INFLATION

Prepared by:
Amna Asim
Definition of Inflation

• Inflation is the persistent increase in the general price level of

goods and services in an economy over a given period of
time. Fewer goods and services are bought when price levels
rise hence the reduction in purchasing power. Also, the main
measure of inflation is the inflation rate. The inflation rate is the
percentage change in a price index. Unlike deflation, inflation is
caused by:
• The increase in the money supply faster than the economic growth can
sustain; or
• The injection of large amounts of money into the economy.
Advantages of Inflation

• Reduction in the amount of real private and public debt;

and
• Increased employment because of nominal wage
rigidity.
Limitations of Inflation

• Increased opportunity cost of holding money;

• Discourages savings and investments; and
• Consumers begin amassing goods in fear of future prices rising.
Hyperinflation

• Hyperinflation is an extreme case of inflation where the inflation

rate increases above 100%. During hyperinflationary periods,
the price level increase by about 500% to 1000% per year.
Here, prices cannot be controlled.
• Hyperinflation happens when there exists a significant rise in
money supply not supported by economic growth. As a result,
the supply and demand for money are at a disequilibrium.
Causes of Hyperinflation

• An imbalance between money demand and supply;

• Excess printing of currency by the central bank; and
• When people lose confidence in their country’s currency.
Effects of Hyperinflation

• Borrowers gain at the expense of lenders; and

• The public transfers wealth to the government.
Deflation
Definition:
• Deflation is a decrease in the price level due to a reduced supply of
money in an economy. Although it raises consumer’s purchasing
power, deflation may have negative outcomes on economic stability
and growth. During a period of deflation, the inflation rate falls below
0%.
Causes of Deflation
• Reduced money supply; or
• Increased economic productivity, which results in having more goods
produced than there is demand for.
Effects of Deflation
• It discourages expenditure and investments; and
• It decreases aggregate demand.
Disinflation

• Whereas deflation is negative economic growth, such a -5%,

disinflation is simply a reduction in the rate of inflation, such as
the inflation rate going from 9% one year to 7% the next year. It
occurs when the rate at which the prices are raising is
diminishing.
• It is important to note that it does not signal the slowing down of
the growth of the economy; it signals a slow in the growth rate
of inflation.
The Construction of Indices used to
Measure Inflation
• Since inflation has the most impact on the general price level of
an economy, it is tantamount to measure inflation using a price
index. As such, it is important to understand how a price index
is modeled so that inflation rates derived from a price index can
be precisely elucidated. This is because inflation is weighed as
the percentage change in the price index.
Price Index
• The steps necessary for creating a price index include:
1.Identify what kind of index you want to develop (yearly, monthly, or
weekly).
2.Identify the basket of goods or services for both the previous year
and the current year, assuming we are interested in a yearly price
index of a particular good.
3.Calculate the general price level of the previous and current year,
respectively.
4.The price index for the base year is then set to be 100. Calculate the
price index for the current year (the observation year).
5.Finally, the inflation rate is the price index for the current year
divided by the price index for the base year minus 1.
A price index demonstrates the average prices of a collection of
goods and services. The majority of the price indexes around the
globe use the Laspeyres method. It’s most common because the
survey data on the consumption market is available with a lag.
However, other methods such as the Paasche and Fisher
methods are also used.
Laspeyres Price Index
The Laspeyres price index measures the change in the price of the
basket of goods relative to the base year weighting. It is given by:
Paasche Price Index
The Paasche Price index measures the change in the price and
quantity of basket of goods and services relative to base year
price and observation year quantity. It is given by:
Fisher’s price index
Example of Construction of Indices used
to Measure Inflation
Consider the following table showing the prices and quantities of Slice
bread and Rice in the years 2017 and 2018.

Quantity (2017) Price per Quantity Quantity (2018) Price per Quantity
(2017) (2018)

Sliced Bread 52 $2.59 51 $2.62

Bag of Rice 36 $0.89 38 $0.85

Calculate the Laspeyres, Paasche, and Fisher price indices and

inflation rate taking 2017 as a base year.