Economics

(b) Cost-push inflation

Activity 3

Visit the library or the Internet and research on the following:

1. Causes of cost-push inflation.

2. Ways of reducing cost-push inflation.

Facts

Cost-push Inflation is also called supply inflation or sellers’ inflation. It is the persistent increase in the prices of goods and services brought about by increase in the cost of production. According to the cost-push theories, inflation is caused by powerful unions or by powerful firms. The process is explained as follows:

Trade unions demand higher wages for their members. Because unions are so powerful, employers accede to their demands even if there are no increases in productivity. But higher wages mean higher costs of production for the firms. Hence, in order to protect their profits, the firms raise their prices.

The higher prices force the unions to demand even higher wages. The firms then raise their prices even higher. This wage-price spiral, as it is often referred to, continues, and the process becomes a vicious circle. Cost-push inflation happens when firms’ costs go up. To maintain their profit margins, firms then need to put their prices up.

P represents price.

Y represents output.

AD represents aggregate demand.

SRAS represents short-run aggregate supply.

From Figure 2 it can be seen that when the costs of production increase, aggregate supply reduces from SRAS1 to SRAS2. Output reduces from to leading to price increase from P1to .

Cost-push inflation may arise from various sources which include:

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.

• Government: If the government changes taxes, this may push up firms’ costs. This is particularly true with excise duties on fuel and oil.

• Changes in interest rates: This can also affect firms’ costs if they have borrowed significant amounts.

• Exchange rate:Exchange rate changes can affect firms’ costs,particularly if they import many of their raw materials. Exchange rate depreciation will increase import prices and may, therefore, increase firms’ costs.

• Increase in the operating costs: These include, among others, high costs of raw materials, high cost of rent, electricity, borrowing capital and advertisements. Normally, when these costs increase, the costs of production will increase and producers react by increasing the prices so that they are able to cover the costs.

Other forms of cost-push inflation may include:

•  Price- wage inflation: This occurs when the increase in the price of goods and services forces the workers to demand for higher wages to meet the increasing cost of living and the producers will react by increasing the prices of the goods and the process will continue.

•  Wage-price inflation: This occurs when workers demand for high wages through their trade unions and this increases the cost of production hence producers react by increasing the prices of the goods.

•  Wage-wage inflation: This occurs when workers of a particular firm demand for high wages as those earned by a different similar firm and this increases the cost of production, hence price increase.

Controlling cost-push inflation

•  Increase in the level of domestic output: The government should increase local production by encouraging local and credit facilities, tax holidays. etc.

•  Imports encouraged: The government should encourage the importations of commodities that are scarce in the domestic economy. There should be no policies trying to block the importation of such commodities. The government should reduce import taxes. It can subsidise importers. This will increase the quantity of goods leading to a fall in prices.

• Discourage the export of goods: Commodities that are lacking in the economy should not be exported. This can be done by imposing high export taxes, and in so doing, the quantity of goods in the country will increase. Prices will consequently fall.

• Price and incomes policy: The other policy which could be adopted for curbing wage-push inflation is to moderate the increasesin incomes and prices. These are known as prices and incomes policies”. The basic idea of a prices and incomes policy is to reduce the wage-price spiral by curbing the growth of prices and incomes, and thereby lowering people’s expectations of inflation. If the rapid growth of wages can be curbed, then subsequent price increases will be reduced.

•  Organisational controls: Organisational controls are sometimes adopted in controlling cost-push inflation. The government assumesownership of major distribution channels. The government may practise rationing. The consumer is not able to get whatever amount of the commodity that he desires.

(c) Profit-push or price mark inflation

Profit-push depends on the degree and extent to which prices are being administered — being determined by the monopoly and oligopoly elements.

The greater the number of oligopolies and monopolies, the greater the possibility of profit-push inflation. Market forces are not important in price determining. Oligopolists and monopolists may raise prices more than enough to offset any cost increase in the hope of getting excessive profits.

(d) Bottleneck/ scarcity/ demand shift or structural inflation

Activity 4

Visit the library or the Internet and research on the following:

1. Meaning of bottleneck inflation.

2. Causes of bottleneck inflation.

3. Ways of reducing bottleneck inflation.

Facts

This is a type of inflation that results from supply rigidities/constraints that cause a reduction in supply of goods and services. It is another variety of cost inflation and it is mainly experienced in LDCs. The inflationary processin LDCs is fundamentally structural, led by food prices due to inelastic nature of food supplies relative to faster growing demand. This inflation is due to structural problems or supply rigidities, which keep down the level of output and hence high prices.

Causes of bottleneck inflation

•  Structural breakdown causing a shortage of goods and services in an economy: The productive capacity of the economy reduces. Capital machines depreciate and there is inadequate capital maintenance, leading to low production.

• Insecurity scares away investors both domestic and foreign. There is a fear of making substantial investment due to the insecurity that prevails. As a result, output reduces and prices rise.

•  Reduction in production of the major sector — agriculture:This may be due to uncontrollable factors such as weather, pests, etc. Agricultural inputs may be lacking, leading to a reduction in agricultural output which pushes up prices.

•  There may be foreign exchange bottlenecks which are due to poor export performance. The export sector performs below capacity. Consequently, less foreign exchange is obtained to buy capital equipment which can be used to set up industries and increase the productive capacity of the economy. Besides, there can be a misallocation of foreign exchange. Instead of using foreign exchange in productive projects, it may be used in non-productive projects

•  Lack of technical and entrepreneurial skills: Structural inflation can also be due to the lack of technical, capital and entrepreneurial skills. This results in a decline in the supply of commodities, leading to a sharp increase in the prices.

Policies for controlling structural inflation

•  Increase the local production of goods and services: The government should offer incentives to private individuals such as credit facilities. Government also should set up its own industrial establishments in an effort to increase local production so as to push down prices.

•  Improve the export sector: This can be done, say by diversifying the economy. Both agricultural and industrial commodities should be exported. The quality of exports should be improved. More foreign exchange can then be obtained which can be used to import capital goods for setting up industries that will increase the level of output. This will help in reducing the prices.

•  Increase the level of agricultural output: Generally, agriculture should be improved. This can be done in a number of ways as for instance, setting up irrigation schemes, provision of credit facilities, improvement of transport facilities, increased agricultural commodity prices, and others.

•  Price and income policy.

•  Proper management of the economy.

(e) Imported inflation

Activity 5

Visit the library or the Internet and research on the following:

1. Meaning of imported inflation.

2. Causes of imported inflation.

3. Ways of reducing imported inflation.

Facts

According to this theory, inflation may be caused by an increase in the prices of imported inputs or by increases in the prices of imported goods. If the prices of imported inputs rise, importers will raise the prices of their products. In addition, if there is inflation abroad, the prices of imported goods will rise, resulting ultimately in domestic inflation.

Policies for controlling imported inflation

Imported inflation is hard to fight because it is exogenous to the economy. It originates from outside the economy. However, there are some solutions.

• Import restrictions: Certainly, this will make the country go without certain commodities although prices are reduced.

•  Import-substitution strategy: Setting up industries to produce goods formerly imported. However, some commodities cannot be import-substituted, for instance, petroleum products.

•  Subsidisation of importers by the government: If importers are subsidised, they will sell their produce at a lower price and hence, a fall in the inflation rate.

(f) Monetary inflation

According to the monetary economists, it is the persistent increase in the prices of goods and services brought by increase in money supply without corresponding increase in goods and services.

(g) Expectation inflation

This is caused by speculation among producers that prices may rise in the future. Hence they create artificial shortage to increase prices.

7.1.5 Consequences of inflation

Activity 6

Describe the effects of inflation in an economy.

Facts

Inflation is considered beneficial as long as it leads to an increase in the income level, output and employment. If it does not achieve the above objectives, it becomes hazardous to the economy. Therefore, inflation has wide ranging effects on the economic, social and political life of a country. Inflation is generally undesirable because it produces some serious social and economic problems. Inflation does not only affect individuals, but also causes problems for the whole economy. The costs of inflation include:

1. Inflation and social effects

Citizens of countries that suffer high levels of inflation year after year generally feel insecure and have a high level of financial anxiety. High levelsof inflation have adverse effects on the poor members of society since they cannot, in the short-run, raise their incomes. Generally, the weaker sections of the population experience poor living conditions in terms of poor feeding, poor clothing and poor housing.

2. Inflation and income distribution

Inflation brings about a redistribution of real income within the society. Some groups become better, and others worse off. This is not a desirable result, for it tends to be the weaker sections of society who lose, and the stronger who gain. Those who become worse off are fixed income recipients such as salary/wage earners, individuals living on past savings and pensioners. As prices rise, the purchasing power reduces. The real income of these persons falls. Related to the above during inflation, the lenders lose money while the debtors gain since they pay back with inflated currencies that have lost value.

3. Inflation and worker’s effort

Generally, inflation encourages individuals to work harder. This is so because individuals would like to maintain their current levels of living. (In Rwanda, individuals work in different places in order to maintain their current levels of living).

4. Inflation and economic growth

Generally, it is believed that rising prices boost the profit expectations of producers and investors. They are encouraged to increase their investments thereby increasing both output and employment. Keynes believes that moderate or creeping inflation will encourage production while galloping or hyper inflation would be dangerous because it creates uncertainties which are not good for production. This prohibits the economic growth performance because it discourages:

      • Investors by reducing their confidence in investing projects with long gestation periods;

      • Exports by reducing their competitiveness in the international market; and

      • Financial savings by eroding their future values.

5. 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.

6. Inflation versus business operations

Inflation distorts business operations. Since prices do not all changeuniformly and at the same speed, it becomes very difficult for business to gauge truly the demands of consumers or the cost of their operations. Specifically, there are a number of ways in which inflation can distort the working of the economic system and in particular the business sector.

      • Mortgage rates: Mortgage rates tend to increase and this makes house purchase more expensive. It is also likely to adversely affect the construction industry engaged in house building, the demand for which will be reduced.

      • Higher short-term interest rates: Costs of holding stock and of financing in progress are raised. Companies relying heavily on bank finance for their working-capital requirements are most affected.

      • Higher long-term interest rates: This poses a problem for companies planning to finance long-term expansion with external borrowing. There is always an element of uncertainty surrounding long-term planning during the time of inflation.

      • Distortion of company profits:  During inflation, company profits appear to be higher than they actually are. The damage that can result from such misleading measurements of company profits is: the payment of excessive dividends to shareholders with the result that inadequate profits are retained within the company; and wage claims from trade unions in view of the high recorded profits as evidence of a strong company position.

      • Adverse effects on investment behaviour:  Inflation may affect the behaviour of investors and lead to less savings being invested in productive ventures. Savings are put into the purchase of residential property, antiquities, gold and various consumer durable goods, all of which would be to hold their value during inflation.Inflation retards saving and investment by reducing the purchasing power of the people.

7. Inflation and the balance of payments

If domestic prices are increasing faster than those in other countries, then domestic goods will have no market. This will have a negative effect on the balance of payments. In other words, if the rate of inflation in a country exceeds that of its competitors, then its exports will become relatively more expensive on international markets.

Likewise, on the home market, imports will become relatively cheaper. The result of this will be to reduce the country’s exports and to increase its imports, depending on the price elasticity of demand for exports and imports. A balance of payments deficit will result.

8. Failure to achieve other goals of economic policy

Inflation makes it more difficult to attain the other targets of economic policy.Full employment becomes very difficult to attain. There is a need for a high level of aggregate demand to create full employment, but inflation can curb the components of aggregate demand (Y = C + + G + X – M).

9. Inflation and politics

Inflation adversely affects the political life of a country. This is because it increases corruption among politicians and erodes political discipline. There is a growing feeling of discontent among the people which results in the loss of faith in the government. Mass discontent sometimes results in political upheavals, which may even result in the fall of the government.

Inflation creates tensions and industrial unrest which can give rise to political unrest and lead to increased support for extreme political parties.

General cures for inflation

Activity 7

Visit the library or the Internet and carry out research on the following:

1. Measures that can be used to reduce the persistent increases in the prices.

2. Relationship between inflation and unemployment.

Facts

Many governments have now come to the conclusion that the successful fight against inflation is their economic priority number one if long-term economic and social stability of a country is to be enjoyed by its citizens.

The success in the fight against inflation is assured when appropriatefiscal and monetary policies are implemented. The specific actions that are undertaken to bring inflation under control include:

Containing government borrowing

The most successful weapon against inflation is maintenance of discipline in the management of public finances. The ideal situation is to aim for a balanced budget that is having expenditures match revenues. The second best option, in the event of a manageable budget deficit, is to finance the deficit from financial markets. Borrowing from the central bank, which is resorting to printing money, should be extremely restricted and at best eliminated.

Avoiding excessive credit expansion

It is the responsibility of the central banks to regulate the stock of money in an economy by using various monetary policy instruments at their disposal. These policy instruments include:

• Restriction of direct lending to government.

• Increase cash ratio and reserve requirements on the commercial banks and financial institutions.

• Sale of securities through open market operation.

• Intervening in the foreign exchange market by selling or buying foreign exchange.

• Adopting a strict monetary policy aimed at reducing money in circulation, for example, selling securities.

• Tight fiscal policy including increased taxation to reduce the amountof disposable income possessed by the people. This will reduce their demand for goods.

• Price and income policies: These include controlling wages and prices such that they do do not increase at any time in order to reduce the rate at which people demand for the goods and services.

• Limiting exports and encouraging imports: Limiting exports will ensure that there are more goods kept at home to meet the demands of the people. Encouraging imports will, on the other hand, increase the inflow of goods in the country.

• Encouraging savings through increasing the interests that are given on the deposits in the financial institutions. This will reduce the amount of money in circulation, hence reducing demand.

• Privatisation so as to encourage the private sector to produce more goods and services. This may be through increased competition and the desire to get more profits during inflation.

• Currency reform: The government can remove the currency which has lost value from circulation and replace it with another currency which has value.

• Promotion of private investment by setting up a conducive investment climate to boost production. This will increase output in an economy.

7.2 Rwanda inflation rates (1997-2016)

The inflation rate in Rwanda was recorded at 6.80% in December 2015. Inflation rate in Rwanda averaged 6.09% from 1997 until 2015, all time high of 28.10% in February of 1998 and a record low of -15.80% in February of 1999. Inflation rate in Rwanda is reported by the National Institute of Statistics of Rwanda.

In Rwanda, the inflation rate measures a broad rise or fall in prices that consumers pay for a standard basket of goods. This page provides Rwanda inflation rates actual values, historical data, forecast, chart, statistics,economic calendar and news. Rwanda Inflation Rate: actual data, historical chart and calendar of releases was last updated in February 2016.

7.3 Unemployment and inflation: The Phillips curve