BBIT 1.

ECONOMICS

INFLATION
DEFINITION OF INFLATION
Inflation may be defined as a macro-economic problem where there is
persistence (continuous/sustained) increase in general price level of goods
and services. Inflation is associated with a situation whereby there too
much money is used in purchasing too few goods, that is, too much
money chasing too few goods. This is because during inflation money
looses its value.

TYPES OF INFLATION
The major types of inflation are:

(1) Creeping inflation: This type of inflation, which is also referred to as

crawling inflation refers to a situation where general price levels increase
at a rate of 2-3 per cent per annum. This type of inflation is considered
healthy or harmless for economic growth because firms and households
can plan for more economic investments. Whenever this type of inflation
is experienced there will be induce or encourage investment and
aggregate demand for goods and services.

(2) Moderate Inflation: So long as the level of inflation is within a single

digit, (4 – 9 per cent per annum) that type of inflation is referred to as
moderate inflation. It is not a harmful inflation and therefore is
considered healthy for economic growth as it encourages investment.

(3) Rapid inflation: This type of inflation is also referred to as run away
inflation and it occurs when the general price levels increase between 9–
20 per cent per annum. It is not good for economic growth because firms
and households find it difficult to predict on the economic trend and it
therefore interferes with the planning processes.

(4) Hyperinflation: This type of inflation is also referred to as galloping

inflation, the general price levels in an economy increase between 50–
100 per cent per annum. Galloping inflation is very bad and harmful for
an economy. During hyperinflation, money as a medium of exchange fails
to perform its function and the currency becomes unacceptable. If an
economy is facing this type of inflation, the government will be forced to
drop its currency and introduce a new one. Hence, hyperinflation can lead
to the break down of country’s monetary system. It occurred in Germany
in 1923 where the prices rose by 250 per cent in just one month!

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(5) Suppressed inflation: It refers to a situation where demand exceeds
supply. However, the effect on prices is minimized through the use of
instruments such as price control or rationing.

(6) Stagflation: This is the combination of high unemployment and

economic stagnation with inflation. It happened in industrialized countries
during the 1970s’ when bad economies were combined with OPEC raising
oil prices exorbitantly.

(7) Expected inflation: When firms and employees negotiate wages and
when companies set their prices, they often consider what inflation might
be in the period ahead. If for example economists predict that the rate of
inflation is likely to increase by 15 per cent this will force the wage
earners to demand more wages in order to adjust to high cost of living.
This type of inflation is also known as wage induced inflation since
workers demand more money in order to adjust to high cost of living.
Expected inflation affects wages and prices because future prices rise
reduce amount of goods and services that today’s wage settlement could
buy. Therefore if people expect inflation their behaviour can lead to
inflation.

CAUSES OF INFLATION
Causes of inflation can broadly be categorized into two: -

1. Cost push inflation.

Cost push inflation occurs when there is an increase in the cost of
production, that is, an increase in prices of factors of production which will
have a tendency of pushing up the general price level of goods and
services. Hence, it is associated with supply and/or cost side of the
market. Cost-push inflation is specifically caused by the following factors:

(a) Increase on wages: When higher wages are paid without a

corresponding increase in productivity, this could cause inflation. An
increase in wage could be due to trade union pressures. Since wages form
a significant part of total cost in production process, any increase in
wages which is not compensated for by increase in productivity will result
in higher cost which will be passed on to consumers as producers seek to
maintain their level of profitability. As a result, there would be a general
increase in prices of goods and services.

(b) Increase in import prices: This could occur when there is an

increase in price of an important import commodity such as crude oil. This
could result to escalating of prices throughout the economy since oil is
often associated with many processes of production. An increase in crude

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oil prices occurred in 1973/74 and 1979/80 when the oil prices
quadrupled (increased in four fold). Import prices may also rise due to
devaluation of currency or depreciation of the exchange rate. This type of
inflation, which is associated with price of import, is referred to as
imported inflation.

(c) Increase in indirect tax: An increase in indirect tax imposed by the

government may also cause cost-push inflation because imposition of
expenditure taxes such as VAT may lead to increase in general price level
of goods and services. However, this will depend on the price elasticity of
demand of a commodity.

(d) An increase in prices of raw materials: This can also lead to cost
push inflation.

2. Demand-pull Inflation.
Demand-pull inflation is also referred to as excess demand inflation
and it occurs when aggregate demand persistently exceeds aggregate
supply at current prices. Since the excess demand cannot be met in the
real terms, the natural market respond is for the prices to rise to a new
equilibrium. All these will depend on the elasticity of demand and also on
the elasticity of supply, since if firms cannot respond to changes
immediately by expanding output a situation of excess demand exist and
inflation will result.

Firms may be unable to respond to demand because of their inability to

obtain adequate resources to meet the demand with the necessary time
period. Because of this resource constraint phenomena there will be no
production leading to shortage and scarcity of goods and services and
hence increasing the general price levels.

Demand-pull inflation may specifically be caused by the following factors:

(a) A general increases in the level of demand for goods and services.
This occurs in a situation of near full employment

(b) Shortage of goods and services due to natural calamities/disasters

such as floods, drought, earthquakes, tsunamis, war etc.

(c) A country trying to achieve an export surplus. Situation because

exports generate foreign exchange at home while reducing production of
goods to be consumed domestically.

(d) Foreign currencies inflow cause increases in money supply since

eventually the domestic currency has to be been issued by the central
bank to exporters. This inflow becomes a source of inflationary pressures.

(e) The expansion of government spending by the borrowing from the

public system especially where there is no match with output could also
result to demand pull inflation. Government borrows from time to time to

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finance shortfall of revenue against expenditure (i.e. budget deficit). This
is referred as deficit financing. If the government borrows directly from
the central bank this will increase money supply because central bank will
simply “print” money, leading to an inflation type referred to as credit
inflation.

MEASUREMENT OF INFLATION
Inflation is measured through: -

1. Consumer Price Index (CPI)

CPI is an index number of prices of commodities. It measures the relative
changes in the prices of a specified set of consumer goods, which will be
bought while an average household on a regular basis. The basket may
consist of commodities such as food, beverages, housing, transportation,
medical care, Kerosene etc. The weights in the index are based on the
survey that it relates to the present day buying patterns. Commodities
representing a large proportion of expenditure will be given more
significant weight in the index.

Advantage of CPI
 Since it is a measure of inflation, it is reliable measure of the cost of
living.

Disadvantages
 Since it is a fix weight index it does not allow the substitution effect
where the consumers may, for instance, select a substitute whose price
has experienced a relatively smaller increase.
 The quality of goods changes such that a price increase may reflect
improved quality rather than inflation and therefore CPI may sometime
overstate price increase.

KASNEB PAST PAPER QUESTION

June 2003 Question 1(a):
(a) Explain the following concepts clearly indicating advantages and
disadvantages of using the concepts when making economic and
business decisions.
(iii) Consumer price index. (5
marks)

2. Produce Price Index (PPI)

PPI may be used to measure the prices that business organizations or
firms pay in large volume wholesale market. The PPI is an index of prices
charged by businesses for raw materials, intermediate goods, finished
goods etc. Prices of (PPI) producer price Index are weighted just like in
CPI.

MEASUREMENT OF INFLATION IN KENYA

In Kenya, measurement of inflation is classified in the following four ways:

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(1)Month-on-month Inflation: It refers to inflation over a period of 12
months for example between March 2005 and March 2006.

(2) Average Annual Inflation: It refers to the average of the month-on-

month inflation over the last 12 months.

(3) Three-month Annualized Inflation: It refers to month on month

inflation that could have been generated if inflation in the last 3 months
were to be maintained through out the year, that is, remain constant.

(4) Underlying Inflation: It refers to changes in general price level that

include changes, in prices of food and any other once and for all price
changes. It normally reflects the influence of monetary expansion on
prices.

EFFECTS OF INFLATION.
Creeping or moderate inflation is healthy for economic growth as it may
lead to more investment and therefore generation of employment.
However, most of the effects of inflation are adverse, undesirable or
unfavourable for the economy as discussed below: -

(1) Effects of inflation on investment.

The effects of inflation especially rapid and galloping are unfavourable
to investment because they increase uncertainty and thus affecting plans
of investors.

(2)Effects of inflation on the functions of money

(a) Money is supposed to be a medium of exchange. However
during inflation, especially galloping inflation, people prefer to
exchange goods for goods because money looses its value and
people have no confidence with the currency as a medium of
exchange.

(b) Money is supposed to be used for deferred payment. However,

during inflation debtors gain as creditors loose because money
value keeps on falling.

(c) Money is used as measure of unit of a value that is we can

compare the value of two commodities with reference to their
prices. However, during the time of inflation it is difficult to
compare the value of two commodities because their price keeps
on changing.

(d) Money is used as a store of value, that is we can sell a

commodity and convert its value inform of money, however
during inflation people prefer to store the value of their wealth in
terms of capital goods because the value of money keeps on
falling.

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 (e) Money is used to move immobile property from one
geographical region to another for example selling a house in
one geographical location and buying a similar house in a
different geographical location. However, during inflation it is
difficult to move immobile property from one geographical
location to another because the value of money keeps on falling
due to increase in general price levels.

(3)Effects of Inflation on Employment.

During inflation especially cost push inflation, many firms will try to cut
down labour cost which will result to actions such as retrenchment,
downsizing, etc, all which will lead to unemployment. Similarly, since
inflation discourages investment the ability of the economy to create
more jobs is hampered.

(4)Effects of Inflation on Exchange Rate and Balance of Payment.

During inflation foreign countries avoid trading with the country which is
affected by inflation in order not to be affected by imported inflation. As
a result, its domestic currency will depreciate vis-à-vis other foreign
currencies. When a country is facing inflation it also suffers from balance
of payment deficit because it may not be producing much goods for
export, especially if it is suffering from the cost-push inflation.

(5)Effects of Inflation on Distribution of Income.

Inflation leads to an arbitrary redistribution of income whereby those
whose income are fixed in monetary terms experience a fall in real
income while debtors gain and creditors loose during the period of severe
inflation.

(6)Effects of Inflation on Cost of Living.

During inflation there is a high cost of living due to increase in price levels
especially of basic commodities and as a result there will be a fall in the
standard of living, and this will worsen especially if an economy is already
suffering from abject (absolute/extreme) poverty.

(7)Effects of Inflation on Interest Rates.

A high rate of inflation has a negative effect on interest received on
savings. This is because real interest rate is calculated by subtracting
the prevailing inflation rate from the nominal rate of interest. For
example if the nominal rate of interest is 12% per annum and the rate of
inflation is 15%, then there would be a negative real interest rate
because real interest rate = Nominal interest rate less/minus inflation
rate. Thus: 12% - 15% = -3%.
Therefore, the higher the rate of inflation, the lower the real interest rate.

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Other effects.
 It leads shoe leather cost: This refers to a situation whereby
consumers move from one producer to another searching for
favourable prices because price levels keep on increasing.
 Menu cost: It refers to situation whereby consumers keep a lot of
money, as they can not plan since the general price level keeps on
increasing, making it difficult to make an accurate prediction.
 Social problems such as high crime rate, immorality, war between
rich and poor and political revolutions, all can occur during the period
of severe inflation.

MEASURES TO COMBAT INFLATION.

Methods applied to control or minimize inflation depend on its causes.
This means different policy measures will be applied depending on
whether the economy is suffering from Demand-pull or Cost-push
inflation. Basically, the two policy measures applied to combat inflation
are:

(1) Monetary Policy.

In case an economy is experiencing demand-pull inflation monetary
policy measures which are aimed at regulating and controlling money
supply will be applied in the following ways:

 The restriction of direct lending. To the government whereby the

central bank will ensure that Government doesn’t borrow from the
bank beyond the legally permitted limit.
1. Increase in cash or liquidity ratio requirements on commercial
banks and other financial institutions and thereby reducing their
ability to create credit and hence money supply, which brings down
level of inflation.
2. Raising the rate of interest or the cost of borrowing through the
sell of treasury bills in open market operations interest rates on
treasury bills influence commercial banks base lending rate. This will
reduce money in circulation and hence reducing inflation.
3. For those banks that may result to central bank for overnight
borrowing, the central bank aims to ensure that the interest rate
charged on such loans are punitive (i.e. punishing or discouraging).
This will ensure that they don’t have excess cash and this will bring
down the level of inflation.
4. The central bank requires the Commercial Banks to deposit
special deposits with them.
5. OMO-open market operation. sell securitizes

6. Other methods.
- Selective credit control.
- Persuasion.
- Directives.

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(2) Fiscal Policy
How is fiscal policy applied to combat inflation caused by demand-pull?
Fiscal policy measures to combat such kind of inflation include:
 Raising taxes in order to cut consumers disposable income and hence
their level of spending.
 Lowering government expenditure.
 Lowering government budgetary deficits in order to discourage
domestic borrowing. Disciplined management of public finance is a
vital weapon in the fight against budgetary deficit. Similarly, the
government should avoid borrowing from the central bank as this
simply means printing paper money, which might result to credit
inflation.

In case of cost-push inflation, the following measures may be

applied:
 Where the increase on general price level is as a result of high wages,
steps may be taken to encourage greater productivity in the
industry and to apply controls over wages and price increases.
 In case cost-push inflation is as a result of increase in import prices
such as oil or crude oil steps may be taken to reduce the quantity of
such imports and probably by looking for alternative and cheaper
sources of supply.
 The Government may also reduce taxes on imported raw
materials or intermediate goods such as crude oil, capital goods
etc, which are used for further production in an attempt to reduce the
prices of factors of production which causes cost-push inflation.
(3) Other Measures
 Price control can also be used to control inflation as non-monetary
and non-fiscal policy measure.
 Wage Flexibility is considered to be a crude method of controlling
inflation where the government deliberately decides to reduce the
wages of public servants with the objectives of controlling wage
induced inflation. This method if adopted can result into a lot of
revolution because trade unions will resist. As a result, retrenchment or
downsizing of civil servants is considered as the best alternative

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THE CONCEPT OF INFLATIONARY AND DEFLATIONARY GAPS

(1) Inflationary Gap: It is said to exist when the aggregate

expenditure/demand exceeds the maximum attainable level of output
(national income), which will result to an upward pressure on prices. The
concept of inflationary gap can be illustrated with the help of the following
diagram.

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 Y = C + I (National
Income)
Aggregate demand

Full employment

AD (Aggregate demand
(Expenditure)

Inflationary
gap

450

Yf Ye

National Income

In the above diagram Yf is full employment level where resources achieve

the maximum attainable level of output. On the other hand, Ye is the
equilibrium level of national income which is greater than full employment
level of income, Yf. As a result, there is an inflationary gap, which is
associated with upward pressure on prices.

Appropriate fiscal policies would be applied to combat this demand pull

inflation. This may be a reduction on government spending or increase in
taxation with the objective being to reduce aggregate demand by the full
amount of inflationary gap.

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KASNEB PAST PAPER QUESTION
May 2004 Question 5(a):
(i) What is the meaning of the term “inflationary gap”? (4 marks)
(ii) With the aid of a diagram, explain the way in which fiscal policy can be
used to correct such a gap in (i) above. (6 marks)

(2) Deflationary Gap: This refers to a situation where aggregate

demand is less than the level of the national income that would ensure
full employment. As a result, there would be a tendency for prices to go
down. This concept can be illustrated in the following simple diagram:

Full employment
Y = C + I (National
Income)
Aggregate demand

Deflationary
Gap AD

450
Ye Yf National Income

A deflationary gap can be treated with an increase on the government

spending or by a reduction on taxes.

KASNEB PAST PAPER QUESTION

Dec 2008 Question 2:
(a) Define the term "deflationary gap" (2
marks)

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(b) Briefly describe the causes of a deflationary gap in an economy. (6
marks)

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