Notes on Inflation

Aims: By the end of this chapter, you will be able to
(i) define inflation and deflation,
(ii) explain the causes of inflation and deflation,
(iii) explain the costs of inflation and deflation, and

  1. Inflation is the persistent rise in the level of prices throughout the country. The rate of Inflation is the percentage increase in the level of price (usually consumer price index but other price indices are also used) over a 12 month period.
  2. Commonly measured using the Consumer Price Index (CPI). In India the more common measure is the Wholesale Price Index (WPI) whereas in UK, the Retail Price Index (RPI) is used.
  3. CPI is a measure based on a basket of goods and services consumed by a typical household.
  4. Let the CPI be 100 in 2005. If the CPI in Jan 2007 was 103.3 and grew to 106.7 in Jan 2008 then the rate of inflation in 2007 was
  5. [(106.7 /103.3) x 100 %] - 100 % = 2.61 % --------------------( * )

    If the CPI in Jan 2007 was 103.3 then compared to year 2005 there was an inflation rate of 103.3 -100 = 3.3 (or 3.3%) from 2005 to 2007.

    Having said so, most economists and policy makers will be more interested in the rate of inflation from a year ago (i.e. year-on-year basis, the calculation using formula ( * ) above).

  6. The rule of 70 is commonly used to estimate how many years will it take before the rate doubles for a given rate. An approximation: 70/2.61 = 26.8 years. If the inflation rate is 2.61 % per year then in about 27 years, the price level will double. A chocolate ice-cream that costs HKD 10 now will cost HKD 20 in 27 years from now if the inflation rate is 2.61 % for every year.
  7. Similarly, deflation is the persistent decline in the level of prices throughout the country. The rate of deflation is the percentage decrease in the level of price (usually consumer price index but other price indices are also used) over a 12 month period.
  8. Diagram 1. Inflation rate of Hong Kong from 1982 to 2007 measured with composite CPI.


    Discussion A.

    (a) Identify a period or periods of rising price levels.

    (b) Identify a period or periods of rising inflation rate.

    (c) Identify a period or periods of falling inflation rate. Economists refer to falling inflation rate as disinflation.

    (d) Identify a period of falling price levels.


    Box 1. Problems in Measuring Inflation rate. (HL)

    (i) Definition of typical household.
    Which basket of goods should be used? What goods and services should be included? Who consume what? Here the problem lies with how the governmental statistical department define the "average" household and its typical consumption of goods and services. Governments are actually aware of this problem. The Hong Kong government actually calculates CPI for low, middle and high monthly income households using their respective consumption patterns as well as composite CPI. Many governments revise the composition of the basket of goods and services regularly to reflect the typical consumption pattern in the economy.

    CPI may understate the inflation for groups in the population who spend unusually large portions of their income of goods and services that increased most in prices.
    Although housing and food accounts for more than 62 per cent of CPI(A) for low income households in Hong Kong, this proportion is less than 57 per cent in the composite CPI. Some Hong Kong households may spend more than 62 per cent of their incomes on housing and food. When food prices and rents increase substantially as from 2007 in Hong Kong, the inflation for low income households that spent more than 62% of their incomes on housing and food will be a lot higher than stated by CPI(A) or composite CPI.

    (ii) Quality of goods and services.
    CPI does not take into consideration of quality of goods and services. If quality is generally improving then the cost of living has not risen as much as suggested by an increasing CPI. Some economists estimate that improvement is technology and quality is about 3% a year.

    (iii) Discounts.
    The CPI measure does not take into consideration of discounts that sellers may offer to buyers. Although the market price of a bottle of A&B Shampoo is Euro 2 but a consumer can buy 2 and get 1 free offer from seller for the same good. In this case, our consumer is only paying a Euro 1.33 per bottle of shampoo. Again CPI has overstate the actual inflation in the economy.

    (iV) Buyer-response / substitution effect.
    CPI does not take into consideration that consumers will change their consumption pattern with a change in relative prices. The CPI assumes consumers will buy the same brands and amount of goods and services as prices increase. In reality this is not the case. When petrol (gasoline) becomes more expensive, consumers can switch to public transportation and cut back on long-distance traveling to cut back on gasoline. If brand A marmalade becomes expensive then cost-conscious consumers can switch to a brand with a lower price. Thus, CPI tends to overstate the inflation rate.

    (v) Underground economy.
    If the economy has official price controls on goods that lead to shortages then consumers will be forced to buy the same goods in the black market at higher prices. In this case, the CPI measure understate the actual inflation in the economy.

    (vi) Non-transaction activities. (housekeeping, painting your own room, etc.)
    These activities improves the living standard of a person without incurring extra expenses for consumers. For instance, a CPI may include the price of haircut and consumers can reduce their monthly expenditure by cutting their own hair at home.

Cost of Inflation

If people can correctly anticipate the rate of inflation and fully adjust prices and income accordingly then the cost of inflation is minor. The inconvenience for consumers is to mentally adjust the notion of "fair prices" when they go shopping and for firms they will have to adjust price tags, price catalogues and menu to reflect price rise. Economists call the costs associated to the adjustment of price lists as Menu Costs of Inflation. However, people often make mistakes with this anticipation and do not fully adjust prices and income. This creates problems beyond the costs of inflation and these burdens are heavier when the rate of inflation is higher and fluctuations become more frequent.

  1. Redistributive effects.
    Inflation distributes income away from people who earn fixed incomes and have no bargaining power. Pensioners, fixed income workers, and people who could not negotiate their rents suffer from inflation. Depositors who earned negative real interest rates also loss because they loss purchasing power for their savings. People who have property and the power to raise rents benefit as well as borrowers who benefit from lower real interest rate benefit from inflation.
  2. Uncertainty and lack of investment.
    Generally, the higher rate of inflation, the more it fluctuates. Thus investors have a more difficult time in anticipating future profits and returns to their investments. This reduces the incentive to invest and in turn lessen the amount of injection into the economy.
  3. Output effects.
    Aggregate Demand (AD) will not shifts out as much as it could and reduces the growth of the economy. This shift in AD can come about from a lower investment level in the economy (see point b above).
  4. Effects on Balance of payment.
    Balance of Payment, roughly put, is an accounting measure that tracks total spending on foreign goods and services + capital outflows, and total incomes from exports + capital inflow. High inflation rate leads to local exports being less competitive in the world market. Export will fall. At the same time, imported goods become cheaper compared to local goods and imports increase. The balance of payment will deteriorate and/or exchange rate will depreciate against foreign currency. We will investigate the problem caused by a deterioration of balance of payment on the economy later.
  5. Decision-making errors.
    When inflation rate is high and fluctuates frequently, consumers will have to estimate inflation rate in deciding their consumption and saving patterns. Whether or not, a person will keep most of his money in liquidity forms depends on what she expect the real interest rate in future. Government also has to take inflation into consideration in deciding what rates to offer for its bills and bonds. The expected returns to an investment will depend on the anticipated inflation rates on costs and revenue. More mistakes are more likely when inflation rate is both high and fluctuates frequently. When mistakes occur in making economic decisions, the economy run less efficiently as some resources can be mistakenly devoted to an investment that proved unprofitable when actual inflation rate exceeds the anticipated inflation rate.
  6. Hyperinflation occurs when prices rise by several hundred per cent or even thousands per cent in a year. Firms will have little incentive to invest in this condition. Firms will have to raise prices constantly and worry about increase in costs of production. Workers will constantly demand for wage increase to keep ahead of inflation. This can lead to wage-price spiral where wages and prices chase each other resulting in AD constantly shifting to the right and AS constantly shifting to the left. People will not wish to save money and will spend the money all some tangible goods as soon as possible. The goods can then later be used for bartering later. Hyperinflation adds to the mental burden of all economic agents as everyone is preoccupied by the persistent increase in price level, the falling purchasing power of money, and the securing of goods. Hyperinflation is often caused by excessive monetary growth in an economy in which money chases after goods and services.
  7. Political instability is likely when people experience high and increasing inflation rate. The classical example was Germany after World War 1 in which the annual inflation was 7000 billion percent by Autumn 1923. People were frustrated and gave rise to Hitler's fascist party in Germany. The recent case of hyperinflation was Zimbabwe which finally ended in January 2009. According to an independent estimate, the annnual inflation rate in Zimbabwe exceeded 1 million percent in May 2008 (The Boston Globe, 21 May 2008).

Costs of Deflation

  1. Put businesses under pressure to reduce costs by all means to remain competitive. This may lead to employment insecurity.
  2. Pressure to cut costs may erode the production base of the economy. Less funds for innovation leading to poorer quality control and probably higher unemployment. Less investment because anticipated deflation reduces the rate of returns to investment and profits.
  3. It may make it difficult to reduce real value of debt burdens. Borrowers suffer under this condition.
  4. Consumers may expect prices to fall further and will postpone purchase. This adds to more deflationary pressure for prices to fall further.

Note: You can modify the above list on "costs of deflation" into the "benefits of modest level of inflation." Thus, modest level of inflation allows firms to raise their prices and profits. Inflation reduces the value of debt.

Causes Of Inflation

  1. Demand-Pull (demand-side) Inflation is the inflation caused by persistent rises in aggregate demand (see diagram 2 below). AD can increase with an increase in consumption, an expansionary monetary and fiscal policies from the government, and inflow of capital from abroad. As AD shifts from AD1 to AD2 as in diagram 2, say due to an increased consumption, firms will respond by increasing outputs and prices. The increase in price level depends on the steepness of AS. If AD stops at AD1 then an increase in injection will cause an inflation as price level adjusts from p1 to p2 as in diagram 2. Once this short-run inflation has occurred, inflation will stop. For inflation to persist there must be a continuous shift in AD to the left from say AD1 to AD2 then to AD3 and so on. In this process, real national income rises with inflation rate. However, the rise in national income will diminish for every increase in inflation rate when the slack in the economy lessens, i.e. the AS becomes more vertical. If AS becomes vertical where the economy is operating at full potential then any shift in the AD has no effect on real national output but only causes an increase in price level. That is excess demand bids up the prices of the fixed real output. "Too much money chasing after too few goods and services." A demand-pull inflation can cause a runaway inflation especially reinforced by wage-price spiral. A demand-pull inflation is typically associated with a booming economy and is the counterpart of demand-deficient unemployment.

  2. Diagram 2. Demand-pull inflation.
    Diagram 3. Cost-push inflation.


  3. Cost-push (supply-side inflation) is the inflation caused by persistent increase in the costs of production. It explains rising prices in terms of factors which raise per unit production cost. Cost-push inflation tends to be self-limiting. The amount of increase in price level depends on the steepness of AS curve.

(i) Wage-push inflation:Theoretically sound because labor costs usually take up 2/3 of production costs. Labour Unions demand wage hike independent of the demand for labour and successful negotiations lead to increase in wage rates. Costs of production increase and AS shifts to the left as in diagram 3 above. Price level increases and real national income/output decreases as in diagram 3. However, the power of labour union is waning in many countries.

(ii) Supply shock variant: "cost-push" due to unanticipated increase in the costs of raw materials or energy inputs. AS shifts to the left. E.g. 1973-74, 1979-80 and the recent (2007/8-) oil shocks. Inflation due to the persistent increase in the price of imported oil can be termed import-price-push inflation.

Exhaustion of natural resources lead to AS shifting to the left and causes inflation. A temporary inflation can also happen when faced by a bad harvest of grains and natural disasters that destroyed production capacities. Theoretically, a temporary deflation can happen with a bumper harvest. However, the latter case is more unlikely because prices tend to be sticky.

(iii) Profit-push inflation in which firms use their monopoly powers to push up prices independent of demand.

(iv) Tax-push inflation due to an increase say VAT.

In the real world it is often difficult to distinguish Demand-pull from Cost-push inflation. In fact, in most cases they occur together and interact with each other (see diagram 4 below). Say an increase in AD from AD1 to AD2 leads to a movement along the AS1 curve and results in higher price level and output. Inflation can lead workers to demand a wage increase and AS shifts to the left from AS1 to AS2. There is a movement along the new AD2 and results in higher price level and a fall in output. People with more income will further shifts AD from AD2 to AD3 which increase price level and output. This set up another round of wage demand and AS shifts to the left again. Inflation rises again but output may not have change so much form the initial level.

Diagram 4. Interaction between demand-pull inflation and cost-push inflation.

Structural (demand-shift) Inflation is inflation caused by the structural change in the pattern of demand or supply in an economy.
The previous two types of inflation are short-run phenomenon while structural inflation can be more permanent. A structural change in the pattern of demand can lead to certain industries or industries concentrated in a certain region going out of business. If prices and wages are sticky downwards in the contracting industries and prices and wages rise in the expanding industries then the economy will still experience an over all increase in price level. The rate of inflation will rise further if the contracting industries cause a reduction in aggregate supply and AS shifts to the left as in diagram 3 above. People who lives in a region in which a contracting industries used to dominate will suffer from both structural unemployment and structural inflation.

Expectations and Inflation. Inflation is influenced by people's expectation of future inflation as much as by shift in AS and/or AD curves. If people expects inflation to be high in future then their action will cause a higher inflation rate. For example, if consumers expects inflation to rise in near future then they will buy now before the actual price increase. One easy way to model this expectation is to use adaptive expectation in which data from today or now is used to predict rate tomorrow. For instance, if the inflation rate is 3% this month then we expect next month's inflation is 3% under adaptive expectation. Another way to model expectation is to use rational expectation where all available information is used to predict rate tomorrow.

Measures to deal with Inflation

  1. Fiscal Policy.
    1. To combat Demand-pull inflation (where AS is vertical), a government can use deflationary or contractionary policy to reduce the rate of growth of aggregate demand. This can be done by increase income tax and cutting government spending.
    2. Cost-push inflation, government can lower corporate tax, lower income tax, and lower government spending (reduces the crowding out effect) to encourage investment and higher productivity.
      In order to reduce the rate of increase in costs of production, a government can also use supply side policy of restraining the bargaining power of labour union, and to provide incentives, grants, and subsidies for firms to increase productivity. These programmes can involve encouraging R&D, subsidies and tax break for investing in productivity enhancing technology, and training schemes for workers. If inflation is fueled by increase in food prices such as rice due to poor and inadequate supply then government can increase subsidise to the cultivation of rice as happen in Malaysia. The effect of supply-side is not immediate. Furthermore, subsidies and grants may actually increase AD that adds to demand-pull inflation.
  2. Monetary Policy that reduces money supply and increases interest rates.
  3. Income Policy inflation adjustment index. Allow a Cost of Living Adjustment (COLA) index be built into employment contract so to reduce the inflation burden on fixed income earners. This COLA index will also improve efficiency as it does away with the need of labour unions negotiating for a wage increase substantially above the inflation rate that may cause further cost-push inflation.
  4. Exchange rate policies pegging, exchange rate regime. If inflation is caused by an inflow of hot money from abroad that raises AD then government can stop this flow of hot money by placing restriction on the movement of speculative money, say into the stock markets. Local currency becomes not freely convertible in the foreign currency market.
  5. Targets- expectation : Inflation Target: the rationale here is that when public knows the objective of inflation target then the public can anticipate policy actions. If public is convinced of the efficacy of government target then it will be easier for this target to be met and inflation be kept within target.
  6. Hyperinflation case: A government in this case has to modify public's expectation and build public confidence in local currency. A change in government and/or monetary authority that is committed to fight inflation can be helpful to modify public's expectation. A commitment to tight monetary policy is reflected by a controlled government spending, immediate stop to a policy of excess monetary growth, a new currency with smaller denominations, and transparency in fighting inflation. Transparency can means reporting the statistical figures of money supply, government spending and inflation regularly to public. Sometimes, a country experiencing an hyperinflation will need to switch and adopt the use of hard currencies like US dollar to stop the hyperinflation from spiralling up.

  7. Exercises

    1. Why are price controls ineffective in controlling Inflation?
    2. What are the different types of Inflation and measures to control them? Use appropriate diagrams in you answer.
    3. What are the costs of inflation?
    4. What are the arguments for and against a 0% inflation target?
    5. Evaluate the effectiveness of demand-side policies in dealing with cost-push inflation.
    6. "The impact of monetary growth of India and excess demand for nontradable goods and assets (especially real estate) is already being felt. Wholesale price inflation of India began rising in May 2006 (from slightly above 4%), reaching an annualized rate of 6.0% in the third week of January 2007. Consumer price inflation is higher still. While this was initially driven by booming international energy prices, and by still-ascendant food price inflation, recent figures show that burgeoning manufactured goods price inflation is now contributing as much as food and fuel prices combined.

      Given tight manufacturing and supporting infrastructure capacity, and the significant time lags involved in augmenting it to meet rising demand, manufacturing is overheating. Faced with demand-led inflation, the Reserve Bank of India (RBI) needs to dampen expenditures. However, in doing so, it will be important not to reduce the credit available for expanding manufacturing capacity more than is necessary to contain inflation.
      " Adapted from Asian Development Outlook 2007.
      1. Define damand-led inflation.
      2. Use an appropriate diagram to explain the demand-led inflation experienced by India.
      3. What can India do to "dampen expenditure" ?
      4. Evaluate the adequacy of implementing only policies to "dampen expenditure" to fight this demand-led inflation.


    7. Study the figures below and answer the following questions.
      Figure 1. Inflation
      Figure 2. HK GDP
      1. Distinguish deflation from decreasing inflation rate with reference to figure 1 above.
      2. Distinguish GDP at current market prices and GDP at chained (2005) dollars in figure 2 above.
      3. Use an AS -AD diagram to explain the change in Hong Kong inflation rate in 1999.