INFLATION AND DEFLATION
Definition of Inflation:
Inflation is the
continuous rise in the general price level of goods and services.
TYPES OF INFLATION
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| Senathon Ipia (+234 7052802574) |
Here, we describe types of
inflation based on what causes them.
1. Demand-Pull inflation
This inflation is due to increase
in aggregate demand for goods and services. Demand-pull inflation occurs when
aggregate demand is more than aggregate supply, resulting in prices increase.
That is, demand-pull inflation arises from excess demand over supply.
Normally, when demand exceeds supply, producers/sellers would raise prices of goods/services.
What triggers demand-pull inflation is therefore consumers activities – demand – it is inflation caused from the demand side.
Demand-pull inflation occurs
during the period of economic boom – when trade activities are high because of
economic prosperity.
2. Cost-Push Inflation
This occurs when there is
increase in cost of production, which makes producers to sell at higher prices
to consumers and/or reduce supply of goods and services. Factors that contribute
to cost-push inflation are: rising wages to company workers, increase in cost
of raw materials, increase in corporate taxes, etc.
Cost-push inflation means that the prices of factors of production have increased, resulting in rise in production cost.
So, what triggers cost-push inflation is producers activities - supply - it is inflation caused from the supply cost side.
3. Creeping
Inflation
This is a slight or small
rise in general price level, about 3% rise a year or less. Creeping inflation
is also known as mild inflation. This type of
inflation is beneficial for economic growth.
It drives economic expansion.
4. Galloping Inflation
This is when general price level rises to 10% or more but less than 50%.
5. Hyperinflation
This is when general price level rises to more than 50%
CAUSES OF INFLATION
(i) High level of Demand:
Inflation could arise as a
result of demand-pull effect. As demand consistently rises, producers/sellers
take advantage of it to increase prices resulting in inflation.
(ii) Rise in production cost
Inflation could also arise
as a result of cost push effect. When cost of production increases, producers
transfer the extra cost to consumers by increasing prices, resulting in
inflation.
(iii) Increase in money supply
When the Central Bank puts
more currency notes into circulation in the economy without increase in output
of goods and services in the economy, more money would be chasing the same quantity of
goods/services. And when those who produce/sell goods/services notice this,
they raise prices.
(iv) Increase in government expenditure
A rise in government
expenditure in the country would increase the amount of money in the economy,
meaning more money would be chasing the same quantity of goods/services,
resulting in rise in prices.
(iv) Weakening Foreign Exchange Rate with High Dependence on
Imports
When your home currency
keeps declining in value vis-à-vis other currencies, imports become more expensive,
resulting in inflation in your country, especially if the economy depends
largely on imports. The inflation in Nigeria
in year 2016 and early 2017 was due to weakening exchange rate, because Nigeria
Note:
Foreign exchange (or FX, for short) is the exchange of one currency for
another, that is, the buying and selling of currencies. And foreign exchange
rate is the rate at which one currency exchanges for another. For example, the
exchange rate of the naira to the dollar on August 14, 2017 was $1= ₦304.60
THEORIES OF INFLATION
Theories of inflation are
an attempt to explain what causes inflation. Demand-pull inflation and Cost-push
inflation are identified in these theories.
According to these
theories, if aggregate demand exceeds
aggregate supply, then price level would go up, meaning demand-pull inflation.
But if aggregate supply falls due to increase in
production cost and aggregate demand does NOT fall, then price level
would go up, meaning cost-push inflation.
Frankly speaking, demand
and supply are the underlying causes of inflation. Usually, inflation would
occur if:
1. the supply of money (local currency) goes up – too much money
in circulation
2. the supply of goods goes down – by this, demand would exceed
supply
3. demand for goods goes up – if supply DOES NOT increase, demand
would exceed supply, by this.
From the foregoing, it is
clear that, with all other things being equal (i.e. ceteris paribus), inflation
is caused by change in demand and supply.
Consider the inflation in Nigeria
The fall in supply of the
dollar in Nigeria with the demand remaining as before resulted in excess demand, making
the “price” or value of the dollar to rise in Nigeria Nigeria Nigeria
Even prices of locally made
goods increased as well. Why? Because each producer/seller had to increase
prices for his/her own goods/services. It became somewhat like this: “if they
increase their prices, I will increase my price too”.
Note :
Excess demand means that DEMAND exceeds
SUPPLY. Similarly, excess supply
means that SUPPLY exceeds DEMAND.
MEASURING INFLATION (BY USING PRICE INDEX)
Price index is
a measure of percentage increase or decrease in the price of goods or services.
There is price index for the producer, wholesaler, and of course, the consumer.
Of all the three, the most widely used by economic statisticians is the Consumer
Price Index, because consumer price is the final price, and therefore the best
measure of inflation and cost of living. Though the producer price index may be
used to estimate inflation, it is NOT as reliable as the consumer price index.
So, inflation
can be measured by:
(a) Consumer Price Index (More reliable)
(b) Producer Price Index
Consumer Price Index (CPI)
Consumer price
index measures changes in the price level of goods and services, as paid by the
consumer. To measure the CPI, we collect
a number of goods and services and their prices. This sample of goods/services
collected to measure inflation and cost of living is referred to as market
basket.
How CPI Is Measured
We compare cost of market
basket of one year with another year. The year we compare the other one with is
known as base year. For example,
if we compare year 2016 price index with year 2010, then year 2010 is the base
year
What CPI Helps Us to
Determine
v
Inflation, which is measured as percentage increase in CPI
v
Cost of living: how cost of goods/services has increased
Calculating the CPI
Consider the market basket
of four goods. The unit price, quantity and market value for both the base year
(yr 2012) and the current year (yr 2016) are given the table below.
BASE
YEAR
|
CURRENT YEAR
|
|||||
Good
|
Qty
|
unit
price
|
Market value
|
Qty
|
unit
price
|
Market value
|
Bread
orange
Petrol
Biscuit
|
4
3
6
10
|
50
10
97
5
|
200
30
582
50
|
4
3
6
10
|
55
15
145
10
|
220
45
870
100
|
Total
|
862
|
1,235
|
||||
Price Index = Current
year/base year x 100 =
1,235/862 x 100 = 143.3%
This means that the
inflation rate between base year (yr 2012) and current year (yr 2016) is 43.3%.
The price index in the base year is always 100. The percentage by which the current
year exceeds the base shows the percentage of inflation. If the price index of
the current year is less than 100, then it shows deflation.
Since this price index
measures cost of goods to the consumer, it is called consumer price index, CPI.
Producer Price Index (PPI)
This is the measure of
price level from the perspective of the producer. If the producers’ price of
goods/services increases, then the price for the consumer must increase.
Note:
Again, in measuring inflation, the
CPI is more effective than the PPI, because the CPI measures final prices of
goods/services. Prices at the producer level are intermediate prices not final
prices. So, CPI is final prices, but PPI is intermediate prices.
General Effects of Inflation
1. Fall in purchasing power/fall in the value of a country’s
currency: If prices increase and your money does not, then you can only
buy less goods/services. So, fall in purchasing power means that the same
amount of money can now buy fewer goods/services. It also means a fall in the
value of the currency–the Naira or any currency.
2. Rise in cost of living: When prices rise, cost of
living is said to have risen, because it would cost more to still buy the same
quantity of goods/services.
3. Fall in Standard of Living: When the same amount
can only afford less quantity of goods/services than before, then there is a
fall in living standard.
Specific Effects of Inflation
4. On Fixed income earners: Fixed income earners lose because
the same amount can now buy fewer basket of goods. Examples of fixed income
earners are civil servants and
people in paid employment in the private sector.
5. On Profits and Business men:
Profits increase when inflation is due to increase in demand (demand-pull
inflation) but profits decrease if the inflation is due to increase in cost of
production (cost-push inflation), especially if the rise in production cost
cannot be shifted to the consumer. So, businesses/business
men gain during demand-pull inflation but lose during cost-push inflation.
6. On Lenders (creditors) and Borrowers (debtors):
Lenders lose and borrowers gain, because the money would have fallen in value at the time it is paid back.
So, the lender, being the owner of the money loses, as the money is repaid to
him.
7. On Government: The government can gain or lose
with inflation.
Govt. gains as the collector of tax
revenue : If it is
demand-pull inflation, government gains by getting more tax revenue from the
increase in business profits.
Govt gains as a debtor: Government is a
big borrower, so it gains like any other borrower if it repays it debts during
inflation, because the real value of what is repaid would be less than what was
borrowed. So whatever the type of inflation, govt
gains as a debtor. Generally, all
debtors gain during inflation. And govt is always a big debtor.
Govt loses with increase in its spending: One way that govt loses is that it
will have to pay more salaries to its employees for them to maintain their
standard of living.
8. On Foreign Trade: Inflation makes your country’s
exports become expensive, discouraging other countries from buying from your
country, so your exports fall. And your country’s imports rise if prices in the
rest of the world are cheaper than your country.
CONTROL OF INFLATION
How inflation is controlled
depends on what causes it.
1. Inflation caused by Excess Money Supply
The measure to use here is
to reduce money supply. Generally, inflation control approach here is use of monetary policy and/or use of fiscal policy. Both monetary policy and
fiscal policy can be used thus:
(i) Restrictive (contractionary)
monetary policy:
Here, the Central Bank
reduces quantity of money in circulation by increasing commercial banks’ cash
reserve ratio, bank rate, special deposit and selling government securities
such as treasury bills, etc. By increasing cash reserve ratio and special deposit, more money is kept with the financial institution (bank), rather than putting it into circulation. In the same vein, by selling govt securities, govt withdraws money from individuals and businesses (investors) that buy the securities.
(ii) Restrictive (contractionary)
fiscal policy:
Here, the government
increases taxes and reduce its expenditure. By this, the government reduces
disposable income without increasing govt. spending. This would reduce the
quantity of money in circulation.
So, if inflation is caused by high quantity
of money in circulation:
And the Government uses
fiscal policy; it has to reduce the quantity of money in circulation by:
(i) increasing taxes
(ii) budgeting surplus.
This means government spends less than it collected from tax revenue. For example,
govt collected N4 trillion as tax revenue but spent N3 trillion. By withdrawing
N4tn and injecting N3tn, the quantity of money in circulation has reduced.
(Please see the topic: “Fiscal
Policy and Monetary Policy”, in a later lesson).
Note:
i. The opposite of
contractionary fiscal policy & monetary policy is expansionary fiscal
policy & monetary policy.
ii. Disposable income = personal
income minus tax
2. Inflation Caused by Excess Demand
This means that demand
exceeds supply. To curb this inflation, increase supply.
3. Inflation Caused by High Cost of Production
Reduce the cost of
production.
DEFLATION
Definition of Deflation
Deflation is persistent fall in the general level of prices of goods and services.
Measuring deflation
Like inflation, the CPI is
used to measure deflation.
Effect of Deflation
Deflation seems to be of
more positive than negative. So, effects of deflation given here are all
positive.
(i) Money lenders (creditors) gain because money now
has a higher value. When the lender gets back his/her money from the borrower,
the purchasing power of the money would have been higher than when it was lent to
the borrower.
(ii) Increase in exports: If a country has deflation,
prices of its goods/services fall and become cheap, making its exports
attractive to other countries, resulting in more exports.
(iii) Improvement in balance of payments: With more
exports, a country would receive more money from foreign trade than it pays to
other countries in imports.
[Remember balance of
payment is the difference between receipts of money from other countries (from
exports) and payments to other countries (through imports). Every country wants
its receipts from exports to be more than its payment for imports]
(iv) Fixed income earners gain because the same amount
can now buy more baskets of goods.
(v) Increase in the value of a country’s
currency (i.e. increase in value of money) because prices fall.
(vi) Reduction in cost of living: If goods/services
become cheaper, then they now cost less than before. This implies a fall in the
cost of living.
(vii) Increase in standard of living: If the same
amount of money can now buy more goods/services, then more of goods/services
can now be afforded, showing improvement in living standard.
CAUSES OF DEFLATION
(i) Low level of Demand:
If demand falls short of
supply, the result is excess supply, which leads to a fall in prices.
(ii) Decrease in Government expenditure
If government spending
falls, the amount of money in the economy would fall, meaning less money will
chase more goods. This would make producers to reduce prices of their goods.
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