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  • Created by: samadhi
  • Created on: 07-04-13 21:21


  • Inflation: is usually defined as a situation in which there is a persistent and excessive increase in the general price level. 
  • During inflation, cost of living rises the purchasing power or the value of money falls.
  • Thus, a greater quantity of money is required to purchase the same amount of goods and services or the same quantity of money will now purchase fewer goods and services than before.
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Cost push inflation: occurs when increasing costs of production are passed on to the consumers in the form of higher prices. This is inflation from the supply side of the economy. 

There are various factors leading to cost push inflation. 

  • First and foremost, the cause of inflation is attributed to an increase in wage costs. It is a widely held view that as prices rise, so real wages fall and this gives rise to another round of wage claims so that eventually a wage price spiral develops.
  •  Most cost-push theories are based on the existence of strong trade unions who make use of their monopoly power in the control of the supply of labour to push for wage increases in excess of those required to offset rising prices.
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  • Besides, inflation may be transmitted into the local economy from other countries suffering from inflation. An increase in import prices for consumer goods will affect the cost of living directly.
  • Increased import prices for fuel and industrial raw materials will have a direct impact on production costs.
  • Furthermore, rising indirect taxes can be a major cause of inflationary pressures in the economy.
  • For instance, an increase in sales tax or value added tax will directly have the effect of raising market prices of all goods and services.
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Rising costs shift the Aggregate Supply curve (AS) upwards, thus, causing the general price level to rise.

 This can be illustrated as follows:

  • The rising production costs shift the AS curve to the left from AS to AS1. With an unchanged AD curve, this reduces the equilibrium level of real income from 0Y to 0Y1 (thereby creating some unemployment) and raises the price level from 0P to 0P1.
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  • Demand-pull inflation exists when aggregate demand (AD) exceeds aggregate output at full employment. 
  • The excess demand for goods and services cannot be met in real terms and therefore it is met by rises in the price of goods. 
  • The excess demand itself can be caused by autonomous increases in government spending, investment, consumption or exports
  • For instance, if consumption increases due to an increase in national income or a fall in income tax, and if the economy is already at full employment, aggregate demand will increase as well as the rate of inflation. 
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The demand pull inflation can be diagrammatically illustrated as follows:

  • The initial price level is 0P where the aggregate demand curve, AD, meets the aggregate supply curve, AS. It should be noted that at full employment level of output, YF, AS is perfectly inelastic.
  • Hence, an increase in aggregate demand curve to AD1 at full employment causes an increase in the general price level to 0P1
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  • Monetarists argue that sustained and severe inflation can be produced only by excessive increases in the money supply. 
  • Sometimes the government tends to implement an expansionary monetary policy whereby there is an increase in the quantity of money injected in the economy. 
  • As a result, a situation of too much money chasing too few goods will emerge. Thus, prices of goods and services will rise. 
  • According to Milton Friedman, “inflation is always and everywhere a monetary phenomenon.” In other words, periods of inflation coincide with increases in the money supply.
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The monetarist inflation can be explained using the Fisher’s quantity theory of money:


  • M is the nominal stock of money in circulation, i.e, money supply.
  • V is the velocity of circulation of money, that is, the speed at which or the number of times that aunit of money changes hands.
  • P is the average price of all transactions
  • T is the total number of transactions that take place during the time period.
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  • Thus, according to monetarists, keeping V and T constant in the short run, changes in money supply (M)will cause a direct and equal proportionate change in the price level (P).
  • For instance, given that V and T are constant, a 10% increase in M would cause a 10% increase in P.
  • This cause-and-effect conclusion is based on the assumption that the volume of transactions is constant because the economy is at full employment, and the velocity of circulation is constant because of the long-run holding habits of firms and households.
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Anticipated inflation: is when the rise in the general price level is one, or close to the one, expected.

  • An anticipated inflation occurs generally when the rate of inflation is stable. 
  • For instance,inflation may be constant 5% per year and therefore households, firms and government are able to build in this figure to their plans.
  •  It will be easier to predict future inflation and hence easier to plan and protect people from harmful effects.

Unanticipated inflation: occurs when inflation either was not expected or is higherthan had been expected.

Households, firms and government are uncertain what the rate of inflation willbe in the future. Unanticipated inflation can bring with it a number of problems.

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Effects of inflation

  • Inflation is an evil to an economy, and hence, reducing inflation is one of the macro-economic aims of every government. 
  • However, the effects of inflation depend on its level, whether it is constant or accelerating and whether it is anticipated or unanticipated. 
  • The higher the rate of inflation the greater the economic costs.

Effects of inflation
1. Shoe-leather costs: 2. Menus costs: 3. Redistribution: 4. Uncertainty and lack of investment: 5. Balance of payment:

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Effects of inflation

Shoe-leather costs: High rates of inflation mean that people and companies may lose considerablepurchasing power if they keep money lying idle and not earning interest.

  • Inflation erodes the value of cash and therefore, firms and households prefer to hold less cash but more interest bearing deposits /assets. 
  • Households and firms are then forced to spend more time transferring money from one type of account to another or putting cash into an account to maximise the interest paid..
  •  Economists refer to shoe leather costs.
  •  These are the costs involved in moving money from one financial asset to another in search of the highest rate of interest.
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Effects of inflation

Menus costs: Firms will also suffer from menu costs. These are the costs involved in changing prices.

For examples, firms have to incur costs by changing price labels or prices in catalogues (new price lists) or on menus or to adjust slot machines.

This involves staff time and is unpopular with customers.

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Effects of inflation

Redistribution: Inflation leads to an arbitrary redistribution of real income.

  • Different income groupswill be affected in different ways. In other words, there will be some “gainers” and some “losers”.
  • Inflation redistributes income away from those on fixed incomes and those in a weak bargaining position to those who can use their economic power to gain large pay, rent or profit increases. 
  • In otherwords, a fall in the value of money will remove purchasing power from those living on fixed incomes,such as pensioners, and redistribute it towards those who draw their living from prices.
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Effects of inflation

Redistribution ...continued 

  • Similarly, weakly unionised workers who cannot gain full compensation for price rises will lose at the expense of strongly unionised workers who can do so. 
  • Furthermore, if inflation is not fully anticipated, that is, if real interest rate is negative, there will be a redistribution of income from lenders to borrowers.
  •  In fact, lenders will lose and borrowers will gain
  • The spending power of lenders will be eroded by inflation
  • since when the money is paid back, less goods will be purchased.
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Effects of inflation

Uncertainty and lack of investment: Some economists claim that inflation creates unemployment and lowers growth.

  • Inflation increases costs of production and creates uncertainty in the business community. 
  • If it is difficult for firms to predict their costs and revenues, they may be discouraged fromundertaking the risk associated with any investment project. 
  • This will reduce the rate of economic growth and employment. 
  • Besides, the measures taken against inflation may sometimes cause more harmful effects than inflation itself. 
  • For instance, a contractionary monetary and fiscal policy measures are likely to raise unemployment and lower economic growth.
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Effects of inflation

Balance of payment: Inflation is likely to worsen the balance of payment. If a country suffers from relatively high inflation, its exports will become less competitive in world market.

  • At the same time,imports will become relatively cheaper than home produced goods. Thus, exports will fall and imports will rise. 
  • As a result, the balance of payment will deteriorate.
  •  If the country adopts a fixed exchange rate system, the deficit will tend to deplete the country’s reserves. 
  • On the other hand, with a flexible exchange rate system, the country with faster inflation and deficit in its BOP is likely to experience a depreciating currency. 
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Effects of inflation (BOP)

  • The currency depreciation itself may create some further inflationary pressure on the domestic economy. 
  • (Depreciation increases the price of the country’s imports) It is undoubtedly true that high rates of inflation are damaging to the economy. 
  • However, a low,stable and correctly anticipated rate of inflation can be beneficial. 
  • It is sometimes argued that a low rate of demand pull inflation is conducive to a faster economic growth.
  •  If the rise in general price is caused by increasing aggregate demand, firms can feel optimistic about the future. 
  • This is because inflation may stimulate profits if prices rise more than costs. Hence, it is an incentive to producers and a stimulus to the economy.
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Effects of inflation - (BOP)

  • In the light of the above exposé, it can be said that a small degree of inflation is beneficial for an economy. 
  • However, if inflation gets out of hand and develops into hyperinflation, the costs can be very serious. 
  • The whole basis of the market economy will be undermined. Firms constantly raise prices in an attempt to cover their increasing costs. 
  • Workers demand huge pay increases in an attempt to stay ahead of the rising costs of living.
  • Thus, prices and wages chase each other in an ever rising wage-price spiral.
  • People will lose confidence in money and may resort to barter system. Hence, all these perils of inflation have made the control of inflation one of the major policy objectives of governments.
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