Money: Inflation and Deflation

Economics SSS 2 Third Term

WEEK 10

Money: Inflation and Deflation

Performance Objectives

Student should be able to:

1. Define inflation.
2. Identify the types of inflation.
3. Identify the causes of inflation.
4. Explain ways of controlling inflation.
5. Identify the effects of inflation.
6. Define deflation.

Content

Definition of inflation

Inflation may be defined as a persistent rise in the general price level of goods and services. Inflation occurs when the volume of purchases is permanently running ahead of production with too much money in circulation chasing too few goods.

Types of inflation

1. Demand-pull inflation: This occurs when consumers have high purchasing power, leading to an increase in aggregate demand without a corresponding increase in supply. The factors responsible for this type of inflation may be due to pollution increase, an increase in workers’ salaries and wages

2. Cost-push inflation: This occurs when increases in the cost of production are passed on to consumers in the form of high prices of goods and services.

3. Hyperinflation: This is also known as galloping or runaway inflation, it occurs when a persistent inflation becomes uncontrollable and the value of money keeps declining rapidly. War, budget deficits etc are the major causes of hyperinflation

4. Persistent or creeping inflation: This is also known as chronic inflation, it occurs when there is a slow but steady rise in the volume of purchasing power and fall in supply of goods and services.

Causes of inflation

1. Low production: Low production of goods and services can lead to their scarcity and when supply cannot meet up with high demand inflation set in.

2. Increase in demand: When the demand for goods and services is greater than supply, these result in inflation

3. War: War is a major cause of inflation as people no longer produce, resulting in a high volume of money pursuing fewer goods

4. Increase in salaries and wages: When salaries and wages are increased without a corresponding increase in the supply of goods and services, it can lead to excess money in circulation chasing fewer goods.

5. High cost of production: When there is a high cost of production, manufacturers build in this high cost into the cost per unit and pass it to consumers lead to cost pull inflation

6. Population increase: A sudden increase in population will result in a corresponding rise in demand for goods and services and if there is no corresponding rise in supply it will result in inflation

7. Hoarding: Hoarding which is the act of creating artificial scarcity of goods can lead to inflation

8. Inadequate storage facilities: When goods produced cannot be stored fit future use it can lead to scarcity resulting in inflation

Effects of inflation

1. Effects on Distribution of Income and Wealth: The impact of inflation is felt unevenly by the different groups of individuals within the national economy some groups of people gain by making a big fortune and some others lose.

(a) Creditors and debtors: During inflation creditors lose because they receive in effect less in goods and services than if they had received the repayments during a period of low prices. Debtors, on other hand, as a group gain during inflation, since they repay their debts in a currency that has lost its value (i.e., the same currency unit will now buy less goods and services).

(b) Producers and workers: Producers gain because they get higher prices and thus more profits from the sale of their products. As the rise in prices is usually higher than the increase in costs, producers can earn more during inflation. But, workers lose as they find a fall in their real wages as their money wages do not usually rise proportionately with the increase in prices. They, as a class, however, gain because they get more employment during inflation.

(c) Fixed income-earners: Fixed income-earners like the salaried people, rent-earners, landlords, pensioners, etc., suffer greatly because inflation reduces the value of their earnings.

(d) Investors: The investors in equity shares gain as they get dividends at higher rates because of larger corporate profits and as they find the value of their shareholdings appreciated. But the bondholders lose as they get a fixed interest the real value of which has already fallen.

(e) Traders, speculators, businesspeople and black-marketers:

They gain because they make more profits from the persistent rise in prices.

2. Effects on Production: The rising prices stimulate the production of all goods—both consumption and capital goods. As producers get more and more profit, they try to produce more and more by utilizing all the available resources at their disposal.

But, after the stage of full employ­ment, the production cannot increase as all the resources are fully employed. Moreover, the producers and the farmers would increase their stock in the expectation of a further rise in prices. As a result hoarding and cornering of commodities will increase.

But such favourable effects of inflation upon production are not always found. Sometimes, production may come to a standstill position despite rising prices, as was found in recent years in developing countries like India, Thailand and Bangladesh. This situation is described as stagflation.

3. Effects on Income and Employment: Inflation tends to increase the aggregate money income (i.e., national income) of the community as a whole on account of larger spending and greater production. Similarly, the volume of employment increases under the impact of increased production. But the real income of the people fails to increase proportionately due to a fall in the purchasing power of money.

4. Effects on Business and Trade: The aggregate volume of internal trade tends to increase during inflation due to higher incomes, greater production and larger spending. But the export trade is likely to suffer on account of a rise in the prices of domestic goods. However, the business firms expand their businesses to make larger profits.

During most inflation since costs do not rise as fast as prices profits soar. But wages do not increase proportionate with prices, causing hardships to workers and making more and more inequality. As the old saying goes, during inflation prices move in escalator and wages in stairs.

5. Effects on the Government Finance: During inflation, the govern­ment revenue increases as it gets more revenue from income tax, sales tax, excise duties, etc. Similarly, public expenditure increases as the government is required to spend more and more for administrative and other purposes. But the rising prices reduce the real burden of public debt because a fix sum has to be paid in instalments per period.

6. Effects on Growth: A mild inflation promotes economic growth, but a runaway inflation obstructs economic growth as it raises the cost of develop­ment projects. Although a mild dose of inflation is inevitable and desirable in a developing economy, a high rate of inflation tends to lower the growth rate by slowing down the rate of capital formation and creating uncertainty.

The control of inflation

1. Monetary policy: In a period of rapid economic growth, demand in the economy could be growing faster than its capacity to meet it. The Central bank could increase interest rates. Higher rates make borrowing more expensive and saving more attractive. This should lead to lower growth in consumer spending and investment. Higher interest rates reduce demand in the economy, leading to lower economic growth and lower inflation.

2. Control of money supply: Monetarists argue there is a close link between the money supply and inflation, therefore controlling money supply can control inflation.

3. Supply-side policies: Policies to increase the competitiveness and efficiency of the economy, putting downward pressure on long-term costs.

4. Fiscal policy: The government can increase taxes (such as income tax and VAT) and cut spending. This improves the government’s budget situation and helps to reduce demand in the economy. A higher rate of income tax could reduce spending, demand and inflationary pressures.

5. Wage controls: Trying to control wages could, in theory, help to reduce inflationary pressures. However, apart from the 1970s, it has been rarely used.

Definition of deflation

Deflation is a general decline in prices for goods and services, typically associated with a contraction in the supply of money and credit in the economy. During deflation, the purchasing power of currency rises over time.

Causes of deflation

1. Budget surplus: Budget surplus serves as a device by which the rate of injecting money into circulation was reduced.
2. Increase in bank rate: This serves to discourage commercial banks from borrowing from central banks and by so doing reduces the bank’s ability o lend money, leading to a reduction in the volume of money in circulation.
3. Increase in production: Increase in production of goods without a corresponding increase in the volume of money in circulation can lead to deflation.
4. Increase in taxation: When taxation increased, it will reduce the volume of money in circulation, thereby causing deflation to occur.

     Effects of deflation

1. Decline in profits: Deflation causes a decline in profits as a result of the low volume of money in circulation.
2. It results in unemployment: Deflation brings about unemployment in the labour market.
3. Fall in prices of goods: As a result of the decline in the volume of money in circulation, price of goods and services tends to fall.
4. Reduction in investment: As a result of low savings, the level of investments tends to be reduced.
5. Creditors gain: Creditors again because money has added value during the period of deflation.
6. Fixed income earners gain: During the period of deflation, fixed income earners gain because wages are fixed and they can buy more goods and services.
7. It encourages savings: Savings is encouraged because the value of money increases during deflation.

    Control of deflation

1. Reduction in taxation: This practice enables people to have more money, thereby increasing their purchasing power and controlling deflation.
2. Reduction in bank rate: This will assist investors to borrow more money from banks, thereby increasing the volume of money in circulation.
3. Increase in wages and salaries: This will help to inject more money into circulation, thereby controlling deflation.
4. Use of open market operation: The central bank does this by purchasing securities from commercial banks. This makes it possible for the commercial banks to be able to lend money out and increase the volume of money in circulation.