INFLATION NOTES

Inflation can be defined as the persistent increase in the general prices of a basket of goods and
services in a country or region over a period of time. 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). CPI is an index that measures the
cost of buying a fixed basket of goods and services representative of purchases of consumers.
The 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 AND CAUSES 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.

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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
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.

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 iii. Increase in money incomes
If money incomes increase due to reasons such a 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
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.

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 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 subsidies
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
Inflation has a number of have on businesses, demand and consumer confidence. These effects
can either be positive or negative as discussed below:

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 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.

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 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
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 policy 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:

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 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. Compulsory deposits-The central bank increases compulsory deposits by commercial
banks to curb inflation
8. 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:

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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.
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
individuals purchasing power and a fall in prices.
3. 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.
4. 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) Control of the Level of demand
The solution to demand-pull inflation is to reduce the level of demand in the economy as
whole. The government can achieve this by using the following two fiscal policies:
 Changing in taxation-An increase in tax such a income tax would reduce consumer
demands for goods and services.
 Reducing government spending-Government spending is an injection into the economy.
If it is restricted the amount of money in circulation would reduce thereby reducing
demand to commodities.

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 f) 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 can 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
 A persistent unfavorable 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.

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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.
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.

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

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

Inflation %

(W)

Unemployment % (U)

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