TOPIC 12: INFLATION:

INFLATION; this refers the persistent increase in the general price level of goods in an
economy in a given period of time.

STATE OF INFLATION; this refers to the speed at which the general price level is rising.
This has two categories;

• Mild /Creeping/Gradual inflation; this is a state of inflation whereby the persistent increase in
the general price level proceeds at a slow rate below 10%.

• Hyper /Run-away/Galloping inflation; this is a state of inflation where the general price level
increases at a very high rate, which exceeds 10%.

TYPES OF INFLATION/ THEORIES OF CAUSES OF INFLATION:

DEMAND-PULL INFLATION; this refers to persistent increase in the general price level that
arises due to excess aggregate demand over aggregate supply.

Causes of demand-pull inflation

1. Excessive issuance of currency
2. Excessive recurrent government expenditure on non-productive activities
3. Excessive inflows of incomes
4. Excessive credit creation

MEASURES THAT CAN BE TO CONTROL DEMAND-PULL INFLATION:

1. Control wages
2. Reduce government expenditure on non-productive activities
3. Increase direct taxes
4. Apply restrictive monetary policy
5. Set maximum price.

STRUCTURAL/BOTTLENECK/ SCARCITY INFLATION; this refers to persistent increase

in the general price level due to supply rigidities in the economy leading to a decline in the supply
of goods.

Causes of structural inflation:

1. Infrastructural breakdown
2. Political instability
3. Unfavourable natural factors
4. Scarcity of raw materials
5. Shortage of foreign exchange

Measures that can be to control structural inflation in the economy

1. Modernise agriculture
2. Improve infrastructure
3. Ensure political stability
4. Ease the acquisition of raw materials.

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 IMPORTED INFLATION; this refers to the persistent increase in the general price
level arising from the importation of goods from countries experiencing inflation.

MONETARY INFLATION; this refers to the persistent increase in the general price
level caused by excessive increase in money supply in the economy.

COST-PUSH INFLATION; this refers to persistent increase in the general price level
that arises out of increasing costs of production.

Cause of cost push inflation in an economy;

1. Increasing costs of raw materials
2. Increasing wages
3. Increasing cost of transportation
4. Increasing level of taxes on goods
5. Increasing interest rate
6. Increasing costs of advertising

Measures that can be taken to control cost push inflation in the economy

1. Subsidise producers.
2. Control wages
3. Control interest rate
4. Set maximum price

Concepts related to cost push inflation

Price-wage inflation/ inflationary spiral; this refers an increase in the general price level due to
an increase in cost of production induced by workers demanding for higher wages as cost of
living increases.

Wage- price inflation; this refers to an increase in the general price level due to increase in cost
of production as workers’ demand for higher wages which forces employers to increase prices of
goods to maintain the profit margin.

Wage –wage inflation; this refers to the increase in the general price level due to an increase in
cost of production following increase in wages in various sectors sparked off by wage increase in
a particular sector.

GENERAL CAUSES OF INFLATION IN DEVELOPING COUNTRIES:

1. Excessive issuance of currency; this increases money in circulation which increases
aggregate demand forcing prices to rise.

2. Excessive credit creation by commercial banks; this increases money in circulation which
increases aggregate demand forcing prices to rise.
3. Excessive borrowing from the central bank by the government; this increases money in
circulation which increases aggregate demand forcing prices to rise.
4. Excessive inflow of incomes; this increases money in circulation which increases aggregate
demand forcing prices to rise.

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5. Excessive government expenditure; this increases money in circulation which increases
aggregate demand forcing prices to rise.

6. Poor political climate; this destroys productive infrastructure and scares away
investors due to fear of loss of lives and property, which limits production forcing prices to
rise.
7. Unfavourable natural factors; these destroy crops and animals which reduces agricultural
produce forcing prices to rise.
8. Break-down of infrastructures; this limits distribution of goods to areas of scarcity causing
shortages forcing prices to rise.
9. Excessive exportation of essential goods; this causes shortage of essential goods forcing
prices to rise.
10. Speculation by traders and consumers; people anticipate that there is likely to be shortage
of goods which makes the traders to hoard them forcing prices to rise.
11. Greed for higher profits by traders; they deliberately increase prices of their goods in order
to increase the profit levels.

12. Importation from countries experiencing inflation; this forces importers to increase prices
of such goods in order to cover the high costs of importation.
13. Rising production costs; the producers are compelled to increase the prices of goods in order
to cover the rising cost of production.
14. Depreciation of the local currency; this makes importation expensive which forces the
importers to increase prices of imported goods.

MEASURES THAT CAN BE TAKEN TO REDUCE INFLATION IN AN ECONOMY:

1. Reduce government expenditure on non-productive activities; this will reduce

money supply which will reduce aggregate demand and thus force prices to fall.
2. Control issuance of currency; this will reduce money supply which will reduce aggregate
demand and thus force prices to reduce.
3. Use restrictive monetary policy; this will reduce money supply which will reduce aggregate
demand and thus force prices to fall.
4. Reduce government borrowing from the central bank; this will reduce money supply
which will reduce aggregate demand and thus force prices to fall.
5. Improve infrastructural facilities; this will ease distribution of goods to areas of scarcity and
minimise shortages and thus force prices to fall.

6. Liberalise the economy; this will remove unnecessary restrictions on economic activities
which will increase supply of goods and thus force prices to fall.

7. Privatise state enterprises; this will increase efficiency in the management of such privatised
enterprises which will lead to increased production and thus force prices to fall.
8. Ensure political stability; this will promote investment since investors will not be scared of
losing their lives and property which lead to increased production and thus force prices to fall.
9. Modernise agriculture; this will ensure continuous production due to use of irrigation
farming which will stabilise supply of goods and thus force prices to fall.

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10. Provide investment incentives; this will reduce the cost of production and attract more
investors to increase production which will force prices to fall.

11. Encourage importation from cheaper sources; this will minimise imported from countries
experiencing inflation.
12. Establish import substitution industries; this will increase domestic production which
minimise importation of goods from countries experiencing inflation.

13. Control the exportation of essential goods; this will ensure large domestic supply of
such essential goods and thus force prices to fall.

14. Increase direct taxes; this reduce will people’s disposable income and purchasing power
which will force prices to fall.

POSITIVE EFFECTS INFLATION

1. It stimulates effort and hard work; people are compelled to work hard in order to earn
income and cope with rising cost of living.
2. It promotes investment; this is because the high profits attract more investors to do business.
3. Promotes economic growth; people produce more in order to enjoy the high profits.
4. Promotes creation of employment; the high profit levels attract investors and set up more
firms.
5. It widens the tax base; the government taxes the high profits and incomes of individuals.

6. It promotes resources utilisation; the high profits increases investment and hence a rise in
demand for raw materials and other inputs.
7. It promotes entrepreneurship; many people are enticed to start businesses and make profits.

8. Debtors gain in real terms; this is because they pay back in a currency which has lost value.

9. It promotes commercialisation; this is because people are enticed to produce more for the
market and make more profits.
10. It promotes labour mobility; people move to more paying jobs in order to cope with the
rising cost of living.

Note; the positive effects apply only to mild inflation.

NEGATIVE EFFECTS OF INFLATION

1. It discourages savings; this is because people spend most of the money on consumption and
they remain with little or nothing for saving.
2. It leads to loss of confidence in the currency; this is because the currency loses value very
fast and people discard it in preference to foreign currency.
3. It worsens the balance of payment problem; this is because it makes exports expensive
which reduces their demand and thus a fall in foreign exchange earnings.

4. It leads to industrial unrest; this is because workers continuously demand for wage increase
so as cope with the rising cost of living.
5. It worsens income inequalities; producers earn more profits from the increasing prices and
become richer while consumers buy goods expensively and become poorer.
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6. It discourages investment; this is due to high cost of production which reduces the profit
levels.
7. It leads to unemployment; this is because some firms collapse due to the high cost of
production and people are laid off.
8. It makes the government unpopular; the public blames the government for not doing enough
to stop the rising prices which make them suffer.

9. It leads to production of poor quality goods; this is because the producers leave out some
the ingredients to cut costs of production.

10. It makes planning difficult; this is because of the rising cost of production which compels
people to redraw production plans or even abandon them.
11. The fixed income earners lose; this is because as prices rise, their real incomes fall which
make them abandon certain goods because they are too expensive.

12. Discourages lending; this is because creditors receive back less in real terms due to continued
loss of money value.
13. It promotes illegal activities; this is because people want to raise money and cope with rising
cost of living.
14. Strains the public; this is because people work very hard to increase incomes in order to cope
with the rising cost of living.
15. It leads to brain drain; this is because the highly trained people migrate to other countries to
seek employment and better standard of living.

Note: the negative effects apply only to hyperinflation

CONCEPTS RELATED TO INFLATION:

DEFLATION; this refers to persistent decline in the general price level of goods due to
a fall in aggregate demand in an economy.
Measures that can be taken to control deflation
1. Use expansionary monetary policy
2. Increase government expenditure
3. Reduce direct taxes
4. Subsidise consumers
5. Increase wages
6. Encourage exports
7. Discourage imports.

REFLATION; this refers to a deliberate government policy to force prices upwards in order
to help an economy to recover from an economic depression.

Instruments of a reflationary policy in an economy include;

1. Reduce direct taxes
2. Increase in government expenditure
3. Encourage exports
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4. Discourage imports
5. Use expansionary monetary policy
6. Increase wages
7. Subsidise consumers

DIS-INFLATION; this refers to policies undertaken by the government to control inflation

SUPPRESED INFLATION; this is a situation where the government reduces the inflation
rate by setting maximum price

HEADLINE INFLATION; this measures changes in the price levels of all goods in
a given country over time.

UNDERLYING/CORE INFLATION; this measures changes in the price levels of

goods excluding the value of foodstuffs in a given country over a given period of time.

STAGFLATION; this is a situation in an economy in which high rates of inflation co-

exists with high rate of unemployment