ECONOMICS — EXTENDED PROGRAMME

CHAPTER 20
Inflation

STUDY NOTES
Textbook pp. 382–398

Prepared for: North-West University · BCom Economics with Econometrics

ECONOMICS — CHAPTER 20: INFLATION Study Notes

Lecture Outcomes
Once you have studied this chapter you should be able to:
■ Define inflation.
■ Distinguish between various measures of inflation: Consumer Price Index (CPI), Producer Price Index (PPI), GDP
deflator.
■ Discuss the main causes of inflation: demand-pull and cost-push inflation.
■ Explain why inflation is a problem (effects of inflation).
■ Suggest policies to fight/curb inflation.

1. What is Inflation?
Inflation

A significant and continuous increase in the general price level (with the quality of goods and services
remaining the same).

Deflation

Negative inflation — the price level is falling.

★ South Africa's inflation target

South Africa implements what is called inflation targeting. The target range is 3 – 6%.

The same R200 note buys progressively less over time as prices rise — in 1994 it filled a trolley, by 2021 it barely fills
a shopping bag. This is inflation in everyday terms: each unit of currency buys fewer goods and services as the
general price level rises.

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ECONOMICS — CHAPTER 20: INFLATION Study Notes

Different Elements of the Definition

Element Explanation

The increase in prices must be significant. An increase of, say, 1% per year might not be
Significant
inflation — it could be ascribed to increased quality of goods and services (Mohr, 2015)

Continuous A once-off rise in prices is not inflation

The price level refers to the average level of all prices in the economy. The increase must
Price level apply to prices in general — increases in the price of individual goods or services (e.g. oil,
electricity, bread) do not by themselves constitute inflation

★ Real-world illustration
A KFC 21-piece bucket cost R4.29 in 1976; by 2023 a comparable bucket cost R274.90. This dramatic,
continuous rise in the general price level over decades illustrates inflation in action.

Figure 1: Annual inflation rate (CPI) for South Africa, 2019–2024 (SARB, 2025)

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ECONOMICS — CHAPTER 20: INFLATION Study Notes

2. Measuring Inflation
Since inflation is a continuous and considerable increase in the general price level, a yardstick is needed to measure
this price level. Inflation is expressed as an annual rate (e.g. 4.1% per year), and is calculated as the percentage
change in a price index from one period to the next.

2.1 Consumer Price Index (CPI)

Consumer Price Index (CPI)

The most commonly used indicator of the general price level. It measures the average cost of goods and
services that are bought by the average South African consumer.

■ Since September 2016, the consumer basket contains 412 products and services (up from 396).
■ Stats SA identifies the basket contents by conducting the Living Conditions Survey (LCS) — products and
services that households spend the most money on.
■ The basket is updated every four years; some items are removed and others added during this exercise.
■ The 412 items fall within 12 categories, each assigned a weight (importance).

There are two common ways to calculate the inflation rate using the CPI:

Method Description

Year-on-Year (Y-O-Y) Compares the CPI for a given year with the CPI for the previous year

Month-on-Month (M-O-M), previous Compares the CPI for a given month with the CPI for the same month in the
year previous year

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ECONOMICS — CHAPTER 20: INFLATION Study Notes

Worked Example 1 — Year-on-Year (Y-O-Y) Inflation

Wonderland's CPI data (2012 = base year):

Inflationt = [(CPIt − CPIt−1) ÷ CPIt−1] × 100

Year CPI Inflation (%)

2012 93.1 –

2013 103.3 10.96

2014 103.3 0.00

2015 107.2 3.78

2016 108.5 1.21

1 2013: Inflation = [(103.3 − 93.1) ÷ 93.1] × 100 = (10.2 ÷ 93.1) × 100 = 10.96%

2 2014: Inflation = [(103.3 − 103.3) ÷ 103.3] × 100 = 0.00% (CPI unchanged → no inflation that year)

3 2015: Inflation = [(107.2 − 103.3) ÷ 103.3] × 100 = (3.9 ÷ 103.3) × 100 = 3.78%

4 2016: Inflation = [(108.5 − 107.2) ÷ 107.2] × 100 = (1.3 ÷ 107.2) × 100 = 1.21%

Practice Exercise — Y-O-Y Inflation

Calculate the inflation rate for each year using the CPI data below (try it yourself before checking the solution):

Year CPI Inflation (%)

2011 98

2012 107

2013 114

2014 120

2015 125

★ Solution
2012: (107−98)÷98×100 = 9.18% | 2013: (114−107)÷107×100 = 6.54% | 2014: (120−114)÷114×100 =
5.26% | 2015: (125−120)÷120×100 = 4.17%

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ECONOMICS — CHAPTER 20: INFLATION Study Notes

Worked Example 2 — Month-on-Month (M-O-M), Previous Year

Inflation2006,month = [(CPI2006,month − CPI2005,month) ÷ CPI2005,month] × 100

Month CPI 2005 CPI 2006 Inflation rate (%)

January 95.2 100.3 5.35

February 95.7 101.3 5.85

March 96.8 102.5 5.89

April 97.2 102.9 5.86

1 January: [(100.3 − 95.2) ÷ 95.2] × 100 = (5.1 ÷ 95.2) × 100 = 5.35%

2 February: [(101.3 − 95.7) ÷ 95.7] × 100 = (5.6 ÷ 95.7) × 100 = 5.85%

3 March: [(102.5 − 96.8) ÷ 96.8] × 100 = (5.7 ÷ 96.8) × 100 = 5.89%

4 April: [(102.9 − 97.2) ÷ 97.2] × 100 = (5.7 ÷ 97.2) × 100 = 5.86%

2.2 Producer Price Index (PPI)

Producer Price Index (PPI)

Measures changes in prices in the early stages of production — i.e. before those changes filter through to
households. PPI is thus used to measure the inflation of prices experienced by the producers of commodities.

Consumer Price Index (CPI) Producer Price Index (PPI)

Pertains to cost of living Pertains to cost of production

Basket consists of consumer goods and services Basket consists of goods only (no services)

Capital and intermediate goods excluded Capital and intermediate goods included

Prices include VAT Prices exclude VAT

Table 20-2: Main differences between the CPI and PPI (textbook p. 383)

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ECONOMICS — CHAPTER 20: INFLATION Study Notes

2.3 GDP Deflator

GDP deflator

While both CPI and PPI measure the prices of a particular basket, the GDP deflator approach attempts to
measure, on average, the prices of ALL goods and services included in GDP. It shows the difference
between nominal and real GDP in a particular year.

GDP Deflator = (Nominal GDP ÷ Real GDP) × 100

Inflationt = [(GDP Deflatort − GDP Deflatort−1) ÷ GDP Deflatort−1] × 100

Worked Example 3 — GDP Deflator

GDP (nominal
Year GDP (constant prices) GDP Deflator Inflation (%)
prices)

2005 137 025 167 370 122.15 –

2006 140 367 173 502 123.61 1.20

2007 138 972 175 263 126.11 2.03

2008 143 280 182 394 127.30 0.94

2009 146 769 187 269 127.59 0.23

1 GDP Deflator2005 = (167 370 ÷ 137 025) × 100 = 122.15

2 GDP Deflator2006 = (173 502 ÷ 140 367) × 100 = 123.61; Inflation2006 = [(123.61 − 122.15) ÷ 122.15]
× 100 = 1.20%

3 GDP Deflator2007 = (175 263 ÷ 138 972) × 100 = 126.11; Inflation2007 = [(126.11 − 123.61) ÷ 123.61]
× 100 = 2.03%

★ Note
Follow the same pattern (calculate the deflator for the year, then apply the inflation formula against the
previous year's deflator) to verify the 2008 and 2009 figures shown above.

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ECONOMICS — CHAPTER 20: INFLATION Study Notes

3. Causes of Inflation
3.1 Demand-Pull Inflation
Demand-pull inflation

Occurs when aggregate demand (AD) for goods and services increases. At below full employment, an
increase in AD results in an increase in BOTH the price level and production/income. After the full
employment level (Yf) is reached, a further increase in AD leads to price increases ONLY — output cannot
rise further.

Demand-pull inflation: successive rightward shifts of AD (AD0→AD1→AD2→AD3) against a fixed AS curve

Causes of demand-pull inflation:

■ Increase in any of the components of GDP (C, I, G, or net exports)
■ Increase in the money supply
■ Decrease in interest rates
■ Decrease in taxation

3.2 Cost-Push Inflation

Cost-push inflation

Occurs when the cost of production increases, shown by a leftward shift of the AS curve (from AS1 to AS2).
This results in an increase in the price level (P1 → P2) and a DECREASE in production and income (Y1 →
Y2).

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ECONOMICS — CHAPTER 20: INFLATION Study Notes

Cost-push inflation: a leftward shift of AS raises the price level but lowers output

Causes of cost-push inflation:

■ Increase in wages and salaries
■ Increase in the price of imported capital and intermediate goods
■ Increase in profit margins
■ Decrease in productivity
■ Natural disasters

★ Key distinction
Demand-pull inflation is driven by too much spending chasing available output (AD shifts right). Cost-push
inflation is driven by rising production costs squeezing supply (AS shifts left). Demand-pull raises both prices
AND output (below full employment); cost-push raises prices but LOWERS output — this combination of rising
prices and falling output/rising unemployment is called stagflation.

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ECONOMICS — CHAPTER 20: INFLATION Study Notes

4. Effects of Inflation
4.1 Distributional Effects
Group Effect

Creditors / Savers / Fixed deposit

Lose if interest rates are not adjusted for inflation
holders

Debtors Benefit — the real value of their loans decreases as prices rise

Producers Benefit if prices rise faster than costs

Lose due to bracket creep / fiscal drag, redistributing income from taxpayers
Taxpayers
to government

Government Benefits from the resulting fiscal dividend

4.2 Economic Effects

Effect Explanation

Inflation erodes the purchasing power of money if wages are not adjusted for
Falling real incomes
price increases

Rising wages push up costs and prices, which in turn drives further wage
Wage-price spiral
demands

Negative real interest rates Occurs when the interest rate on savings is lower than the inflation rate

Affects lower-income households the most, as they hold most of their wealth in
Increases inequality
cash

Business uncertainty Lowers investor and business confidence, discouraging investment

Lower international Lowers demand for exports and increases demand for imports, leading to
competitiveness currency depreciation

Interest rates tend to rise in inflationary economies, potentially conflicting with

Cost of borrowing
the employment and growth objectives

Stagflation Inflation and unemployment increasing at the same time

4.3 Social & Political Effects

■ Inflation results in an unhappy society.
■ Social and political unrest — inflation causes a climate of conflict and tension.

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ECONOMICS — CHAPTER 20: INFLATION Study Notes

5. Remedial Policies for Curbing Inflation

5.1 Policies Against Demand-Pull Inflation
Policy Detail / risk

Increase interest rates and/or reduce the money supply — risks pushing the
Contractionary monetary policy
economy into a recession

Reduce government spending — also risks pushing the economy into a

Contractionary fiscal policy
recession

5.2 Policies Against Cost-Push Inflation

Policy Detail / risk

Government restricts wage rises Could create conflict between government, business and labour

Reduce corporation tax Reduces the cost of production for firms

Government provides subsidies Could promote inefficiency among subsidised firms

6. Key Formulas — Quick Reference

Concept Formula

CPI inflation (Y-O-Y) [(CPI this year − CPI previous year) ÷ CPI previous year] × 100

[(CPI this month − CPI same month last year) ÷ CPI same month last
CPI inflation (M-O-M, previous year)
year] × 100

GDP deflator (Nominal GDP ÷ Real GDP) × 100

[(Deflator this year − Deflator previous year) ÷ Deflator previous year]

Inflation via GDP deflator
× 100

SA inflation target range 3% – 6%

Demand-pull inflation Caused by a rightward shift of AD

Cost-push inflation Caused by a leftward shift of AS

Stagflation Inflation and unemployment rising together

7. Self-Check Questions
Try these before checking the answer key at the end of this document.
1. Inflation is defined as
A. a once-off increase in the price of a single good B. a significant and continuous increase in the general price level C. any increase
in interest rates D. a decrease in the general price level
2. Deflation refers to
A. a slowdown in the rate of inflation B. negative inflation — the price level is falling C. an increase in the price level above target D.
a fixed exchange rate policy
3. South Africa's inflation target range is
A. 0–2% B. 2–4% C. 3–6% D. 6–10%
4. The most commonly used indicator of the general price level in South Africa is the
A. PPI B. CPI C. GDP deflator D. Gini index

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ECONOMICS — CHAPTER 20: INFLATION Study Notes

5. Since September 2016, the CPI consumer basket contains how many products and services?
A. 396 B. 412 C. 300 D. 500
6. The PPI differs from the CPI in that the PPI
A. includes VAT and excludes services B. excludes VAT and includes only goods (no services) C. measures only import prices D. is
calculated annually only
7. The GDP deflator is calculated as
A. Real GDP ÷ Nominal GDP × 100 B. Nominal GDP ÷ Real GDP × 100 C. Nominal GDP − Real GDP D. Real GDP − Nominal GDP
8. Demand-pull inflation is caused by a shift of
A. AS to the left B. AD to the right C. AS to the right D. AD to the left
9. Which of the following is a cause of cost-push inflation?
A. A decrease in interest rates B. An increase in the money supply C. An increase in wages and salaries D. A decrease in taxation
10. At below full employment, an increase in AD leads to
A. higher prices only B. higher output only C. both higher prices and higher output D. no change in either price or output
11. Once full employment (Yf) is reached, a further increase in AD leads to
A. price increases only B. output increases only C. both price and output increases D. deflation
12. Which group benefits from inflation because the real value of their loans falls?
A. Creditors B. Savers C. Debtors D. Fixed deposit holders
13. Inflation and unemployment rising at the same time is called
A. stagflation B. deflation C. disinflation D. hyperinflation
14. A contractionary monetary policy used to curb demand-pull inflation risks
A. accelerating inflation further B. pushing the economy into a recession C. increasing government spending D. reducing interest
rates

Answer Key
1-B, 2-B, 3-C, 4-B, 5-B, 6-B, 7-B, 8-B, 9-C, 10-C, 11-A, 12-C, 13-A, 14-B

Where to Read More in the Textbook

■ Chapter 20 core content: pp. 382–398
■ Table 20-2 (CPI vs PPI differences): p. 383
■ Month-on-month and year-on-year calculations: pp. 382–383
■ Next chapter: Chapter 14 — The Monetary Sector

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