inflation is the sustained upward movement in the overall price level of goods and services in the economy. It has the effect of devaluing a particular currency.
Governments aim to control inflation because it reduces the value of money and the spending power of households, governments and firms.
The consumer price index
The consumer price index (CPI) is a common method used to calculate the inflation rate. It measures price changes of a representative basket of goods and services (those consumed by an average household) in the country.
The CPI versus the RPI
Both the consumer price index and the retail price index (RPI) can be used to calculate the rate of inflation.
- The items included in the calculations
- The population base
- The method of calculation
Calculating the CPI or RPI
A price index is used to indicate the average percentage change in prices compared with a starring period called the base year. The CPI and RPI compare the price index of buying a representative basket of goods and services with the base year, which is assigned a value of 100.
Calculating changes in the CPI or RPI gives the rate of inflation. To do so, two steps are involved:
• collection of the price data on a monthly basis
• assigning the statistical weights, representing different patterns of spending over time.
The causes of inflation
There are two main causes of inflation. These relate to demand-pull inflation and cost-push inflation.
Cost-push inflation is caused by higher costs of production, which makes firms raise their prices in order to maintain their profit margins.
Demand-pull inflation is caused by higher levels of aggregate demand (total demand in the economy) driving up the general price level of goods and services.
- Monetary causes of inflation are related to increases in the money supply (see Case Study on Zimbabwe) and easier access to credit, e.g. loans and credit cards.
- Imported inflation occurs due to higher import prices, forcing up costs of production and therefore causing domestic inflation
The consequences of inflation
Inflation can complicate planning and decision making for households, firms and governments, with many consequences as outlined below.
- Menu costs – Inflation impacts on the prices charged by firms. Catalogues, price lists and menus have to be updated regularly and this is costly to businesses. Of course, workers also have to be paid for the time they take to reprice goods and services.
- Consumers – The purchasing power of consumers goes down when there is inflation – there is a fall in their real income because money is worth less than before. Therefore, as the cost of living increases, consumers need more money to buy the same amount of goods and services.
- Shoe leather costs – Inflation causes fluctuations in price levels, so customers spend more time searching for the best deals. This might be done by physically visiting different firms to find the cheapest supplier or searching on line. Shoe leather costs represent an opportunity cost for customers.
- Savers – Savers, be they individuals, firms or governments, lose out from inflation, assuming there is no change in interest rates for savings. This is because the money they have saved is worth less than before. For example, if interest rates average 2 per cent for savings accounts in a country but its inflation rate is 3 per cent, then the real interest rate on savings is actually – I per cent. Hence, inflation can act as a disincentive to save. ln turns, this leads to fewer funds being made available for investment in the economy.
- Lenders – Lenders, be they individuals, firms or governments, also lose from inflation. This is because the money lent out to borrowers becomes worth less than before due to inflation.
- Borrowers – By contrast, borrowers tend to gain from inflation as the money they need to repay is worth Jess than when they initially borrowed it – in other words, the real value of their debt declines due to inflation. For example, if a borrower takes out a mortgage at 5 per cent interest but inflation is 3.5 per cent, this means the real interest rate is only 1.5 percent.
- Fixed income earners – During periods of inflation, fixed income earners (such as pensioners and salaried workers whose pay do not change with their level of output) see a fall in their real income. Thus, they are worse off than before as the purchasing power of their fixed income declines with higher prices. Even if employees receive a pay rise; the rate of inflation reduces its real value. For example, if workers get a 4 per cent pay rise but inflation is 3 per cent, then the real pay increase is only 1 percent.
- Low income earners – Inflation harms the poorest members of society far more than those on high incomes. Low income earners tend to have a high price elasticity of demand
- Exporters – The international competitiveness of a country tends to fall when there is domestic inflation. In the long run, higher prices make exporters less price competitive, thus causing a drop in profits. This leads to a fall in export earnings, lower economic growth and higher unemployment.
- Importers – Imports become more expensive for individuals, firms and the government due to the decline in the purchasing power of money. Essential imports such as petroleum and food products can cause imported inflation (higher import prices, forcing up costs of production and thus causing domestic inflation). Hence, inflation can cause problems for countries without many natural resources. inflation can cause problems for countries without many natural resources.
- Employers – Workers are likely to demand a pay rise during times of inflation in order to maintain their level of real income. As a result, labour costs of production rise and, other things being equal, profits margins fall.
While the prices of goods and services tend to rise, the prices of some products actually fall over time. This is perhaps due to technological progress or a fall in consumer demand for the product, both of which can cause prices to fall. Deflation is defined as a persistent fall in the general price level of goods and services in the economy
The causes of deflation
The causes of deflation can be categorised as either demand or supply factors. Deflation is a concern if it is caused by falling aggregate demand for goods and services (often associated with an economic recession and rising levels of unemployment).
- Unemployment – As deflation usually occurs due to a fall in aggregate demand in the economy, this causes a fall in the demand for labour – that is, deflation causes job losses in the economy.
- Bankruptcies – During periods of deflation, consumers spend less so firms tend to have lower sales revenues and profits. This makes it more difficult for firms to repay their costs and liabilities (money owed to others, such as outstanding loans and mortgages). Thus, deflation can cause a large number of bankruptcies in the economy.
- Wealth effect -As the profits of firms fall, so does the value of their shares during times of deflation. This means that dividends and the capital returns on holding shares fall, thus reducing the wealth of shareholders.
- Debt effect – The real cost of debts (borrowing) increases when there is deflation. This is because real interest rates rise when the price level falls. For example, if interest rates average 1.0 per cent but the inflation rate is – 1.5 per cent, then the real interest rate is 2.5 percent (imagine the situation of falling house prices while having to pay interest on mortgages taken out when prices were higher). Thus, with deflation and the subsequent rising real value of debts, both consumer and business confidence levels fall, further adding to the economic problems in the country
Aggregate supply (AS) or domestic final supply (DFS) is the total supply of goods and services that firms in a national economy plan on selling during a specific time period. It is the total amount of goods and services that firms are willing and able to sell at a given price level in an economy.
Aggregate demand is an economic measurement of the total amount of demand for all finished goods and services produced in an economy.