Inflation

Definition of inflationInflation: a continuous and considerable rise in prices in general.

• Neutral: does not look to specific causes.

• Process: a continuous increase in prices.

• General rise in prices: inflation only when prices of most goods and services in the economy are increasing.

The measurement of inflationThe consumer price indexCPI: an index which reflects the cost of a representative basket of consumer goods and services.

• CPI figures then used to calculate the inflation rate. • Done by calculating the percentage change in CPI from one period to

the next. • Expressed as an annual rate.

Month on the same month during the previous yearInflation can be calculated 2 ways…

Annual average on annual average

The producer price indexProducer price index (PPI): measures prices at the level of the first significant commercial transaction.

For example…• imported goods measured when entering the country • manufactured goods priced when they leave factory

PPI includes capital & intermediate goods, but excludes services (which account for 45,8% of the CPI basket). Based on a completely different basket of items than the CPI. Where items overlap, their weighting differs

Main differences between the CPI and PPI

The effects of inflationWe consider three sets of effects of inflation…1. distribution effects2. economic effects3. social and political effects

1. Distribution effectsInflation affects distribution of income and wealth. HOW? Inflation benefits debtors (borrowers) at the expense of creditors (lenders). WHY?Real value (or purchasing power) of money falls when prices increase. EXPLAIN…

For example…• Peter borrowed R10 000 from Paul on 1 January 2009 to be repaid on 31 December

2010. • Interest at 5 % per annum (R500 per year). • CPI rose from 103,1 in January 2009 to 113,0 in December 2010. • Real value (purchasing power) of R10 000 (in January 2009) therefore fell to…

• R10 000 × 103,1/113,0 = R9124 in December 2010.

• In real terms, Paul did not receive the full amount• Redistribution of wealth from the lender (Paul) to the borrower (Peter).

On top of that…• If nominal interest rate < inflation rate, Paul receives less real interest

than the agreed R500 per year.• Nominal interest rate (5%) - inflation rate (9.6%) = real interest rate (-

4.6%). • nominal interest rate < inflation rate = negative real interest rate

Lender disadvantaged by…• real value of wealth (R10 000) declines • interest income received not sufficient to compensate for inflation.

Who loses and who gains? • Most people are creditors (lenders) as well as debtors (borrowers). • People with mortgage bonds (debtors) benefit – real value of their

loans decreases as prices increase. • Young people - net borrowers; old people - relatively fixed nominal

incomes (eg pensions)• Inflation tends to redistribute income and wealth from the elderly to

the young.

Private sector – government• Government (debtor) also benefits.• Total gov.• debt = R891 billion in December 2010.• Government gains at expense of the holders of the public debt

Inflation may result in lower economic growth & higher unemployment due to… • Private sector anticipate inflation - profitable new production

opportunities missed. • Speculative practices: speculative demand in shares, property, foreign

currencies, precious metals etc increase. Investment in new factories and machinery declines.• Discourages saving in fixed deposits and pension fund contributions.• Balance of payments problems: exports lose international

competitiveness & price of imports increases as currency weakens

• This will continue as long as SA’s inflation rate remains out of step with trading partners.

2. Economic effects

3. Social and political effects

When rents, service charges, transport prices go up, the frustration often gives rise to social and political unrest.Increasingly expensive consumer goods leads to uncertainty

Expected inflation…Increase in rate of inflation → expectations of further rises. People seek compensation for expected higher inflation. If they succeed, this results in raising the actual rate of inflation.

Caused by…Trade unions base wage claims on expected higher inflation → claims granted → production costs rise → prices rise → actual inflation rises.

Firms raise prices due to expected cost increases → rise in actual inflation.

Firms increase prices to raise funds to purchase materials they expect to be more expensive → increase in prices to cover costs → increase in actual inflation.

Consumers buy things now instead of later when inflation expected to rise → increased demand raises prices → increase in actual inflation.

So, are falling prices preferable???

Read box 8.1 in your text books to find out the answer…

The causes of inflation

Demand-pull inflation

Caused by… • Increased consumption spending by households (C)• Increased investment spending by firms (I)• Increased government spending (G) • Increased export earnings (X)• Decreased import spending (Z)

Cost-push inflation

Triggered by increases in the cost of production which push up the price level.

Sources of cost-push inflation...• Increases in wages and salaries: makes up 50 % of cost of producing

GDP. • Increase in cost of imported capital and intermediate goods. • Increases in profit margins. • Decreased productivity. • Natural disasters: droughts & floods,

Anti- Inflationary

Policy

Appropriate anti inflation policy depends on -̄� type of inflation.

Choosing the right weapon for the job!

Demand-pull inflation,• contractionary monetary & fiscal policy

• raising interest rate, raising tax rates & reduce rate of increase in government spending.

• reduces inflation, but opp. cost is decreased total output, and therefore higher unemployment.

Cost-push inflation • Why won’t contractionary monetary & fiscal policy work here???• Need to increase aggregate supply, BUT much more difficult to achieve.

The costs of anti-inflation policy

Other macroeconomic policy objectives also important. Impacts of anti-inflationary policy on other objectives must be taken into account.

Before combatting inflation, consider the following:• Nature of the inflation being experienced• Interrelationships between inflation and other objectives • Costs of failing to achieve other objectives • Benefits of a reduction in the inflation rate

Inflation targeting5 essential features

1. Public announcement of quantitative inflation targets. • who should determine the target? • what index should be used to calculate the target? • over what period should the target be achieved?

2. Acceptance by government that primary goal of monetary policy is to achieve price stability

3. Use of a wide range of variables to decide on appropriate setting of the policy instruments (eg the repo rate).

4. Increased transparency - central bank regularly inform public/markets about plans, objectives and decisions.

5. Accountability for attaining its inflation objectives.

Advantages of inflation targeting:

Easily understandable – explicit quantitative target.Makes clear that monetary policy aimed at achieving price stabilityImproves accountability of central bank.Anchors inflation expectations – good for price and wage determination & investment.Limits discretion of central bank governor – must consult with committee of experts

Disadvantages of inflation targeting:

Relies heavily on forecasts in uncertain economic environment.

Wrong forecasts hurt central bank’s credibility.

Difficult to react to external economic shocks • Too stringent damages economic growth & employment• No action – miss target & lose credibility

Many elements of the inflation process are beyond the control of the central bank.