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INTRODUCTION TO INFLATION
AS LEVEL ECONOMICS
Syllabus Code: 9708

Inflation:
Inflation is a sustained increase in price level of goods and services in an economy over a period of time
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In an
extreme form of inflation prices rise at a phenomenal rate and terms such as inflation, runaway inflation
and galloping inflation have all been used to describe these conditions
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Types of inflation:
Under conditions of hyperinflation people lose confidence in the currency’s ability to carry out its
functions
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When things have become as bad as this the only possible course of action is to
withdraw the currency and issue new monetary units
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Creeping inflation is a low level of inflation which generally occurs due to economic activity
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Stagflation is a type of inflation in which inflation and unemployment rises together
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Indeed, seeing a low
and steady rise in prices may encourage firms to produce more
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In contrast to a low rate of inflation is hyperinflation
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At the start of the twenty-first century,
Zimbabwe experienced an inflation rate so high that economists had difficulty measuring it
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Hyperinflation occurs when inflation gets out of control and sometimes results in people resorting to
barter system of trade
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The distinction between money values and real values:
Money values or nominal values are the values at the prices operating at the time
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To convert money values into real values, the figures are multiplied by the price index in the current
year and divided by the price index in the base year
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The worker may think he has received a 20% pay rise
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If the consumer price index was 100 in 2015 and 125 in
2016, his wages in real terms would have changed to: ＄6,000 x 100/125= $4,800
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With an inflation rate of 25%, a 20% pay rise will mean that the worker will be
able to buy fewer goods and services
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This can
occur due to existence of strong trade union where wages are pushed up
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If these products are
bought by majority households it is most likely to create inflation
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Stable Inflation: An inflation in which the rate of inflation remains constant
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This means the rate of inflation is stable
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In this inflation the percentage usually ranges
from 1% to 6%
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Anticipated Inflation: This is an inflation in which predictions reveals that inflation is likely to take place
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In another case, when shortages are expected

for goods that are consumed by majority households is likely to create inflation
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Non Anticipated inflation: This is inflation in which no prediction is made for inflation to take place as
this inflation suddenly occurs
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Another factor that can contribute
towards unanticipated inflation can be imported inflation as this is an increase in prices of goods and
services in other countries resulting in inflation in our country
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Stable inflation is not harmful as measures can be taken to prevent the harms
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Unanticipated inflation is the worst type of inflation as no measures are taken to combat such inflation
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SUMMARIZED DRAWBACKS OF INFLATION:
• Purchasing power decreases
• Real income decreases
• Standard of living worsens
• Unemployment increases
• Business failures increases
• Imports increases
• Exports decreases
• May worsen the balance of payment
• Investors' confidence decreases which further decreases local and foreign direct investment
• Burden on the government increases as it becomes difficult to manage the economy
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The potential costs include:
• A reduction in net exports: Inflation may reduce the international competitiveness of a country's
products and so increase import expenditure and lower export revenue
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• An unplanned redistribution of income: Some people may gain and some people may lose as a result
of inflation
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This is because borrowers will pay back less in real terms and lenders will
receive less
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For example, catalogues,
price tags, bar codes and advertisements have to be changed
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• Shoe leather costs: These are the costs involved in moving money from one financial institution to
another in search of the highest rate of interest
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It occurs when the income levels
corresponding to different tax rates are not adjusted in line with inflation
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It can be argued, however, that this is a cost of an inefficient tax
system rather than a cost of inflation
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This may dissuade firms from investing, which will have an adverse
effect on economic growth
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This arises when inflation causes consumers and
firms to confuse price signals
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A rise in the price of a product may not mean that it has become more expensive relative to
other products
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Inflationary noise can result in consumers and firms making the wrong
decisions
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This may result in
a misallocation of resources
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As a result, they may act in a way that will cause inflation, for
example, workers may press for higher wages, firms may raise prices to cover expected higher costs and
consumers may seek to purchase products now before their prices rise further
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Consumer price index includes
all those goods that are available and bought by consumers
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Three Things Required for Measuring Inflation:
1) Basket of good
2) Weight
3) Base year
Basket of good is taken into account which consists of all those goods that are bought by consumers for
example bread, eggs and so on
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Weight is the relative importance or proportion of income spent on the good
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Different goods have different
weights in different countries for example, in Pakistan the proportion ofspending on entertainment is
less than to other western countries
Base year is the previous year prices picked for comparing inflation from one year to another
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This means the base year should neither be
extreme high or extreme low inflation
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CAUSES OF INFLATION:
Inflation can be caused by two main factors: too much demand in the economy or rising costs
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The same occurs at a macroeconomic level
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Demand-pull inflation is caused by excessive demand in the economy
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Excessive increases in
aggregate demand in the UK can come about for a variety of reasons
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Interest rates could be low and consumers are spending
large amounts on their credit cards, or consumer confidence could be rising because house prices are
rising
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Perhaps they are responding to large increases in
demand from consumer and need extra capacity to satisfy that demand
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• World demand for UK exports may be rising because of a boom in the world economy
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Cost-push inflation occurs because of rising costs
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• Imports can rise in price
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An increase in the price of imported semimanufactured goods and raw materials, used as component parts of domestically produced
manufactured goods, will feed through indirectly via an increase in the price of domestically produced
goods
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The more price
inelastic the demand for their goods, the less will such behavior result in a fall in demand for their
products
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Firms will try to pass on increases in their costs to customers
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Competition in the market may
mean that it finds it difficult to pass on these price rises and maintain sales
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Sometimes, inflation may be primarily demand-pull in nature
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In a stable but growing economy with no demand-side or supply-side shocks, inflation is likely
to be caused by a mix of the two factors
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Indeed, deflationary policy measures are those designed to reduce aggregate
demand
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It results in a rise in the value of money, with each currency unit having greater purchasing power
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Disinflation occurs when the inflation rate falls but is still positive
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In this case, the price level is still rising but at a slower rate
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The effects of deflation are, however, heavily influenced by the cause of deflation
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Good deflation occurs as a result of an increase in aggregate
supply
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As well as output increasing, employment may rise and the international competitiveness of
the country's products may increase
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In this case output falls, which may result in higher unemployment
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Consumers may delay their purchases, expecting prices to fall
further in the future
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These measures will reduce demand further and economic activity will decline
again

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