INFLATION

Refers to the persistent increase in the

general price level.
Stagflation. Is a situation where high levels
of inflation co-exists with high levels of
unemployment in an economy.
The costs of stagflation include:
 High costs of living
 Widens income inequality.
 Decline in welfare/standards of living.
 Decline in savings.
 Creates social tension.
 High dependency burden
 Decline in investment.
 Loss of public confidence in a country’s
currency.
Solutions.
 Increase government expenditure.
 Encourage production.
 Reduction in taxes. This increases
disposable income and encourages
investment.
 Liberalized monetary policy eg reduction
in interest rate
 Increasing GNP
Deflation. It is the persistent fall in the
general price level.
Reflation. It’s a deliberate government
policy to stimulate production by increasing
prices to recover from a depression. This is
achieved through using tools of reflationary
policy that is.
Reducing taxes
Increasing government expenditure
Expansionary monetary policy
Increasing wages.
Disinflation. Is a government attempt to
stop inflation in order to maintain the value
of money.
Inflationary spiral. Is where persistent
increase in prices leads to increase for
higher wages which increases the cost of
production leading to an increase in prices
which again causes demand for higher
wages.
Suppressed inflation. Is a situation where
demand exceeds supply but the effect of
this on prices is reduced by price control.
Open inflation: This refers to inflation that
is not suppressed, i.e. prices are permitted
to rise without being interfered with by the
relevant authorities.
Underlying inflation: This is inflation calculated by not
considering the prices of foodstuffs.
Headline inflation: This is inflation calculated
by considering the prices of foodstuffs.
Classification of inflation.
(a) Creeping or mild or gradual inflation.
This refers to the slow increase in the price of
 goods and services at a rate which is less
than 3%. Creeping inflation is the mildest
form and is conducive for economic progress
and growth. It is a good state of inflation
because a small rise in price acts as an
incentive to producers. Savings, investment,
output and employment opportunities all
increase. In this form, the prices rise
unnoticeably over a long period of time.
(b) Walking or trotting or moderate
inflation. This is where the increase in the
price level is a single digit or less than 10%
per annum. It is a warning to the government
to control it before it gets out of control.
(c) Running inflation. This is the type
where the prices increase at a rate between
10-20% per annum.
(d) Hyperinflation or galloping or
runaway inflation. This is the rapid increase
in the price of goods and services between
the rates 20 to even more than 100%. In
hyper-inflation, the prices rise every moment
without limit. In effect, money becomes
worthless and in time, a new currency will
have to be introduced. This state of inflation
is noticeable by the public and it is a bad
state of inflation. It discourages producers
since consumers are reluctant to buy
commodities at high prices. Savings,
investment, output and employment
opportunities reduce.
Types of inflation[theories]
Demand pull inflation. It’s the type of inflation
which arises out of excess aggregate demand
over aggregate supply for goods and services at
full employment levels of income.
This is caused by:
 Excessive issuance of currency. This leads to
excessive money supply.
 Expensive government expenditure
 Excessive inflow of income from abroad
 Increasing demands for exports
 Uncontrolled creation of credit by commercial
banks.
 Reduction in taxation: This increases
disposable income of the people, hence
increasing their demand.
 Increase in population: Increases in the
population of a country raises the general
level of aggregate demand of the people for
goods and services.
 Deficit financing
 Trade union activities: In countries where
labor laws are respected, trade unions are
very strong. They constantly demand for
higher wages, shorter working hours, more
holidays with pay and other amenities.
Solutions.
 Use of progressive taxation (increasing direct
taxes)
 Reduction in government expenditure.
 Wage freeze
 Use of restrictive monetary policy to reduce
money supply.
 Price control especially for major activities
 Bank rate
 Moral suasion
 Selective credit control
 Legal reserve requirement.
Cost push inflation.
This is the type of inflation that arises due to an
increase in the cost of production, which is
shifted to consumers in form of high prices.
Trade unions demand higher wages for their
members. Because unions are so powerful,
employers accede to their demands even if there
are no increases in productivity. But higher
wages mean higher costs of production for the
firms. Hence, in order to protect their profits, the
firms raise their prices.
It is caused by:
 Changes in interest rates: This can also affect
firms’ costs if they have borrowed significant
amounts.
 Exchange rate: Exchange rate changes can
affect firms’ costs, particularly if they import
many of their raw materials. Exchange rate
depreciation will increase import prices and
may, therefore, increase firms’ costs.
 Increase in the operating costs: These
include, among others, high costs of raw
materials, high cost of rent, electricity,
borrowing capital and advertisements.
Normally, when these costs increase, the
costs of production will increase, and
producers react by increasing the prices so
that they are able to cover the costs.
  Wage increases: Wages are a major
proportion of costs for many firms and so if
wages are increasing, this may well cause
cost-push inflation.
 Government: If the government changes
taxes, this may push up firms’ costs. This is
particularly true with excise duties on fuel
and oil.
 Price- wage inflation: This occurs when the
increase in the price of goods and services
forces the workers to demand for higher
wages to meet the increasing cost of living
and the producers will react by increasing the
prices of the goods and the process will
continue.
 Wage-price inflation: This occurs when
workers demand for high wages through their
trade unions, and this increases the cost of
production hence producers react by
increasing the prices of the goods.
 Wage-wage inflation: This occurs when
workers of a particular firm demand for high
wages as those earned by a different similar
firm and this increases the cost of production,
hence price increase.
Controlling cost-push inflation
 Increase in the level of domestic output: The
government should increase local production
by encouraging local and credit facilities, tax
holidays. etc.
 Imports encouraged: The government should
encourage the importations of commodities
that are scarce in the domestic economy.
  Discourage the export of goods: Commodities
that are lacking in the economy should not
be exported. This can be done by imposing
high export taxes, and in so doing, the
quantity of goods in the country will increase.
Prices will consequently fall.
 Price and incomes policy: The other policy
which could be adopted for curbing wage-
push inflation is to moderate the increases in
incomes and prices.
 Organizational controls: Organizational
controls are sometimes adopted in controlling
cost-push inflation. The government assumes
ownership of major distribution channels. The
government may practice rationing. The
consumer is not able to get whatever amount
of the commodity that he desires.
Bottleneck/scarcity/structural inflation.
Arises from supply rigidities leading to shortage
in supply of goods in the domestic market.
It is caused by:
 Un favorable natural factors/natural hazards
 Breakdown of infrastructure
 Political instability
 Breakdown in industrial production eg
machinery breakdown in key industries
 Speculation by traders who create artificial
shortages by hoarding goods.
 Foreign exchange shortages. This reduces the
volume of imports.
Solutions
 Improvement of infrastructure
 Ensuring political stability
 Liberalization of the economy
  Modernization of agriculture
 Provision of subsidies and loans to investors
to increase domestic production.
 Improvement in technology in order to tame
the natural factors.
Imported inflation.
Arises due to importation of goods in a country
that is experiencing inflation. It is caused by:
 Importing consumer goods from a country
affected by inflation.
 Rising prices in the world market
 High price of fuel
 High foreign exchange rate. This makes the
country meet high costs of importation
leading to an increase in domestic prices.
Solution
 Use of import restrictions
 Setting up import substitution industries
 Liberalization of trade
 Subsidizing importers of raw materials and
essential goods.
Monetary inflation.
Arises from an increase in money supply leading
to persistent increase in the general price level.
Note: an increase in money supply may not
necessarily cause inflation.
 When marginal propensity to save is high
 When price control measures are efficient
 When there is corresponding increase in the
rate of production of goods and services.
Speculative inflation (expectational
inflation)
Arises out of expected shortages of commodities
which causes excessive buying leading to
persistent increase in prices.
CAUSES OF INFLATION.
 Unfavorable natural factors (natural hazards).
This leads to poor performance of the
agricultural sector which causes a reduction
in supply leading to persistent increase in
prices.
 Breakdown of infrastructure. This reduces
industrial production and causes shortages in
supply of goods.
 Increasing costs of production. Eg increasing
prices of fuel; increasing interest rate. This
makes it expensive to produce which causes
supply shortages and persistent increase in
price.
 Depreciation of local currency. This leads to
declining value of local currency in relation to
foreign currencies which causes foreign
exchange shortages, makes it expensive to
import leading to persistent increase in price.
 Poor political climate (political instability)
which destroys productive productivity of
infrastructure. This creates poor investment
climate which limits production and causes
shortages in supply.
 Greed for high profits by traders. they
constantly charge high prices for
commodities in order to make profits.
 Increasing importation of goods from
countries experiencing inflation. Such
commodities are imported at high prices
which increases the cost of production
leading to persistent increase in prices in the
domestic economy.
 Speculation by traders who hoard
commodities. They expect prices to continue
rising and therefore create artificial
shortages by hoarding goods leading to
persistent increase in prices.
 Increased income inflows from abroad. This is
converted into local currency which increases
money supply. This creates excessive
demand for goods and services leading to
persistent increase in price.
 Increased demand for exports. This creates
shortages of goods in the domestic market
and persistent increase in price.
 Excessive government expenditure. This is
not followed by increased production and as
a result, demand exceeds supply of goods
leading to persistent increase in price.
 Un controlled creation of credit by
commercial banks. This leads to increased
money supply which increases demand for
 goods and services leading to a persistent
increase in price.
 Excessive issuance of currency. This is not
followed by high rate of production of
commodities. Therefore, it creates excessive
demand over supply of goods leading to
persistent increase in price.
POLICY MEASURES TO CONTROL INFLATION.
 Development of infrastructure eg roads to
allow easy movement of resources leading to
increased production of goods.
 Provide investment incentives which helps to
encourage investors leading to increased
production. Eg tax holidays on production
units of essential goods.
 Privatization of state enterprises. This helps
to increase efficiency and encourages more
production to overcome scarcity goods.
 Liberalization of the economy. This helps to
reduce monopoly and expand the production
of goods and services since it allows free
participation in economic activities.
 Use of progressive taxation which involves
increasing direct taxes. This helps to reduce
purchasing power of individuals and cuts
down excessive demand for commodities.
 Improving political climate ie ensure political
stability, provide a good investment climate
leading to increased production of
commodities.
 Control issuance of currency. This helps to
reduce money supply.
 Sale of securities to the public eg frequent
sale of treasury bills. This helps to reduce
money supply and cuts down excessive
 aggregate demand. (use of restrictive
monetary policy)
 Reduction on government expenditure
especially on provision of non-essential
goods. This helps to reduce aggregate
demand.
 Encouraging importation of goods from
cheaper sources and friendly countries. This
helps to reduce on the cost of production.
Positive effects of inflation.
 It encourages investment. This is due to high
profits that motivate producers to increase
investment.
 It encourages hard work and effort. This is
necessary for people to maintain their
standard of living.
 It increases employment opportunities. This
is because of expanded production in order
to take advantage of high profits.
 Encourages productivity which stimulates
economic growth, output increases through
the effects of excess demand and profits.
 Encourages forced savings. Small savings are
accumulated to buy a reasonable amount of
goods.
 Increase in tax revenue. The tax base widens
as a result of expanded production.
 Encourages entrepreneurship which leads to
high creativity and innovations. This is due to
increased desire to make profitable business.
 Helps to commercialize the economy. This
reduces the size of subsistence sector.
 Encourages labor mobility. Labor becomes
highly mobile to earn a living.
 Increases exploitation of idle resources. This
is because of high profit margins which
 encourages optimum use of resources. to
supply more commodities and take
advantage of increased demand.
 Borrowers gain. This is because they pay
back the original currency which has lost
value.
 Increases marginal efficiency of capital. This
makes it profitable to increase production by
employing on an extra unit of capital.
 Mild inflation helps the country to get out of a
depression and achieve recovery. This is due
to increasing aggregate demand.
Negative effects
 Savings are discouraged. This is due to
constant loss of money value.
 Makes governments unpopular. This is due to
loss of public confidence in the value of
money.
 Worsens balance of payment problem.
Exports become expensive and this reduces
foreign exchange earnings.
 Fixed income earners suffer. This is due to
high costs of living.
 Reduces production which limits output
produced. This arises from an increase in the
cost of production.
 Lending is discouraged and therefore
creditors stand to lose.
 Discourages investment. This is due to an
increase in the cost of production. It makes it
expensive to produce.
 Encourages illegal activities like smuggling,
corruption, black markets. This is because of
the need to make more profits by the
businessmen.
  Low quality goods are produced and
consumed. This causes a decline in the
standards of living.
 Planning becomes difficult eg interest rate
increases during inflation which makes it hard
to implement development plans.
 Creates industrial unrest. This is due to
constant demand for higher wages.
 Leads to brain drain. Skilled manpower
moves to other countries with affordable
costs of living.
 Worsens income inequality. Some people get
better off since they earn more income while
others get worse off which causes misery
among sufferers.
Under what circumstances may inflation be
desirable in an economy. Or Circumstances
under which an increase in money supply
may not lead to inflation.
 When there is need by the government to
encourage investment. Potential investors
may be attracted by the high prices which
increases production.
 When there is need to increase employment
opportunities. inflation may increase
investment and production leading to more
employment.
 When the economy is operating at excess
capacity. Inflation may attract people to
increase exploitation of idle resources and
ensure that they are fully utilized.
 When an economy is suffering from economic
depression, inflation may increase
investment expenditure which increases
demand leading to expanded production.
  When there is need to stimulate economic
growth through the effects of excessive
profits. Inflation may encourage investment
which helps to increase output.
 When marginal efficiency of capital is low, it
may be increased by inflation. This is
because high profits may stimulate
production which makes it more profitable to
employ an extra unit of capital.
 When there is need to stimulate demand and
therefore expand market for goods and
services in an economy, mild inflation may be
desirable.
 When inflation is used by the government as
a tool to promote cost saving instead of
introducing new taxes which may be
unpopular.
 When the government want to encourage
people to invest in assets eg land, houses,
inflation may help people to prefer such
assets instead of cash that loses value
quickly.
 When there is need to redistribute income
from wage earners with low marginal
propensity to save to profit earners with high
MPC.
Explain the theoretical relationship
between inflation and unemployment using
the Philips curve.
The Phillips curve expresses an inverse
relationship between the rate of increase in
wages and the unemployment rate. workers are
less likely to demand wage increases when there
is a large army of unemployed persons, hence a
lower inflation rate. When unemployment is low,
competition among employers for scarce labor
services, forces wage up, hence a higher inflation
rate. The higher the rate of unemployment, the
lower the rate of inflation; and the lower the rate
of unemployment, the higher the rate of
inflation.”

From the above graph, point A shows a high rate

of employment therefore the higher the
unemployment rate the lower the inflation rate
while the lower the unemployment rate, the
higher the inflation rate. The rate of
unemployment is high at 5% while the rate of
inflation is low at 2%. Point B shows a higher rate
of interest of 6% while the unemployment rate is
low at 3%