Meaning of Inflation

Inflation can be defined as the persistent rise in the general price level of goods and services.

Inflation is the rate at which the general level of prices for goods and services is rising, and, subsequently, purchasing power is falling.

Inflation occurs when the volume of purchases is permanently running ahead of production and too much money in circulation chasing fewer goods. In economics inflation is a sustained increase in the general price level of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation reflects a reduction in the purchasing power per unit of money – a loss of real value in the medium of exchange and unit of account within the economy. A chief measure of price inflation is the inflation rate, the annualized percentage change in a general price index (normally the consumer price index) over time.

Types of Inflation

There are three main types of inflation. These are:

  1. Demand pull inflation: Demand pull inflation occurs when consumers have high purchasing power leading to increases in aggregate demand without a corresponding aggregate supply. This type of inflation occurs when the demand for goods and services is greater than their supply. This arises as a result of increase in population or increase in workers’ salaries
  2. Cost Push inflation: Cost push inflation occurs when increases in cost of production are passed on to the consumers through increase in price of goods and services sold. This is when there is increase in the prices of goods due to the increase in the cost of production.
  3. Hyper Inflation: 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. This type of inflation can be caused by war or budget deficit.
  4. Persistent or creeping inflation: Persistent or creeping inflation is also known as chronic inflation, it occurs when there is a slow but steady rise in the volume of purchasing power and a fall in supply of goods and services

Causes of Inflation

The following are the causes of inflation

  1. Low Production: Low production of goods and services can lead to their scarcity and when supply cannot meet up with the demand, inflation will set in.
  2. War: War is a major cause of inflation as it will stop people from producing therefore resulting in high volume of money purchasing fewer goods.
  3. High cost of production: when the cost incurred for the production of goods and services is high, the cost of selling will be high so that the producer can make profit; which leads to cost push inflation.
  4. Budget deficit: When government expenditure is more than its income, it results in budget deficit and this lead to inflation.
  5. Population increase: A sudden rise in the population will result in a corresponding rise in the demand for goods and services and if there is no corresponding increase in the supply of goods there will be inflation.
  6. Money laundering: when there is too much money released or injected into the economy, the prices of goods will increase and therefore lead into inflation.
  7. Inadequate storage facilities: When goods produced cannot be stored for future use, it can lead to scarcity resulting in inflation.
  8. Level of importation: High cost of importing raw materials can lead to high cost of goods which is passed to consumers leading to cost- pull inflation.

Effects of inflation

Inflation has both negative and positive effect

The Positive effects of inflation are

  1. It brings about higher profit margin for the sellers of goods and services
  2. It yields higher tax rate for the Government
  3. It encourages higher output from the producers
  4. There will reduction in the burden of debt because there is too much money in circulation

The Negative effects of inflation are

  1. There will be loss in the value of money
  2. It discourages investors from investing
  3. It discourages savings because people spend more to purchase goods and services.
  4. It discourages exportation
  5. It creates balance of payment problems
  6. It brings a fall in standard of living
  7. Creditors will loose
  8. Income redistribution; there will be a fall in real income especially pensioners and fixed salary earners.

Control of inflation

Ways by which inflation can be controlled are the following

After experiencing inflation of 50% plus in the mid 1990s, inflation in Nigeria is currently 7.9% in November 2014.

With these statistics, we can consider ways that inflation could be reduced.

  1. Monetary Policy

With growth of 3.8%, demand in the economy could be growing faster than capacity can grow to meet it. This leads to inflationary pressures. We can term this demand pull inflation. Therefore, reducing the growth of Aggregate demand should reduce inflationary pressures.

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. A higher interest rate should also lead to higher exchange rate, which helps to reduce inflationary pressure by

  • making imports cheaper
  • Reducing demand for exports and
  • Increasing incentive for exporters to cut costs.

Interest rates were increased in the late 1980s / 1990 to try and control the rise in inflation

2. Fiscal Policy

The government can increase taxes (such as income tax and VAT) and cut spending. This improves the budget situation and helps to reduce demand in the economy.

Both these policies reduce inflation by reducing growth of Aggregate Demand. In Nigeria’s case, the economy seems to be growing reasonably strongly. Therefore, we can reduce inflationary pressures without causing a recession.

If Nigeria had high inflation and negative growth, then reduce aggregate demand would be more unpalatable as reducing inflation would lead to lower output and higher unemployment. They could still reduce inflation, but, it would be much more damaging to the economy.

Other Policies to Reduce Inflation

  1. Wage Control

If inflation is caused by wage inflation (e.g. powerful unions bargaining for higher real wages), then limiting wage growth can help to moderate inflation. Lower wage growth helps to reduce cost push inflation, and helps to moderate demand pull inflation.

However, as the UK discovered in the 1970s, it can be difficult to control inflation through incomes policies, especially if the unions are powerful.

This seeks to control inflation through controlling the money supply. Monetarists believe there is a strong link between the money supply and inflation. If you can control the growth of the money supply, then you should be able to bring inflation under control. Monetarists would stress policies such as:

  • higher interest rates (tightening monetary policy)
  • reducing budget deficit (deflationary fiscal policy)
  • Control of money being created by government
  1. Discouragement of importation: Government should discourage the importation of goods from countries that are experiencing inflation.
  2. The use of income policies: The use of income policies such as wage freeze, delay in promotion etc. is also a way of controlling inflation.
  3. Increase in Production: Inflation can be reduced in increasing the level of production or output in order to bring down the prices of goods.
  4. Granting of subsidy to enterprises: through the granting of subsidies to enterprise and companies producing essential products to reduce the cost of production and the product prices.

Terminologies associated with inflation

  1. Disinflation: A slowing in the rate of price inflation. Disinflation is used to describe instances when the inflation rate has reduced marginally over the short term. Although it is used to describe periods of slowing inflation, disinflation should not be confused with deflation. /the essence of disinflation is to control inflation by direct by direct control of consumer expenditure.
  2. Spiral Inflation: It is a cycling of worsening inflation as higher prices result in higher wages, increase in cost and resulting in higher prices.
  3. Inflationary gap: A description of a condition that arises in an economy of the difference between a country’s real gross domestic product (GDP) and the level of GDP with full employment in the economy. The inflationary gap is so named because a rise in the level of an economy’s GDP will cause an increase in consumption leading to higher prices. It is a economic situation where the total demand in the economy exceeds the total supply of goods and services available to satisfy demand
  4. Reflation: is the act of stimulating the economy by increasing the money supply or by reducing taxes, seeking to bring the economy (specifically price level) back up to the long-term trend, following a dip in the business cycle. It is the opposite of disinflation which seeks to return the economy back down to the long-term trend. It is an economic state of affairs in which prices, employment, output etc. are picking up again as a result of government policy to that effect.
  5. Slumpflation: It is a state or period of combined economic decline and rising inflation. Slump inflation is marked by the idleness and under utilization of resources as capital and labor at the same time as the general price level is rising and the value of money falling.
  6. Stag-inflation: is a term used in economics to describe a situation where the inflation rate is high, the economic growth rate slows down, and unemployment remains steadily high. It refers to high increases in the price level which are not accompanied by any increases in industrial production.

Test and Exercise

  1. The persistent rise in the prices of goods and services is (a) inflation (b) slumpflation (c) deflation (d) hyper inflation.
  2. The followings are the ways by which inflation can be controlled except (a) decrease in production (b) use of fiscal policy (c) wage control (d) monetarism.
  3. One of the positive effect of inflation is (a) It discourages savings (b) Higher tax yield (c) fall in the standard of living (d) loss of value of money.
  4. All the following can bring about inflation except (a) war (b) high production (c) low production (d) budget deficit.
  5. The type of inflation that occurs when there is increase in the cost of production and is passed to consumers in form of high price is (a) demand pull inflation (b) hyper inflation (c) cost- push inflation (d) persistent or creeping inflation.

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