Inflation – SS2 Economics Lesson Note (Third Term)

Inflation is a persistent rise in the general level of prices of goods and services. It occurs when the money supply increases without a corresponding increase in the volume of production. Its main types are demand-pull, cost-push, hyperinflation and creeping inflation. It has positive and negative effects, and the government can control it through several policies.

Behavioural objectives

By the end of the lesson, students should be able to:

• define inflation and state its types;
• list the causes of inflation;
• state the positive and negative effects of inflation;
• explain ways of controlling inflation;
• explain terms such as inflation gap, inflation spiral, disinflation, reflation, stagflation and slumpflation;
• define deflation and state its causes.

What are the types of inflation?

Demand-pull inflation

This occurs when there is excess demand for goods and services over the supply. The factors responsible may include population increase and increases in workers’ salaries and wages.

Cost-push inflation

Producers pay for factors of production, so any slight increase in the price of a factor input shows in the price per unit. For example, if the price of flour, sugar or butter rises, the price of bread automatically rises.

Hyperinflation

This occurs when the prices of goods and services rise so fast that money loses its value, or its ability to buy goods. War, budget deficits, etc. are the major causes of hyperinflation. It is also known as galloping inflation or runaway inflation.

Creeping inflation

This occurs when there is a slow but steady rise in the general prices of goods and services. It is also known as persistent inflation.

What are the causes of inflation?

1. Excess demand for goods and services, for example demand-pull inflation.
2. Low productivity, for example in agriculture.
3. Increase in salaries and wages.
4. High cost of production.
5. Budget deficit, that is, when government expenditure is more than its income.
6. Increase in population, which forces demand to rise.
7. Excessive bank lending.
8. The high cost of importing raw materials, which leads to a high cost of goods.
9. Hoarding, which is the act of creating artificial scarcity.
10. Industrial action by workers, for example strikes and tools-down.
11. Poor storage facilities.
12. Money laundering, which is the mass transfer and injection of money into circulation.

What are the effects of inflation?

Inflation is a necessary evil. In other words, it has positive and negative effects on the overall economy.

Positive effects of inflation

1. During inflation, the debtor gains at the expense of the creditor.
2. The inflation period is a period when businessmen make a profit.
3. Inflation stimulates investment.
4. The employment rate is high during inflation.
5. Because of points 2, 3 and 4 above, inflation helps the economy to grow.

Negative effects of inflation

1. Lenders (creditors) incur a loss because money loses its value as inflation persists.
2. Distortion in the economy due to agitation for increases in wages and salaries.
3. Fixed-income earners, for example salary earners, suffer a lot during inflation.
4. Money loses its value during inflation.
5. It leads to balance of payments problems.
6. Inflation discourages savings, since money loses its value day in and day out.
7. Fall in the living standard of the people.

How can inflation be controlled?

1. To stem inflation, the government should encourage industrialisation to make goods and services available.
2. Where inflation is triggered by an increase in money supply, an effective interest rate policy could be adopted, that is, raising the interest rate to discourage excess borrowing.
3. Effective use of fiscal policy, for example taxation to reduce the disposable income of workers, can help to check inflation.
4. Removal of bottlenecks in the distribution system. This will enhance the free flow of goods.
5. Legislation could be put in place to check the activities of hoarders.
6. Contractionary monetary policy can also help to check inflation where it is caused by an increase in money supply.
7. Subsidies for farmers and businesses will help to solve the problem of rising prices of inputs, for example hoe and cutlass.
8. Wage freezing, that is, the government should not increase salaries.

What terms are associated with inflation?

• Inflation gap: An economic situation in which total demand in the economy exceeds the total supply of goods and services available to satisfy demand. To work it out, subtract the total money value of the actual goods and services available from the total amount of money available for spending.
• Inflation spiral: A price increase makes workers demand higher wages and salaries. This causes a further rise in the general level of prices, and the cycle repeats.
• Disinflation: The direct control of consumers’ expenditure as a way of checking inflation. This is done by reducing the supply of money, increasing interest rates, etc.
• Reflation: The economic state in which prices, employment, output, etc. are picking up again as a result of conscious government policy.
• Stagflation: A situation in which a high rate of inflation exists at the same time as industrial production is slowing down.
• Slumpflation: An economic condition in which much reduced economic activity exists together with inflation.

What is deflation?

Deflation is a persistent fall in the general level of prices. It happens when the volume of money in circulation is not enough for the prevailing economic situation. It is the direct opposite of inflation.

What are the causes of deflation?

1. Failure of the government to spend, that is, a budget surplus.
2. Increases in bank interest rates, which discourage borrowing so that money supply drops.
3. Productivity that exceeds demand, together with a decrease in money supply.
4. Excessive taxation of workers, which leaves them with little disposable income. Their marginal propensity to consume drops and this leads to deflation.

Evaluation

1. Define inflation.
2. Distinguish between demand-pull inflation and cost-push inflation.
3. State four causes of inflation.
4. Explain three ways of controlling inflation.
5. Define deflation and state two of its causes.

Assignment

1. An inflation in which the price level rises steadily at an average rate of about 2% per annum is best described as: (a) galloping (b) induced (c) creeping (d) suppressed (e) run-away.
2. Inflation in any economy: (a) has no monetary connection (b) implies a sustained decrease in the general price (c) always increases the value of the national currency (d) tends to redistribute income (e) tends to bring down market prices.
3. Which of the following statements is not true in an inflation period? (a) the purchasing power of money diminishes (b) wages rise simultaneously with the price (c) more money runs after a limited quantity of goods (d) fixed-income earners lose (e) aggregate real demand exceeds aggregate real supply.
4. Inflation caused by an increase in demand is known as: (a) cost-push inflation (b) hyperinflation (c) demand-pull inflation (d) creeping inflation (e) runaway inflation.
5. One way to solve the economic problem of inflation in a country is by increasing the: (a) supply of commodities (b) supply of currency (c) salaries of workers (d) demand for commodities.