INFLATION KNEC NOTES

A situation where there is persistent rise in the general price level of goods and services in the economy.

Types and causes of inflation in an economy

General causes of inflation

1. High cost of production/cost push effects

It may arise from the following:-

  • High cost of raw materials
  • High wages and salaries
  • High cost of transport
  • High fuel cost
  • High level of taxation
  • High interest rate/cost of borrowing money
  • High cost of advertisement

2. Excessive demand for goods and services (demand pull effects)

If the demand is excessively high and supply is low it would force the suppliers to increase the price of goods and services due to the forces of demand and supply in the market.

3. Irrational expansionary monetary policy

It results into uncontrolled increase in the supply of money leading to increased purchasing powers that eventually leads to increase in the level of aggregate demand as opposed to the level of aggregate supply thereby leading to general rise in supply of goods and services.

4. Desire for higher profits

The desire by business firms to make higher or super normal profits makes them to raise the prices of goods and services leading to inflation.

5. Excessive Government expenditure in the economy

It leads to excessive/increased money supply without corresponding output of goods and services leading to inflation in the economy.

6. Political instability

It disrupts production in the economy contributing to shortage of goods and services which may eventually lead to inflation as the producer tries to cover up the losses incurred.

7. Depreciation of the local currency

When the local currency loses value against foreign currency then the prices of goods begin to rise due to increase in the price of level of imports.

8. Rising of fuel prices

When prices of petroleum products rise then the general price level in the economy also rises because it affects almost every sector in the economy but more particularly the industrial and transportation sectors.

9. Excessive printing of money

The Central bank may also lead to increase in money supply without corresponding increase in output of goods and services. When excess money is printed this may eventually lead to inflation.

 

Types of Inflation

  1. Demand pull inflation (demand side inflation)

This is a situation where aggregate demand exceeds aggregate supply at current prices and at full employment level of the economy so that prices keep on rising. This type of inflation is usually associated with full employment situation where an increase in demand leads to upward movement in prices. Demand pull inflation is sometimes described as ‘a situation where there is too much money chasing a few goods.’

In the diagram above, the aggregate demand curve, AD0, and the aggregate supply curve (AS0) gives the equilibrium price (Po) and the equilibrium quantity (Qo).

Suppose the aggregate demand increases and the aggregate supply remains constant, the aggregate demand d curve ADO shifts upwards to AD1. Assuming the aggregate supply side remains constant, and then the price level will change from Po – P1 thus the economy experiences inflation. This type of inflation caused by increase in aggregate demand as aggregate supply remains the same is called demand pull inflation

 

  1. Cost push inflation (supply side inflation)

This type of inflation originates on the supply side and is a situation where rising prices are initiated and sustained by the rising prices of factors of production.

It occurs when costs are pushed upwards by the increases in factor prices i.e. cost of production.

Considering the diagram above, and the AS1 and AD1, their point of intersection will give us the equilibrium price level p1 and equilibrium quantity Q1. Due to increased costs of production that forces the producers to cut down their level of production, the AS curve shifts to the left from AS1 to AS2 increasing the equilibrium price from P1 to P2 and since this occurs, the economy experiences inflation.

Types of Cost push inflation

  1. Wage push inflation

Is an inflation that occurs when trade unions are strong enough to cause an increase in the wages especially where there is excess demand for labour due to competitive nature of the market. The workers may also demand for wages increase due to increased cot of living in the economy. Higher wages would mean higher cost of production and if the increase in wage rate exceeds the increase in productivity then the aggregate supply curve shifts to the left leading to commodity shortage that will force prices upwards. Besides, the producers will increase the prices of products in order to cope up the increased cost of production.

  1. Profit push inflation

This is inflation which results from increased prices in order to obtain excess profit; may be the effect of monopolist operations in the market. If there is large number of monopolists in the economy, then there will be a greater possibility of profit push inflation since price determination depends on the monopolist.

Measures to correct cost push inflation

1. Provision of subsidies to producers

The government can help to reduce the cost of production by giving producers assistance in form of subsidies. This reduces the prices of factors of production to affordable level.

2. Increase the availability of goods

This can be achieved in the following ways:-

  1. Through increased local production of goods and services.
  2. Through importation of goods and services that are lacking.
  • Price policy: The government institutes price control by fixing maximum prices for essential goods so as to control inflation.

3. Income policy: the Government sets a maximum wage rate which is followed by wage freeze in order to reduce the rising wage rate in the economy that may cause inflation.

Measures to correct demand pull inflation

1. Restrictive/contractionary monetary policy

This policy reduces money supply in the economy by selling government securities, increasing the bank rates, increasing the legal requirements in the economy e.t.c. It reduces the level of money circulation in the economy which in turn affects the purchasing power of consumers and thus leading to reduction of aggregate demand towards aggregate supply.

2. Restrictive fiscal policy-This involves the reduction in government expenditure and increase in domestic taxes so as to reduce the disposable incomes and purchasing powers of the public.

3. Restrictive income policy

Is where the Government fixes maximum wage rates in order to reduce the purchasing power of the consumers and the gap between demand and supply. The wages are kept constant through wage freeze so that the workers demand stays constant to avoid demand exceeding supply.

4. Price policy

The government controls the prices of major commodities.This helps to prevent prices from rising continuously.

5. Through increased importation of goods

The supply can be increased by importing from other countries. This policy includes reducing restrictions/barriers on imports so as to increase the supply and goods in the economy in order to reduce the pressure of aggregate demand on domestic goods.

6. Increase in the flow of foreign investment

Since this type of inflation occurs in a period of full employment when there are no additional resources for production the government can encourage foreign investors to bring in more resources so as to raise output.

Other types of inflation

  1. Suppressed inflation: is a situation where demand exceeds supply but the effects are minimized by the use of such devices such as price control and rationing.
  2. Bottle neck/structural inflation: it is caused by a reduction in the output (supply) of the major sectors due to inevitable and /or unforeseen factors.
    1. Structural break down in production process.
    2. Fall in agricultural production due to bad weather, pests, floods etc.
    3. Foreign exchange constraints.
    4. Shortage of technical and entrepreneurial skills.
    5. Mismanagement of the economy.
  3. Imported inflation: it arises from importing goods and services from countries that are already experiencing inflation. It therefore means that a country imports the other country’s inflation in form of higher prices of imports e.g. high prices of petroleum products (oil) may lead to higher cost of transport which may affect all other sectors of the economy leading to general price increase.
  4. Inflation spiral: is a situation in which persistent rising prices leads to arise in the cost of living and demand of higher wages by workers to raise their standards of living.

Once the wages increase the prices of goods and services rise further leading to further increase in the cost of living and more demand for upward adjustment and the process continues without end.

General Measures to control inflation

  1. Restrictive monetary policies
  2. Reducing Government expenditure in order to control the purchasing power.
  3. Increasing the rates of taxation in order to reduce the purchasing power.
  4. The consolidation of allowance and wage freezing for those in high income.
  5. Provision of investment incentives in order to encourage more investors.
  6. Improving the infrastructure to facilitate resource movement and consequently increase production.
  7. Privatization move or drive in order to boost production in the economy.
  8. Controlled printing of money.
  9. Provision of subsidies to producers to minimize the price rise.

Effects of inflation in an economy

  1. Discourage savings: it affects the rate of saving through constant loss of money value i.e. it represents a major disincentive to save and therefore discourages investment initiatives as well.
  2. Balance of payment problem: the rising prices at home would lead to a fall in export, because they become too expensive for the foreigners to buy yet imports become cheaper.
  3. Unfair income distribution: during times of inflation some groups become better off while others worsen off, the stronger groups gain while the weaker group losses and this causes misery among majority who cannot afford high prices of goods and services.
  4. Unemployment: some workers may be forced to quit wage employment especially in urban areas because they cannot afford high cost of living.
  5. Falls in real income: fixed income earners of the salaried workers suffer from inflation as their real income falls with the size of prices of goods and services.
  6. Effects of the exchange rates: the foreign currency (dollar) will buy less of our currency (kshs) because the purchasing power of the foreign currency falls as the domestic prices rise and this may affect the nation.
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