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Inflation
Inflation is defined as a situation where the general prices of a basket of goods and
services in a country or region are rising. It occurs when there is an upward trend in
prices of all commodities and not in prices of just a few. Inflation leads to a reduction in
the value of money and its purchasing power. i.e. during inflation, a given amount of
money buys less of a commodity than before the inflation set
Types Of Inflation
a) Moderate / creeping/ mild inflation
Refers to a type of inflation in which the general prices increase slowly. The percentage rate
of price increase is usually less than 10. It can be beneficial to both the business people as
well as the debtors. It benefits the business people in that they buy goods when the prices are
low and sell them later when prices have risen. Similarly the debtors benefit because they
would buy goods at the current price and pay for them in the future at the same old price and
not the high price the commodity would be selling at that time.
b) Galloping /rapid inflation
Describes a situation where the general price levels increase rapidly at a percentage of tens
or hundreds.
c) Hyper-inflation / Run away inflation
Describes a situation where the rise in price levels is extremely high. In this situation the
inflation rates can be in thousands or even in millions per cent per annum. Under hyper-
inflation people lose confidence in money as a medium of exchange and as a store of value.
In such a situation consumers use a lot of money to buy few goods and services. This type of
inflation would appear unlikely to happen. It however happened in Germany in 1923 and the
country had to do away with its currency system to restore its monetary confidence.

Causes of Inflation
Either inflation may be caused by an increase in demand thereby forcing prices upwards or
by factors on the supply side that bring about increase in prices. The cause of inflation can
thus be classified into two broad categories; demand pull inflation and cost push inflation.

A. Demand-pull inflation:
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This type of inflation comes about where there is excessive demand for goods and services
in the economy causing a rise in prices. The rise in demand pulls prices upwards, hence
the term “demand pull:. In this situation, there is: too much money chasing too few goods:
The following are some of the factors that cause demand pull inflation.
i. Increase in government expenditure
The government finances its activities from the revenue it collects mainly from taxes,
levies and fines. In situation where the government is not able to raise enough money
from its main sources, it can resort to borrowing from the central Bank or in the very
extreme cases, it may print more money.
When the government spends the money, it in effect makes more money available to
people thus increasing aggregate demand, which in turn may lead to upward pressure on
the prices of goods and services.
ii. Effects of credit creation by the commercial banks
Credit creation is the process through which banks lend out money to individuals and
businesses. Through this process, commercial banks can lend out more money that the
deposits they hold. This process increases the money supply, which in turn leads to an
increase in consumers purchasing ability. The increased consumer’s ability to purchase
more goods and services increases the aggregate demand which eventually leads to
inflation.
iii. Increase in money incomes
If money incomes increase due to reasons such an increase in export earnings, or increase
in wage earnings, the people’s purchasing power will increase. This will have upward
pressure on prices as demands for goods and services increase.
iv. General shortages of goods and services
Shortages of commodities supplied may bring about demand pull inflation in that the
demand would be higher than supply. The high demand hence pulls the prices of the
commodities upwards. Shortages may be caused by factors such as, adverse climatic
conditions, hoarding, and smuggling, withdrawal of firms from the industry and decline
in levels of technology.
AS
Price level
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P2
AD2
P1
AD1
O
Y1 Y2 Real national income

With an increase in aggregate demand from AD 1 to AD2, there has taken place an increase
in real national income from Y1 to Y2 and an increase in the price level from P1 to P2.
B. Cost-Push Inflation
An increase in the total production costs of goods and services may lead to an increase in
prices of the commodities. These increases in prices may result into a type of inflation
referred to as cost-push-inflation. The term “cost-push inflation” is used because it is the
cost of production that pushes up the prices. The following are some of the factors that
may bring about cost push inflation.
i. Rise in wages and salaries
An increase in wages and salaries may increase the cost of labor. Such increase may be
brought about by pressure from workers and trade unions for better pay. The increased
cost of labor may be reflected in the increased prices of commodities which in turn would
cause inflation.
ii. Increase in taxes
Increase in indirect taxes, such as VAT, can increase the cost of production and cause
firms to raise their prices.
iii. Increase in profit margin
A desire by management or shareholders to raise profit margin, can lead to an increase in
price. This is possible especially where there’s no price control.
iv. Increase in cost of inputs other than labour
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Cost-push inflation may arise from increase in cost of inputs other than labour such as
raw materials and capital. These inputs can either be locally available or imported
inflation. This can in turn, increase the prices of locally produced goods. For example,
an increase in prices of imported oil may lead to inflation as imported oil is used in the
manufacture of many products.
v. Reduction in subsides
The government may reduce subsides for a commodity. The removal of a subsidy
implies that a producer would have to meet that part of cost which the government was
paying through subsidization. This would eventually be reflected in the increase in the
price of the commodity.
AS2 AS1
Price level

P2
P1
AD
O
Y2 Y1 Real national income
In the diagram above, an increase in the costs of production results in an upward shift of
aggregate supply curve from AS1 to AS2. This results in a reduction in real national
income from Y1 to Y2 and an increase in the price level from P1 to P2.

Effects of Inflation in an Economy

Inflation has a number of have on businesses, demand and consumer confidence. These
effects can either be positive or negative as discussed below:
a. Positive effects of inflation
i. Benefit to debtors
Inflation may benefit debtors’ in that they end up paying less in real terms. This is
because the debtors pay for the commodities in the future at the old low prices and
not at the high prices which the commodity would be selling.
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ii. Benefit to the sellers

Sellers may benefit from inflation in that they buy commodities when prices are low
and sell them later when prices are high thereby making more profits.
iii. Motivation to work
Inflation may have some motivating effect to work as people try to cope with effects
of inflation by working harder. As prices of commodities go up people may find that
they are not able to buy the amount of commodities they were buying before the
inflation set in. In an effort to maintain their standards of living, they may work
harder in order to earn more.
b. Negative effects of Inflation
i. Reduction in profits
A rise in prices of commodities may lead to reduced sales volume for firms. This in
turn may reduce the firm’s profits.
ii. Wastage of time
Inflation can be wasteful in that individuals and firms may waste a lot of time shopping
around for reasonable prices. The time so wasted can be an extra cost to the individual
or firm. Similarly, firms may waster a lot of time adjusting their price list to reflect new
prices.
iii. Increases in wages and salaries
During inflation, firms are usually pressurized by employees and trade unions to raise
employees’ wages and salaries to cope with inflation. A conflict may arise between
the parties concerned, regarding the level of increase that is adequate.
iv. Decline in standards of living
During inflation, consumers’ purchasing power decreases. This is so especially for
people who earn fixed incomes such as pensioners. The reduction in purchasing
power brings abut a decrease in standard of living.
v. Loss to creditors
Creditors lend out when the value of money is high. At the time of payment, the
creditors receive less in real money terms. Since its value has been eroded by
inflation.
vi. Retardation of economic growth
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Inflation may create a situation where business people are not willing to take risks,
invest in new ventures, expand production or hire more workers. This would be more
than the exports resulting into unfavorable balance of payment.
vii. Adverse effects on the balance of payments
Inflation may have adverse effects on the balance of payments. If inflation is high in
the domestic economy, exports become more expensive leading to a fall in their
demand.
On the other hand, the imports from countries not experiencing inflation become
relatively cheap thus increasing their demand. This implies that the imports would be
more than the exports resulting into unfavorable balance of payment.
viii. Loss of confidence in the monetary system
High levels of inflation may lead to loss of confidence in money both as a medium of
exchange and a store of value. This may lead to a collapse of the monetary system.

Controlling Inflation (Anti-inflationary measures)

Inflation is not desirable and for this reason the government may adopt policies meant to
reduce or control it to a manageable level. The anti- inflationary policies are divided into
three categories:
a. Monetary policies
b. Fiscal policies.
c. Non- monetary policies

a) Monetary policies (Control of Money Supply)

In most cases inflation will occur when the amount of money in circulation is greater
that the available goods and services. The government should ensure that increase in
money supply is matched with increase in goods and services. Monetary policy
influences the economy through changes in the money supply and available credit.
The central bank uses the following monetary policy instruments to control money
supply/ to remove inflation:
1. Bank rate policy. During inflation, the bank rate is raised. In view of this
commercial banks also increase the interest rates/lending rates thus discouraging
borrowing hence a reduction in the amount of money in circulation.
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2. Open market operation. During inflation, the central bank sells government
securities such as treasury bills and government bonds through open market
operations (OMO). This reduces the excess money in circulation.
3. Reserve requirements. During inflation, the central bank increases the reserve
requirements. This reduces the amount of money at the disposal of commercial banks
for lending purposes. This helps to control the amount of money in circulation
4. Rationing of credit. All commercial banks get loans from the central bank up to
a specific limit. During inflation, this limit is reduced.
5. Margin requirements. Margin requirement is the difference between the value of
the security and the amount of the loan advanced against that security. During
inflation, the margin requirement is raised.
6. Consumers selective credit control. Here the central bank discourages the
purchase of commodities on installment basis to check inflation.
7. Restricting terms of hire purchase agreement and credit sales in order to
reduce demand for commodities sold. This can be done by:
a. Increasing the rate of interest.
b. Reducing the repayment period.
c. Increasing the amount required as down payment.

b) Fiscal Policies
Fiscal policy refers to the deliberate change in either government spending or taxes to
stimulate or slow down the economy. It is the budgetary of the government relating to
taxes, public expenditure, public borrowing and deficit financing. Fiscal policy is
based on demand management i.e raising or lowering the level of aggregate demand
by controlling government expenditure, consumption expenditure and investment
expenditure. The main fiscal policy measures are:
1. Public expenditure. During inflation the government reduces its expenditure
leading to a reduction in the amount of money in circulation and a fall in prices.
2. Changes in taxation. Changes in tax rates can help in the stabilization of the
economy. For example, a decrease in tax rates increases disposable income in relation to
national income. Hence consumption rises at every level of national income. With
increase in aggregate demand for goods, employment increases. A rise in tax rates causes
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a decrease in disposable income, creates a larger budget deficit and reduces inflation. Also
high inflation reduces individual’s purchasing power and a fall in prices.
3. Changes in government expenditure. If inflation is at or above the level of full
employment in the economy, the government can reduce prices by restricting its own
unproductive expenditure.
4. Public borrowing. Public borrowing reduces aggregate demand for goods hence
reducing the price level. If the government borrows money from individuals and spends it
on more productive purposes, the production of goods increases and prices tend to fall.
5. Balanced budget changes. A balanced budget decrease has a mild contractionary
effect on national income and hence bringing down the price level.
6. Control of deficit financing. If the government resorts to deficit financing e.g bank
borrowing and printing of notes to finance the budget deficit, money supply in the
country increases and this pushes prices upwards. Deficit financing should be avoided.

c) Non-monetary measures
1. Wage Adjustment. Wages must be raised at regular intervals to enable the
individuals to maintain their purchasing power at the same level.
2. Output Adjustment. The government must take steps to increase the production of
goods, so that the rise in price level is checked.
3. Price control. The government fixes prices or imposes direct controls on prices of
essential/basic commodities.
4. Rationing. Here the purchase of specific commodities is controlled. The
individuals can purchase a specific quantity only during a specific period.
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