Unit 7: INFLATION
Key unit competence:
Learners will be able to describe the impact of inflation on an economy.
My goals
By the end of this unit, I will be able to:
- Identify the states,types and causes of inflation.
- Explain the effects of inflation and measures to control it by central banks.
- Explain the relationship between inflation and unemployment using the Philips curve.
- Examine the causes and effects of inflation on the Rwandan economy.
- Analyse measures to control inflation in Rwanda.
- Use the Philips curve to illustrate the relationship between inflation and unemployment.
- Be aware of the effects of inflation in an economy and advocate for appropriate measures to control it.
7.1 Inflation
7.1.1 Meaning
Inflation is a situation where there is a persistent rise in the general price level. The general price implies an average of different commodity prices.
Some commodity prices are falling, whereas others are rising and others are stable. However, an economy experiencing inflation has most of the commodity and service prices rising.
If prices stabilise at a certain high level for some time, such a situation is not referred to as inflation but just a high cost of living.
Activity 1
Mr Habiyambere has a family of seven people and stays in Rulindo District. The family enjoys eating rice and beans. The prices of these goods have increased from July 2015 to February 2016 from 600 FRW, 700 and 800 FRW for rice and 350, 400, 450 FRW and to 500 FRW for beans. Throughout the time, because of the increase in the prices, he has been forced to reduce the quantity he has been buying or even sometime, they fail to eat supper and their standard of living has gone down tremendously. It was widely seen that there was also low levels of employment. From the case study:
1. What name is given to the situation where prices keep on increasing time after time?
2. What are the types of increase in prices?
7.1.2 Measurement of inflation
Inflation can be measured by recording the per cent increase in an index of general prices over a period of a year. There are various indices that can be used for this purpose but the one most commonly used is the retail price index.
The retail price index records changes in the prices of a variety of goods and services that enter into the average household’s budget weighted according to their relative significance in the household expenditure.
The inflation rate is the percentage rise in the price level. That is:
Where P1is the current year’s price level and P0 is last year’s price level.
If for example, a kilogramme of meat did cost 2,000 FRW in 2015 and it costs 2,500 FRW in 2016, the rise in prices is
7.1.3 Terms used in inflation
Stagflation: This refers to the situation where there is coexistence of both inflation and unemployment in an economy. The relationship between inflation and unemployment is that when unemployment rate is low, workers will be in strong position to demand for high wages which will lead to increase in prices by the employers, hence high rate of inflation. On the other hand, when the rate of unemployment is high, there will be competition for jobs and this brings down the wage rate which results into a lower rate of inflation.
Deflation: This refers to the persistent fall in the general prices of goods and services in an economy.
Reflation: This is the deliberate government policy of forcing prices upward to recover the economy from a depression. It uses policies that increase aggregate demand such as reduction in taxation, increase in government expenditure, encouraging exports, expansionary monetary policy and increase in wages, etc.
Suppressed inflation: This refers to the situation where aggregate demand exceeds aggregate supply but prices are not allowed to rise because of government price control.
Open inflation: This refers to inflation that is not suppressed, i.e. prices are permitted to rise without being interfered with by the relevant authorities.
Underlying inflation: This is inflation calculated by not considering the prices of foodstuffs.Headline inflation:This is inflation calculated by considering the prices of foodstuffs.Inflationary spiral: This is a situation where the increase in price leads to increase in the demand for high wages which in turn increases the cost of production and employers react by increasing the prices and the process increases.
7.1.4 Classification of inflation
Inflation can be classified according to the following:
1. According to the degree of intensity
Under this, we have the following types of inflation:
(a) Creeping or mild or gradual inflation
This refers to the slow increase in the price of goods and services at a rate which is less than 3%. Creeping inflation is the mildest form and is conducivefor economic progress and growth. It is a good state of inflation because a small rise in price acts as an incentive to producers. Savings, investment, output and employment opportunities all increase. In this form, the prices rise unnoticeably over a long period of time.
(b) Walking or trotting or moderate inflation
This is where the increase in the price level is a single digit or less than 10% per annum. It is a warning to the government to control it before it gets out of control.
(c) Running inflation
This is the type where the prices increase at a rate between 10-20% per annum.
(d) Hyper inflation or galloping or runaway inflation
This is the rapid increase in the price of goods and services between the rates 20 to even more than 100%. In hyper-inflation, the prices rise every moment without limit. In effect, money becomes worthless and in time, a new currency will have to be introduced. This state of inflation is noticeable by the public and it is a bad state of inflation. It discourages producers since consumers are reluctant to buy commodities at high prices. Savings, investment, output and employment opportunities reduce.
2. According to the causes
(a) Demand-pull or excess demand inflation
This is the persistent increase in the prices of goods and services brought about by demand exceeding supply of goods and services at full employment levels of incomes. This happens when the economy is operating at full capacity and no further increase in output can be achieved. If in such circumstances, the level of aggregate demand continues to rise so that it exceeds what the economy can produce. The effect of this excess demand is to cause prices to rise.
P represents price.
Y represents output.
AD represents aggregate demand.
LRAS represents long-run aggregate supply.
From Figure 1 above, it can be seen that when aggregate demand increases from
to
the price level increases from
to
Causes of excess Demand Inflation
Activity 2
Visit the library or the Internet and research on the following:1. Causes of demand-pull inflation.2. Ways of reducing demand-pull inflation.
Facts
There are a number of different ways in which aggregate demand for goods and services can be greater than full employment aggregate supply. Aggregate demand may increase due to a number of factors which include:
Trade union activities: In countries where labour laws are respected, trade unions are very strong. They constantly demand for higher wages, shorter working hours, more holidays with pay and other amenities. In democratic countries, governments are often compelled to accede to the unreasonable demands of the workers. The increase in the wages increases the purchasing power of the workers and, therefore, the aggregate demand.
Deficit financing: In times of war or under other abnormal situations requiring huge increases in government spending, the government to be able to meet this expenditure may resort to deficit financing which increases the money supply in the hands of the public which increases their demands for goods and services, resulting in inflation.
Increase in population: Increases in the population of a country raises the general level of aggregate demand of the people for goods and services. If population increases rapidly when there is no corresponding increase in the volume of goods and services, there will be excess demand which in turn will shoot up the prices.
Credit expansion: The expansion of credit may be resorted to either as a matter of policy by the government or by commercial banks. The central bank can expand credit by lowering the bank rate or by purchasing government securities. The commercial banks can expand credit through lowering the cash reserves. The expansion of credit is generally resorted to in periods of increasing economic activity and once it starts, it continues for a sufficiently long time period.
Increase in public expenditure: Aggregate demand may also increase due to an increase in public expenditure. This may either be to meet the requirements of defence or of economic development or for boosting the level of economic activity in the country. This increases money in circulation, hence demand and prices will go up.
Expansion of exports: If the export of commodities increases, fewer goods would be available for domestic consumption. Consequently, this would make the existing demand at home excessive of the available quantity of goods and in the end, the prices will go up.
Reduction in taxation: This increases disposable income of the people, hence increasing their demand. This will further increase the prices of goods and services if not backed by increase in the supply of goods and services.
Policies for demand-pull inflation
Policies to address demand-pull inflation should be geared towards reducingdemand in the economy.
Such policies include the following:
Restrictive monetary policy to reduce the amount of money in circulation: This can be done with the use of the monetary policy instruments:
Open market operations: This involves buying and selling of treasury bills and bonds to the general public by the central bank through the commercial banks. When the government wants to reduce money in circulation, it will sell securities to the public and when the public buys, money will reduce in circulation.
Legal reserve requirements (variable reserve requirements): This is the amount of money which by law is supposed to be kept by commercial banks in the central bank. When the central bank wants to reduce money circulation, it increases the legal reserve requirement such that the commercial banks do not have enough money to lend to the public. Sometimes the commercial banks ask the people to make special deposits which are above the legal reserve requirement.
Bank rate: The central bank raises the bank rate to the commercial banks. In turn, all commercial banks raise their interest rates. The business people and other borrowers find it very difficult and expensive to get credit. In this way, therefore, credit is restricted and hence less money in circulation.
Selective credit control: The central bank can instruct commercial banks to favour some sectors of the economy and disfavour others. For instance in Rwanda, commercial banks can be instructed to favour the agricultural and industrial sectors, and loans made more difficult to obtain for those people who want to buy cars or luxurious goods.
Moral suasion/persuasion: The central bank persuades commercial banks to control the amount of money being lent to customers to reduce the amount of money in circulation. Although not backed by law, commercial banks will always agree.
Margin requirement: This is collateral security (requirement) needed by the commercial banks before giving out loans. When the banks want to reduce money in circulation, it sets a higher requirement to reduce the amount of borrowing.
Fiscal policy: Under fiscal policy, the following can be adopted to address demand-pull inflation:
(a) Reduction in government expenditure: One way of reducing demand for goods and services is to decrease government expenditures. This will mean that people will get lower incomes. Employment rates will be reduced; and consequently aggregate demand will fall, thereby reducing the inflationary pressures.
b) Increase taxes: Another alternative to reduce aggregate demand for goods and services is to increase taxes. Taxes are always used to remove money from the pockets of the public and this reduces the disposable income. Aggregate demand falls, tending to reduce the inflationary pressures provided this increase in taxation does not lead to wage increases.
Reduction in tariffs: Reduction in tariffs or increases in import quotas may help ease aggregate demand for domestic goods. However, this may encourage dumping and consequently home industries may adversely be affected.
Price and income policies: This is the least effective method of controlling demand-pull inflation. This policy is concerned with controlling prices of major commodities and keeping down wages. The government fixes minimum prices. However, maximum priceshave a number of problems, for instance, the creation of black markets and corruption.
(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
The coexistence of persistent inflation and widespread unemployment is a relatively new phenomenon. Before 1950, many economists believed that unemployment and inflation could not exist simultaneously.A. W. Phillips, a British economist was among the first to call attentionto the relation between the rate of change in wages and the level of unemployment. He developed what he called the Phillips curve.The Phillips curve expresses an inverse relationship between the rate of increase in wages and the unemployment rate. He explained that workers are less likely to demand wage increases when there is a large army of unemployed persons, hence a lower inflation rate. When unemployment is low, competition among employers for scarce labour services, forces wages up, hence a higher inflation rate.This inverse relationship between the rate of inflation and the unemploymentrate is called the Phillips curve. He then concluded that:“The higher the rate of unemployment, the lower the rate of inflation; and the lower the rate of unemployment, the higher the rate of inflation.”From Figure 5 above, point A shows a lower rate of employment at 2% while the rate of unemployment is high at 5%. Point B shows a higher rate of interest of 6% while the unemployment rate is low at 3%.7.4 Circumstances under which an increase in money supply may not lead to inflation
Increase in money supply may always lead to an increase in demand for goods and services which in turn may cause persistent increase in the prices of goods and services. However sometimes, an increase in money in an economy may not necessarily lead to inflation under some circumstances as follows:When there is an effective tax system, increased money will be taxed. Due to this, an increase in taxation will reduce the money in circulation, hence the prices may not increase.
When increased money is saved: This means that the additional money is saved, hence the demand may remain low leading to low prices and low rates of inflation.
In case of high marginal propensity to save, all the additional money that the persons received will be saved. This only works when the people have a low marginal propensity to consume.
In case there is a corresponding increase in the goods and services, increased demand will be served with increased supply.
In case the additional money supply is used to service an external debt: It means that all the money that increases in the economy is going to move out of the country through capital outflow.
When there is a high price control: This may be by the government through price legislation. Even if the demand increases through an increase in the money in circulation, the prices will not increase because of government price control.
Unit assessment
1. Study the table below on inflation forecast for Rwanda and answer the question that follows.
Basing on the inflation forecast in Rwanda, in your own view as an economics student, examine the possible measures that the government of Rwanda should take to control inflation to its minimum level.
2. Inflation is sometimes caused when too much money purchases few goods, under what circumstance may too much Rwandan francs not cause inflation in the country?
3. The persistent increase in the prices of goods of late has been both a blessing and a curse to the people of Rwanda. Elaborate the statement.
7.5 Glossary
Creeping inflation:The slow increase in the price of goods and services at a rate which is less than 3%.
Cost-push inflation: The persistent increase in the prices of goods and services brought about by increase in the cost of production. It is sometimes called supply or seller’s inflation.
Demand pull inflation: One which results from demand exceeding supply. It is sometimes called excess demand inflation.
Deflation: The persistent fall in the general prices of goods and services in an economy.
Disinflation: The fall in the inflation rates.
Expectation inflation: The type of inflation caused by speculation among producers that prices may rise in the future. Hence, they create artificial shortage to increase prices.
Headline inflation: Inflation calculated by considering the prices of food stuffs.
Inflationary spiral: A situation where the increase in price leads to increase in the demand for high wages which in turn increases the cost of production and employers react by increasing the prices and the process continues.
Imported inflation: The type of inflation that occurs from importation of goods and services from countries already suffering from inflation.
Monetary inflation: The persistent increase in the prices of goods and services brought about by increase in money supply without corresponding increase in goods and services.
Open inflation: Inflation where prices are permitted to rise without being interfered with by the relevant authorities.
Reflation: The deliberate government policy of forcing prices upward to recover the economy from a depression.
Structural inflation: The persistent increase in the price of goods and services brought about by supply rigidities or bottlenecks.
Stagflation: The situation where there is coexistence of both inflation and unemployment in an economy.
Suppressed inflation: The situation where aggregate demand exceeds aggregate supply but prices are not allowed to rise because of government price control.
Trotting inflation: Onewhere the increase in the price level is a single digit or less than 10% per annum.
Underlying inflation: The type of inflation which is calculated by not considering the prices of foodstuffs.
Walking inflation: The type of inflation where prices increase at a rate between 10-20% per annum. Hyper-inflation is the rapid increase in the price of goods and services between the rates 20 to even more than 100%. It can also be called run away or galloping inflation.
Unit summary
• Meaning and measurement of inflation
• Terms used in inflation
• Classification of inflation
• According to intensity
• According to causes
• Consequences of inflation
• Solutions to inflation
• Rwanda inflation rate
• Phillips curve
• Money supply and inflation