INFLATION
Inflation is a persistent or sustained rise in the price level over a period of time. Figure 1 below
shows the monthly inflation rates for the period July 2013 to July 2014, in Jamaica.
[Source: Planning Institute of Jamaica (PIOJ) website,
2015]
It can be seen that the rate fluctuated over the period peaking in September due to the lagged effect of
drought conditions causing an increase in the prices of vegetables and starchy foods, and the increase in
bus fares. The rate was at its lowest, -0.3%, in April 2014, due mainly to the reduction in the cost of
electricity.
Hyperinflations are periods of rapid sustained increases in the overall price level.
Deflation is a decrease in the overall price level. During what month did deflation take place in
the period July 2013 to July 2014?
Disinflation is a reduction in the inflation rate; prices are still increasing but at a slower rate.
During what month(s) did disinflation take place in the period July 2013 to July 2014?
Inflation is measured by observing the change in the price of a large number of goods and
services in an economy. In order to calculate inflation, a number of goods that are representative
of the economy are put together into what is referred to as a "market basket” or “basket of
goods”. The cost of this basket is then compared over time. This results in a price index, which is
the cost of the market basket today as a proportion of the cost of that identical basket in the base
year (the year all other years are compared with).
Prepared by: Sharon Hall & Andrew Mighty Page 1 of 7
Revised: Academic year 2015/16
Calculating the price index and the inflation rate
The formula used to calculate the price index is: Cost of the basket in current year * 100
Cost of basket in the base year
Example: Let the basket of goods consist of four items – patties, T-shirts, jeans and compact
disc. We will use hypothetical data for simplicity.
The 2014 Price Index (2010 = 100) based on the typical market basket consumed
Monthly Average price Cost of basket at
purchases 2010 2014 2010 2014
prices prices
30 patties $100 $ 120 $3,000 $3,600
2 T-shirts 850 1,000 1,700 2,000
1 pair jeans 1,500 2,500 1,500 2,500
1 compact disc 90 50 90 50
$6,290 $8,150
Price index in 2014 = $8150 * 100 = 130.57
$6290
The annual inflation rate is the percentage change in the price index from one year to the next.
It is given by:
Inflation rate in current year = current year price index – previous year price index * 100
previous year price index
Using information from the earlier example, if the price index in 2013 was 125, the inflation rate
of 2014 would be:
130.57 – 125 * 100 = 4.46%
125
In Jamaica, inflation is measured using different indices. The Consumer Price Index (CPI),
however, is the one that is most commonly used. The CPI shows the rate at which prices change
between two periods for the same basket of goods. The goods and services included in the CPI
basket of goods are those considered legal retail consumer items that have standard weights or
measures. The major groups in the Jamaican CPI are food and non-alcoholic beverages; housing,
water, gas electricity and other fuels; and transportation.
Figure 2, below, shows the percentage of the goods and services that comprise the Consumer
Price Index Basket in Jamaica. Food and non-alcoholic beverages has the largest percentage of
37% while alcoholic beverages and tobacco, the smallest percentage of 1%.
Prepared by: Sharon Hall & Andrew Mighty Page 2 of 7
Revised: Academic year 2015/16
Source: Bank of Jamaica (BOJ) website 2015
Figure 2
Types & Causes of inflation
There are many theories as to the cause of inflation. We will briefly explore a few below:
Inflation brought about by an increase in demand (called Demand Pull Inflation)
Inflation brought about by an increase in the costs of the factors of production (called
Cost Push Inflation)
Demand pull inflation starts with an increase in aggregate demand (AD). AD is the total
spending on goods and services made in the economy. AD = C + I + G + (X-M). This
increase in AD can arise by increases in the quantity of money, increases in government
purchases, or increases in net exports because any of these three increases aggregate
demand and shift the AD curve rightward. But if this increase is a one-time only event,
the result is a higher price level but not inflation. For inflation to occur, aggregate
demand needs to continue to increase. In this case the aggregate demand curve will
continually shift to the right. For instance, increases in money supply will lead to
increases in aggregate demand because consumers will have greater amount of money to
spend. Typically, suppliers are not able to respond quick enough, or sufficiently, to the
additional demand. The result is that the increase in spending of the population will
Prepared by: Sharon Hall & Andrew Mighty Page 3 of 7
Revised: Academic year 2015/16
exceed the capacity of the country to produce goods and services (i.e. this will invariably
create a situation where aggregate demand for goods and services exceeds the aggregate
supply resulting in demand pull inflation). This is shown by the shift of the aggregate
demand curve to the right as seen in Figure 3 below.
Price Level AS
PL3
PL2
PL1
AD3
AD1 AD2
Figure 3 National Output
Cost-push inflation starts with a decrease in the short-run aggregate supply, which may be as a result of
increases in costs of production or if there is a supply shock such as a drought. This causes the
aggregate supply (AS) curve to shift to the left. AS is the total amount of output in the economy.
When firms' costs increase they will raise their prices in order to maintain the real value of their
profits. This will result in the real incomes of the owners of the factors of production e.g. wages,
falling. In an attempt to maintain their real income, labour will demand higher money wages and
this will in turn raise costs. Other factors that may cause factor costs and therefore production
cost to increase include:
Increases in factor prices e.g. oil price increase.
An increase in wage settlements in excess of any increase in productivity.
A devaluation or depreciation of currency leading to an increase in prices of imported inputs.
Interest rate increases which increases the cost of borrowing.
Indirect taxation increases or the removal (or reduction) of subsidies.
Cost push inflation can be shown using the aggregate demand and aggregate supply curves. In
this case, aggregate supply decreases so the aggregate supply curve shifts to the left, as in Figure
4 below.
Prepared by: Sharon Hall & Andrew Mighty Page 4 of 7
Revised: Academic year 2015/16
Price Level AS3
AS2
AS1
PL3
PL2
PL1
AD
Figure 4 National Output
It is clear that both types of inflation exist in Jamaica based on the evidence. However cost push seem to
be the more dominant of the two. In Jamaica, manufacturers import a high percentage of the raw material
needed in the production process. The Jamaican dollar has depreciated by more than 200% since 1989
when it was US $1 = J$5.50. These depreciations have serious implications for production costs of these
manufacturers who invariably pass on the higher cost to their customers. Firms also tend to reduce their
demand for factors of production because of the higher cost, including cost of labour. This gives rise to
higher unemployment rate. The twin evil of high inflation and unemployment has been observed in
Jamaica’s economic experience.
Consequences of Inflation
Expenditure Switching: Goods and services produced locally become more expensive during times of
high inflation. This has a twin effect. In one instance, Jamaican export have become less competitive in
terms of prices, hence export volume falls over these periods. In the other instance, some domestic
consumers substitute away from local goods in favour of cheaper foreign goods (expenditure switching).
The overall effect has been a worsening balance of payments deficit.
Erosion of Fixed Income: People with fixed incomes, including fixed saving accounts and those whose
wages rise slower than inflation experience an erosion in their real income over time. In Jamaica,
inflation has averaged 8% over the period 1998 to 2004, whilst public sector wages have crept up by 2-
3% over the same period. The result has been a reduction in the purchasing power of Jamaicans, a
reduction in demand in most areas and ultimately a cutting back on employment for those firms
experiencing a decline in demand for their products.
Reduction in investment as it becomes increasingly difficult to plan in an ever-changing environment.
Indeed business risk is higher as there is greater uncertainty
Rise in inequality as merchants are usually able to avoid the impact of inflation by passing on the higher
prices to consumers.
Prepared by: Sharon Hall & Andrew Mighty Page 5 of 7
Revised: Academic year 2015/16
Possible Solutions
Addressing Demand-pull Inflation
The aim is to reduce aggregate demand in the economy. Government can use fiscal policy to
achieve this goal. The government can either increase taxes or cut spending or both. Increased
taxes will reduce disposable income, and hence consumer demand. Reduced government
spending will result in less demand for items purchased by the government. Overall any one, or
combination of these measures, will reduce aggregate demand.
The Government, through the Central Bank, can also employ monetary policy to reduce overall
demand in the economy. It can decrease the money supply. In this case, interest rates will rise
and this will deter investment, ultimately reducing aggregate demand, and reducing inflationary
pressures.
Addressing Cost-push Inflation
Grants or increase production subsidies to reduce production cost
Promote appreciation of the domestic currency, which should reduce the cost of imported
material.
Controlling money wages to keep down costs of production eg. the public Memorandum
of Understanding which helps to contain cost for the Government.
Direct price control.
Prepared by: Sharon Hall & Andrew Mighty Page 6 of 7
Revised: Academic year 2015/16
TUTORIAL QUESTIONS
1. What is the difference between disinflation and deflation?
2. The consumer price index is the main index used to calculate the inflation rates. What other rates
can be used? Why are they not the preferred indices used to calculate the inflation rate?
3. Assume the typical shopping basket contains 50 Cakes, 25 T-Shirts, 10 pairs of Jeans and 20
Juices. The table shows their average prices for 2010 - 2014.
Calendar Cake T-Shirt Jeans Juice
Year ($) ($) ($) ($)
2010 10 50 200 40
2011 15 75 240 45
2012 15 85 270 45
2013 15 100 310 55
2014 20 100 300 50
Assuming that the base year is 2010,
a. How much did the shopping basket cost in 2010 through to 2014?
b. What is the CPI in 2010 through to 2014?
c. What is the inflation rate from 2011 through to 2014?
4. In most countries, the CPI is used to calculate inflation. The following table shows the CPI for the
years 2008 – 2013, of Jamaica:
2008 2009 2010 2011 2012 2013
130.2 142.7 160.7 172.8 184.7 202.0
The base period is December 2006.
What was the inflation rate in each of the last four (4) years?
5. With the aid of diagrams explain:
a. cost push inflation
b. demand pull inflation
Prepared by: Sharon Hall & Andrew Mighty Page 7 of 7
Revised: Academic year 2015/16