Economics Slides CHP 20

Chapter 20:
Inflation
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Master ECONOMICS FOR SOUTH AFRICAN STUDENTS
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CHAPTER 20: INFLATION
CHAPTER OUTLINE
LEARNING OUTCOMES
20.1 DEFINITION OF INFLATION
20.2 THE MEASUREMENT OF INFLATION
20.3 THE EFFECTS OF INFLATION
20.4 THE CAUSES OF INFLATION
20.5 ANTI-INFLATION POLICY
IMPORTANT CONCEPTS
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LEARNING OUTCOMES
Once you have studied this chapter, you should be able to
• define inflation
• describe how inflation is measured
• distinguish between different measures of inflation
• explain why inflation is regarded as a problem
• distinguish between three approaches to explaining what causes inflation
• explain demand-pull and cost-push inflation
• mention policies that can be used to combat inflation
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LO: define inflation
20.1 DEFINITION OF INFLATION

Inflation is a continuous and considerable rise in prices in general
• Four important aspects

– neutral definition (does not mention causes)
– continuous rise – process
– considerable increase in prices
– general price level – not individual prices
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LO: describe how inflation is measured
LO: distinguish between different measures of inflation
20.2 THE MEASUREMENT OF INFLATION

Using the consumer price index to measure inflation
• Based on CPI, but CPI is index of price of basket, not a rate
• Calculate the rate of change in CPI, i.e. calculate the percentage change in
the CPI from one period to the next
Two methods of calculating

• Month on same month of previous year
• Year on year (annual average on annual average)
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THE MEASUREMENT OF INFLATION LO: describe how inflation is measured
Using the consumer price index LO: distinguish between different measures of inflation
Table 20-1 The consumer price index and

inflation in South Africa 2012–2013 (Textbook
page 383)
EXAMPLE
Month on same month of
1
previous year
Year
Compare theon year
index (annual
value for December
2
average
2012 and 2013 on annual average)
105,4 – 100 X 100 = 5,4%

Compare the index value using the
100
average per year
103,4 – 97,8 X 100 = 5,7%

Click on the numbers to see calculations.
100
Click again to hide.
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THE MEASUREMENT OF INFLATION
Using the producer price index to measure inflation

• Also important price index but differs from CPI
• PPI measures prices at the level of the first significant commercial
transaction
Manufactured goods are priced when they leave the

factory, not when they are sold to consumers.
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The producer price index LO: distinguish between different measures of inflation
Differences between CPI and PPI
Table 20-2 Main differences between the CPI and PPI (Textbook page 383)
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The producer price index LO: distinguish between different measures of inflation
Two methods of calculating

• Month on same month of previous year
• Year on year (annual average on annual average)
see Table 20-3
Table 20-3 Annual rates of increase in CPI and

PPI, 2013 (Textbook page 384)
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THE MEASUREMENT OF INFLATION
The implicit GDP deflator

• CPI and PPI use basket of goods but economists might want to look at the
prices of all goods and services
• GDP = the prices of all goods and services
• The difference between nominal GDP and real GDP = implicit GDP deflator
GDP deflator: An index based on the difference between nominal GDP and real GDP, as this indicates what
happened to prices (i.e. the inflation rate). An implicit index since it is a side-effect of the calculation
of economic growth.
Real GDP: Valuing all the goods and services produced within the boundaries of a country in a year (GDP), using
constant prices. Real GDP is adjusted to eliminate the effects of price changes over time, as the calculation is made
in terms of the prices ruling in a certain year (the base year). This enables economists to compare movements in
GDP across years. As opposed to nominal GDP.
Nominal GDP: Valuing all the goods and services produced within the boundaries of a country in a year (GDP) using
current prices, in order to calculate the size of GDP in that particular year. It is not possible to compare GDP across
different periods when using current prices. As opposed to real GDP.
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LO: explain why inflation is regarded as a problem

Is inflation a problem? Why?
Distribution effects
Economic effects
Social and political effects
Click on the arrows to reveal more information.

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Distribution effects
• some individuals or groups lose while others benefit
• who loses and who wins?
• debtors tend to gain at the expense of creditors

̶ Affected by real interest rate
• young tend to gain at the expense of elderly
• government tends to gain at expense of private sector
̶ bracket creep, fiscal dividend Click on the arrows to.
• poor households more affected by inflation
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Economic effects
• Distribution
impact on employment
effects and growth
• inflation tends to stimulate speculative activity
• resources used to try to live with or gain from inflation
• Economic effectsneglected
productive activity
• saving discouraged
• Social
exportsand
may political
suffer effects
• imports may be stimulated
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Social and political effects

• people unhappy
• social and political unrest may ensue
See Box 20-1 The destructive power of inflation (Textbook page 386)
See Box 20-2 Falling prices: a consumer’s heaven? (Textbook page 387)
• Deflation
– continuous fall in prices in general
– falling prices even more damaging than rising prices
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THE EFFECTS OF INFLATION LO: explain why inflation is regarded as a problem
Expected inflation
• inflation may result in the expectation of further inflation

• self-fulfilling prophecy
• may give rise to hyperinflation
– very high inflation which tends to escalate out of control
See Box 20-3 Hyperinflation (Textbook page 387)
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LO: distinguish between three approaches to explaining what causes inflation
LO: explain demand-pull and cost-push inflation
20.4 THE CAUSES OF INFLATION

Three approaches:
• the demand-pull and cost-push approach
• the structuralist approach
• the conflict approach
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THE CAUSES OF INFLATION LO: distinguish between three approaches to explaining what causes
Demand-pull and cost-push inflation
inflation
Demand-pull inflation LO: explain demand-pull and cost-push inflation

Demand-pull inflation
• Prices pulled up by increase in aggregate demand
• Could be the result of any or combination of components
of AD
– C, I, G, X
– usually accompanied by increase in M (money stock)
Demand-pull inflation: This occurs when the aggregate demand for goods and services increases while aggregate supply
remains unchanged. The excess demand pulls up the prices of goods and services. An approach to the diagnosis of
inflation. See also the structuralist approach, the conflict approach and cost-push inflation.
FIGURE 20-1 Demand-pull inflation: Demand-pull inflation occurs when the aggregate demand for goods and services
increases. This is illustrated by the rightward shifts of the AD curve from AD1 to AD2, AD3 and AD4. As long as there is still
excess capacity in the economy, the increases in the price level will be accompanied by increases in production and income.
However, when full employment is reached, further shifts in the AD curve (from AD3 to AD4) lead to price increases only.
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inflation
Demand-pull inflation LO: explain demand-pull and cost-push inflation
Figure 20-1 Demand-pull

inflation (Textbook page 389)
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LO: distinguish between three approaches to explaining what causes
THE CAUSES OF INFLATION inflation
Cost-push inflation
• Prices pushed up by increase in costs (production)
• Sources of cost push

– increased wages and salaries
– increased cost of imported capital and intermediate goods
– increased profit margins
– decreased productivity
– natural disasters
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inflation
Cost-push inflation LO: explain demand-pull and cost-push inflation
Figure 20-2 Cost-push inflation

(Textbook page 390)
Cost-push inflation occurs when the cost
of producing each level of total
production Y increases. This is illustrated
by an upward (leftward) shift of the AS
curve from AS1 to AS2. Increases in the
price level are accompanied by
reductions in aggregate production or
income Y (and therefore also by
increases in unemployment). In the
diagram the price level increases from
P1 to P2 and the level of income falls
from Y1 to Y2.
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The structuralist approach to inflation

Inflation process is the result of the interaction between these three
interrelated sets of factors:
Underlying factors
Initiating factors
Propagating factors
See Box 20-4 The inflation process: a case

study (Textbook page 392) Click on the arrows to reveal more information.
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The conflict approach to inflation
• Ex ante = before the fact

• Ex post = after the fact
Figure 20-3 A simplified view of the

conflict approach (Textbook page 394)
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LO: mention policies that can be
used to combat inflation
20.5 ANTI-INFLATION POLICY
• Demand-pull inflation
– use restrictive monetary and fiscal policy
– prices decreases but production and income also decreases
– trade-off situation
• Cost-push inflation
– cannot use restrictive monetary and fiscal policy
– restrictive policy would increase unemployment further
– ideal is to increase supply
– Incomes policy
– difficult in practice
• Structuralist approach
• Conflict approach
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ANTI-INFLATION POLICY LO: mention policies that can be used to combat inflation
The costs of anti-inflation policy

Negative effects on:
• Economic growth
• Full employment
• Balance of payments stability
Policy makers need to take many factors into consideration.
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Indexation
When inflation cannot be stopped attempt to reduce its negative effects.
(*expected inflation)
Indexation means that prices, wages, pensions and so on are linked to price
indices (for example, the CPI) to eliminate the distribution effects of
inflation.
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Inflation targeting
What is inflation targeting?

• Key features
– announcement of quantitative targets
– price stability primary goal of monetary policy
– broad approach to inflation diagnosis
– transparency
– accountability
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The case for inflation targeting

• Advantages (include):
– easy to understand (transparent)
– explicit yardstick (helps accountability)
– provides good guide for decision makers
– anchor for inflation expectations
– limits discretion of policymakers
• Disadvantages (include):
– complicated approach
– incorrect forecasts can impair central bank credibility
– external economic shocks problematic
– many elements of the inflation process beyond central bank control
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Inflation targeting in South Africa

• have a target range not a point target
• revised on a rolling basis
• repo rate = policy instrument
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IMPORTANT CONCEPTS
• Inflation • Deflation
• Consumer price index • Demand-pull inflation
• Headline inflation • Cost-push inflation
• Producer price index • Stagflation
• GDP deflator • Incomes policy
• Distribution effects • Underlying factors
• Real interest rate • Initiating factors
• Bracket creep • Propagating factors
• Fiscal dividend • Conflict approach
• Economic effects • Effective claims
• Social and political effects • Indexation
• Hyperinflation • Inflation targeting
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Chapter 20:

20.1 DEFINITION OF INFLATION

• Four important aspects

20.2 THE MEASUREMENT OF INFLATION

Two methods of calculating

Table 20-1 The consumer price index and

105,4 – 100 X 100 = 5,4%

103,4 – 97,8 X 100 = 5,7%

Using the producer price index to measure inflation

Manufactured goods are priced when they leave the

Differences between CPI and PPI

Two methods of calculating

Table 20-3 Annual rates of increase in CPI and

The implicit GDP deflator

20.3 THE EFFECTS OF INFLATION

Social and political effects

Click on the arrows to reveal more information.

20.3 THE EFFECTS OF INFLATION

• debtors tend to gain at the expense of creditors

20.3 THE EFFECTS OF INFLATION

20.3 THE EFFECTS OF INFLATION

Social and political effects

• inflation may result in the expectation of further inflation

See Box 20-3 Hyperinflation (Textbook page 387)

20.4 THE CAUSES OF INFLATION

Demand-pull and cost-push inflation

Figure 20-1 Demand-pull

• Sources of cost push

Figure 20-2 Cost-push inflation

The structuralist approach to inflation

See Box 20-4 The inflation process: a case

The conflict approach to inflation

• Ex ante = before the fact

Figure 20-3 A simplified view of the

The costs of anti-inflation policy

Policy makers need to take many factors into consideration.

What is inflation targeting?

The case for inflation targeting

Inflation targeting in South Africa

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