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Inflation
Definition
 Inflation is the general progressive increase in prices of goods and services in an
economy
 Inflation means a sustained increase in the general price level of goods and
services in an economy.

Features
 Inflation exists when money supply exceeds available goods and services.
 Inflation is the sustained upward trend in the general level of prices’ and not the
price of only one or two goods.
 a persistent and appreciable rise in the general level or aver­age of prices’. In
other words, inflation is a state of rising prices, but not high prices.
 It is not high prices but rising price level that con­stitute inflation. It constitutes,
thus, an over­all increase in price level.
 It can, thus, be viewed as the devaluing of the worth of money. In other words,
inflation reduces the purchasing power of money. A unit of money now buys less.
Inflation can also be seen as a recurring phenomenon.
 Purchasing power is the value of a currency expressed in terms of the number of
goods or services that one unit of money can buy.
 While measuring inflation, we take into ac­count a large number of goods and
services used by the people of a country and then cal­culate average increase in
the prices of those goods and services over a period of time.
 A small rise in prices or a sudden rise in prices is not inflation since they may
reflect the short term workings of the market.
 Inflation leads to an increase in the cost of living.
 Inflation creates problems in the economy because it reduces the value of
money, thereby increasing the cost of buying products in the country.
 When the general prices of products go up, it does not mean that all prices of
goods and services are going up some prices will actually go down

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The prices of some products may remain the same or even decrease, but
on average the prices of the products are rising.

Causes/types of inflation
• Demand pull
• Cost push

Cost push inflation

 This is inflation caused by increase in the cost of production of firms.
 Changes in cost of production affect the supply of a product
 An increase in cost of production causes a decrease in supply hence a shift to the
left
 A decrease in cost of production causes an increase in supply hence a shift to the
right.
 An increase in cost of production will push the prices up whilst a decrease will
push prices down
 Cost of production may rise due to an increase in the prices of raw materials,
machinery and wages.
 An increase in the cost of production leads to a decrease in the production of
goods and services because firms are aiming at maximizing profits.
 The diagram below illustrates how costs of production cause inflation.

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Effects of Cost of Production

• If the cost of production rises, it forces the supply curve to shift to the
left.
• The shift of the supply curve to the left, from S1 to S2, means less goods
are now being produced.
• The price of goods will then rise from P1 to P2.

Ways in which costs increase

Raw materials

Raw materials are the things required to make a certain product. An increase in raw
materials like wheat will cause increase in the price of bread. Each product has its
own particular raw materials but they are some raw materials common to all
products. Fuel is a common raw material for all products. Fuel like petrol, disiel and
electricity are crucial raw materials for all production process.

An increase in fuel will cause an increase in cost of production for all products. this
is because fuel is used in all aspects of production.

Raw materials can either be purchased locally or imported from other countries.
Raw materials imported are affected by movemenent in exchange rates. A loss in
value of the local currency will increase the cost of raw materials.

For example

• Zimbabwe is buying raw materials (wheat) from America

• Intial Exchange rate: us$1=$200rtgs
• Cost of raw materials (wheat) in America ­us$1000
• So the cost of wheat in rtgs is us$1000 x 200 = 200 000rtgs
• If the exchange rate changes to us$1: 250rtgs
• So the cost of wheat in rtgs will be now be us$1000 x 250rtgs =250
000rtgs
• The cost of wheat in America remains at us$1000 but in Zimbabwe the
cost has changed from 200 000rtgs to 250 000rtgs.

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Wages and salaries

• Wages is the reward for labour and forms a greater proportion of the
production costs
• All production requires labour which is mental and physical effort
• High wages mean high cost of production and more money in
circulation as workers would have more money
• Therefore the firms will pass on the cost to consumers in form of higher
prices of goods and services.
• Wages usually increase as a result of higher cost of living
Interest

• Interest is the reward of capital

• Firms borrow capital from the bank to invest so high interest rates
means high costs of production.
• The high costs will be passed on to customers through higher prices
Taxation

An increase in indirect taxes (i.e taxes on goods and services) will increase the price
of goods and services. The effect of an indirect tax is to increase the price of
products.

Rentals

The reward of land is rent. Rent is a common expense to many businesses who do
not own their premises. An increase in rentals will increase the cost of doing
business. Rent is a fixed cost that does not change with output.

Demand pull inflation

• This occurs when total demand increases at a faster rate than total
supply.
• It occurs when the economy is growing faster than the normal trend.
• When the supply of money in an economy exceeds the available goods
and services, it will result in demand pull inflation.
• If total demand exceeds total supply, firms will respond by pushing up
prices.
• Total demand may rise due to a rise in consumer demand.
• Total demand rises because of a rise in investment .
• Increase in government expenditure causes demand to rise.
• An increase in net exports causes total demand to rise due to an increase
in income.
• Given full employment, such increase in total demand leads to an
upward pressure in prices.

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Effects of a Rise in Demand

• An increase in demand from AD to AD2 will force firms to increase
prices from P1 to P2.

wage­price spiral
 Wage­price spiral is a condition when wages are increased due to inflation.
 This increase in wages causes firms to raise prices further.
 This further increase in prices leads to a further demand for wage increases,
which stimulates more price increases.
 The reason is that rising wages increase cost of production and the increased
costs are passed on to the consumers in the form of higher prices.
 Also, rising wages give consumers greater disposable income and therefore
cause increased consumption and aggregate demand.

EFFECTS OF INFLATION
• Inflation affects consumers, producers, government and the functions of
money in the economy.

Effects of inflation on consumers

 Inflation causes a fall in the real value of money, reducing the purchasing power
of consumers.
 Due to an increase in the general price levels, consumers can no longer buy the
same basket of goods and services using the same income.
 For example, an individual who was able to buy grocery worth $50 in 2021
would buy the same quantity of goods and services for $100 in 2022
 Inflation causes a fall in real income of consumers.
 Real income is the income of individuals that is adjusted for inflation.

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 This affects people with fixed incomes such as pensioners.
 Inflation causes uncertainty to consumers which makes it hard for them to plan
ahead.
 This results in consumers being reluctant to spend their income thereby
reducing consumption.
 Inflation reduces consumer savings.
 If the inflation rate is increasing faster than the interest rate, consumers’ savings
will lose value.
 For example, if the inflation rate increases by 9% and the interest rate increases
by 5%, it means there is a negative interest of 4%.
 Inflation reduces the variety of products offered to consumers since suppliers
will not be able to produce more products as a result of increased cost of
production.
 Inflation causes hoarding and black market in an economy which cause
shortages of goods and services.
 Inflation causes low standards of living due to shortage of goods and services.
 This makes it hard for consumers to afford basic goods and services.

Effects of inflation on producers.

 Inflation increases the cost of production since the cost of raw materials increase.
 This makes it hard for producers to produce more goods and services.
 It reduces competitiveness of domestic products in the international market
because an increase in the costs of production results in an increase in
exports.This makes consumers to opt for imports which become cheaper.
 Inflation affects infant firms as they find it hard to survive and grow due to
higher costs of production.
 It reduces the growth of firms due to uncertainty.
 Inflation makes it hard for firms to plan ahead as they cannot properly forecast
on their revenues and costs.
 Inflation results in an increase in menu costs, which are costs of reprinting the
price tags of their products since prices keep on changing within a short period
 Inflation encourages borrowing since real rate of interest tends to fall. Under
inflationary periods interest payment tends to be easy
 Inflation discourages lending so there be less credit transactions
 Inflation causes a fall in profits of producers who sell their goods on credit.
 When the amount of money is paid after a certain period of time, it would have
lost its value if it was not adjusted for inflation.
 When the inflation rate is higher than the interest rate, there is reduction in
savings. The firm’s income which is saved for reinvestment will be eroded by
inflation.

Effects of inflation on government

 Inflation affects the government because it results in a decrease in economic
growth. The decrease in economic growth is illustrated in the diagram below.

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 From the graph, when there is cost push inflation, the PPC shifts inwards
resulting in the reduction of both consumer and capital goods produced by firms
in an economy.
 Production of goods is reduced from BB to AA, which results in negative
growth.
 Negative economic growth is associated with many problems which include
increase in unemployment and lower standard of living.
 Increased unemployment increase government expenditure in trying to cater for
the unemployed.
 Government may incur additional costs trying to provide goods and services that
are short in supply.



 The government finds it hard to fulfil its financial obligation such as paying civil
servants.
 This may result in economic unrest due to increased strikes by workers.
 Inflation may lead to the collapse of the monetary system.
 The government may be forced to introduce a new currency.
 Inflation results in the government being unable to provide essential goods and
services like health and education.
 High level of inflation may cause political instability.
 Inflation leads to a fall in exports and imports will rise

The effects of inflation on functions of money.

Inflation and medium of exchange
• When inflation is rapid, the currency may become unaccepted as
medium of exchange.
• The consumers and other economic agents resort to barter trade or the
use of other countries’ currencies.
• For example, in Zimbabwe in 2008, the bearer cheques which were
being used as a medium of exchange became unaccepted and the
government had to legalise the use of currencies from other countries
such as the rand from South Africa and US dollar.

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Inflation and unit of account.
• Due to an increase in inflation, it becomes hard to compare values of
different products in an economy.
Inflation and store of value.
• The wealth of individuals and firms will be eroded away as the money
loses value each day.
• So, inflation reduces people’s savings in an economy especially when
the real rate of interest is negative.
Inflation and standard of deferred payment
 If inflation is high, it becomes unprofitable for firms and individuals who sell on
credit.
 When the consumers finally pay for the goods and services, the money that the
supplier gets will be of lesser value.
 The suppliers will not be able to cover the costs they incurred in the production
process thereby making losses.
 Producers may shut down their operations because they will no longer be able to
cover even the fixed costs of the factories.
 Individuals become unwilling to become creditors, rather they want to become
debtors.
 When they pay back, the money would have lost value thereby creditors lose out.

Measurement of inflation
 The rate of inflation in a country is measured by calculating the average
percentage change in the prices of goods and services over a period of time.
 However, it is difficult to obtain up to date information on prices of a variety of
goods and services in a country.
 Most countries track the prices on selected goods and services
 In Zimbabwe, ZIMSTATS collects information and tracks on a number of items
that comprise the consumer basket.
 The consumer basket contains essentials and basic goods and services.
 This basket is then tracked across various retailers and wholesalers over a period
of time whether a year or half year.
 The prices tracked will then be used to calculate consumer price index(CPI) and
retail price index (RPI)
 CPI and RPI are calculated in the same manner, the only difference is type of
goods, services and households used.
 The CPI measures price changes from the perspective of the consumer and
tracks the price changes in various goods and services.
 The RPI looks at price changes from the sellers' perspective by measuring the
prices of raw materials that are in production.

Consumer price index (CPI)

 CPI is a measure that examines the weighted average of prices of a basket of
consumer goods and services, such as transportation, food and medical care.
 It is calculated by taking price changes for each item in the predetermined
basket of goods and averaging them.

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 Changes in the CPI are used to assess price changes associated with the cost of
living.
 The CPI is one of the most frequently used statistics for identifying periods of
inflation or deflation.
 Most countries use CPI as a measure of inflation providing a cost of living index.
 The average price of the consumer basket in the first year of calculation is 100.

Retail price index (RPI)

 Retail Price Index (RPI) is a measure of inflation published monthly by the

ZIMSTATS office.
 RPI measures the change in the cost of a representative sample of retail goods
and services.
 Many employers also use it as a starting point in wage negotiation.
 The RPI includes an element of housing costs, for example Council tax,
mortgage interest payments, house depreciation, buildings insurance, ground
rent, solar PV feed in tariffs and other house purchase costs such as estate
agents' and conveyancing fees.

Policies to curb inflation

Monetary policy.

 The major goal of a contractionary monetary policy is to reduce the money

supply within an economy.
 This is done by decreasing money supply and raising interest rates.
 This leads to a reduction on spending.
 There is also less available credit which leads to less spending.
 Reduction in spending is important during inflation because it helps to reduce
the rate of economic growth and, in turn, the rate of inflation.
 When the Reserve Bank of Zimbabwe increases interest rate, banks have to
increase their bank rates as well.
 If banks increase their rates, less people want to borrow money because it costs
more to do so. Therefore, is decrease in spending which lowers inflation.

Fiscal policy

 Fiscal policy can be defined as government’s actions to influence an economy

through the use of taxation and spending.
 A deflationary fiscal policy is used to control inflation.
 A deflationary fiscal policy involves reducing government expenditure and
increasing taxation.
 The government should reduce its spending.
 For example, it may stop expenditure on projects such as construction of roads,
airports, hospitals and schools, among others.
 It can reduce transfer payments. Transfer payments are the payments that are
made by the government to households where there is no production of goods

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and services. Employment benefits and assistance when there are emergencies
such as floods are examples of transfer payments.
 The government may need to stop provision of subsidies to firms. It can also
choose to delay the repayment of debts to the public.
 The reason for the government to cut its expenditure is to reduce the level of
demand in the economy, which in turn reduces inflationary pressure.
 To control inflation, the government can increase the level of taxation.
 It can introduce new direct taxes and increase the rate for existing taxes.
Raising taxation results in lower purchasing power resulting in less inflationary
pressure.

Anti inflationary policies

Fiscal policy
To deal with demand pull inflation at full employment
deflationary fiscal policy
 Involves raising tax or cutting government expenditure
 increasing income tax will reduce consumption
 increasing corporate tax will reduce investment
 reduce gvt spending will directly lower AD
 all these will lead to reduction to AD which has a downward multiplier effect
hence removing the inflationary gap
Inflationary Gap:

 Inflationary gap is the amount by which the actual aggregate demand exceeds
‘aggregate supply at level of full employment’
Deflationary Gap:
 Deflationary gap is the amount by which actual aggregate demand falls short of
aggregate supply at level of full employment’.

Challenges when using fiscal policy

1. increasing income tax may force workers to demand a rise in wages causing cost
push inflation
2. its difficult to cut government spending ,its unpopular with politicians
3. reducing investment reduces future output

Fiscal policy to deal with cost push inflation

 reducing corporate tax will reduce firm's costs
 reduce income tax will lower wage claims
 increasing subsidies
 reducing gvt prices
 lowering wages increments in public sector

Fiscal policy on monetary inflation

 reducing gvt expenditure to match tax revenue so as to avoid gvt borrowing

Monetary policy on demand pull inflation

 Use deflationary monetary policy

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 raise interest rate so as to reduce investment and consumer spending
 reduce bank lending

Challenges
 if consumers are optimistic about the future may continue to borrow and increase
consumption
 high rate of inflation make borrowers to benefit even if the interest rates are high

Monetary policy on cost push inflation

 use expansionary monetary policy
 reduce interest rates so as to increase consumption and investment
 the intention is to increase output and employment

Exchange rate policy

 use higher exchange rate
 it lowers the price of imported finished products
 reduces cost of imported raw materials
 puts pressure on local firms to lower their costs and prices

Exchange rate policy

 fixed exchange rate
 put pressure on local firms to keep their costs and prices low

Incomes policy

 refers to collective governmental effort to control the incomes of labour and

capital, usually by limiting increases in wages and prices.
 The term often refers to policies directed at the control of inflation, but it may
also indicate efforts to alter the distribution of income among workers, industries,
locations, or occupational groups.
 The aim of income policy is to link the growth of incomes to growth of
productivity so as to avoid cost push inflation

 sometimes take the form of complete freeze on wages and prices

 wage and price freeze slow down the pace of inflation
 they lead to suppressed inflation
 they act as a temporary measure

Effectiveness of income policies

 its difficult to maintain a freeze on wages and prices
 trade unions strongly oppose wage freezes

Difficulties with income policies

 problem of allowing exceptions to wage freezes
 some workers will demand exceptional treatment
 difficult to control rent on private property as landlords can choose to use their
property
 difficult to enforce income policies in the private sector

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Calculation of inflation

1. Consumer price index (CPI)

2. Retail price index ­RPI
3. Wholesale price index­WPI
4. Producer price index­PPI
5. GDP deflator

What is index
 In economics and finance, an index is a statistical measure of change in a
representative group of individual data points.
 These data may be derived from any number of sources, including company
performance, prices, productivity, and employment.
 Economic indices track economic health from different perspectives.
 Index number is a technique of measuring changes in a variable or group of
variables with respect to time, geographical location or other characteristics.
 There can be various types of index numbers, but, in the present context, we are
concerned with price index numbers, which measures changes in the general
price level (or in the value of money) over a period of time.
 Price index number indicates the average of changes in the prices of
representative commodities at one time in comparison with that at some other
time taken as the base period.

Features of Index Numbers:

(i) Index numbers are a special type of average. Whereas mean, median and mode
measure the absolute changes and are used to compare only those series which are
expressed in the same units, the technique of index numbers is used to measure the
relative changes in the level of a phenomenon where the measurement of absolute
change is not possible and the series are expressed in different types of items.

(ii) Index numbers are meant to study the changes in the effects of such factors which
cannot be measured directly. For example, the general price level is an imaginary
concept and is not capable of direct measurement. But, through the technique of index
numbers, it is possible to have an idea of relative changes in the general level of
prices by measuring relative changes in the price level of different commodities.

(iii) The technique of index numbers measures changes in one variable or group of
related variables. For example, one variable can be the price of wheat, and group of
variables can be the price of sugar, the price of milk and the price of rice.

(iv) The technique of index numbers is used to compare the levels of a phenomenon
on a certain date with its level on some previous date (e.g., the price level in 1980 as
compared to that in 1960 taken as the base year) or the levels of a phenomenon at
different places on the same date (e.g., the price level in Zimbabwe 1980 in
comparison with that in other countries in 1980).

Steps or Problems in the Construction of Price Indjex Numbers:

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The construction of the price index numbers involves bthe following steps or
problems:
1.Selection of Base Year:
 The first step or the problem in preparing the index numbers is the selection of
the base year.
 The base year is defined as that year with reference to which the price changes in
other years are compared and expressed as percentages.
 The base year should be a normal year.
 In other words, it should be free from abnormal conditions like wars, famines,
floods, political instability, etc.
 Base year can be selected in two ways­ (a) through fixed base method in which
the base year remains fixed; and (b) through chain base method in which the base
year goes on changing, e.g., for 1980 the base year will be 1979, for 1979 it will
be 1978, and so on.

2. Selection of Commodities:
 Since all commodities cannot be included, only representative commodities
should be selected keeping in view the purpose and type of the index number.
 In selecting items, the following points are to be kept in mind:
(a) The items should be representative of the tastes, habits and customs of the people.
(b) Items should be recognizable,
(c) Items should be stable in quality over two different periods and places.
(d) The economic and social importance of various items should be considered
(e) The items should be fairly large in number.
(f) All those varieties of a commodity which are in common use and are stable in
character should be included.

3.Collection of Prices:
 After selecting the commodities, the next problem is regarding the collection of
their prices:
(a) From where the prices to be collected;
(b) Whether to choose wholesale prices or retail prices;
(c) Whether to include taxes in the prices or not etc.

While collecting prices, the following points are to be noted:

(a) Prices are to be collected from those places where a particular commodity is traded
in large quantities.
(b) Published information regarding the prices should also be utilised,
(c) In selecting individuals and institutions who would supply price quotations, care
should be taken that they are not biased.
(d) Selection of wholesale or retail prices depends upon the type of index number to
be prepared. Wholesale prices are used in the construction of general price index and
retail prices are used in the construction of cost­of­living index number.
(e) Prices collected from various places should be averaged.

4.Selection of Average:

 Since the index numbers are, a specialised average, the fourth problem is to
choose a suitable average.

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 Theoretically, geometric mean is the best for this purpose. But, in practice,
arithmetic mean is used because it is easier to follow.

5.Selection of Weights:
 Generally, all the commodities included in the construction’ of index numbers are
not of equal importance.
 Therefore, if the index numbers are to be representative, proper weights should be
assigned to the commodities according to their relative importance.
 For example, the prices of books will be given more weightage while preparing
the cost­of­living index for teachers than while preparing the cost­of­living index
for the workers.
 Weights should be unbiased and be rationally and not arbitrarily selected.

Purpose of Index Numbers:

 The most important consideration in the construction of the index numbers is the
objective of the index numbers.
 All other problems or steps are to be viewed in the light of the purpose for which
a particular index number is to be prepared.
 Since, different index numbers are prepared with specific purposes and no single
index number is ‘all purpose’ index number, it is important to be clear about the
purpose of the index number before its construction.

6.Selection of Method:
 The selection of a suitable method for the construction of index numbers is the
final step.
There are two methods of computing the index numbers:
(a) Simple index number and
(b) Weighted index number.
Simple index number again can be constructed either by – (i) Simple aggregate
method, or by (ii) simple average of price relative’s method.
 Similarly, weighted index number can be constructed either by
(i) weighted aggregative method, or by
(ii) weighted average of price relative’s method.
 The choice of method depends upon the availability of data, degree of accuracy
required and the purpose of the study.

Types of Index Numbers:

Wholesale Price Index Numbers:
 Wholesale price index numbers are constructed on the basis of the wholesale
prices of certain important commodities.
Retail Price Index Numbers:
 These index numbers are prepared to measure the changes.in the value of money
on the basis of the retail prices of final consumption goods.
Cost­of­Living Index Numbers:
 These index numbers are constructed with reference to the important goods and
services which are consumed by common people.

Working Class Cost­of­Living Index Numbers:

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 The working class cost­of­living index numbers aim at measuring changes in the
cost of living of workers.

Wage Index Numbers:

 The purpose of these index numbers is to measure time to time changes in money
wages.

Industrial Index Numbers:

 Industrial index numbers are constructed with an objective of measuring changes
in the industrial production.

Example
We want to look at the following years
2013, 2017, 2020,2021
Step 1 Choose a base year
I choose year 2013

Step 2: selection of commodities

I select
1.Food
2.Fuel
3.Clothes
4.Education

Step 3 Collection of prices

2013 2017 2020 2021

food 52 50 55 55
fuel 27 25 32 29
clothes 17 15 14 20
Education 90 100 70 105

Step 4 Selection of average

We use the arithmetic mean

Step 5:Selection of weights

 All commodities are important but there are commodities which are more
important than others.
 This depends with the person or household in question.

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 For example to students education is more important than clothing since 5 days
of the week you are in uniform
 So the weights indicate the relative importance of a commodity
I choose these weights
Food 40%
Fuel. 20%
Clothing 20%
Education 20%

Purpose of index
To calculate changes in general price level

Step 6 Selection of method

We use the weighted index method
Cost of basket (2013)
The small t is representing time or year

Formula we multiply the 2013 prices with the weight

Food - (52 * 0.4) = 20.8

Note: 40% = 0.4
Fuel - (27*0.2)=5.4
Clothing-(17*0.2)=3.4
Education-(90*0.2)=18

Cost of basket
20.8+5.4+3.4+18=47.6

Cost of basket 2017

Food -(50*0.4)=20
Fuel -(25*0.2)=5
Clothing-(15*0.2)=3
Education-(100*0.2)=20

20+5+3+20= 48

Cost of basket 2020

Food-(55*0.4)=22
Fuel-(32*0.2)=6.4
Clothing-(14*0.2)=2.8
Education-(70*0.2)=14

22+6.4+2.8+14=45.2

Cost of basket 2021

Food -(55*0.4)=22

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Fuel-(29*0.2)=5.8
Clothing-(20*0.2)=4
Education-(105*0.2)=21

22+5.8+4+21= 52.8

Our base year is 2013 meaning that will be our denominator

2017
(48/47.6)*100=100.84
So it means prices increased by 0.84% thats inflation

2020
(45.2/47.6)*100=94.96
Meaning prices went down by 5.04% and that is deflation

2021
(52.8/47.6)*100= 110.92
Meaning prices went up by 10.92%

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