INFLATION

It is defined as the persistent increase in the general price level (prices).

Note:
General Price level implies that a variety of commodity prices are considered, therefore
we cannot talk of inflation by considering one or two commodities.
During inflation, money value falls and as a result people need more money to buy a
certain amount of commodities. Inflation is measured either by use of consumer price
index or by use of the GDP deflator.
Classification of inflation
Inflation is classified according to state or cause.
State of inflation: It refers to the rate at which the general price level increases.
The state of inflation includes:
Creeping / Mild / Gradual Inflation.
This is where the general price level increases at a low rate.
At times the public may not easily notice the price increase and the rise in prices is slow
over a long period of time. This rate of inflation is advantageous in that it motivates
the produces and encourages them to produce more and get more profits while causing
little effect on the consumers’ income and their attitude towards consumption.

Hyper/Galloping/Runaway inflation.
This is where the general price level increases at a high rate/fast rate. The increase
may be in days, hours and weeks. This rate of inflation has a negative effect on the
consumption pattern of the people and it discourages both production and investment.
CLASSIFICATION ACCORDING TO CAUSES/TYPES OF INFLATION /THEORIES
OF INFLATION.
1.DEMAND PULL INFLATION
This is a type of inflation that arises when Aggregate demand exceeds aggregate
supply. It occurs at full employment level of resources. For example as wages of
workers increase they would want to spend their higher incomes on goods but if the
extra goods are not produced, the excess demand will have the effects of increasing
prices. This situation at times can be described as “too much money chasing few
goods”

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 Causes of demand pull inflation.
(i) Excessive government expenditure.
(ii) Excessive issuing of currency by the central bank
(iii) Un-controlled credit creation by commercial banks
(iv) Excessive/increased inflow of incomes from a broad
(v) Increased exportation of essential goods
(vi) Reduced importation of goods
(vii) Hoarding of goods by business men
(viii) Greed for profits by business men/Desire of excessive profits

Solutions to demand pull inflation

(i) Government may increase direct taxes so as to reduce disposable incomes and
reduce the Aggregate demand thus forcing prices to reduce.
(ii) Government may adopt a restrictive monetary policy so as to reduce the amount
of money in circulation thereby reducing Aggregate demand and forcing prices to
fall.
(iii) Government can reduce its expenditure especially on activities that are not
productive in order to reduce the amount of money in circulation and reduce
Aggregate demand hence reducing prices.
(iv) Government may legislate maximum price accompanied by rationing so as
to reduce aggregate demand and prices.
(v) Government should control wages so as to reduce Aggregate demand
/purchasing power and thus reducing prices.
(vi) Government should reduce exportation of essential goods so as to avail
adequate supply in the domestic market.
(vii) Government should increase imports to supplement domestic supply and
ensure adequate supply.
Effects of demand – pull inflation.
Positive effects.
(i) It encourages hard work.
(ii) It encourages innovations and inventions.
(iii) Leads to increase employment opportunities.
(iv) Leads to increase in investment.
(v) Leads to increase resource utilization.
(vi) Leads to increased tax revenue
(vii) Debtors stand to gain

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 Negative effects
(i) It discourages savings
(ii) It worsens BOP position
(iii) Fixed income earners lose
(iv) Creditors stand to lose
(v) It makes planning difficult
(vi) It raises interest rates on loans
(vii) It encourages illegal activities such as smuggling due to shortage of goods
(viii) Government may become unpopular
(ix) It leads to loss of confidence in the country’s currency
(x) It leads to production and consumption of poor quality goods
NB: The detailed explanations can be got from the general effects of inflation

2. COST PUSH INFLATION.

This is a type of inflation that arises out of increase in the cost of production that forces
producers to increase prices of final goods so as to maintain their profits.
OR
Refers to persistent increase in the general price level that arise out of increase in the
cost of production forcing produces to raise prices of final goods so as to maintain their
profits.
The different forms of cost-push inflation include:-
(i) Price-wage inflation.
This is inflation which occurs when prices of commodities are increasing
which makes workers demand for higher wages. This results into increased
production costs which forces producers to increase price of final goods.

(ii) Wage-push inflation.

This is inflation that occurs when workers through their trade unions demand
for higher wages thus forcing producers to increase the prices of their
commodities.

(iii) Wage-wage inflation

This is inflation that occurs when workers demand for higher wages after
realizing that their counter parts in similar firms are paid higher wages.

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(iv) Profit-push inflation
This is inflation that occurs when entrepreneurs due to the need to maximize profits
increase the prices of their commodities.

(v) Raw material-push inflation.

This is inflation that occurs when prices of raw materials increase forcing
producers to increase prices of their commodities.

Causes of cost push inflation

(i) Rising costs (prices) of fuel/energy
(ii) Rising costs (Prices) of raw materials/imported inputs
(iii) Rising wages/salaries
(iv) Rising advertising costs
(v) Increasing interest rates on loans /increasing costs of borrowing
(vi) Rising costs of rent/storage facilities
(vii) Break down of infrastructure
(viii) Increasing prices of commodities makes workers demand for higher wages
which increases production costs and leads to continuous rise in prices of all
commodities (i.e. price-wage inflation).
(ix) Inter-wage comparison of wages among workers. A rise in wages of workers
in one firm causes an upward increase in wages of workers in similar firms.
As entrepreneurs increase wages, total costs and prices increase leading to
wage-wage inflation.
(x) Depreciation/devaluation of the local currency

Causes of cost push inflation in Uganda

(i) Rising costs (prices) of raw materials
(ii) Rising costs (prices) of fuel/petroleum products
(iii) Depreciation of the local currency
(iv) Breakdown of infrastructure
(v) Rising wages rates
(vi) Rising costs of borrowing/rising interest rates on loans
(vii) Rising rental rates/rising cost of storage of goods.
(viii) Rising cost of transport
(ix) Rising cost of advertising
(x) Rising indirect taxes

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3. STRUCTURAL/BOTTLENECK/SCARCITY INFLATION
This is a type of inflation that arises out of supply rigidities which cause
shortage/scarcity of goods/commodities resulting in increasing prices.
OR
It refers to the persistent increase in the general price level arising out of supply
rigidities that cause scarcity of goods.
Causes of structural inflation
(i) Natural hazards which cause a fall in supply of agriculture products leading to
a rise in prices.
(ii) Political instability which destroys productive infrastructure leading to scarcity
of commodities hence a rise in prices.
(iii) Break down of infrastructure which causes shortage in the supply of goods
leading to a rise in prices
(iv) Shortage of raw materials leading to a scarcity of final goods thus a rise in
prices
(v) Shortage of foreign exchange
(vi) Breakdown of key/major industries/production units.
(vii) Speculation by business men which creats artificial shortages
Causes of structural inflation in Uganda
(i) Political instability
(ii) Breakdown of infrastructure
(iii) Shortage of raw materials/inputs
(iv) Speculation/hoarding of business men
(v) Natural hazards
(vi) Breakdown of some major/key industries/production units
(vii) Shortage of foreign exchange
Solutions/Remedies to structural inflation
(i) Government should develop infrastructure through construction of roads,
energy facilities etc. This reduces production costs and enables producers to
increase output and also eases the transportation of goods to the market
thus controlling prices.
(ii) Agriculture should be modernized. This ensures constant supply of
agricultural raw materials and food to the producers and consumers
respectively thus controlling prices increases.
(iii) Political stability should be improved and maintained. This ensures safely and
security of the lives and property of investors thus enabling them to

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 concentrate on economic activities thus increasing output and reducing
prices.
(iv) Government should provide investment incentives to private investors. These
reduce production costs and increase the volume of goods produced thus
reducing prices.
(v) Public enterprises should be privatized. This promotes efficiency and
expansion of the production scale which results into increased output and
reduced prices.
(vi) Economy should be liberalized. This reduces production costs and helps to
increase the level of investment as more enterprises are set up thus
increasing production of goods and services.
(vii) New industries should be established and old ones rehabilitated, so as to
increase production of goods and services hence reduce prices.
(viii) Importation of raw materials should be encouraged to supplement those
available on the local market and encourage more production of goods and
services hence reducing prices.
Question:
Explain the measures that have been taken by government to control
structural inflation in Uganda

4. IMPORTED INFLATON
This is a type of inflation that arises from importation of goods from countries
that are experiencing inflation such goods may be capital goods, fuel or
intermediate goods.
OR
It refers to persistent increase in the general price level due to importation of
goods from countries experiencing inflation.
Solutions to imported inflation
(i) Import substitution industries should be set up to increase domestic
production and reduce importation from countries experiencing inflation.
(ii) Producers who use imported raw materials should be subsidized to enable
them produce at a low cost thus reducing prices of final goods.
(iii) Importation of non-priority goods should be minimized.
(iv) People should be encouraged to import from cheaper sources
(v) Government may adopt beggar-my neighbour policy i.e. where government
may send delegates to other countries to negotiate for lower prices.

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 Foreign exchange inflation
This type of inflation results from depreciation/devaluation of the local currency. A
slight devaluation/depreciation of the local currency may lead to price rise for all
imported inputs and this can exert pressure on costs of production leading to an
increase in the general price level.
Speculation inflation
This arises out of hoarding of commodities by business men and middle men leading to
scarcity hence a rise in their prices.
Monetary inflation
This is a type of inflation that is caused by an increase in money supply which is not
accompanied by an increase in the volume of goods and services.

OR
Refers to the persistent increase in the general price level due to an increase in money
supply which is not accompanied by an increase in the volume of goods and services.

The monetary, excessive demand and rising costs are only symptoms of inflation but
not causes. When money supply increases at a rate that is higher than that of real GDP,
the inevitable effect is inflation. Therefore this theory of inflation is based on the
quantity theory of money i.e. MV=PT where it is assumed that a change in money
supply has a direct and proportionate effect on the general price level since it is
assumed that V and T are constant.
Note:
The theories of inflation include
(i) Demand pull theory
(ii) Cost-push theory
(iii) Structural/bottleneck
(iv) Monetary theory
(v) Imported inflation theory

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 Causes of inflation in an economy
1. Natural disasters in form of prolonged drought, excessive rainfall etc. These
reduce productivity in the agricultural sector which results into reduced supply of
agricultural commodities thus increasing prices.
2. Uncontrolled credit creation/excessive credit creation by commercial banks. This
encourages many people to borrow which results into too much money in
circulation and increased purchasing power leading to increasing prices.
3. Political insecurity. This scares away potential investors for fear of losing their
lives, destroys existing properties and infrastructure and this discourages
production which results into shortage commodities and hence increase in prices.
4. Increased inflow of incomes from abroad/excessive inflow of incomes from
abroad. This increases money supply in an economy which increases aggregate
demand leading to increasing prices.
5. Excessive issuing of currency by the central bank. This increases money supply
without increasing the volume of goods and services thus creating excess
demand and rising prices.
6. Excessive government expenditure. This increases the amount of money in
circulation thus increasing aggregate demand and increasing prices.
7. Importation of goods from countries experiencing inflation. Such high prices plus
high costs of transport, insurance and freight charges etc result into increasing
and higher prices in the local market as importers try to maintain their profits.
8. Increased/excessive exportation of (essential) goods. This creates scarcity of
goods in the local/domestic market thus increasing prices.
9. Depreciation/Devaluation of the local currency. This increases the price of
foreign currency which in turn increases the cost of imported inputs/raw
materials and this forces producer to increase the prices of finished products so
as to cover the costs and maintain their profits.
10. Breakdown of infrastructure in form of roads, energy facilities etc. this makes it
difficult to transport raw materials to market center and finished commodities to
production units thus causing shortages of goods hence increase in prices.
11. Speculation by traders as they anticipate rise in future prices of goods and so
they hoard them which causes artificial shortages in the market hence rising
prices.
12. Greed for profits by businessmen/traders. This makes them increase the prices
of their commodities in order to increase their profit margins leading to rising
prices.
13. Break down of some key production units/industries. This creates scarcity of
commodities thus increasing prices in the market.
14. Rising production costs due to rising wages. Interest rates, fuel prices etc. This
forces producers to increase the prices of final goods so as to cover costs and
maintain their profits.
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 15. Excessive borrowing from the central bank by government. This increases
money supply and creates excess aggregate demand over aggregate supply
leading to rising prices.
16. Shortage of foreign exchange. This reduces the ability of a country to import
commodities thus causing shortages in the domestic market hence rising prices.

Question:
Explain the causes of inflation in Uganda
Measures to control/reduce inflation in an economy
1. Government should reduce its expenditure especially on activities that are not
productive. This reduces the amount of money in circulation and limit aggregate
demand thus causing a fall in prices.
2. Government may adopt a restrictive monetary policy so as to reduce the amount of
money in circulation and reduce aggregate demand thereby reducing prices.
3. Government should control issuing of currency by the central bank. This reduces
the amount of money in circulation and limits aggregate demand hence controlling
rising prices.
4. Government should develop infrastructure by constructing roads, power stations etc.
This reduces production costs and enable firms to increase output thus reducing
prices.
5. Government may control wage increases. This reduces the purchasing power of
the workers which controls their demand for commodities leading to a fall in prices.
6. Government can reduce indirect taxes on essential raw materials. This lowers
production costs and attracts more production thus reducing prices of final
commodities.
7. Government should fix maximum price for essential goods, accompanied by
rationing. This controls price increases because it is illegal to sell above the
maximum price.
8. Government may increase direct taxes on people’s incomes. This reduces their
disposable incomes thus reducing their purchasing power and aggregate demand
hence controlling price increases.
9. Government should privatize public enterprises this promotes efficiency and
expansion of scale of production which increases output and hence reducing prices.
10. Government can provide (tax) incentives to private investors. This reduces
production costs and increases the volume of output produced thus reducing the
general price level.

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11. Government should liberalize the economy. This reduces production costs and
increases the level of investment as more enterprises are set up thus increasing
production of goods and services and controlling price increases.
12. Agriculture should be modernized e.g. through carrying out irrigation. This ensures
constant supply of food and agricultural raw materials thus controlling price
increases.
13. Government should maintain political security. This ensures safety and security of
the life and property of investors which attracts them and also enable people to
concentrate on economic activities thus increasing output and reducing prices.
14. Business men/traders may be encouraged to import from cheaper sources. This
supplements locally produced goods thus availing more goods to the market hence
reducing prices of commodities.
15. Government should encourage setting up of import substitution industries. This
increases production of formally imported goods which increases supply of goods in
the local market thus minimizing importation from countries experiencing inflation.
16. Government should discourage exportation of essential goods. This avails more
goods and avoids shortages thus controlling increase in prices.
17. Government can encourage use of instruments of credit e.g. use of postdated
cheques. Thus reduces the amount of money in circulation which reduces
purchasing power and aggregate demand leading to a fall in prices.

Guiding Questions:
1. Discuss the measures being taken to control inflation in Uganda.

2. Explain the measures that have been taken to control inflation in Uganda.

3. Suggest steps that may be taken to control inflation in Uganda.

4. How are the tools of the monetary policy used to control inflation in an
economy (one sided answer) i.e. by increasing the bank rate, through
selling securities to the public etc.

Effects/Consequences/Impacts/Implications of inflation
Inflation has both positive and negative effects

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 Positive effects/merits/advantages
1. Mild inflation stimulates hard work. This is because people strive to increase their
incomes so as to meet the rising cost of living.
2. It stimulates investment. This because an increase in prices level increase the profit
levels of investors thus inducing them to invest more.
3. It increases employment opportunities. This is because the rising prices increase
profitability and encourage more investment and expansion of production scale
which increases demand for workers.
4. It increases revenue from taxes. This is because government it imposes high taxes
on people’s income so as to reduce disposable income and control inflation.
5. It encourages forced saving. This is because as people are taxed they are forced to
reduce consumption because of high prices.
6. Debtors stand to gain in real terms. This is because they pay back less in terms of
goods and services.
7. It encourages innovativeness and creativity among workers. This is because they
look for different ways of increasing their earnings so as to maintain a high standard
of living.
8. It encourages labour mobility. This is because workers are willing to move from low
paying jobs to high paying jobs in order to increase their earnings and cope with the
rising cost of living.
9. It increases the level of resource utilization. This is because of increased profit
levels potential investors are encouraged to use more of the available resources in
order to increase output.
10. It stimulates economic growth. The producers are motivated to expand the scale
of production and increase the volume of output so as to get more profits.
11. It promotes commercialization/monetization of the economy. This is because
producers expand their scale of production and increase output so as to earn high
profits.
12. It stimulates entrepreneurship since many people are encouraged to take risks in
business ventures in order to earn high profits.
13. It encourages setting up of import substitution industries in order to increase
production of formerly imported goods and minimize importation from countries
experiencing inflation.
14. Where there is economic depression, mild inflation enables the economy to
recover as rising prices stimulate production and employment

Negative effects/Demerits/Disadvantages/Costs of inflation

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 1. High rate of inflation discourage saving. This is because of increased expenditure
on consumption which reduces the amount of money available for saving.
2. High rates of inflation worsen the balance of payment position. This is because high
domestic prices reduce exports leading to low foreign exchange earned.
3. It promotes social vices such as crimes, immorality. This occurs as people try to
increase their incomes in order to cater for the increased cost of living.
4. Creditors lose. This is because they get back less in real terms of goods and
services when they are paid back.
5. Leads to closure/collapse of some firms this is due to increased production costs
making it difficult for firms to maintain their profit levels
6. It discourages investment by both local and foreign investors because of increased
production costs and reduced profits.
7. It leads to industrial unrest. This is because workers constantly demand for higher
wages in order to meet the high cost of living. This reduces the volume of output
and profit levels.
8. It increases the problem of unemployment. This is because of increased production
costs which forces producers to reduce the number of people employed.
9. It makes fixed income earners suffer. This is because their real incomes fall and
their consumption levels reduce which worsens their economic welfare.
10. It makes planning difficult. This is because it increases the cost of project
implementation thus forcing government to abandon some of its planned projects.
11. It encourages brain drain. This because it increases the cost of living which
frustrates the skilled labour forcing many to go and work in other countries that
have relatively stable prices.
12. It makes government become unpopular. This is because some people feel that
government is not doing enough to control the rising prices and improve people’s
standards of living
13. It encourages production and consumption of poor quality goods. This is because
producers try to reduce their production costs by reducing the volume and the quality
of inputs.
14. It worsens income inequality. This is because the poor spend their little incomes
on purchase of highly priced goods produced by the rich businessmen thus
transferring incomes from the poor to the rich producers inform of high profits.
15. It makes people lose confidence in the country’s currency since money loses its
ability to store people’s wealth due to constant loss of value.
16. It over strains people. This is because they work for long hours in order to increase
their earnings/incomes and maintain their standard of living/cope with the rising
cost of living.
17. It leads to capital flight/capital outflow. This is because potential investors fear to
invest in the country because of high production cost and low profit levels.

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 Other concepts of inflation
1. Headline inflation. This refers to increase in the general price level which
includes food prices.

2. Underlying inflation (core inflation). This refers to the increase in the general
price level which excludes food prices.

3. Open inflation. This is a situation in which prices are left to increase without
being checked by government intervention.

4. Suppressed inflation. This is a situation where aggregate demand exceeds

aggregate supply but pries are not allowed to increase due to government maximum
price control and rationing.
OR
It is a situation where prices increases are checked by government intervention inform
of maximum price control, and rationing of essential goods/commodities.
However, once the controls are removed prices increase.
NOTE: Suppressed inflation creates problems such as corruption, black-marketing etc.
5. Inflationary spirals. These occur when a persistent rise in prices leads to a
demand for higher wages which increases the cost of production leading to a rise in
prices which again lead to demand for higher wages.

6. Stagflation. This refers to a situation where there exists both high rates of
inflation and high rates of unemployment in an economy.

OR
It refers to the co-existence of both high rates of inflation and high rates of
unemployment in an economy.

Note:
This is common mainly in Less developing countries with structural rigidities
e.g. failure of investment to have desired effects such as increased output
and increased employment.

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 Causes of stagflation
(i) Rapid increase in wages. This increases production costs,
forcing producers to reduce output and lay off workers.
(ii) Increased importation. This reduces demand for locally produced output leading
to reduced domestic production forcing firms to lay off workers.
(iii) Reduction in exports. This discourages production for export making producers
lay off workers.
(iv) Increase in direct taxes reduces disposable incomes and aggregate demand,
forcing producers to reduce output and lay off workers.
(v) Increase in prices of raw materials/inputs. This increases the cost of production
and prices of final goods which reduces aggregate demand forcing producers to
reduce output and lay off workers.

Costs/problems associated with stagflation

(i) Causes decline in investment
(ii) Cause decline in savings
(iii) Increases income inequality
(iv) Increases the cost of borrowing
(v) Promotes social tension/social unrest/makes government unpopular
(vi) People lose confidence in the country’s currency
(vii) Increases cost of living
(viii) Increases dependence burden
(ix) Causes decline in economic welfare
Solutions/remedies to stagflation
(i) Interest rates on loans should be reduced to reduce the cost of borrowing and
encourage borrowing by investors. This leads to increase in employment and
output.
(ii) Direct taxes should be reduced to increase disposable incomes and aggregate
demand. This stimulates investment, leading to an increase in output and
employment.
(iii) Government should increase its expenditure so as to increase aggregate demand
and encourage production. This increases output and employment.
(iv) Government should reduce cost of factor inputs. This increases output and
employment.

5. REFLATION

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 This is deliberate government policy aimed at forcing prices upwards so as to
recover from economic depression.
OR
It is the deliberate government policy aimed at stimulating production by increasing
prices of commodities after economic depression.

INSTRUMENTS OF REFLATIONARY POLICY

These include:
(i) Reduction in direct taxes on people’s income so as to increase disposable
income and increase aggregate demand.
(ii) Increasing government expenditure in order to increase the amount of money in
circulation and increase aggregate demand.
(iii) Encouraging exports so as to create shortages of commodities in the local
market leading to an increase in prices.
(iv) Adoption of an expansionary monetary policy so as to increase money supply
and increase aggregate demand and prices.
(v) Increasing the wages of the workers in order to increase their purchasing power
and aggregate demand.

8.DEFLATION
This refers to the persistent fall in the prices of goods and services in an economy.

Effects of deflation
(i) It increases the unemployment level. This is because of falling prices, profits
reduce and many firms close due to inability to cover costs and consequently
workers are laid off.
(ii) It reduces government revenue from both direct and indirect taxes. This is
because of declining tax bases as firms close.
(iii) Debtors suffer since it makes the value of their debts rise because of a fall in
prices and making it difficult for them to pay.
(iv) Creditors/lenders stand to gain because they receive more in real terms than
that was lent out due to an increase in the value of money.
(v) It leads to low rate of economic growth due to a decline in output as a result of
decline prices and profits.
(vi) Fixed income earners gain because their real incomes increase with falling of
prices, enabling them to buy more goods than before.

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(vii) It discourages investment. This is due to reduced prices and profits.
Control of deflation
It can be controlled by adopting expansionary monetary and fiscal policies.

Expansionary monetary policies include:

(i) Reducing the bank rate
(ii) Reducing the margin requirement
(iii) Buying securities from the public. These increase the money supply, and
aggregate demand which stimulates economic growth.
Fiscal policies include;
(i) Increasing government expenditure
(ii) Reducing direct taxes
(iii) Increasing wages and income. All these increase investment and output.
Guiding Questions:
1. Why is it necessary to control inflation in Uganda?
2. Why may government induce inflation?
3. Why may inflation be undesirable in an economy?
4. Why may inflation be desirable?
5. Under what circumstances may inflation be desirable in any economy?
6. Examine the effects of inflation in Uganda.
The following are the circumstances under which inflation may be desirable.
(i) When there is economic depression so as to stimulate the economy from
recovery.
(ii) When there is need to stimulate investment
(iii) When there are under utilisted resources so as to increase output
(iv) When there is need to redistribute incomes from wage earners with low marginal
propensity to save to profit earners with high marginal propensity to save.
(v) When marginal efficiency of capital is low an inflationary situation will raise it and
then encourage investment.
(vi) When there is need to stimulate demand/expand the market
(vii) When there is need to stimulate economic growth through the effects of excess
demand, production and investment.
(viii) When government uses it as a means of forced saving instead of introducing
new taxes which may prove unpopular.
Note:

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Treasury bills – These are financial securities issued by a central bank as a means for
government to borrow for short term periods.
A wage price spiral – This refers to wage increases pushing up prices, the rise in
prices producing further wage claims and thus further prices increases and so on.
Deficit financing: it refers to government expenditure in excess of its current revenue
from taxation as a means of raising effective demand.

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