Lecture Notes on

Inflation: Meaning, Theories, and

Costs/Effects

Madhav Prasad Dahal

Associate Professor of Economics

1
 What is inflation?
• Edward Shapiro defines inflation as, “ a
persistence and appreciable rise in the
general level of prices”.

2
 Types of Inflation

Classification Criterion for Classification

i. Open or Suppressed Working of the Market
Inflation Mechanism
ii. Creeping ,Moderate, or Rate at which Prices Increases
Galloping Inflation,
Hyperinflation
iii. Anticipated and Expectations of Inflation
Unanticipated Inflation

iv. Cost-push or Demand-pull Causes of Inflation

Inflation 3
 Types of Inflation
i.If inflation is open, the market economy basically continues
to function as a process in which prices are set. Any excess
demand (the goods or factor gap) leads to an increase in
prices and money wages.

Suppressed inflation occurs when government controls

prevent goods prices and money wages from rising, so that
excess demand is not reduced but suppressed. If controls are
lifted, one must reckon with increases in the general price
level and in money wages.

4
 Types of Inflation
ii. The criteria underlying the price rate increase classification is the rate of
the observed increase in the general price level.

• Inflationary processes in which the increase in prices does not exceed 2-3
percent per annum and in which there are no expectations of inflation to
speak of may be characterized as “creeping” inflation. In other words, when
the price rise is very slow like that of a snail or creeper, it is called creeping
inflation.

• .Such as increase in prices is regarded safe and essential for economic

growth.

• Higher rates of price increase are labeled “moderate”;a further acceleration

of the increase in prices merits the epithet “galloping”. However one cannot
set exact boundaries between any two these categories.
5
 Types of Inflation
Hyperinflation: Price increases ,which in general are also accelerating ,can
be called “hyperinflation”. P. Cagan(1956,p.25) defines this as a condition
in which the general price level is increasing at a rate more than 50 percent
per month.

• Samuelson and William D. Nordhaus(2004:741), “Hyperinflation is

inflation at extremely high tares(say,1000, 1milliom, or even 1 billion
percent a year).”

• In reality, hyperinflation is a situation when the rate of inflation becomes

beyond measure and absolutely uncontrollable. Prices rise many times
every day. Such a situation brings a total collapse of monetary system
because of the continuous fall in the purchasing power of money

6
•In hyperinflation money loses its function as a store of value
and at least partly as a medium of exchange. In the period
after World War I, hyperinflation occurred in various
European countries such as Germany, Poland,
Austria,Russia,and Hungary. After World War II, it
occurred in South American countries.

7
 Anticipated and Unanticipated Inflation
iii. Anticipated inflation: It is the rate of Inflation that is Realized
beforehand, that is, the rate of inflation which most people think will
exist at some time in the future.

When people/businesses can make accurate predictions of inflation,

they can take steps to protect themselves from its effects. For
example,

i. Households may also be able to switch savings into deposit accounts

offering a higher nominal rate of interest or into other financial
assets such as housing or equities where capital gains over a period
of time might outstrip general price inflation.

ii. Companies can adjust prices and lenders can adjust interest rates. 8
 Anticipated Inflation
•Suppose that all prices are rising at 3 percent each year and
everyone expects this trend to continue. Would there be any
reason to get excited by inflation?

•Economists generally believe that anticipated inflation of

modest rates have little effect on economic efficiency or on the
distribution of income and wealth. Prices would simply be a
changing measure to which people adjust their behavior.

9
 Anticipated Inflation
•But the reality is that inflation is usually unanticipated. For
example, the Russian people had become accustomed to stable
prices for many decades. When prices were liberalized in 1992,
no one not even the professional economists, guessed that
prices would rise by 1000 fold over the next five years. People
who were unlucky enough to hold their wealth in rubles saw
their savings become worthless. In more stable countries like
the United States, the impact of unanticipated inflation is less
dramatic, but the same general point applies. An unexpected
jump in prices will impoverish some and enrich others.
10
 Unanticipated Inflation
•Unanticipated inflation: It is a rate of inflation which has not
been predicted by economists and which therefore comes as a
surprise to business people, governments and workers.
• Unanticipated inflation occurs when economic agents (people,
businesses and governments) make errors in their inflation
forecasts.
•Actual inflation may end up well below, or significantly above
expectations causing losses in real incomes and a redistribution
of income and wealth from one group in society to another.
•When inflation is volatile from year to year, it becomes difficult
for individuals and businesses to correctly predict the rate of
inflation in the near future.
11
 Unanticipated inflation
•Where changes in inflation are not factored into decision
making – can lead to:

–Changes in distribution of income: e.g. factoring in inflation

above actual levels in wage negotiations may lead to a
redistribution of income from employers to employees

–Effects on Employment: e.g. wage settlements higher than

inflation due to incorrect anticipation of inflation imposes costs
on employers and may lead to job losses.
Thus in conclusion only unanticipated inflation produces real effects; that is
only unanticipated inflation affects output and employment.
12
 Demand-pull vs. Cost –push inflation
• iv. The demand-pull cost –push inflation depends on the
cause of inflation. Demand pull is considered to result from
excess aggregate demand ;cost-push occurs from a shift in
the aggregate supply function. In the recent literature on
inflation ,however, this dichotomy has lost the central role
with which traditional theory endowed it. It is a
consequence of the failure to identify empirically the two
types of inflation.

13
 Types of Inflation
• M.Bronfenbrenner and F.D. Holzmann distinguish four types
of Inflation:

(i) Inflation is as condition of generalized excess demand in

which “too much money chases too few goods”.

(ii)Inflation is a rise of the money stock or money income

either total or per capita[ Bronfenbrenner and
Holzman,1963,p.599]

Both definitions are causal. In the first case inflation is traced

to demand in the goods market; in the second inflation is
explained as the result of a change in the money supply.
14
 Types of Inflation
•Milton Friedman has popularized the monetarist causal definitions.
“Inflation is always and everywhere a monetary phenomenon . . .and
can be produced only by a more rapid increase in the quantity of
money than in output”[Friedman 1970,p.24]

(iii) Inflation is a rise in price levels with additional characteristics

or conditions ; it is incompletely anticipated ;it leads(via cost
increases) to further rises; it does not increase employment and real
output; it is faster than some “safe” rate ;it arise “from the side of
money” measured by prices net of indirect taxes and subsidies and
/or it is irreversible.[Bronfenbrenner and Holzman,1963,p.599

15
 Types of Inflation
•This is an extended version of symptom-based definitions of inflation
that requires the increase in the general price level to have certain
characteristics.

(iv) Inflation is a fall in the external value of money as measured by

foreign exchange rates, by the price of gold ,or indicated by excess
demand for gold or foreign exchange at official rates.[Bronfenbrenner
and Holzman,1963,p.599]

The fourth definition emphasizes external developments in the

general price level. Inflation is measured by movements in exchange
rate, a method appropriate for open economies under certain
conditions. 1
6
 Costs of Inflation
►Inflation will not only affect individuals, but will also cause

problems for the whole economy. There are economic and social

costs of inflation.

Money loses its value: People lose confidence in money as the value

of savings is reduced. This is particularly the case with rapid

inflation.

Inflation can get out of control: Price increases lead to higher wage

demands as people try to maintain their living standards.

Businesses then increase prices to maintain profits and so it goes on.

17
 Costs of Inflation
Consumers and businesses on fixed income lose out: They lose

out because the real value of their incomes falls. Many

pensioners are on fixed pensions so inflation reduces the real

value of their income year on year.

Employees in poor bargaining positions lose out: People in low

paid jobs with little or no trade union protection.

Inflation favours borrowers at the expense of savers: This is

because inflation erodes the real value of existing debts. Also the
rate of interest on loans may not cover the rate of inflation.

18
 Costs of Inflation
Uncertainty: If inflation keeps varying, then firms may be

reluctant to invest in new plant and equipment as they may be

unsure of what the government will do in the future. People also

may be uncertain and reluctant to spend. Both of these factors

could reduce the long-term level of economic growth.

It disrupts business planning: Although businesses are aware

of what has happened to prices in the past, they cannot be

certain what ill happen in the next few months and years.

Budgeting becomes difficult and this may affect investment.

19
 Costs of Inflation
Income redistribution: Many people have to live on fixed

incomes, particularly those on pensions. The higher the level of

inflation the less their income will be worth. This effect can also

happen among people who are working, as their incomes go up

either faster or slower than inflation. These effects can

arbitrarily redistribute income. With redistribution of income,

the economic conditions of the borrowers improve and that of

the lenders, deteriorate. However, this situation is more

dependent on the real interest rates.

20
 Costs of Inflation
•Menu costs: This is a general term for all the inconvenient costs

that businesses and individuals face. As prices increase they have to

redo their price lists, change price labels, reprint menus and so on.

Extra costs to firms of changing price information increases. This

can be important for companies who rely on bulky catalogues to

send price information to customers.

21
 Costs of Inflation
•Global competitiveness: Inflation initiates competitiveness in the
worldwide markets. The higher are the prices of the products of a country,
the lesser are the scopes of competition, which subsequently reduces the
country's exports. For example, if Nepal has higher inflation than the rest
of the world it will lose price competitiveness in international markets. This
assumes a given exchange rate. If the exchange rate depreciates, this may
help to restore some of the lost competitiveness. This rise in relative
inflation leads to a fall in the world share of Nepal’s exports and a rise in
import penetration. Ultimately, this will lead to a fall in the rate of
economic growth and the level of employment. But, this situation may be
counterbalanced if there is a fall in the exchange rate.

22
 Costs of Inflation
Disorder and improbability: With high inflation, the residents of a
country become indecisive about the ways of spending their money,
and what to spend their money on. It is under this circumstance that
the country's commercial firms become indifferent and less willing
towards investment, as they are not sure about their future profits.

 Shoe leather costs: This means making savings on losing bank

interests. As a result, the customers hold less cash amounts and
frequent the banks more. When prices are unstable there will be an
increase in search times to discover more about prices. Inflation
increases the opportunity cost of holding money, so people make more
visits to their banks and building societies (wearing out their shoe
23
leather!).
 Costs of Inflation
• The problems of a wage-price spiral: Price rises can lead to higher
wage demands as workers try to maintain their real standard of
living. Higher wages over and above any gains in labour
productivity causes an increase in unit labour costs. To maintain
their profit margins they increase prices. The process could start all
over again and inflation may get out of control.

• Higher inflation causes an upward position in inflationary

expectations that are then incorporated into wage bargaining. It can
take some time for these expectations to be controlled. Higher
inflation expectations can cause an outward shift in the Phillips
Curve.
24
 Costs of Inflation
Inflation can also cause a reduction in the real value of savings:

Especially if real interest rates are negative it can also cause a

reduction in the real value of savings.. This means the rate of interest

does not fully compensate for the increase in the general price level. In

contrast, borrowers see the real value of their debt diminish. Inflation,

therefore, favours borrowers at the expense of savers. Inflation

usually leads to higher nominal interest rates that should have a

deflationary effect on GDP.

25
 Costs of Inflation
Inflation can also cause a disruption of business planning: Uncertainty

about the future makes planning difficult and this may have an adverse

effect on the level of planned capital investment.

Budgeting becomes a problem as firms become unsure about what will

happen to their costs. If inflation is high and volatile, firms may demand

a higher nominal rate of return on planned investment projects before

they will go ahead with the capital spending.

These hurdle rates may cause projects to be cancelled or postponed until

economic conditions improve. A low rate of new capital investment

clearly damages long-run economic growth and productivity.

26
 Costs of Inflation
Cost-push inflation usually leads to a slower growth of
company profits which can then feed through into business
investment decisions.

Inflation distorts the operation of the price mechanism and

can result in an inefficient allocation of resources. When
inflation is volatile, consumers and firms are unlikely to have
sufficient information on relative price levels to make informed
choices about which products to supply and purchase.

27
 Anticipated And Unanticipated Inflation
• When inflation is volatile from year to year, it becomes difficult for
individuals and businesses to correctly predict the rate of price inflation that
will happen in the near future. When people are able to make accurate
predictions of inflation, they can anticipate what is likely to happen and take
steps to protect themselves. For example, people can attempt for increases in
money wages so as to maintain their real wages. Savings can be shifted into
accounts offering a higher rate of interest or into assets where capital gains
might exceed general price inflation. Companies can adjust their prices;
lenders can adjust interest rates.

• Unanticipated inflation occurs when economic agents (people, businesses and

governments) make errors in their inflation forecasts. Actual inflation may
end up well below, or significantly above expectations.
28
 Inflation Theories: Causes of Inflation
(i) Demand-Pull Inflation :One of the principal causes of
inflation is excessive demand - 'too much money chasing too
few goods'. If demand is growing faster than the level of
supply, then prices will increase. When aggregate demand for
goods and services in the economy rises above its aggregate
supply, there is natural rise in prices. Output will increase as
well, as there is a shift along the aggregate supply curve, but
because supply cannot keep up with demand prices go up as
well. This is shown in the diagram 1:

29
 Demand-Pull Inflation
Diagram :1
Price Level
AS

P3 B3

B2
P2
B1
P1 AD3

AD2
AD1
0 Output
Q1 Q2Q3

30
 Demand-pull inflation
• Demand-pull inflation will therefore usually occur along with
a booming economy. To avoid demand-pull inflation
concerned government authorities need to try to keep the
economy growing at a steady, but not excessive rate - a tall
order!

31
 Cost-Push Inflation - What pushes inflation up?
•Cost-push inflation happens when firms' costs go up. To
maintain their profit margins, firms then need to put their
prices up. In other words cost increases have pushed inflation
up. Cost-push inflation may arise from various sources:

•Wage increases: Wages are a major proportion of costs for many

firms and so if wages are increasing, this may well cause cost-
push inflation.

•Material cost :The increase in the prices of basic raw materials

(both domestic and imported)essential for production pushes
inflation up.
32
 Cost-push Inflation
• Government :If the government changes and raises taxes,
this may push up firms' costs. This is particularly true
with excise duties on fuel and oil. Changes in interest
rates can also affect firms’ costs if they have borrowed
significant amounts.

• Abroad: Exchange rate changes can affect firms' costs,

particularly if they import many of their raw materials.
An exchange rate depreciation will increase import prices
and may therefore increase firms costs.
33
 Cost -Push Inflation
Diagram :2
Price Level AS2
AS1

P2 B2
P1
B1

AD1
0 Output
Q2 Q1
34
•Inflation and Money: The role of the money supply?

•Many economists argue that one of the main causes of inflation is

excessive money supply growth. The origins of this theory lie with

Monetarist economists. Perhaps the best known Monetarist is Milton

Friedman, and much of the research on this theory was done by him at

Chicago University.

•Monetary theory of inflation draws on the Quantity Theory of Money to

suggest that if the amount of money in the economy grows faster than

the growth in the level of potential output, then this will feed inflation.
35
 Structural Theory of Inflation
The structural theory of inflation claims that inflation is not caused merely by
the excess of demand over supply but built into an economy due to structural
maladjustment in the economy.

It is blending of demand-pull and cost-push theories of inflation. It is

commonly found prevailing in developing and least developed
countries(LDCs).

• Factors causing inflation under the structural theory

i. Food supply bottlenecks(Inelastic supply of food grains)

ii. Resource gap(Fiscal deficit)

iii.Infrastructural bottlenecks

iv.International price hike(mainly prices of petroleum products).

 Structural Theory of Inflation
i.Shortage of food grains because of less and low food production in LDCs; a mismatch

between low agricultural productivity and growing population causes inflation.

ii.More expenditure than revenue because of growing activities and role of the

government; but output can not be increased overnight to meet the growing demand

and demand-pull type of inflation occurs.

iii.Imported goods are to be paid in foreign currency but if there is no sufficient foreign

exchange reserves ,more is to be paid to buy foreign currencies or to be borrowed and

it ultimately raises prices.

iv.Transportation and communication problem. There is lack of integrated

market(markets are fragmented).

v.Countries which have to import large volume of petroleum products suffer from

rising prices because of rising prices of the petroleum products.

 The Structural Theory Of Inflation
•One version of the structural theory which seems appropriate to some

developing countries, focuses on the gap between imports and exports.

Because of the rising demand for manufactured goods, imports tend to

increase faster in those countries than the ability of the traditional

exporting industries to pay for them. Difficulty is experienced in

substituting home manufactures for imports, partly because home markets

are often too small to support the required industries and partly because

the development of manufacturing itself requires extensive imports of

machinery and structural materials. Consequently, there is a continuous

downward pressure on the international value of the country’s currency;

this is felt in a continuous upward pressure on the country’s internal

38
 The Structural Theory Of Inflation
•Alternatively, inflation in such countries may result from social
and political pressures to provide employment for the overflow
into the towns of a rapidly growing rural population; since
there is a shortage of savings, this leads to excessive creation of
new credit in one way or another and thus to a straightforward
“demand-pull” inflation.

39