Economic Chapter 9: Economic Inflation 

 

Inflation  refers  to the continuous   (persistent)   rise  in the general  price  level  of goods  and  services   in the economy  in a given  time.  It is measured   using price indices by the following   formula:

Where P_t =present year price index, P_t-1 = previous year prices

State of inflation

The  state of inflation  refers  to the  speed  (rate)  at which  the  general  price  level  of  commodities    are increasing  in the economy  at a given  time.

Classification of inflation

(1) According   to the state of inflation

• Mild (creeping / gradual/moderate) inflation. This is where the persistent   increase   in the general price level proceeds   at a slow rate usually   not exceeding   10%.  This state of inflation   is good since it acts as an incentive   to the producers.     It increases   savings, investments,    and output and employment   opportunities.                                                                                    .
• Hyper (Run away / Galloping) Inflation. This  is where  the general  price  level  increases   at a very high rate,   the  increase   taking   place   within   hours,   days  or  weeks   and  the  percentage    point increase  per  annum  exceeds  20%. In this  case,  money  loses  total value  and  people  prefer  to hold real  goods   than  money.   This   state   of inflation    is bad because   it discourages    production     as consumers   are reluctant to buy commodities   at very high prices.

(2) According   to causes

(a) Demand pull inflation

Demand pull  inflation  is where  the persistent   increase   in the general  price  level  arises  out  of excess aggregate  demand  for goods  and services  over  aggregate   supply  at conditions   of full  employment.     It is described as a situation where there is too much money chasing too few goods.

The figure above shows that increase   in aggregate    demand   from AD1    to   AD3    is   accompanied      by higher    output    as   well    as   higher prices.  Increase in    aggregate demand     beyond     AD₃ does not increase   output but only prices.     At AD₃, the     economy      attains      full employment   level 0Qf.

Causes of demand pull inflation

1. Increase in money supply which leads to increased aggregate demand hence persistent increase in prices.
2. Increase in population growth. This increases the consumption   of commodities    in the economy hence demand pull inflation.
3. Increase in disposable incomes of individuals as a result of increased wages and salaries for the workers. This increases the purchasing power of individuals hence increased   aggregate   demand.
4. Increase in   exportation   of  scarce  commodities   and   a  decrease  in  importation   of  scarce commodities
5. Increase in government expenditure in the economy. This increases money supply hence demand pull inflation

Policies (solutions)   for demand – pull Inflation

1. Using restrictive monetary policies for example increasing bank  rate,  sale  of treasuring   bills  and bonds  to the public,  credit  squeeze  etc. This helps to reduce money supply in the economy.
2. Using restrictive fiscal policies in form of reducing government expenditure   and increasing   direct taxes to reduce on the disposable incomes of individuals.
3. Using trade policies. These aim  at  increasing    the  importation    of  scarce   commodities    in  the economy   and  discouraging   the  exportation   of  the  scarce  commodities    from  the  economy.     This increases aggregate supply.
4. Using wage freeze policy. This is aimed at keeping   down the salaries   and wages   of workers through maximum   wage legislation.
5. Using price control policies. This  is concerned    with   controlling    prices   of major   consumer commodities   in the economy through use of maximum   price legislations.
6. Using production policies aimed at increasing the   volume   of goods   and   services    through liberalization   and privatization.

(b) Cost push inflation

Cost push  inflation is where  the persistent   increase  in the general  price  level  arises  out of increase  in the  costs  of production   which  increases   the  prices  of  commodities   for  example   increase   in wages, interest,  rent  and prices  for raw materials.    The costs are shifted to consumers   in form of high prices of the consumer goods.

From  the graph,  there  is a continuous   shift in the supply  curve  to  the  left  (decrease   in supply)  due to increase   in the, costs  of production     at   constant     demand.        This increases   the prices of commodities    in the economy.

Forms (causes) of Cost-push Inflation

1. Wage Push Inflation. This occurs when the increase   in the wage rate exceeds   the increase   in productivity   of workers.   This leads to a reduction   in supply of commodities.
2. Wage – wage inflation. This occurs   as a result   of inter-sectoral    comparison    of wages   among workers.   The  increase   in  wages  in  one  sector  or  firm causes   an  upward  revision    of  wages   in similar  occupations   in the  economy.    As entrepreneurs    increase   wages, costs of production   and prices also increase.
3. Wage price Inflation. This occurs when workers   demand   for high wages   through   their trade unions.   The increase in wages leads to an increase in the costs of production   and prices.
4. Price – wage (Spiral) Inflation. This occurs   when there   is an increase   in commodity   prices leading   to workers   demanding    for high wages.    This increases   the costs   of production    hence continuous   rise in prices of all commodities.
5. Profit Push inflation (Mark-up Inflation). This occurs when the producers   (monopolists)   restrict output with the aim of charging high prices to get high profit margins.

Policies (solutions)   to cost push inflation

1. Providing subsidies to the producers so as to increase in the level of domestic   output.
2. Encouraging the importation of scarce commodities in the economy by the government
3. Discouraging the exportation of scarce commodities.
4. Wage control measures to reduce on the high wage demands by workers.
5. Use of non-monetary remunerations for workers.

(c) Structural (Bottleneck)   Inflation

Structural  inflation  is  where  the persistent   increase   in  the  general   price  level  arises  out  of  supply rigidities  in the economy  which  keep down  the level of production.

Causes of structural inflation

1. The poor performance of the agricultural sector due to bad weather,   pests and diseases,   floods etc.
2. Break  down  of the  industrial  sector  for  example   due  to  depreciation    of  the  machines. This results into low production   and hence high prices.
3. Inadequate managerial and entrepreneurial skills which   result   in low production    leading   to increased prices.
4. Existence of political instabilities which discourage   both domestic   and foreign   investors.   This reduces output and hence high prices.
5. Speculation by businessmen who create artificial shortages by hoarding   goods.
6. Infrastructural break down in form of poor roads.
7. Scarcity of raw materials due to limited foreign exchange.   Producers   fail to import scarce raw materials hence low levels of production.

Solutions to structural Inflation

1. Economic diversification. Improving   on the export   sector   through   export   diversification    and production   of quality   exports.    This increases   foreign exchange  earnings which  can  be used  for buying  raw materials   necessary   for production.
2. Encouraging local production of goods and  services   by  offering   incentives   in  form  of  credit facilities  to producers.
3. Ensuring political stability aimed at creating a favourable (conducive)   investment   climate.
4. Improvement in technology so as to increase productivity of factors of production.
5. Infrastructural development
6. Expansion of the industrial sector
7. Modernization of the agricultural sector

(d) Imported inflation

Imported  inflation  is where  the persistent   increase  in the general  price  level  arises  out  of  importing highly  priced  commodities   and other  raw materials  from countries  already   experiencing   inflation.

Policies (Solutions) to imported inflation

1. Use of import restrictions so as to restrict on the volume of imports into the country.
2. Use of import substitution strategy so that goods formerly imported are produced domestically.
3. Subsidization of importers of essential commodities by the government.    This helps the importers to incur fewer costs and hence charge low prices.
4. Encouraging the use of domestic raw materials where possible
5. Economic integration to get cheaper goods through trade creation.

(e)  Suppressed Inflation.

This is where the excessive persistent   increase in   the general price level of commodities   is controlled   by the government through the use of price controls.

(f)  Open Inflation.  

This   is where   inflation   is not controlled   by the government    through   price controls,  rationing  and other  means.

Stagflation, deflation and reflation

Stagflation  refers  to the economic   situation  in which  high  inflation  rates  co-exist  with  high  levels  of unemployment   in the economy.    It is caused  by decline  in aggregate   supply  which  leads  to decline  in output  hence  unemployment   due to laying  off of workers.

 Costs of stagflation

1. Increasing cost of living
2. Decline in standards of living
3. Decline in investment
4. Decline in savings
5. Loss of confidence in the country’s   currency
6. It worsens income inequalities among people
7. It raises the cost of borrowing
8. It leads to social distress

• Deflation. This  refers  to the  persistent   (continuous)   fall  in the  general  price  level  of  goods  and services  in the economy.
• Reflation. This refers to the policy used by the government   to lift the economy out of a deflation or depression.

 

General cause of inflation in developing countries (Uganda)

1. Excessive printing of money by the central bank to finance budget deficits. This increases   money supply in the economy hence inflation.
2. Increase in costs of production.  This is due to increase   in wages,   costs of raw materials, fuel prices,   high   taxes” etc.  Which   force   producers   to increase   the prices of commodities     in the economy.
3. Persistent political Instabilities.  These scare away the potential   investors   leading to low output. This  leads  to shortage  of goods  and services  hence  inflation.
4. Importation of commodities and raw materials from countries experiencing inflation.   High prices  of imports  like fuel,  capital  goods  other  commodities   lead to an increase  in the production costs  leading  to cost push  inflation,                                                                                                   .
5. Supply rigidity such as bad weather, pests and diseases, poor infrastructure    etc.  Especially   in the agricultural sector.  This reduces agricultural   output hence an increase in the food prices.
6. Effects of structural adjustment programs (SAPS) such as privatization,   retrenchment    etc.
7. Desire for excessive profits by businessmen.  This forces them to increase the prices of goods and services  in the economy.
8. Excessive aggregate demand for goods and services as compared   to their supply.   For example due to increase in population.
9. High degree of speculation in business.  Traders   create   artificial   shortages   with   the aim   of increasing prices for their goods and services.
10. Depreciation of the local currency through forces of demand and supply of foreign currencies.
11. Increased printing of counterfeit currency which leads to increase in circulation of money in the economy.

Policies   (measures) to control inflation   in developing    countries

1. Selling government securities to the public. This is aimed   at reducing   money   supply   and aggregate demand in the economy as a way of controlling   inflation.
2. Increasing direct taxes. This helps to reduce the disposable incomes   of the individuals    and to check on aggregate demand.
3. Reducing government  expenditure  for example  through  retrenchment   so as to reduce  on money supply  and aggregate  demand  in the economy.
4. Maintaining political stability and security by the government   through democratic   governance and use  of amnesty  act.   This helps to create a favorable   investment   climate hence   increasing the supply of goods and services in the economy.
5. Use of import and export policies. Policies   aimed   at restricting    the exportation    of scarce commodities    and importation    of commodities    which   are scarce   in the economy    should   be promoted.   This helps to increase on the availability   of commodities   in the economy.
6. Controlling the importation of goods   and raw materials from   countries   experiencing inflation.  This is done by the government   adopting import substitution   development    strategy   to produce commodities   formerly imported.    This helps to check on imported inflation.
7. Use of population control measures. This is aimed at reducing population   growth  rates  through the use  of appropriate   family  planning   methods.    This helps to check on excessive   demand.  For goods and services.
8. Construction of social and economic infrastructure.   For   example   construction     of roads, rehabilitation of production    units   etc.  This helps to facilitate   the distribution    of goods   and services from rural to urban areas hence controlling   inflation.
9. Reducing government borrowing from the central   bank for deficit   financing.   This   helps   to reduce excessive money supply in the economy.
10. Use of price control measures for example use of maximum price legislation, rationing   etc.  to check  on inflation.
11. Use of wage freeze policies. These are aimed at controlling wages of workers through the use of wage freeze and restraint.    This helps to check on the disposable   incomes   of individuals    hence reducing money supply and aggregate   demand.
12. Providing investment incentives. There is need   for  the  government    to  create   a  conducive investment   climate  by  providing   investment   incentives   to both  foreign   and  local   investors   in form of subsidization   and  granting  tax holidays.   This helps to increase production   of goods and services in the economy.
13. Use of currency reforms in case the level of inflation is very high. This helps to reduce money supply in the economy.
14. Use of privatization policy. This helps  the  private   individuals    to  get  involved   in  production hence  increasing  the supply  of goods  and services  in the economy
15. Liberalization of the economy. This allows for a number   of individuals    to get involved   in exchange  of goods  and services  with  limited  unnecessary   government   intervention

Effects   (implications) of inflation

Advantages/merits/Positive effects (Implications) of inflation

Mild Inflation is healthy to the economy in the following ways;

1. It stimulates production of goods and services in the economy.  This is due to high prices and profit  margins  received  by producers.    This leads to economic growth.
2. It stimulates people’s effort to work. Individuals   work hard in order to maintain   their standards of living.
3. It encourages forced savings. This is as a result of the high profits realized by those involved   in business.   This promotes investments   in the economy.
4. It increases employment opportunities.  This is due to increased    investments    and economic activities taking place in the economy.
5. It increases government revenue. The government   taxes the high profits got by those involved in economic activities.   Such revenue is used to finance recurrent and development   expenditures.
6. It stimulates entrepreneurial skills in the economy. This is because it encourages   innovations and creativity  hence  increase  in investments   in the economy
7. It encourages food production in the economy. Local farmers take advantage   of the high price to produce more food to sell in the domestic market.
8. It encourages labour mobility in the economy.  Individuals   move   to other areas in search of better  paying jobs  so as to make  their  ends meet.
9. It  encourages  the  adoption  of import  substitution  industrial  strategy  as  a result  of  imported inflation.  This accelerates   industrialization    in the economy.
10. Borrowers (debtors) stand to gain as a result of mild inflation. This is as a result of a fall in the real interest   rate  charged   on  the  borrowed   funds  by  financial   institutions    which   benefits   the borrowers
11. It increases resource utilization in the economy. This increases the  production    of  goods  and services.

 

Disadvantage/demerit/Negative effects (implications) of inflation

Hyper Inflation is undesirable   in the economy in the following ways;

1. It leads to low standards   of living. This   is due to increase in the cost of living   resulting   from high prices of commodities   and production   of poor quality commodities.
2. It discourages savings in the economy. Individuals   spend a lot of money to purchase   few goods. This reduces the level of investments   in the long run.
3. It worsens the balance of payment position of the country.  This   is  because   it  discourages exports  by making  them  expensive   and  encourages   imports  as they  become   cheaper  to the  local importers.   This reduces   foreign exchange   earnings   and increases   foreign   exchange   expenditure hence balance of payment problems.
4. It increases the levels of-unemployment   in the economy.  This is because   inflation   discourages investment   and production   activities in the economy.   This leads to low levels of incomes.
5. It discourages both foreign and domestic investments.  Inflation   increases   the  production   costs and  this reduces  the production   of goods  and  services  hence  low  levels  of economic   growth  and  development.
6. Inflation accelerates brain drain. Qualified  and  trained   labour  is forced  to leave  the  country   to go and work  in foreign  countries  where  the value  of money  is high and stable.
7. Inflation leads to income inequalities. It makes the rich to earn more incomes at the expense   of the poor.   This is worse for the low fixed salary earners.
8. Inflation leads to rural urban migration.  This is because   it becomes less profitable    to grow crops in rural areas.   As a result, people move to urban areas to start businesses   where the profit margins are relatively high.
9. It leads to misallocation of resources. Resources are diverted   from the production   of essential commodities   to non-essential (luxurious) commodities   which are more profitable.
10. It encourages illegal activities in the economy. Such activities include corruption and smuggling of goods and services.   This is because people struggle   to maintain   their standard   of living as a result of inflation.
11. It encourages dumping in the economy. Foreigners sell their commodities in local markets   at prices  lower  than  those  charged  in  their  countries.   This retards the growth   of domestic   infant industries which charge high prices due to high production   costs.
12. It makes it difficult for the government to plan and budget. The continuous fall in the value of money due to inflation makes it difficult to meet the planned targets.
13. It makes the government in power unpopular. The members of the opposition   use inflation   as the ground for criticizing   the government etc.
14. It leads to loss of confidence in the local currency by the public. This is due to continuous fall in the value of the currency.
15. It discourages lending by financial institutions. This is because they stand to lose as a result of a fall in the real money value.
16. It leads to industrial unrests. This is due to constant demand for high wages by workers through their trade unions.

Why is it difficult    to control   inflation in developing countries?

1. The  need  to  import  essential  commodities  which   are   lacking   in  the   country    for   example petroleum  products  makes  it difficult  to control  imported   inflation.
2. High rates of rural-urban migration. This increases the costs of living in towns hence inflation.
3. Frequent wage increases by the government.   This leads to high levels of disposable   incomes hence increase in demand for goods and services.
4. Low productivity in the agricultural sector. This leads to shortage of food hence increase   in food prices.
5. High levels of corruption and embezzlement of public funds meant for productive activities. This leads to shortage of goods and services hence inflation.
6. The need for high revenue from indirect taxes by the government causes producers   to increase prices of their commodities.
7. Lack of appropriate measures to control population   growth.  This leads to excessive   demand   for goods and services hence inflation.
8. Occurrence of unforeseen circumstances for example bad weather,   pests and diseases   which lead to shortage of goods and services especially in the agricultural   sector.
9. Political instabilities and insecurity. These demand for increased government   expenditure   hence increased money supply in the economy.
10. Limited capital required to set up industries to increase domestic production    of goods   and  services.
11. Existence of poor infrastructure in the economy. Poor infrastructure   in form  of poor  transport and  communication    facilities  makes  it difficult  to distribute   goods  from  the production    areas  to market  centers.
12. Underdeveloped financial sector. This makes it difficult to use the tools of the monetary policy to control money supply in the economy hence inflation.

 

Revision questions

 

Section  A questions

 

1  (a) Distinguish   between  creeping  inflation  and galloping  inflation

(b) Mention any two merits of creeping (mild) inflation.

2 (a)    Define the term “Reflation”

(b)    State three causes of structural inflation in an economy

3 (a) Distinguish   between structural inflation and imported inflation

(b) Outline two solutions to imported inflation  in your country

4  (a)  Distinguish   between  state of inflation    and reflation

(b)  Mention two solutions to structural inflation in Ugnada

5 (a)  Distinguish   between  state of inflation  and type of inflation.

(b) Mention  two possible  remedies  to cost push  inflation  in an economy

6. (a) With the help of diagrams,  distinguish  between  Cost push  and demand  pull  inflation.
7. State four reasons why an increase in money supply may not necessarily lead to inflation
8. State any four policy measures that should be taken to control cost push inflation in an economy.
9. Distinguish  between the following types of inflation.

(a)  Suppressed   Inflation and Open Inflation

(b) Speculative   inflation     and monetary inflation

(c) Underlying   inflation and headline inflation

10 (a)   Distinguish   between demand pun inflation and bottleneck   inflation.

(b)  Give two causes of demand pull inflation in your country.

11 (a) Define the term disinflation.

(b) State three instruments   of a disinflation   policy.

12   Explain the relationship   between the following

(a)  Unemployment and inflation in your country

(b) Inflation and the real value of money.

 

Section B questions

1  (a)  Why may  creeping  inflation  be desirable  in your country

(b) Suggest the measures that should be taken to tackle inflation in your country

2  (a) What  are the causes  of inflation  in Uganda?                              .

(b)  Explain the measures being taken to control inflation in your country.

3  (a)  Distinguish   between  deflation  and inflation

(b)  Assess the impacts (implications)   of inflation in an economy

4. (a) Explain why the government  may induce  inflation  in an economy?

(b)  Account   for  the  persistent   increase   in the  general  price  level  of  goods  and  services   in  your country.