse(s) through the economy and over time, and, in so doing,
generates/sustains the process of rising prices.

Once prices and/or costs have risen somewhere in the economy, these increases have to be transmitted to the rest of the
economy and over time to generate or sustain an inflation process.

This is where the propagating factors come in.

Broadly speaking, four sets of propagating factors can be distinguished.

• The first is the various interrelationships that exist between prices, wages and profits in the economy.
• A second set of propagating factors (or elements of the inflationary transmission mechanism) is to be found in the
interaction between domestic prices, the balance of payments and the exchange rate.
• A third propagating factor, namely the increase in the money stock.
• A fourth is inflationary expectations
 THE CONFLICT APPROACH

Analysts are not in agreement whether the issues dealt with here are causes or results.

In all cases where these phenomena have been observed there was a disjoint between the
money supply and production, income and spending levels.

According to this approach, inflation then is a symptom of a fundamental disharmony in society

which results in a continuous imbalance between the rate of growth in the real national income
and the rate of growth of the total effective claims on this income.
 THE CONFLICT APPROACH
The rival interest groups each strive to gain larger shares of the “pie” by claiming higher money incomes,
and this results in inflation.

Inflation is the symptom of a lack of effective economic and/or political mechanisms to achieve a prior
reconciliation of the conflicting claims on the national income.
The costs of inflation are not immediately obvious. Three sets of effects of inflation will
be examined:
Distribution Effects
• Inflation benefits debtors (borrowers) at the expense of creditors.
• Inflation tends to redistribute income wealth from the elderly to the young.
• Redistribution from the private sector to the government.
 THE EFFECTS OF INFLATION
Economic Effects
• Anticipating inflation – Decision makers become more concerned with anticipating inflation than with seeking
profitable new production opportunities.
• Speculative practices – People try to outwit each other by speculating in shares, foreign currency (exchange),
price of precious metals etc. instead of engaging in productive investments (new factories, machinery and
other equipment).

Economic Effects
• Discourages saving – By reducing the value of existing savings, inflation may also discourage saving in
traditional forms (fixed deposits, pension fund contributions etc.).
• Balance of payment problems – Inflation increases the costs of export industries and import-competing
industries. If the inflation rate in SA is higher than that of our major trading partners and international
competitors, then South Africa’s international competitiveness could be adversely affected.
 THE EFFECTS OF INFLATION
Social and Political Effects
• Price increases make people unhappy and different groups in society blame one another for increases in the
cost of living.

The possible impact of anti-inflation policy on other macroeconomic objectives

should be taken into account.
The following should therefore be considered:
• The nature of the inflation being experienced
• The possible interrelationships between inflation and other objectives or problems such as
economic growth and unemployment.
 COMBATING INFLATION
The possible costs of failing to achieve other objectives such as economic growth and full
employment

The possible benefits of a reduction in the inflation rate (bearing in mind that a marginal
reduction is often the only realistic possibility)

The possible costs or side-effects of the policy measures that are to be implemented in the
attempt to reduce the inflation rate to the desired level
 MEASURES TO CURB INFLATION
In the case of demand-pull inflation: (Show graphically)

Restrictive monetary policy:

• Increase interest rate
• Limiting the increase in money supply

Restrictive fiscal policy:

• Reduction in government spending
• Increase in taxation
 MEASURES TO CURB INFLATION

In the case of cost-push inflation: (Show graphically)

The appropriate response would be to increase aggregate supply, illustrated by a rightward (or
downward) shift of the AS curve.
• One of the options is to apply an incomes policy (reduce production costs - Control/lower wages, salaries,
profits or increase productivity) (supply side),
• While another option is to apply the policy recommendations of the supply-side economists. (decrease in tax
rates)
 ANTI-INFLATION POLICY

Inflation Targeting
Its key features are thus:
• The announcement of quantitative inflation targets
• The primacy of price stability as the objective of monetary policy.
• A broad-based, pragmatic approach to the analysis of inflation.
• Transparency
• Accountability
 ADVANTAGES OF INFLATION TARGETING
It is easily understandable, with the policy objective formulated in the form of an explicit quantitative target – this
makes the framework extremely transparent.

It makes it very clear that monetary policy is aimed at achieving price stability – this reduces uncertainty and
enhances sound planning in both the private and public sectors.
It enhances the coordination of economic policy, since both the government and the central bank are publicly
committed to the same inflation target.

It serves as a coordination device for inflation expectations, particularly with regard to price and wage
determination, thereby avoiding or reducing the problems arising from widely differing inflation expectations.

By affecting inflationary expectations it can also help to reduce inflation.