CHAPTER 9: INFLATION

Study Guide — Identification | True or False | Enumeration

I. THE MEANING OF INFLATION

• Inflation — the term is generally used to mean any sustained or continuing increase in price.
Inflation is not a monopoly of the Philippines. It is a
Inflation is a universal experience of all countries, both developed and developing. The difference lies
only on the magnitude of price increases countries suffer from.
• Hyperinflation — a phenomenon where prices shoot up sharply at excessively high rates that normal
economic relationships are disrupted. Money becomes virtually worthless and ceases to do its job as a
standard of value and medium of exchange. The economy may literally be thrown into a state of
barter.
Example: Germany, early 1920s — the Weimar Republic financed a staggering reparations bill of 132
billion gold marks by running the printing press. During 1922, the German price level went up 5,470
percent. In 1923, the price level rose to 1,300,000,000,000 times.
In the Philippines, hyperinflation took place during the Japanese occupation, when people had to bring
bagfuls of paper money just to buy a kilo of fish or vegetables.

II. UNDESIRABILITY OF INFLATION

Inflation negates the economic objective of improving the quality of life of people. Three groups are
severely affected:
1. People with fixed incomes — with increased prices, this group loses out because the income they
receive now would be able to buy less than before; thus, their economic welfare is diminished.
2. Pensioners from the Social Security System (SSS) or the Government Service Insurance System
(GSIS) — increased prices result in a net loss to the pensioner unless benefits are adjusted to the
inflation rate.
3. Creditors — they lose out because the fixed amount of principal and interest they lent out would
now be valued less. Example: if interest rate charged by the creditor is 12% but the inflation rate is
20%, the net loss of the creditor would be 8%.
Much of the reason why the economic welfare of people deteriorates during inflation is the depreciation
in the purchasing power of the peso.

III. INFLATION GAINERS

Although there are significantly greater numbers of people who register net losses rather than net gains,
there are three groups of gainers:
4. People who have flexible incomes — e.g., businessmen would gain more if prices of commodities
they produce and sell go up.
5. Speculators — the perceptive and lucky individuals who are able to buy goods at cheaper prices and
then sell them later at higher prices because of inflation (e.g., grocery, appliances, land, jewelry).
 6. Debtors — unless there is an automatic adjustment for inflation, debtors usually gain because the
value of the money they borrowed before would now have more value. Other gainers include people
who built houses in the '70s through housing loans with SSS or GSIS.

IV. DEMAND-PULL INFLATION

• Demand-pull inflation — inflation is said to be demand-pull if those who buy goods and services
desire to purchase goods and services greater than what the economy can produce. In other words,
excess demand for commodities would tend to push prices up.
When there is an increase in demand, prices will tend to go up and output of goods and services would
also tend to increase. However, if the economy is already at full employment, the effect of the increase in
demand would only be translated through increase in prices (Figure 64: shift of demand curve from D 1 to
D2 resulted in an increase in price from P1 to P2).

Circumstances / Causes of Demand-Pull Inflation

• Increase in the supply of money — without an increase in the supply of money, no major inflation
can last very long. Excessive supply of money in the circular flow would invariably lead to upward
movement of prices.
• Quantity Theory of Money — the theory that traces the increase in prices to money supply.
• Cyclical booms — good times encourage high investments; these investments, through the
multiplier, create large increase in demand for goods and services pressuring prices to go up.
• Wartime periods — extraordinary levels of government expenditures feed the military to high levels
of expenditures, which do not contribute much to increase in production.
• Elections — election campaigns invariably include a big amount of expenditures injected into the
economy; this is why prices usually rise after elections.

V. THE QUANTITY THEORY OF MONEY

In general, the greater the volume of transactions in the economy, the higher the level of money required
to finance the transactions. If the GNP rises, the transactions requirements for money will also rise.
The equation:

• M — is the supply of money.

• V — is the velocity of money, i.e. the number of times the average peso is spent on final goods and
services.
• P — is the general price level, or the average price at which each unit of physical output is sold.
• Q — is the physical volume of goods and services produced.

The Modern Version — Monetarists

Milton Friedman, a Nobel Prize Winner in Economics based at the University of Chicago, revived the
theory postulating that M and P are directly related.
• Monetarists — believers in the modern (Friedman) version of the quantity theory of money; they
assert that a degree of control on M helps to control the level of GNP, and put more emphasis on
monetary policy than fiscal policy.
Believers of this school do not necessarily accept the constancy of the velocity of money; they admit the
possibility of changes in V, except that they believe V can reasonably be predicted.

VI. COST-PUSH INFLATION

• Cost-push inflation — the type of inflation where increases in the costs of production push prices
up. It is believed that such a shift (in the supply curve) usually results from increases in the cost of
production of inputs and raw materials, increase in the monopoly mark-up, and increase in wage
costs.
Example: the “great oil price shock” — in the early '70s, oil which had been selling for as little as $3.00
per barrel suddenly shot upward to $14.00 per barrel, resulting in a major increase in the general price
level.

Four Factors Behind Cost-Push Inflation

7. Increases in the cost of production of inputs and raw materials (e.g., the oil price shock).
8. Demand for higher wages by labor unions — if firms accede to the demand for higher wages, they
have no recourse but to pass on the costs to the consumers through higher prices.
9. Monopolies in society — powerful monopolistic firms can raise their prices disproportionately when
wages are raised or when other cost of inputs increase.
10. Devaluations of the peso — devaluation makes the peso worth less in relation to the dollar; since the
economy is highly import-dependent, higher cost of imports (mainly crude oil and capital goods)
means higher prices.
Figure 65 shows a cost-push effect that restricts the aggregate supply function; this shift to the left (S1 to
S2) results in a higher price level (P2) and lower income level (Y2).

VII. THE PHILLIPS' CURVE

• Phillips' curve — the empirical relationship of unemployment to inflation. It is named after A.W.
Phillips, who first plotted such points for the United Kingdom, using annual data for the period 1948–
1969.
Low unemployment is associated with tightness in the labor market and high levels of consumer income
and demand. High unemployment implies soft labor markets and low inflation rates.
The Phillips curve calls attention to the idea of trade-off between unemployment and inflation — the
economy can opt for low unemployment, but only at the price of a high rate of inflation; or it can opt for
price stability, but at the cost of a high unemployment rate.
Note: in the Philippines, high unemployment rates can exist side-by-side with high inflation rates, an
exception to the Phillips curve relationship found in Britain, the United States, and Europe.

VIII. MEASUREMENT OF PRICE INCREASES

There are at least four commonly used measures of price increases:
• Consumer Price Index (CPI) — the most popular and the most used measure as it reflects what
happens to the living standards of most of us, the consumers. It is intended to provide a general
measure of average monthly and annual changes in the retail prices of commodities commonly
bought by consumers in the Philippines, covering all income households.
 • Retail Price Index (RPI) — designed to measure monthly changes of the prices at which retailers
dispose of their goods to consumers and end users.
• Wholesale Price Index (WPI) — measures monthly changes in the general price level of
commodities that flow into wholesale trade intermediaries in Metro Manila; hence, it measures price
changes during trade turnover.
• Stock Price Index (SPI) — serves as a measure of the changes in, and to trace the movement of the
average prices of company shares of stocks traded in the Makati and Manila Stock Exchanges.

Details on the CPI

• Base year: 1994 (1994 = 100).
• Computed following the Laspeyre's formula.
• Weights utilized were based on the Family Income and Expenditure Survey (FIES) conducted by
the National Census and Statistics Office in 1990.
• Price data are collected from retail outlets in Metro Manila (11 markets), in all provincial capitals,
and in more or less 600 municipalities throughout the country.
• Some 400 items are included in the CPI “fixed market basket” of goods and services.
• Agencies charged with price data collection: Bureau of Agricultural Economics (BAEcon),
National Census and Statistics Office (NCSO), and National Food Authority (NFA).

Details on the RPI

• “Retail price” refers to the price at which sellers accept orders for spot or earliest delivery usually in
small quantities — transactions on cash basis in the open market.
• Base year: 1994; replaces the CB series which had 1985 as the base period.
• Follows the Laspeyre's formula; weights derived from the values of expenditures of goods and
services of consumers from the retail sector as obtained from the 1985 Input-Output table.
• The RPI market basket contains the same food and non-food commodities as the CPI, with an
expanded list of construction materials, but excludes light, water, rentals, wages, and other
services items.

Details on the WPI

• Base year: 1994, replacing the 1985-based CB series.
• Follows the Laspeyre's formula, utilizing as weights the value of sales of commodities traded in the
wholesale market in 1985.

IX. THE MEANING OF THE INDEX

• Index number — a statistical measure designed to show changes in a variable or group of related
variables (price, quantity, value), with respect to time, geographic location, or other characteristics
such as income, profession, and the like.
Index numbers compare figures which show changes in a given variable. The most common variables
used in index numbers are price and quantity.
Among the more commonly used index numbers are the consumer price index, retail price index,
wholesale price index, and the cost-of-living index.
Price, Quantity, and Value Relatives
The simplest kinds of index numbers are called relatives, because they compare the price, quantity, or
value of only one commodity between two time periods or localities. There are three types:
• Price Relative (PR)
• Quantity Relative (QR)
• Value Relative (VR)

• Pn — price during a given year.

• Po — price during the base year.
• Qn — quantity during a given year.
• Qo — quantity during the base year.
• Vn — value during a given year.
• Vo — value during the base year.
Since value = (price) x (quantity), the formula for value relative may be transformed as:

The Base Year

• Base year — the year with which variables (that is, price, quantity, and the like) during a given year
are being compared. It might also be called the reference year, that is, we refer prices back to that
year.
Two major factors in choosing the base year:
11. It should be a “normal” or “typical” year — no economic phenomenon of an extraordinary nature
happened during that year.
12. It should not be too far back in the past — as time passes, a year closer to the present is picked.
Rule to remember: in interpreting an index number, the figure corresponding to the base year is always
equal to 100. We get the difference between a given index number and 100 to determine the percent
change.

X. PRICE INDEX NUMBERS

There are three types of price index numbers:
13. Price Relative
14. Unweighted Price Index — a. Simple Aggregative Price Index; b. Average of Price Relatives
15. Weighted Price Index — a. Laspeyres Index; b. Paasche Index

Simple Aggregative Price Index (SAPI)

• ΣPn — sum of the prices of the commodities during the given year.
• ΣPo — sum of the prices of the same commodities during the base year.
Disadvantage: it gives, in effect, equal weight to each commodity; therefore, the commodity with the
largest unit price exerts the greatest influence on the outcome.
Average of Price Relatives
Derived by getting the average of the price relatives, applying PR = Pn/Po for each commodity, then
averaging the results. It yields a better result than SAPI, but still carries the disadvantages of an
unweighted price index.
Advantage of using an unweighted price index: simplicity in the computations.

Weighted Price Index Numbers

In weighted index numbers, the quantity of each commodity enters the computations — this eliminates
the disadvantages of an unweighted index number. The Laspeyres index number is more commonly used
than the Paasche index number.

Note: the given year weights are used (per the book's note under the formulas).
Interpretation of viewpoint: the Laspeyres index looks from the past to the present, while the Paasche
index looks from the present to the past.
• Laspeyres (L.I.) — we want to know how much the bill of goods in the base year will cost in the
given year.
• Paasche (P.I.) — we want to know how much the bill of goods in the given year would have cost in
the base year.

XI. MEASURES TO CURB INFLATION

There are basically two methods by which inflation may be controlled: through monetary policy or
fiscal policy. The only way to fight inflation and avoid side effects is to reverse the movement that caused
the inflation in the first place.

Against Demand-Pull Inflation

• Monetary policy: a “tight money” situation is suggested — lessening money in circulation,
increasing interest rates to inhibit investments, increasing the reserve requirement of banks, and
minimizing or closing rediscounts.
• Fiscal policy: if inflation is caused by deficits in government spending, an appropriate policy is to cut
back on such spending; if spending is essential (e.g., war against insurgents), new taxes should be
considered to cut down on consumption and investment.

Against Cost-Push Inflation

• Best counter-remedy: break up the monopoly power which makes such cost push possible.
• Second-best solution: a set of wage and price controls — though these usually only postpone
inflation, since they do nothing to eliminate its cause.
• In cases of real increases in costs from shifts in the production function, there is little that can be done
unless there is a willingness to give up the policies that caused the problem, or ways are found to
increase productivity.
Monetary Policy (Bangko Sentral)
• Monetary policy — the province of the Bangko Sentral or the monetary authority; by means of this,
the Bangko Sentral is able to make the supply of money scarce or plentiful, as the overall national
objectives would require.
The Bangko Sentral has six tools of policy which it may use to control money supply:
16. Exercise of fiat authority to issue paper money.
17. Control of the bank's reserve requirements.
18. Use of discount (or rediscount) policy.
19. Use of open market operations.
20. Selective credit controls.
21. Use of moral suasion.
Notes on the tools: changes in reserve requirement are considered a blunt instrument used only when
reserves are grossly out of line with economic requirements. Open-market operations are considered a
“fine-tuning” instrument that more subtly influence bank reserves and money supply.

Fiscal Policy
• Fiscal policy — concerned with the utilization of public expenditure, taxation, and public debt so as
to achieve desired economic objectives. It is supposed to assist in the reduction of wild swings in
economic activity and in the promotion of a stable growth of income over time, greater employment,
and a more equitable distribution of income and wealth.
Taxes deprive households and businesses of both income and money.

Monetary vs. Fiscal Policy

• Monetary policy is “like a string” — it can pull back inflation, but it cannot push in times of
recession to stimulate economic activity.
• Monetary ease and restraints can only affect the ability to borrow; they do not play directly on
people's propensity to consume and to save.
• Fiscal policy has the advantage of hitting both income and money supply; monetary policy's
advantage is that it is easier and quicker to impose than fiscal policy.
• In the final analysis, the containment of inflation rests on both the fiscal and monetary authorities.

XII. KEY FIGURES TO REMEMBER (from Tables/Figures)

• Figure 63: Inflation rate High: 3.8% (August 2012); Low: 2.6% (April and May 2013) (June
2012–June 2013).
• February 2005 inflation rate: 8.5% (vs. 8.4% the previous month; used 2000 as the base year).
• February 2004 inflation rate: 4%; Q1 2004 average: 4.1%.
• Table 28 base year for inflation rates: 1994 = 100.
• Table 30: Purchasing Power of the Philippine Peso is based on CPI (1994 = 100); as CPI rises,
purchasing power of the peso declines (e.g., 1994 = 1.00, 2002 = 0.60).
• German inflation 1922: prices up 5,470%; 1923: prices up 1,300,000,000,000 times; reparations bill:
132 billion gold marks (presented April 27, 1921).
• Oil price shock: from $3.00 to $14.00 per barrel in the early '70s.
 • Phillips' Curve data period: 1948–1969; distorted years: 1952 and 1953 (Korean War and price
controls).

XIII. TRUE OR FALSE — PRACTICE PROMPTS

(Use the definitions above to test yourself. Statements are paraphrased prompts — go back to the notes
above to verify true/false.)
22. Inflation is a phenomenon unique to the Philippines.
23. Creditors generally gain during inflation.
24. Debtors generally gain during inflation.
25. Demand-pull inflation results when desired purchases exceed what the economy can produce.
26. Cost-push inflation results from a rightward shift in the supply curve.
27. The Laspeyres index uses base year quantities as weights.
28. The Paasche index uses base year quantities as weights.
29. In an index number, the base year figure is always equal to 100.
30. Monetary policy can effectively stimulate the economy during a recession.
31. The CPI is computed using the Laspeyre's formula with 1994 as the base year.

XIV. ENUMERATION — PRACTICE PROMPTS

32. Enumerate the three groups who lose out (are severely affected) during inflation.
33. Enumerate the three groups of inflation gainers.
34. Enumerate the four commonly used measures of price increases.
35. Enumerate the three types of price index numbers.
36. Enumerate the two types of weighted price index numbers.
37. Enumerate the six tools of policy used by the Bangko Sentral to control money supply.
38. Enumerate the four factors behind cost-push inflation.
39. Enumerate the circumstances/causes under which demand-pull inflation occurs.