SCHOOL OF BUSINESS

ECO 1302: INTRODUCTION TO MACROECONOMICS

BY LECTURER MILKAH NJUGUNA Prepared by lecturer Milkah W

TOPIC: INFLATION

In this topic, we shall cover the following areas:

 Definition
 Types of inflation
 Classification of inflation and the causes.
 Measurement of inflation
 Effects of inflation in an economy.
 Measures to alleviate or combat inflation in an economy.
 The concept of inflationary gap and deflationary gap.

1. DEFINITION OF INFLATION
Inflation may be defined as a macro-economic problem where there is persistence
(continuous/sustained) increase in general price level of goods and services. Inflation is
associated with a situation whereby there too much money is used in purchasing too few goods,
that is, too much money chasing too few goods. This is because during inflation money loses
its value.

2. TYPES OF INFLATION
The major types of inflation are:

(1) Creeping inflation: This type of inflation, which is also referred to as crawling inflation
refers to a situation where general price levels increase at a rate of 2-3 per cent per annum.
This type of inflation is considered healthy or harmless for economic growth because firms and
households can plan for more economic investments. Whenever this type of inflation is
experienced there will be induce or encourage investment and aggregate demand for goods and
services.

(2) Moderate Inflation: So long as the level of inflation is within a single digit, (4 – 9 per
cent per annum) that type of inflation is referred to as moderate inflation. It is not a harmful
inflation and therefore is considered healthy for economic growth as it encourages investment.

(3) Rapid inflation: This type of inflation is also referred to as runaway inflation and it occurs
when the general price levels increase between 9–20 per cent per annum. It is not good for
economic growth because firms and households find it difficult to predict on the economic
trend and it therefore interferes with the planning processes.

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(4) Hyperinflation: This type of inflation is also referred to as galloping inflation, the general
price levels in an economy increase between 50–100 per cent per annum. Galloping inflation
is very bad and harmful for an economy. During hyperinflation, money as a medium of
exchange fails to perform its function and the currency becomes unacceptable. If an economy
is facing this type of inflation, the government will be forced to drop its currency and introduce
a new one. Hence, hyperinflation can lead to the breakdown of country’s monetary system. It
occurred in Germany in 1923 where the prices rose by 250 per cent in just one month!

(5) Suppressed inflation: It refers to a situation where demand exceeds supply. However, the
effect on prices is minimized through the use of instruments such as price control or rationing.

(6) Stagflation: This is the combination of high unemployment and economic stagnation with
inflation. It happened in industrialized countries during the 1970s’ when bad economies were
combined with OPEC raising oil prices exorbitantly.

(7) Expected inflation: When firms and employees negotiate wages and when companies set
their prices, they often consider what inflation might be in the period ahead. If for example
economists predict that the rate of inflation is likely to increase by 15 per cent this will force
the wage earners to demand more wages in order to adjust to high cost of living. This type of
inflation is also known as wage induced inflation since workers demand more money in order
to adjust to high cost of living. Expected inflation affects wages and prices because future
prices rise reduce amount of goods and services that today’s wage settlement could buy.
Therefore if people expect inflation their behaviour can lead to inflation.

3. CLASSIFICATION OF INFLATION

Causes of inflation can broadly be categorized into two: -

1. Cost push inflation

Cost push inflation occurs when there is an increase in the cost of production, that is, an
increase in prices of factors of production which will have a tendency of pushing up the general
price level of goods and services. Hence, it is associated with supply and/or cost side of the
market. Cost-push inflation is specifically caused by the following factors:

(a) Increase on wages: When higher wages are paid without a corresponding increase in
productivity, this could cause inflation. An increase in wage could be due to trade union
pressures. Since wages form a significant part of total cost in production process, any
increase in wages which is not compensated for by increase in productivity will result in
higher cost which will be passed on to consumers as producers seek to maintain their level
of profitability. As a result, there would be a general increase in prices of goods and
services.

(b) Increase in import prices: a country that is importing commodities from another country
is likely to import inflation e.g. inform of intermediate goods. This could occur when there
is an increase in price of an important import commodity such as crude oil. This could result
to escalating of prices throughout the economy since oil is often associated with many
processes of production. An increase in crude oil prices occurred in 1973/74 and 1979/80

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 when the oil prices quadrupled (increased in four fold). Import prices may also rise due to
devaluation of currency or depreciation of the exchange rate. This type of inflation, which
is associated with price of import, is referred to as imported inflation.

(c) Increase in indirect tax: An increase in indirect tax imposed by the government may also
cause cost-push inflation because imposition of expenditure taxes such as VAT may lead
to increase in general price level of goods and services. However, this will depend on the
price elasticity of demand of a commodity.

(d) Changes in the exchange rate –Its estimated that when a country devalues its currency
e.g. by 4% it will cause a 1% inflation increase (devaluation makes export cheaper and
imports expensive)

(e) General increase in prices of raw materials: This can also lead to cost push inflation.

(f) Mark up pricing-This is a tendency by many firms of fixing prices above the unit cost in
order to make maximum profits. If the cost of production increases with an aim of
maintaining profit margin at a higher prices for commodities.

(g) Structural rigidity of factors of production -whenever factors of production fail to move
quickly from one place to another or from one use to another this may call for an increase
in the cost of production. This in turn leads to an increase in price level of goods and
services.

2. Demand-pull Inflation
Demand-pull inflation is also referred to as excess demand inflation and it occurs when
aggregate demand persistently exceeds aggregate supply at current prices. It arises when there
is an increase in aggregate demand which tends to out way the value of output at full
employment of resources. Since the excess demand cannot be met in the real terms, the natural
market respond is for the prices to rise to a new equilibrium. All these will depend on the
elasticity of demand and also on the elasticity of supply, since if firms cannot respond to
changes immediately by expanding output a situation of excess demand exist and inflation will
result.

Firms may be unable to respond to demand because of their inability to obtain adequate
resources to meet the demand with the necessary time period. Because of this resource
constraint phenomena there will be no production leading to shortage and scarcity of goods and
services and hence increasing the general price levels.

Demand-pull inflation may specifically be caused by the following factors:

(a) A general increases in the level of demand for goods and services. A rise in aggregate
demand at full employment of resources will cause a rise in prices of various goods and
services.
(b) Shortage of goods and services or lack of supply- due to natural calamities/disasters
such as floods, drought, earthquakes, tsunamis, etc. when there is a general shortage of
commodities demand tend to exceed supply hence there is an increase in price levels.
(c) A country trying to achieve an export surplus situation because exports generate foreign
exchange at home while reducing production of goods to be consumed domestically may

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 lead to low supply which in turn may cause an increase in prices of goods and services in
the economy.

(d) Foreign currencies inflow cause increases in money supply since eventually the domestic
currency has to be been issued by the central bank to exporters. This inflow becomes a
source of inflationary pressures where most people with access to the foreign currencies
may demand more goods and services and this may in turn lead to high prices.

(e) Social evils- This creates an artificial shortage which causes price levels to go up e.g.
hoarding.

(f) The increased or expansion of government spending- This may cause a hyper-inflation
e. g. through the increase in investment in large projects taken by the government. Also by
the borrowing from the public system especially where there is no match with output could
also result to demand pull inflation. Government borrows from time to time to finance
shortfall of revenue against expenditure (i.e. budget deficit). This is referred as deficit
financing. If the government borrows directly from the central bank this will increase
money supply because central bank will simply “print” money, leading to an inflation type
referred to as credit inflation.

3. Monetary inflation

Economists believes that inflation is a monetary phenomenon and it is always caused by an

increase in quantity of money in circulation i.e. when money supply is more.

4. MEASUREMENT OF INFLATION

Inflation is measured through:

1. Consumer Price Index (CPI)

CPI is an index number of prices of commodities. It measures the relative changes in the prices
of a specified set of consumer goods, which will be bought while an average household on a
regular basis. The basket may consist of commodities such as food, beverages, housing,
transportation, medical care, Kerosene etc. The weights in the index are based on the survey
that it relates to the present day buying patterns. Commodities representing a large proportion
of expenditure will be given more significant weight in the index.

Advantage of CPI
 Since it is a measure of inflation, it is reliable measure of the cost of living.

Disadvantages
 Since it is a fix weight index it does not allow the substitution effect where the consumers
may, for instance, select a substitute whose price has experienced a relatively smaller
increase.
 The quality of goods changes such that a price increase may reflect improved quality rather
than inflation and therefore CPI may sometime overstate price increase.

2. Produce Price Index (PPI)

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PPI may be used to measure the prices that business organizations or firms pay in large volume
wholesale market. The PPI is an index of prices charged by businesses for raw materials,
intermediate goods, finished goods etc. Prices of (PPI) producer price Index are weighted just
like in CPI.

MEASUREMENT OF INFLATION IN KENYA

In Kenya, measurement of inflation is classified in the following four ways:

(1) Month-on-month Inflation: It refers to inflation over a period of 12 months for example
between March 2005 and March 2006.

(2) Average Annual Inflation: It refers to the average of the month-on-month inflation over
the last 12 months.

(3) Three-month Annualized Inflation: It refers to month on month inflation that could have
been generated if inflation in the last 3 months were to be maintained throughout the year, that
is, remain constant.

(4) Underlying Inflation: It refers to changes in general price level that include changes, in
prices of food and any other once and for all price changes. It normally reflects the influence
of monetary expansion on prices.

5. EFFECTS OF INFLATION
Creeping or moderate inflation is healthy for economic growth as it may lead to more
investment and therefore generation of employment. However, most of the effects of inflation
are adverse, undesirable or unfavourable for the economy as discussed below: -
(1) Effects of inflation on investment

The effects of inflation especially rapid and galloping are unfavourable to investment because
they increase uncertainty and thus affecting plans of investors.

(2) Effects of inflation on the functions of money

(a) Money is supposed to be a medium of exchange. However during inflation,

especially galloping inflation, people prefer to exchange goods for goods because
money loses its value and people have no confidence with the currency as a medium
of exchange.

(b) Money is supposed to be used for deferred payment. However, during inflation
debtors gain as creditors loose because money value keeps on falling.

(c) Money is used as measure of unit of a value that is we can compare the value of
two commodities with reference to their prices. However, during the time of
inflation it is difficult to compare the value of two commodities because their price
keeps on changing.

(d) Money is used as a store of value, that is we can sell a commodity and convert its
value inform of money, however during inflation people prefer to store the value of
their wealth in terms of capital goods because the value of money keeps on falling.

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 (e) Money is used to move immobile property from one geographical region to
another for example selling a house in one geographical location and buying a
similar house in a different geographical location. However, during inflation it is
difficult to move immobile property from one geographical location to another
because the value of money keeps on falling due to increase in general price levels.

(3) Effects of Inflation on Employment

During inflation especially cost push inflation, many firms will try to cut down labour cost
which will result to actions such as retrenchment, downsizing, etc, all which will lead to
unemployment. Similarly, since inflation discourages investment the ability of the economy to
create more jobs is hampered.

(4) Effects of Inflation on Exchange Rate and Balance of Payment

During inflation foreign countries avoid trading with the country which is affected by inflation
in order not to be affected by imported inflation. As a result, its domestic currency will
depreciate vis-à-vis other foreign currencies. When a country is facing inflation it also suffers
from balance of payment deficit because it may not be producing much goods for export,
especially if it is suffering from the cost-push inflation.

(5) Effects of Inflation on Distribution of Income

Inflation leads to an arbitrary redistribution of income whereby those whose income are fixed
in monetary terms experience a fall in real income while debtors gain and creditors loose during
the period of severe inflation.

(6) Effects of Inflation on Cost of Living

During inflation there is a high cost of living due to increase in price levels especially of basic
commodities and as a result there will be a fall in the standard of living, and this will worsen
especially if an economy is already suffering from abject (absolute/extreme) poverty.

(7) Effects of Inflation on Interest Rates

A high rate of inflation has a negative effect on interest received on savings. This is because
real interest rate is calculated by subtracting the prevailing inflation rate from the nominal
rate of interest. For example if the nominal rate of interest is 12% per annum and the rate of
inflation is 15%, then there would be a negative real interest rate because real interest rate =
Nominal interest rate less/minus inflation rate. Thus: 12% - 15% = -3%.
Therefore, the higher the rate of inflation, the lower the real interest rate.

Other effects
 It leads shoe leather cost: This refers to a situation whereby consumers move from one
producer to another searching for favourable prices because price levels keep on increasing.
 Menu cost: It refers to situation whereby consumers keep a lot of money, as they cannot
plan since the general price level keeps on increasing, making it difficult to make an
accurate prediction.

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 Social problems such as high crime rate, immorality, war between rich and poor and
political revolutions, all can occur during the period of severe inflation.

6. MEASURES TO COMBAT INFLATION

Methods applied to control or minimize inflation depend on its causes. This means different
policy measures will be applied depending on whether the economy is suffering from monetary
inflation, Demand-pull or Cost-push inflation. Basically, the policy measures or ways that can
be applied to combat inflation are:

(1) Monetary Policy

In case an economy is experiencing monetary inflation, inflation monetary policy measures
can be taken to control it.
NB: Monetary measures are the measures which are adopted by central bank of any given
country and are aimed at regulating and controlling money supply and can be applied in the
following ways:

 The restriction of direct lending to the government whereby the central bank will ensure
that Government doesn’t borrow from the bank beyond the legally permitted limit.
 Rationing of credit-during inflation the central bank rations the amount of money to
commercial banks which is available for lending. This action is meant to reduce the amount
of money in circulation.
 Open market operation- during inflation central bank sells securities to the public in
order to reduce the amount of money in circulation.
 Bank rate policy- during inflation the bank rate is raised to which in turn lead to increased
rate of interest on loans and this help to discourage the public from borrowing so as to
reduce the supply of money.
 Increase in cash or liquidity ratio requirements on commercial banks and other financial
institutions and thereby reducing their ability to create credit and hence money supply,
which brings down level of inflation.
 For those banks that may result to central bank for overnight borrowing, the central bank
aims to ensure that the interest rate charged on such loans are punitive (i.e. punishing or
discouraging). This will ensure that they don’t have excess cash and this will bring down
the level of inflation.
 The central bank requires the Commercial Banks to deposit special deposits with them.
 Reserve requirement- commercial banks are supposed to keep a certain proportion of
the deposits with the central bank and during inflation this amount is increased to reduce
the amount of money in circulation.
-

(2) Fiscal Policy

How is fiscal policy applied to combat inflation caused by demand-pull?

Fiscal policy measures to combat such kind of inflation include:

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 Raising taxes in order to cut consumers disposable income and hence their level of
spending. During inflation more taxes are imposed on goods and services and on
individuals such that the purchasing power could fall which in turn reduces demand and
so the price.
 Lowering government or Public expenditure- during inflation the government reduces
its expenditure and as a result money supply in circulation is reduced and this will help to
solve the problem of inflation (when demand is low, price levels are also low)
 Public borrowing- during inflation the government borrows from the public and uses this
money on more productive projects. In this case production of goods and services will
increase which leads to more supply and then to a fall in prices.
 Lowering government budgetary deficits in order to discourage domestic borrowing.
Disciplined management of public finance is a vital weapon in the fight against budgetary
deficit. Similarly, the government should avoid borrowing from the central bank as this
simply means printing paper money, which might result to credit inflation.

(3) Direct intervention- non monetary measures- these measures include;

 Wage adjustments – It’s where the government may intervene in fixing wages. This
is to enable the individuals to maintain their purchasing power at the same levels. Where
the increase on general price level is as a result of high wages, steps may be taken to
encourage greater productivity in the industry and to apply controls over wages and
price increases.
 Wage Flexibility is considered to be a crude method of controlling inflation where the
government deliberately decides to reduce the wages of public servants with the
objectives of controlling wage induced inflation. This method if adopted can result
into a lot of revolution because trade unions will resist. As a result, retrenchment or
downsizing of civil servants is considered as the best alternative
 Price controls –the government should ensure that prices of necessities are fixed such
that there cannot be price increases.
 Rationing of commodities – purchasing of certain commodities is controlled and
individuals can only purchase a specified quantity over a specified period of time.
 Output adjustment- steps must be taken to by the government to increase / improve
production of goods and services so that price levels may not increase significantly.
 The Government may also reduce taxes on imported raw materials or intermediate
goods such as crude oil, capital goods etc, which are used for further production in an
attempt to reduce the prices of factors of production which causes cost-push inflation.
 Reduce the quantity of such imports and probably by looking for alternative and
cheaper sources of supply, in case cost-push inflation is as a result of increase in import
prices such as oil or crude oil.

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 7. THE CONCEPT OF INFLATIONARY AND DEFLATIONARY GAPS

(1) Inflationary Gap: It is said to exist when the aggregate expenditure/demand exceeds the
maximum attainable level of output (national income), which will result to an upward pressure
on prices. The concept of inflationary gap can be illustrated with the help of the following
diagram.

Y = C + I (National
Income)

Full employment

AD (Aggregate demand
(Expenditure)
Aggregate demand

Inflationary
gap

450

Yf Ye

National Income

In the above diagram Yf is full employment level where resources achieve the maximum
attainable level of output. On the other hand, Ye is the equilibrium level of national income
which is greater than full employment level of income, Yf. As a result, there is an inflationary
gap, which is associated with upward pressure on prices.

Appropriate fiscal policies would be applied to combat this demand pull inflation. This may be
a reduction on government spending or increase in taxation with the objective being to reduce
aggregate demand by the full amount of inflationary gap.

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(2) Deflationary Gap: This refers to a situation where aggregate demand is less than the
level of the national income that would ensure full employment. As a result, there would be a
tendency for prices to go down. This concept can be illustrated in the following simple
diagram:

Full employment
Y = C + I (National
Income)

Deflationary
Gap AD
Aggregate demand

450
Ye Yf National Income
A deflationary gap can be treated with an increase on the government spending or by a
reduction on taxes.
Prepared by lecturer Milkah W

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