Chapter 20: Inflation
Definition & measurement
Definition
❖ Continuous & considerable rise in general prices of economy from 1 year to next
❖ 4 important aspects:
⬧ Neutral definition which doesn’t mention cause
⬧ Continuous rise = it’s a process
⬧ General price level = not individual prices
Measurement
❖ Consumer price index:
⬧ Index of prices of representative basket of consumer g+s of average household
𝑛𝑒𝑤 𝐶𝑃𝐼−𝑜𝑙𝑑 𝐶𝑃𝐼
⬧ Calculate %∆ in CPI from 1 period to next ( 𝑥100 = % 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛)
𝑜𝑙𝑑 𝐶𝑃𝐼
⬧ Headline inflation = measure of total inflation in economy, based on unadjusted CPI for all
urban areas
⬧ Calculated month on same month of previous year with year average OR
year on year with annual average
❖ Producer price index
⬧ Measures prices at level of 1st significant commercial transaction
- Prices when they leave the factory, not sold to consumers
⬧ Calculated month on same month of previous year with year average OR
year on year with annual average
CPI PPI
⬧ Cost of living ⬧ Cost of production
⬧ Basket consists of consumer g+s ⬧ Basket consists of goods only
⬧ Capital & intermediate goods excluded ⬧ Capital & intermediate goods included
⬧ VAT incl ⬧ VAT excl
❖ The implicit GDP deflator
⬧ Nominal GDP - Real GDP
⬧ Side effect of calc of economic growth
⬧ When economists want to look at prices of all g+s & not just basket
Effects of inflation
Social & political effects
❖ Unhappy people
❖ Social & political unrest ensues which negatively impacts economic progress
Distribution effects
❖ Effects from distribution of income & wealth among economic participants due to inflation
❖ From creditors to debtors; from elderly to young; from private sector to gvrn; from poor to wealthy
❖ Result of bracket creep & fiscal dividend
Economic effects
❖ ↓ Economic growth & ↑ unemployment
❖ Expected inflation & speculative practices
❖ Discouraged savings
❖ BoP problems
Real interest rate
❖ Difference between nominal interest rate & inflation rate
❖ Nominal rate ˂ inflation rate = negative real interest rate:
⬧ ↓ Real value of money lended & interest received
❖ Nominal rate ˃ inflation rate = positive real interest rate:
⬧ No redistribution of income but redistribution of wealth
Bracket creep
❖ ↑ Nominal income but real income remains same
❖ If income tax schedule remains unchanged = inflation ↑ average rates of personal income tax
❖ Redistributes income from taxpayers to gvrn
Fiscal dividend
❖ ↑ Gvrn revenue from tax through inflation
Deflation
❖ Continuous ↓ in general prices
❖ ↓ prices is more damaging than ↑ prices
Expected inflation
❖ Inflation result of expected further inflation
❖ Self-fulfilling prophecy
❖ Results in hyperinflation (very high inflation that escalates out of control)
Causes of inflation
Demand-pull inflation approach
❖ When ↑AD but AS remains unchanged
❖ Excess demand pulls up prices of g+s
❖ C + I + G + X accompanied by ↑ in money stock
Cost-push inflation approach
❖ Prices pushed up by ↑ in costs of production
❖ Sources of cost-push:
⬧ ↑ Wages & salaries
⬧ ↑ Cost of imported capital & intermediate goods
⬧ ↑ Profit margins
⬧ ↓ Productivity of FoP
⬧ Natural disasters (agricultural products)
Structuralist approach
❖ Inflation result of interaction between these 3 factors:
⬧ Underlying factors:
- Factors that provide background
- Traditions, values, norms of society
- Political strength & bargaining power of trade unions
- Size of public sector
- Exchange rate regime
- Degree of openness of economy
⬧ Initiating factors:
- Factors that trigger / intensify inflation
- Demand-pull / cost-push
- Natural disasters
- ↑ Indirect taxes
⬧ Propagating factors:
- Factors that transmit initiating impulses through economy & over time, & sustain ↑ prices
- Expectation of inflation
- Endogenous ↑ in money stock
- Interaction between domestic prices, BoP, exchange rate
Conflict approach
❖ Inflation is symptom of fundamental disharmony in society that
causes imbalance between rate of growth in real national income &
rate of growth of total effective claims on income
❖ No consensus on appropriate division / distribution of national income
❖ Ex ante = before the fact
❖ Ex post = after the fact
❖ Effective claims = claims back ed by some power
Anti-inflation policy
Demand-pull inflation
❖ Use restrictive monetary policy (↑ interest rates)
❖ Use restrictive fiscal policy (↑ taxes & ↓ gvrn spending)
❖ ↓ Prices but also ↓ production & income
⬧ Trade-off situation
Cost-push inflation
❖ Don’t use restrictive policies (would ↑ unemployment more)
❖ ↑ supply with incomes policy:
⬧ Establishes balance between growth in income & growth in productivity
⬧ Gvrn intervention in determination of wages & prices
⬧ Solution to supply shock
❖ Difficult in practice
Indexation
❖ Prices, wages, pensions linked to price indices (CPI) to eliminate distribution of effects of inflation
❖ Attempts to ↓ negative effects when inflation can’t be stopped
Inflation targeting
❖ Setting target for inflation by gvrn & central bank when price stability is primary goal of monetary
policy
❖ Central bank has independence to pursue this inflation target
❖ Key features:
⬧ Announcement of quantitative targets
⬧ Price stability primary goal of monetary policy
⬧ Broad approach to inflation diagnosis
⬧ Transparency
⬧ Accountability
❖ Advantages:
⬧ Easy to understand (transparent)
⬧ Explicit yardstick (helps accountability)
⬧ Provides good guide for decision makers
⬧ Anchor for inflation expectations
⬧ Limits discretion of policymakers
❖ Disadvantages:
⬧ Complicated approach
⬧ Incorrect forecasts impair central bank credibility
⬧ Problematic external economic shocks
⬧ Many elements of inflation beyond control of central bank(gvrn spending & unions)
❖ In SA:
⬧ Have target range not point
⬧ Revised on rolling basis
⬧ Repo rate is the policy instrument
Costs of anti-inflation policies
❖ Negative effects on:
⬧ Economic growth
⬧ Full employment
⬧ BoP stability
Unemployment & inflation: The Phillips Curve
Impact on
Change in AD
Production Price level Unemployment
Increase Increase Increase Decrease
Decrease Decrease Decrease Increase
Stagflation
❖ Period of economic stagnation characterised by low economic growth & high unemployment +
inflation
Phillips curve
❖ Curve that demonstrates inverse relationship between inflation
& unemployoment
❖ ↑ Inflation = ↓ employment, vice versa
Trade-off principle
❖ Unemployment & inflation traded off against one another
❖ Phillips curve doesn’t provide for sta gflation = Phillips curve
shits to right during stagflation
Incomes policy
❖ Cost-push inflation / stagflation creates policy dilemma
❖ In 1970s several countries experimented with incomes policies to ↓ inflation + unemployment
❖ Extremely difficult to implement incomes policy successfully since it inhibits the market
mechanism
Other supply-side policy actions - 1980s US
❖ ↓ Tax rates to stimulate saving + investments & tightly control inflation
⬧ ↑ Interest rates; ↑ budget deficits; negative influence on investment & no ↓ unemployment