What is Inflation
This refers to the persistent increase in the general price level of goods and services in an economy in a given period of time..
OR Inflation is defined as the persistent and continuous increase the general price level of goods and services in an economy in a given period of time. For a condition or situation, to be referred to as inflation; price must be increasing but not necessary high.
- The increase in prices must be persistent.
- The increase in prices must be for all or most of the commodity.
- Inflation measures the value of money and it is measured with respect to time. When prices of commodities increase, the value of money falls and when prices of commodities decreases, the value of money rises.
Value of money refers to the amount of goods and services a unit of money can buy from the market e.g. if a student has shs. 1000 and buys 2 pens, then the value of money is expressed in terms of the two pens bought.
Measurements Of Rate Of Inflation
The rate of inflation in an economy can be measured by the use of price indices.
Rate of inflation =current year price-base year indices *100
Base year price index
If the computed price index =108, then the rate of inflation
If the computed current year price index is 95, then
Rate of inflation=95-100*100
This implies that the general price level of goods and services has fallen this is what is referred to as deflation.
This is the persistent decrease in the general price level of goods and services in an economy.
States of Inflation/ Classification
This refers to the speed at which the general price level of goods and services is increasing. There are two major states of inflation
Mild/ creeping/Gradual inflation
This is where by the persistent increase in the general price level of goods and services proceeds at a very slow rate which is usually less than 10%
This state of inflation is desirable for an economy and it has good number of advantages.
This is where by the general price level of goods and services an economy is increasing at a very high rate usually 10% and more. Usually this state of inflation is undesirable for an economy and it has a number of disadvantages.
This type of inflation greatly reduces the value of money in the short period of time.
Theories Of Inflation
These theories explain the cause of the different types of inflation.
The demand pull theory of inflation.
This explains that inflation in an economy is caused by excessive aggregate demand for goods and services over the aggregate supply at full employment level of resources. Excessive aggregate demand, which is not matched with supply results into increase in price hence inflation.
The cost-push Theory of inflation.
This explains that inflation in an economy is brought about by rising costs of production. Due to increased costs of production, producers have to increase prices of their goods in order to maintain their profit margin hence leading to an inflationary situation.
Structural Theory of Inflation.
This theory explains that inflation in an economy comes about as a result of supply rigidities.
Supply rigidities like natural calamities, political; instabilities, breakdown of the country’s infrastructure etc. hinder production of goods and therefore lead to an increase in prices.
Speculative Theory of inflation.
This explains that inflation in an economy comes about as a result of speculative tendencies in an economy by the producers or consumers .
If producers predict that prices are going to increase in the near future, they hoard goods which results into shortages and hence increase in prices.
In the same way, if consumers predict that prices are going to increase drastically in the near future, they may increase their purchase in the current period resulting into excess demand and thus increase in prices of goods and services.
Monetary Theory of Inflation.
This explains that inflation in an economy is caused by increases in the money supply which is not accompanied by the corresponding increase in production of goods and services .
Excessive money supply results into a situation where there is too much money purchasing few goods and services hence the increase in prices.
Types and Causes of Inflation and the Solutions
Demands pull inflation. This refers to the persistent increase in the general price level of goods and services in an economy which is brought about by excessive demand for goods and services over the aggregate supply in an economy at full employment level of resources. OR
Demand pull inflation is one that arises out of excessive aggregate demand over aggregate supply (at full employment of resources).
Demand pull inflation is caused by factors that lead to an increase in aggregate demand for goods and services in an economy.
Causes of demand pull inflation.
- Excessive issuance and printing of a country’s currency by the central Bank . This leads to an increase in the amount of money in circulation which increases peoples purchasing power and aggregate demand for goods and services.
- -Excessive government expenditure. This also increases the money supply, people’s purchasing power and aggregate demand for goods and services.
- -Excessive inflow of incomes from abroad. This leads to an increase in aggregate demand for goods and services.
- -Uncontrolled credit creation by the commercial banks. This increases the level of lending which increases the amount of money in circulation and aggregate demand.
- -Excessive borrowing by the government from the central bank .this also leads to an increase in government expenditure which increases the amount of money in circulation and thus results into increasing aggregate demand.
- Excess demand for the country’s exports especially by the neighboring countries. This creates shortages of these goods in the country. As the goods become scarce, the prices increase.
- Excessive wage increase.
It can be controlled/ solved by the use of measures that reduce/ control aggregate demand in addition to other measures.
- Increasing direct taxes on income.
- Reducing government expenditure.
- Use of a restrictive monetary policy e.g. sale of treasury bills and bonds to the public.
- Reduce government borrowing from the Central Bank.
- Use of wage control measures to prevent wage increases e.g. wage freeze and wage restraint. NB: Wage freeze is the legally backed government policy of keeping wages at a specific level for a specified period of time so as to control inflation.
Wage restraint is a voluntary restriction of wage increases by employers and trade unions so as to check/ control inflation.
Use of price controls especially maximum price legislation where prices can’t go above those set by the government.
However, price controls result into suppressed inflation.
This is one where aggregate demand for goods and services is greater than aggregate supply but when increases in the prices have been prevented by measures like price controls, rationing of goods.
This is one which occurs when aggregate demand exceeds aggregate supply but the government minimizes it by using price control and rationing of goods. 1a) Distinguish between cost push and demand pull inflation.
b) Mention two causes of demand pull inflation in your country.
2a) Distinguish between deflation and reflation.
b) Mention two instruments of reflationary policy. 3a) Distinguish between creeping and runaway inflation.
b) Give two policy instruments for controlling inflation in your country.