Notes on Inflation & Deflation
Definitions & Measurement
Inflation is a sustained rise in the general price level.
The inflation rate is calculated as the percentage increase in the consumer price index (CPI).
Inflation Rate (t) = (CPIt – CPIt–1)/CPIt–1 × 100%
where CPIt = ∑[(Pit/Pi base year × 100) × Wi]
CPI is a price index that measures the changes in prices of a weighted basket of goods and services consumed by the average household in one year with that of the same basket in a base year. Used to track inflation.
It is calculated by choosing a basket of goods and services purchased by the average household, dividing them into categories, assigning a weight to each category based on the proportion of total expenditure spent on it, choosing a base year, measuring the prices of the goods and services in the current year as well as in the base year.
Suppose only two goods produced in the economy, Good A and Good B. Base year is 2018 (i.e. CPI2018 = 100).
CPI2022 = [(12/8 × 100) × 1/4] + [(14/16 × 100) × 3/4] = 103.125
CPI2021 = [(10/8 × 100) × 1/4] + [(15/16 × 100) × 3/4] = 101.563
Inflation (2022) = (CPI2022 – CPI2021)/CPI2021 × 100% = (103.125 – 101.563)/101.563 × 100% = 1.538%
Generally, inflation is considered low when 3 per cent or less. Singapore has a record of low inflation.
Galloping Inflation is usually considered to be above 20%. (No universal definition).
Hyperinflation is usually considered to be above 1000%. An example of hyperinflation is the 6.5 × 10108 per cent inflation in Zimbabwe in 2008. Venezuela too!
Headline Inflation versus Core Inflation:
Core Inflation = Inflation rate based on CPI that excludes goods with highly volatile prices, usually food and energy. Better for forecasting long-term trend in inflation. Note: In Singapore it is housing and car prices that are excluded.
Be aware of difficulties of using CPI such as (IB Model Essay in Macro Model Essay Book):
- Is the Basket of goods and Services representative? Who is actually average?
- Are the weights accurate and representative?
- Is the quality of the goods constant? In reality it is not and such qualitative changes are not taken into account in the CPI
- Hidden Inflation - Shrinkflation
(IB Only) Producer Price Index: An index measuring the changes in average prices of factors of production, and therefore measures price level changes from the perspective of producers rather than consumers; however, it is assumed that price changes will eventually be handed down to consumers in the form of higher prices. Since the PPI measures price level changes at early stages in production, it is useful in predicting changes in future inflation (as measured by changes in the CPI). IB Model Essay on PPI in Macro Model Essay Book.
Causes of Inflation
When aggregate demand (AD) is increasing near or at full employment. This also happens when the AD is increasing at a much faster rate than the aggregate supply (AS).
An increase in AD will lead to a shortage of goods and services resulting in a rise in the general price level (GPL).
Furthermore, as the economy is near or at full employment, firms have to compete for the scarce resources due to a lack of spare capacity in the economy and this would lead to a rise in the prices of factor inputs leading to higher unit cost of production resulting in higher GPL (movement along the aggregate supply curve!).
Note: 2 shortages give rise to DD-Pull Inflation. Shortage in the Final Goods Market and Shortage in the Labour (or Resouce) Market.
(Diagram will be explained in class)
In a small and open economy like Singapore, demand-pull inflation is mainly due to an increase in external demand which accounts for a large proportion of the AD. In recent times, during post-covid economic recovery, domestic consumption has also contributed to some extent.
In the United States, a large and open economy, demand-pull inflation is mainly due to an increase in domestic consumption which accounts for the largest proportion of the AD.
Note: It is not just about the AD increasing but also that AS not increasing as quickly. Consider both aspects.
Monetarists believe that inflation is always and everywhere a monetary phenomenon. By this, they mean that inflation can only be produced by a more rapid increase in the money supply than in output. Think ultra low interest rates (cheap money) and easy money (easily available) leading to increase in AD.
The hyperinflation of 6.5 × 10108 per cent in Zimbabwe in 2008 was an extreme monetary phenomenon. The central bank of Zimbabwe was compelled by the government to purchase the bonds that it issued. As a result, the money supply in Zimbabwe increased rapidly. However, as the amount of goods produced in Zimbabwe did not increase at the same rate, the rapid increase in the money supply led to a situation of ‘too much money chasing too few goods’ which resulted in hyperinflation.
After many years of quantitative easing in the US, Europe and Japan, (2008 US Financial Crisis and recent Covid Pandemic), the current inflation rates are also contributed in part by monetary phenomenon. High stock and housing prices lead to increased wealth and thus consumption.
Cost-push inflation is a sustained rise in the GPL due to a rise in the cost of production in the economy, independent of demand. To maintain profit margins, firms will increase prices at the same output levels leading to a decrease in short-run AS resulting in a shortage of goods and services and hence a rise in the GPL.
- Higher Resource Prices: Prices of raw materials and intermediate goods increase, perhaps due to an adverse supply shock.
2. Wage Push Inflation: Labour Unions bargain for higher wages. Could also be due to government policies such as a higher minimum wage.
3. Imported Cost-Push Inflation: Price of imports increase in domestic currency for example due to exchange rate depreciation or other factors affecting foreign / global markets. Oil prices are often involved here and prices can spike due to world demand and/or supply factors. A recent example is the Russia-Ukraine war that has led to a shortage of oil in the world.
4. Tax-push Inflation: For example, the government raising goods and services tax or increasing foreign worker levy.
5. Profit-push Inflation: In the event that firms with monopoly power push up prices. For example, in the energy market. It can cause higher costs throughout the economy.
Cost-push inflation in Singapore is mainly imported in nature due to a lack of natural resources. Oil prices have alot to do with it as oil affects practically every industry, as transport costs and energy costs affect every industry directly or indirectly.
It also occurs due to domestic factors but to a smaller extent. Wages in Singapore generally do not rise substantially due to harmonious tripartite relationsbjuip between Government, Labor Unions and Employers as well as the less restrictive foreign worker policy. However, in recent years due to increases in Foreign Worker Levy as well as the Progressive Wage Model, a type of minimum wage policy invented in Singapore. Hikes in the GST also increase domestic cost pressures.
Other Important Terms
Disinflation - A decrease in the rate of inflation over a given time period.
Stagflation - A situation in which there is a recession or economic stagnation and inflation simultaneously. For example, in October 1973 when the OPEC imposed an oil embargo against the United States and others, it led to a large decrease in the supply of oil resulting in a sharp rise in the prices. Some economists have also been predicting stagflation in 2023.
Deflation - Persistent fall in GPL (Opposite of Inflation)
Wage-Price Spirals - Inflation leads to even higher inflation. Occurs when labour unions successfully fight for higher wages in order to maintain real wage in the face of inflation. This increases costs of production and lead to another round of inflation, which may prompt unions to demand for higher wages again.
Shrinkflation - When your chicken rice comes with less chicken and the price remains the same. Essentially, inflation disguised!
Exam Tip !
External Causes versus Domestic Causes and Relative Effectiveness of Policies
Consequences of Inflation
Costs of Inflation
Rise in Cost of Living, reducing Standard of Living
Fall in the Real Value of Savings, which may in turn lead to less Consumption (if target savers) and less funds for Investments -> AD
Fall in Investments due to greater uncertainty/risks and fall in business confidence
Fall in Net Exports due to fall in price competitiveness
Lower Economic Growth and Employment (due to above)
Deterioration in the Balance of Trade, Current Account. Can lead to exchange rate instability (depreciation) and deterioration in Capital and Financial Account. Deterioration in Balance of Payments.
High Shoe-leather Costs & Menu Cost -> Lower Productivity
Redistribution of Real Income and Wealth (Especially Unanticipated Inflation). Fixed Income earners and Creditors/Savers Lose. Variable Income eaners and Borrowers tend to Gain. Weak versus Strong Unions.
Social-Political Instability due to all the above
REALISE WHY GOVERNMENTS / CENTRAL BANKS SO CONCERNED ABOUT REINIING IN INFLATION!
Note: Real Wage Growth = Nominal Wage Growth - Inflation Rate
Real Interest Rate = Nominal Interest Rate - Inflation Rate
Benefits of Inflation?
Low Demand-Pull Inflation -> Sign of buoyant economy. May lead to higher Profit Margins and Boost Business Confidence. Boosting Investment, Economic Growth and Employment.
Details will be covered during our economics lessons.
Deflation is a sustained fall in the general price level.
Benefits of Deflation
Fall in Cost of Living, increasing Standard of Living
Rise in the Real Value of Savings, which may in turn lead to more Consumption (if target savers) and more funds for Investments -> AD
Rise in Net Exports
Boost Economic Growth and Employment (due to above)
Improvement in the Balance of Trade, Current Account and hence Balance of Payments.
Costs of Deflation
Deflationary Spiral leading to recession
Widespread Bankruptcy as Real Value of Debts Increase -> Fall in Investment as well
Rise in Real Interest Rates -> Deter Consumption and Investment
Fall in Economic Growth and Employment (due to above)
Redistribution of Wealth from Debtors to Creditors (especially unanticipated deflation)
Note: Causes of Deflation - Both Falling AD (“Bad deflation”) and Increasing AS (“Good deflation”)
But Good Deflation can easily turn Bad due to Deflationary Spiral. Hence, governments want to avoid deflation. Policies also work less well in tackling deflation than inflation.
Details will be covered in our economics classes.