Inflation and deflation

Types of inflation can be classified according to its causes and rate of spread or intensity.

Types of inflation according to its causes

1. Demand pull inflation
2. Cost push inflation

Other types of inflation are

1. Imported
2. Structural

From the diagram, increase in aggregate demand from $D_0$ to $D_1$ leads to increase in price from $P_0$ to $P_1$, which is the inflation point.

Causes of demand pull inflation

1. Rapid increase in population. The higher the population, the higher demand of goods and services.
2. Decrease in government taxes. Leads to increase in personal disposable income which increases the purchasing power of an individual.
3. Increase in wages or income of an individual. Increase in people's income leads to increase in purchasing power.
4. Increase in government expenditure. This will lead to increase in supply of money. Increased money supply increases the rate of purchasing power which increases aggregate demand.
5. Increase in capital inflow through exports leading to increase in money supply.
6. Printing more money by the government through expansion of monetary policies.
7. Increase in exports of essential goods which leads to increase in foreign exchange, hence more supply of money, which increases aggregate demand.
8. Decrease in imports of essential goods which leads to increase in aggregate demand for such goods.
9. Decrease in output as a result of restriction by monopolists causing artificial shortage in an economy which will cause increase in demand for those goods.

Measures to control demand pull inflation

1. Increase in direct taxation which will reduce personal disposable income.
2. Reduction in government expenditure. This will reduce supply of money in the economy.
3. Reduction in wages of workers.
4. Increase in importation of essential goods so as to reduce the problem of scarcity.
5. Use of restrictive monetary policies, i.e., contractionary monetary policies that reduce money supply in the economy.
6. Discourage rapid population growth so as to reduce the demand for goods and services.
7. Encourage saving which will reduce aggregate goods demand.

Is the kind of inflation caused by increase in cost of production, i.e., increase in wages, rent, interest, and increased cost of equipment which can be used for production process.

Causes of cost push inflation

1. High cost of raw materials, especially those which are imported.
2. High advertising cost.
3. High wages to workers.
4. Trade unions.
5. Increase in transport cost due to increase in price of fuel in the world market.

1. Creeping or mild or gradual inflation. This refers to the slow increase in general price level. The increase in the general price level is less than 3%. It encourages production and it does not distort relative prices or income severely.
2. Walking, trotting, or moderate inflation. This is where the increase in the general price level is a single digit or less than 10% per annum. It is a warning to the government to put measures to control it before it goes out of hand.
3. Running inflation. This is when prices increase at the rate of 10–20% per year. It requires strong measures to control it.
4. Hyperinflation or runaway or galloping inflation. This is the rapid rise in the general price level where inflation ranges from 20% even more than 100% per annum. Inflation becomes unmanageable and prices rise many times every day. Money loses value and people prefer to hold real goods or assets rather than money.

• Wage-wage inflation. This occurs due to inter-firm or inter-sector wage negotiations among workers. A rise in wages in one sector or firm causes revision of wages in similar occupations in the economy. As employers increase wages, total cost and prices also increase.

This is occurring as a result of a combined element of cost push and demand-pull inflation. It occurs when there is a structural change in the element of situation, e.g.:

1. In a situation where some industries are expanding while others are declining, in the case of expanding industries higher wages have to be paid in order to attract labour. Increasing wages causes inflation as a result of increase in cost of production.
2. Increase in production may result in the increase in demand for goods and services.

Causes of structural inflation

1. Temporary breakdown of economic sectors like agricultural sector and industrial sectors.
2. Shortage of productive inputs, i.e., if factors of production are in shortage. There will be low production in the economy hence aggregate demand being greater than aggregate supply.
3. Political instabilities. This will discourage production.
4. Speculation by businesses. This causes artificial shortage by holding their goods expecting that they will get more money in the future.
5. Shortage of foreign exchange to increase importation.
6. Poor transport system to reach goods in all parts of the country.

Measures to control structural inflation

1. Improvement of transport system so as to enable goods and services to reach all parts of the country.
2. Modernization of agriculture so as to improve agricultural activities.
3. Provision of productive inputs, i.e., factors of production should be available at cheap prices.
4. Creation of goods in a conducive atmosphere which promotes production.
5. Price control measures, i.e., there should be a price commission which will be responsible for setting minimum and maximum prices (price ceiling and price floor).

Is a type of inflation which is the result of imported goods and services from a country which is affected by inflation.

Causes of imported inflation

1. Importation of goods at high prices from countries experiencing inflation.
2. Rising prices in international market.
3. Import shortage.
4. Inelastic demand for imports.
5. Protection against imports, i.e., through import duties.
6. Expansionary monetary policies which lead to high import demand.

a. Effects on production. Production takes place in two periods: short run and long run.

• Effect of inflation in the short run. In the short run, increase in price will encourage production because producers will sell their products at higher prices.

At this period:

1. Wages or salaries cost adjust slowly.
2. Fixed charges such as rent, electricity, water supply, and other charges adjust slowly.
3. Contracts and supply of raw materials cover long period until further orders are placed. The producer will use profit earned to increase production and possibly employment to stimulate demand.

b. Effect of inflation in the long run. Inflation will discourage production as the money value falls, hence all the cost of production will rise, causing negative effects on production.

c. Effect of inflation on producers or profit earners. These gain most during inflation as profit margins increase considerably during inflation but in short run only.

d. Wages and salary earners. These also lose during inflation although not as much as fixed earners. Their losses will eventually be reduced due to wages and salary adjustments. During inflation the value of savings falls, i.e., rate falls, this discourages saving and encourages borrowing.

e. Lenders. During inflation, lenders tend to lose due to the fact that they are paid back their money when its value is low.

Social-political effects

Inflation has also effects on social and political affairs to the economy such as:

1. Crimes
2. Unemployment
3. Political instability

Negative effects of inflation

1. Agriculturalists lose because prices of agricultural commodities tend to lag behind inflation. Their savings, welfare, and productivity fall.
2. Workers suffer when there is inflation because their wages tend to lag behind inflation.
3. The standard of living of fixed income consumers (like pension earners, those who depend on past savings) falls.
4. It discourages people from saving in financial institutions because of fear that their money would lose value. Financial institutions are forced to increase the rate of interest, and this increases cost of borrowing and leads to further inflation.
5. It reduces the purchasing power of the majority since it redistributes income from the majority (peasants and workers) to the minority (business people).
6. Creditors lose because they are paid back in inflated currency. This discourages lending by individuals and financial institutions.
7. It leads to political unrest and demand for high salaries by workers. Therefore, it increases when people fail to meet the high cost of living, etc.
8. Inflation leads to balance of payments (BOP) problem by discouraging exports and encouraging imports. Exports reduce because outsiders dislike buying from a country where prices are high. Imports increase because outsiders like to sell in a country where prices are higher.
9. Inflation may be used against the production of exports whose prices are determined on the world market. Prices remain fixed whereas costs of production increase in the domestic currency. People shift to production for domestic markets to fetch higher prices.
10. Where there is hyperinflation there is need to revise plans for tax structure and contracts to match with the new price structures. This is time-consuming and can lead to failure to achieve objectives of plans and programs.
11. Inflation leads to rural-urban migration since it becomes less profitable to grow crops in rural areas. People shift to towns to start businesses. This discourages agriculture in rural areas and leads to urban unemployment and development of slums in towns.
12. It undermines the external value of the currency which calls for devaluation of the currency. This makes importation of raw materials difficult.
13. It leads to black market, e.g., to create artificial shortages.

Positive effects of inflation

Hyperinflation is inevitable in the economy. However, mild inflation may be healthy to the economy in the following ways. It increases the profit level of business (commercial producers) since cost of production rises slower than price of commodities. This encourages investment.

1. It makes workers and peasants work harder to maintain their standard of living after the increase in prices, which may provide incentives for people to engage in economic activities.
2. It reduces the level of unemployment since there would be a lot of money to spend and stimulate production and to invest and create more jobs.
3. It encourages businesspeople to get loans since they would expect money to have lost value by the time of paying back.
4. It encourages people to produce goods to sell in the domestic market where price is high.
5. By encouraging urbanization, it leads to an increase in demand for food which encourages agriculture.

Policies for inflation are mainly macroeconomic policies which aim at stability, efficiency, and fair distribution of wealth. A policy for inflation depends on the causes of inflation. Policy instruments should reduce aggregate demand and increase supply.

1. A tight (restrictive) monetary policy. This involves the use of various tools of monetary policy to reduce money supply and squeeze consumption, e.g., increase in bank rates, selling securities to the public, increasing reserve rates, etc. To reduce money supply and aggregate demand, at the extreme the government can also demonetize the currency by declaring the old one useless and introducing a new one.
2. Fiscal policy. This includes the reduction of government expenditure and increase of taxes to reduce aggregate demand. A surplus budget where the government collects more revenue than its expenditure is a strong tool. The government can also do internal borrowing to reduce money supply and also postpone repayment of internal debts to the time when inflation is controlled.
3. Reorganization of distribution channel of goods, e.g., restoration of scarce commodities and rationalization of major distribution channels. According to the kinked demand curve, it does not pay for the oligopoly to raise or lower prices.