INFLATION

This refers to the persistent increase in the general/ average price level of goods
and services over a given period of time.

Inflationary rate

This refers to the percentage increase in the general price level.

MEASUREMENT OF INFLATION

The following are the methods used to calculate inflation.

1. Use of price index.

Under this method, inflation rate is calculated as follows;
− −1
× 100
−1
Where Pt is the price of the current year
Pt-1 is the price of the previous year
2. Use of GDP deflator
Under this method, inflation rate is calculated as follows

× 100

OR

× 100

STATE OF INFLATION
This is the speed at which the general price level is increasing in the economy
and its categorized according to different types of inflation and includes the
following;
1. Creeping/ mild inflation
This refers to an increase in the general/ average price level at a slow rate
usually less than 10% per annum. This state of inflation is desirable.

2. Moderate/ running inflation

This is one whereby the persistent increase in the general price level proceeds at
a high rate usually above 10% per annum. Such inflation adversely/ negatively
affects the poor and the middle class groups hence it requires strong monetary
and fiscal policies or else it leads to hyper inflation.
3. Hyper/ galloping/ runaway inflation
This refers to inflation where the general price level increases at a very high
rate, the increase taking place within hours, days or weeks and the percentage
point increase per annum is over 20%.
THEORIES OF INFLATION
There are many theories of inflation and these include;
♫ Cost push inflation
♫ Demand pull inflation
♫ Structural inflation
♫ Imported inflation
♫ Monetarist inflation
♫ Speculative inflation
♫ Wage – wage inflation
♫ Wage – price inflation
♫ Price – wage inflation
COST PUSH INFLATION
This refers to a persistent increase in the general/ average price level due to rising
cost of production.
Causes of cost push inflation
♫ Rising costs of raw materials
♫ Rising wages and salaries
♫ Rising costs of energy/ fuel
♫ Rising rates of rent
♫ Rising costs of borrowing
♫ Rising rates of indirect taxes
♫ Rising transport costs
♫ Rising costs of improving working conditions due to trade union pressure.

Solutions to cost push inflation

♫ Reduce bank rate/ lending rates by the central bank.

♫ Improving infrastructures like roads to reduce on transport costs
♫ Reducing indirect taxes
♫ Offering subsidies to producers to reduce the cost of production.
♫ Wage control measures/ controlled trade union influence

DEMAND PULL INFLATION

This refers to a persistent increase in the general/ average price level due to
aggregate demand being greater than aggregate supply at full employment situation
of national income/ resources.
Causes of demand pull inflation
♫ Increase in wage levels hence increased purchasing power
♫ Increase in population size
♫ Excessive issuance of currency which increases aggregate demand in the
economy without corresponding increase in output.
♫ Reduced importation of essential goods that are highly demanded in the local
market.
♫ Excessive exportation o f essential goods which reduces domestic supply.
♫ Excessive government expenditure on non productive activities.
♫ Natural factors/ industrial unrests/ breakdowns which lead to a fall in
production levels.
♫ Excessive inflows of income from abroad.
♫ Uncontrolled creation of credit by commercial banks.
♫ Reduced direct taxation which increases purchasing power of the people.

Measures to reduce demand pull inflation

♫ Reduce government expenditure especially on provision of non-essential

products.
♫ Increase direct taxes to reduce disposable income.
♫ Control export of essential goods.
♫ Encourage importation of essential goods that are highly demanded in the local
market especially from cheaper sources.
♫ Undertake restrictive monetary policy to reduce the amount of money in
circulation e.g. increase the bank rate.
♫ Wage control measures/ controlled trade union influence
♫ Control population growth rates.

STRUCTURAL INFLATION
This refers to a persistent increase in the general price level due to supply rigidities
and structural bottlenecks in the sectors of the economy leading to a decline in the
supply of essential goods.

OR

Is one caused by supply rigidities in the economy.

Causes of bottleneck inflation

♫ Breakdown of infrastructures such as bridges, roads causing difficulty in

transporting commodities form areas of plenty to areas of scarcity.
♫ Natural calamities/ hazards such as floods, droughts, etc causing drastic
reduction in supply of agricultural commodities.
♫ Political instabilities. These discourage productive activities causing shortage of
goods and services leading to increase in prices.
♫ Scarcity/ exhaustion of raw-materials/ inputs.
♫ Breakdown of major industries hence causing shortage of goods in the economy
leading to increase in prices.
♫ Shortage of foreign exchange.
♫ Speculation by businessmen.
♫ Hoarding of goods by traders.

Solutions to structural inflation

♫ Improve infrastructures e.g. roads

♫ Improve political climate
♫ Agricultural modernization to reduce dependence on nature e.g. undertaking
irrigation to overcome the problems of natural calamities like drought.
♫ Importation of raw-materials/ inputs from other countries hence ensuring
continued production thereby overcoming problems of scarcity of goods.
♫ Encourage private, local and foreign investors/ further liberalization of the
economy.
♫ Rehabilitation and establishment of industries.
♫ Diversification of production.

IMPORTED INFLATION

Is one where the persistent increase in the general price level is as a result of a
country importing from another country prone to inflation/ experiencing inflation
leading to price increment in the domestic economy.

Possible solutions

♫ Encourage importation from cheaper and friendly sources.

♫ Reducing on import tariffs and subsidizing importers of essential goods.
♫ Undertake import substitution industrial strategy to produce goods that were
formerly imported.
MONETARIST INFLATION
This is one whereby persistent increase in the general price level is due to
excessive money supply in the economy without corresponding increase in the
value of output.
SPECULATIVE INFLATION
This is one which arises due to anticipation of future increase in prices that
eventually leads to increase in demand forcing the producers to increase prices of
goods and services.
WAGE – WAGE INFLATION
This occurs due to inter-sectoral comparisons among workers whereby workers
with the same type of employment demand for a high wage when workers in
similar occupations are also earning a high wage elsewhere forcing the employers
to increase prices so as to effect those wages.
WAGE PRICE INFLATION
This is one where workers demand for increased pay without corresponding
increase in output forcing employers to increase prices of final goods in order to
increase workers’ wages and also maintain their profit margins.
PRICE WAGE INFLATION (INFLATIONARY SPIRAL)
This is one that arises due to continuous increase in prices which increases the cost
of living forcing workers to continuously demand for higher wages forcing the
employers to increase prices of goods and services so as to increase wages for the
workers
OR
This is a situation where the increase in the price level in the economy forces the
workers to demand for higher wages leading to increase in the cost of production
and thus firms (producers) are forced to increase prices of goods and services
which again forces workers to demand for higher wages.
GENERAL CAUSES OF INFLATION
1. Breakdown of infrastructures. This makes it very expensive and difficult to
transport raw-materials to production centres and finished goods to markets.
This results into low levels of production causing shortage of commodities in
the economy leading to increase in prices.
2. Excessive/ uncontrolled credit creation by commercial banks. This increases
the volume of money in circulation causing excessive aggregate demand over
aggregate supply leading to increase in prices.
3. Excessive issuance of currency by the central bank. This increase the volume
of money in the country thereby causing excessive aggregate demand over
aggregate supply causing increase in prices of goods and services.
4. Excessive inflow of funds from abroad. This results into excessive money
supply in the economy causing excessive aggregate demand leading to increase
in prices.
5. Excessive government expenditure on non productive activities. This leads
to excessive money supply in the economy leading to excessive aggregate
demand over aggregate supply causing increase in prices.
6. Excessive exportation of essential goods. This leads to shortage of goods in
the domestic economy yet their demand is high hence leading to increase in
prices.
7. Decline in the value of the local currency relative to other currencies. This
makes importation of raw-materials and other essential commodities becomes
very expensive leading to price increase in the domestic economy.
8. Rising costs of production e.g. rising wages, interest rates, fuel prices, etc.
These costs force the producers to increase the prices of final goods and
services in order to cover such costs and at the same time maintain their profit
margins..
9. Importation of goods from countries experiencing inflation. LDCs over rely
on imports but some of these imports are bought from countries that are prone
to inflation and therefore they are sold in the domestic market at higher prices
thereby causing imported inflation.
10.Greed for profits by traders. Some traders want to obtain a lot of profits
therefore cause artificial shortages of goods by hoarding them so as to increase
prices.
11.Speculation by traders and consumers. As consumers anticipate future price
increases, they increase their demand for the available goods on the market
whose price is expected to increase. Such increase in demand forces the
producers to increase prices of goods and services.
12.Natural hazards/ calamities such as drought, landslides, floods. These lead
to drastic fall in supply from agricultural sector yet demand for such
commodities is increasing forcing prices upwards.
13.Political instability/ unfavourable political climate in some parts of the
country. This leads to destruction of productive infrastructure leading to low
levels of output in the economy in relation to demand causing prices to
increase.
NOTE
Emphasis on explanations should address issues/ factors that lead to scarcity of
goods relative to their demand forcing prices upwards.

OR
Factors that put too much money in circulation leading to excessive aggregate
demand without corresponding increase in output pushing prices upwards.

ASSIGNMENT
To what extent is inflation in developing countries caused by rising costs of
production?
SOLUTION
To a minor extent, inflation in developing countries is caused by rising costs of
production such as;
- Rising costs of raw materials
 - Rising wages and salaries
- Rising costs of energy/ fuel
- Rising rates of rent
- Rising costs of borrowing
- Rising rates of indirect taxes
- Rising transport costs
- Rising costs of improving working conditions due to trade union pressure.

To a larger extent, inflation in developing countries is caused by other factors

other than rising costs of production as explained below;

- Breakdown of infrastructures.
- Excessive/ uncontrolled credit creation by commercial banks.
- Excessive issuance of currency by the central bank
- Excessive inflow of funds from abroad.
- Excessive government expenditure.
- Excessive exportation of essential goods.
- Decline in the value of the local currency relative to other currencies
- Importation of goods from countries experiencing inflation
- Greed for profits by traders
- Speculation by traders and consumers.
- Natural hazards/ calamities such as drought, landslides, floods.
- Political instability/ unfavourable political climate in some parts of the
country.

EFFECTS OF INFLATION ON AN ECONOMY

POSITIVE EFFECTS
1. Mild inflation helps the economy to recover from a recession/ depression.
This is because the increasing prices being experienced in the economy promote
more investments and lead to increase in the supply of goods due to increased
profits thereby pulling the economy out of a recession.
2. It stimulates peoples’ effort. This is because they have to work harder to meet

the rising cost of living as prices of goods and services increase thereby helping
the country to increase its productive capacity.
3. Increased prices stimulate investments since they increase the profits of the

producers and such investments lead to increased production (output) leading to

high economic growth rate.
4. Employment opportunities may be generated. This is due to the fact that as

prices increase, entrepreneurs are encouraged to work harder and increase their
scale of production which necessitates employment of more workers.
5. It may encourage adoption of import substitution strategy. Imported

inflation encourages the country to adopt import substitution industrialization

strategy so as to produce internally formerly imported industrial goods as a way
of reducing importation of highly priced industrial goods hence leading to
increased industrial development in the economy.
6. Government revenue increases. This is mainly through increasing direct taxes

on incomes of the rich so as to reduce their purchasing power. The revenue

collected through taxation is used to meet government expenditure needs.
7. It encourages forced savings. This is because the funds that would have been

spent are saved to be used later on when the inflation rates are low because as
prices increase, the purchasing power of money reduces.
8. It encourages innovativeness and creativity in the economy. This is arises

due to the need for producers to obtain higher profits and survive the hard times
when inflation rates are high. Producers increase research and improve their
 production techniques so as to continue surviving in business leading to
improved quality and quantity of output produced in the economy.
9. Borrowers/ debtors stand to gain. This is because they borrow money when

its purchasing is high due to low prices of goods but pay back or return the
money when inflationary rates are high implying that by the time they pay back
this money, its purchasing power is low.
10. It encourages labour mobility. As prices persistently increase, it forces labour

especially skilled labour to move to different areas hence being able to utilize
such skilled labour for production hence promoting growth of such areas.

NEGATIVE EFFECTS

1. Discourages local and foreign investors due to persistent increase in the

production costs and also increased prices of goods and services leads to
reduced demand for goods and services making producers to make losses.
2. Worsens BOP position. This is because of the heavy expenditure required by
the country to import goods to supplement domestic output hence worsening the
country’s BOP position.
3. It leads to loss of confidence in the country’s currency. This is because as
prices persistently increase, the value of money falls continuously making
people not to trust the country’s currency as a medium of exchange.
4. Leads to uneven distribution of income. High rates of inflation negatively
affect the poor and middle class groups as compared to the high income earners
hence leading to income inequalities.
5. It makes planning difficult. Planning on the side of producers, government
and consumers becomes very difficult since prices are not stable therefore being
unable to know how much to save and how much to spend.
6. Leads to industrial unrests especially strikes. This is because workers
continuously demand for higher wages to meet the rising cost of living and this
disrupts the production process leading to less output being produced by the
industries.
7. Leads to brain drain. Inflation makes the economy and the country’s highly
skilled manpower to move to other countries where there is economic stability
and better paying opportunities leaving the country with limited supply of
skilled manpower hence retarding economic growth and development.
8. People are strained because they have to work extremely hard, forego leisure
and work under poor working conditions in an attempt to cope with the rising
cost of living.
9. Government becomes unpopular. This is because the population blames the
government for their suffering due to its failure to curb inflation resulting into
demonstrations, riots and sometimes political instabilities.
10.Lending is discouraged as creditors stand to lose. This is because whenever
prices increase, the value of money declines therefore lenders receive back their
money with a low purchasing power than when they lent it out before the price
increase.
11.Leads to production and consumption of poor quality goods. This is
because production becomes less affordable due to high costs involved.
12.It encourages illegal activities such as corruption, smuggling which makes
the government to lose a lot of revenue that would otherwise be realized
through taxation.
13.Discourages savings. This is because the funds that would have been saved are
used to purchase goods and services at higher prices thereby limiting the level
of capital accumulation in the country.
14.Leads to collapse of some firms. High costs of production incurred by firms
during periods of high inflation rates such as high costs of raw-materials , fuel,
rent force some firms to close down leading to reduced output and retarded
economic growth.
15.Leads to unemployment. This is because some firms are forced to close down
as production costs increase and others substitute labour with machines to
increase on resource exploitation and also cut down the costs of supporting
existing labour.
16.Fixed income earners suffer. This is because as prices increase, the purchasing
power of these people reduces since their income remains the same yet the cost
of living is rising. This lowers their standards of living.
ASSIGNMENT
Why does government control inflation in your country?
NOTE
A student should be well versed with negative effects of inflation if they are to
attempt this question.
Answers should address the intention/ objectives.
SOLUTION
- To attract local and foreign investors
- To reduce capital outflow
- To avoid loss of confidence in the country’s currency.
- To reduce uneven distribution of income.
- To ease planning
- To reduce industrial unrests arising due to demand for higher wages
- To reduce brain drain
- In order to avoid straining the people which arises as the cost of living rises.
 - To make government more popular
- To encourage lending by creditors
- To discourage production and consumption of poor quality goods/ to
promote production of better quality products
- To avoid/ overcome illegal activities such as corruption, smuggling arising
out of hyper inflation.
- To encourage savings
- To encourage resource exploitation/ to accelerate economic growth.

MEASURES THAT SHOULD BE TAKEN TO CONTROL

INFLATION IN LDCs/ UGANDA
1. Reduce government expenditure especially on provision of non essential
goods. This helps to reduce the amount of money in circulation thereby
reducing aggregate demand in the economy leading to a fall in prices of goods
and services.
2. Further liberalize the economy. Liberalization of the economy involves
removing unnecessary restrictions on economic activities hence giving people
liberty to carry out economy activities without unnecessary government
interference. This increases the level of output in the economy and competition
among producers and traders leading to a fall in prices of goods and services.
3. Improve the investment climate. This is achieved through providing tax
holidays, free land for investment, subsidies to reduce production costs and
attract more investors which help to increase output in the economy hence
leading to a decline in the prices of goods and services.
4. Development of infrastructure such as roads, bridges, railways. These
infrastructures facilitate fast and cheap movement of raw materials to
production centres and finished products to markets thereby leading to
 increased production/ supply of goods and services hence controlling structural
inflation.
5. Undertaking a contractionary/ restrictive monetary policy for example
increased bank rate, sale of government securities. Such a policy reduces the
capacity of commercial banks to create credit thereby reducing the amount of
money in circulation hence controlling aggregate demand leading to a decline in
prices of goods and services.
6. Control issuance of currency by the central bank. The central bank should
control issuance of currency especially that which is not in line with the level of
economic activities in the country so as to reduce excessive money supply in
the economy which helps to reduce aggregate demand thereby controlling
demand pull inflation.
7. Modernization of agriculture. This should transformed form subsistence to
commercial high yielding production through use of methods such as irrigation,
land reforms, improving of infrastructures, use demonstration farms, etc. This
helps to increase the supply of agricultural commodities hence leading to a fall
in prices.
8. Carrying out further privatization of state owned enterprises i.e.
transferring of ownership of state owned enterprises to private individuals.
This is increases efficiency in the running of the enterprises and the scale of
production also expands thereby increasing production of goods and services in
those enterprises hence controlling structural inflation.
9. Improve political climate/ atmosphere, through negotiating for peace talks
with rebels and other discounted groups in the country hence promoting
production of more goods and services and also attract more investors thus
increasing the productive capacity of the country leading to a fall in prices of
goods and services.
10.Reduce indirect taxes especially on essential goods such as petroleum
products, soap, sugar, etc so as to reduce production costs which eventually
leads to a fall in prices of goods and services.
11.Control export of some goods produced in the country e.g. sugar, meat and
other food stuffs. Their exportation should be controlled so as to ensure
adequate supply of such goods in the local market hence overcoming the
problem of scarcity leading to a decline in prices.
12.Undertake import substitution industrial strategy, whereby goods that were
formerly imported are produced internally thus enabling the country to
overcome imported inflation which arises due to importation of goods from
countries experiencing inflation.
13.Increase direct taxes especially on high income earners so as to reduce their
disposable income which reduces their purchasing power hence controlling the
level of aggregate demand in the economy leading to a fall in prices of goods
and services.
14.Encourage the use of instruments of credit such as cheques, bank drafts,
promissory notes. This helps people to move with such written documents
instead of moving with big sums of money that encourage them to spend
thereby controlling aggregate demand leading to a fall in prices.
15.Use of price controls, especially maximum price legislation i.e. a policy where
prices are fixed below equilibrium price such that even when there is excess
demand, prices cannot be increased.
16.wage control measures/ controlled trade union influence
17.Compulsory saving schemes e.g. NSSF.

ASSIGNMENT
Why may an increase in money supply not necessarily lead to inflation in your
country?
SOLUTION
An increase in money supply may not necessarily lead to inflation in my
country because there may be an increase in money supply but when…
- There is price controls especially maximum price legislation i.e. a policy
where prices are fixed below equilibrium price such that even when there is
excess demand, prices cannot be increased.
- The marginal propensity to save is high such that the percentage of
additional incomes is saved but not consumed.
- The increase in money supply is accompanied by an increase in output.
- The increase in money supply is accompanied by higher direct taxes on
peoples’ income which reduces their disposable income thereby controlling
the purchasing power of consumers.
- There is an increase in the rate of interest.
- An increase in money supply is channeled to production of capital goods.
- An increase in money supply is followed by a reduction in the volume
exports.
- An increase in money supply is followed by an increase in the volume of
imports
- The economy is undergoing an economic recession characterized by low
investments, low incomes, high poverty levels etc hence an increase in
money supply only helps to stimulate economic activities through increased
purchasing power of consumers.
- The increase in money supply aims at exploiting idle resources such that as
exploitation of resources increases, the volume of goods and services also
increases hence not leading to inflation.
 OTHER CONCEPTS
1. DEFLATION
Refers to a persistent decrease in the general price level of goods and services
mainly due to a fall in aggregate demand
Causes of deflation
♫ Reduced government expenditure especially on provision of essential goods.
♫ Use of restrictive monetary policy e.g. increased bank rate.
♫ Increased direct taxes on peoples’ income.
♫ Reduced incomes/ wages.
♫ Reduced inflow of incomes from abroad.
♫ Reduced exportation of goods causing excessive supply of goods in the local
market.

Effects of deflation

♫ Leads to high unemployment levels. This is because as prices fall, even

profits reduce and many firms close down because they are unable to cover
the average cost of production.
♫ Leads to decline in government revenue because some firms reduce output.
♫ High income earners suffer. This because large scale traders/ industrialists
and real estate developments are faced with falling prices of their products
which reduces their profit margins.
♫ Discourages investments since low prices scare both local and foreign
investors.
♫ Leads to slow economic growth rate since low prices lead to declining
output.
♫ It makes people gain more confidence in the currency because as prices
reduce, the value of money increases.
 ♫ Creditors gain as debtors lose. This is because creditors receive back their
money when it has more purchasing power than when it was lent out.
♫ It leads to low resource exploitation due to decline in profit margins as price
falls hence leading to resource wastage.
2. STAGFLATION
Is a situation in which high inflation rates co-exist with high levels of
unemployment.
Effects of stagflation
♫ Leads to brain drain
♫ Results into low government revenue
♫ It results into low production
♫ Increases income and wealth inequalities.
♫ Leads to low aggregate demand for goods and services.
♫ Leads to decline in savings.
♫ It makes the government unpopular.
♫ Etc.
Measures for reducing stagflation
♫ Reduce direct taxes to increase disposable income which increases
consumption hence encouraging investments.
♫ Subsidize producers to reduce production costs.
♫ Use of expansionary monetary policy e.g. reducing the bank rate which leads
to provision of cheap/ affordable loans for investments.
♫ Increase government expenditure especially on productive ventures hence
increasing the level of production thereby increasing employment
opportunities and reducing inflation through increased output.
3. STAGNATION
 This refers to an economic period of static economic activities characterized by
low levels of investments, low levels of employment and constant economic
growth rates.
Causes
♫ low income levels
♫ reduced government expenditure
♫ high indirect taxes
♫ unfavourable political climate/ political instability

Measures to curb stagnation

♫ Use of expansionary monetary policy e.g. reducing the bank rate.

♫ Increasing government expenditure especially on provision of essential
goods.
♫ Reduction of direct taxes. This helps to increase disposable incomes of
consumers thereby stimulating investment, employment and output.
♫ Giving incentives to investors such as tax holidays, subsidies, etc. Such
incentives lead to increased investment, employment creation and output
hence helping the economy to overcome stagnation.
♫ Improve the political climate. This helps to promote economic activities and
attract more investors thereby leading to increase in incomes, investment,
output and employment opportunities.
♫ Develop infrastructure.
♫ Etc.
4. REFLATION (REFLATIONARY POLICY)
This refers to the deliberate government policy of forcing prices upwards so as
to recover from an economic recession.
Instruments of reflationary policy
 ♫ Tax reduction
♫ Expansionary monetary policy.
♫ Increase in government expenditure/ subsidization
♫ Increasing wages
♫ Encouraging exports
5. OPEN INFLATION
This is one where the persistent increase in the general price level is as a result
of operation of a free market system whereby resource allocation is done by
market forces of demand and supply with limited or no government
intervention.
6. SUPPRESSED INFLATION
Is a situation where demand exceeds supply but the effect of this on prices is
minimized by price controls and rationing.
Effects
♫ Leads to misallocation of resources whereby producers shift their resources/
capital from commodities that are rationed and have price controls to
commodities that have no such controls.
♫ It reduces incentives of producers to work hard. This is because putting of
price controls and rationing reduces the producers’ profit margins hence
reducing their scale of production.
♫ It results into trade malpractices such as smuggling, black marketing so as to
sell commodities at a higher price hence government losing a lot of revenue
that would have been got from taxes.
♫ It increases employment problems. This is because some firms are forced to
close down while others substitute labour with machines as a way of cutting
down labour costs.
 ♫ Leads to exploitation of consumers especially on commodities where there
are no price controls by government hence leading to low standards of
living.
7. HEADLINE INFLATION
This is where persistent increase in the general price level in the economy
includes the prices of foodstuffs.
8. UNDERLYING INFLATION
This is whereby the persistent increase in the general price level in the economy
includes all commodities in the country but excludes prices of foodstuffs.