Inflation | O Level Notes Economics 2281

LESSON 12- INFLATION

Main Lecture:

1.What is Inflation?

Inflation refers to a general and sustained rise in the level of prices of goods

and services. That is, prices of the vast majority of goods and services on

sale to consumers just keep on rising and rising! Prices change over time so

inflation is always given per period of time - per month or per year. For

example the inflation rate in Pakistan in 2009-2010 was 10.15 % . That is,

on average the prices of all goods and services rose by 10.15 paisa in every

rupee over that year.



2. How does the government calculate Inflation?

An index of consumer prices, the retail price index (RPI), shows the change

in the general price level in percentage terms over time. It seeks to calculate,

the changes in the price of a very large 'shopping basket' of the products

bought by consumers. There are a number of stages in constructing a price

index. Firstly, a base year has to be selected. Government statisticians try to

select a relatively standard base year in which there were no dramatic

changes, in other years are compared to this figure. Then, the spending

patterns of house holds are observed by carrying out surveys of house hold

expenditure from a sample of representative house holds. From the

information obtained, the main commodities being bought by households are

identified and weights are assigned to each commodity which reflect the

proportion of expenditure on that commodity. Each month government

officials find out information about prices of these commodities and estimate

the change in prices. Having assigned weights to different items included in

the index and measured price for each category, and then sum up the

weighted index of each category to obtain the Retail Price Index.



For Example

Commodity Weights x Price Index = Weighted Price



Index

Food 0.4 x 130 = 52

Housing 0.1 x 120 = 12

Transport 0.3 x 105 = 31.5

Entertainment 0.2 x 90 = 18

1.0 RPI = 113.5



Hence using data from the above table, it can be said that relative to the base

year, prices have increased by 13.5% (113.5 - 100)



3. Causes of Inflation

(i) Government policies:

Some economists argue that governments only have themselves to blame for

the high inflation rates. This is because some governments try to boost

demand to reduce unemployment in the economy in periods when labour

unemployment is high and rising. For a time the increase in demand will

reduce unemployment as firms take on more resources to produce more

goods and services. However, inflation soon begins to rise as aggregate

demand increases faster than output. Eventually the high inflation reduces

the purchasing power of people's incomes and demand for goods and

services begins to rise.

The government also aims for economic growth. However, it is a known fact

that economic growth also results in inflation.

(ii) Demand-pull Inflation:

Inflation caused by an increase in aggregate demand is called demand-pull

inflation. Aggregate demand in an economy will rise if spending by

governments, consumers and/or firms increases. Consumers will be able to

spend more of their incomes if they reduce saving or if a government cuts

income taxes. An increase in aggregate demand will cause prices to increase



and inflation to rise if firms are unable to increase supply of goods and

services at the same rate.

(iii) Cost-push Inflation

Inflation caused by higher costs feeding into higher prices is called cost-push

inflation. The cost of producing goods and services can rise because workers

demand increases in wages or cost of raw material rises etc. Firms may pass

these higher costs on to consumers as higher prices so that they do not have

to suffer a cut in their profits. A rise in costs is likely to cause a fall in

supply. As supply falls, prices will rise (keeping other factors constant).

(iv) Imported Inflation

Many materials and finished goods and services are imported from overseas.

An increase in their prices will also boost inflation in Pakistan. This

imported inflation can occur if the value of the Pakistani Rupees falls against

foreign currencies like the US dollar or Euro. As the value of Rs falls the

price paid for imported products will rise even if the prices of those goods in

US dollars, Euros or other foreign currencies have not changed. The reverse

is also true: if the value of the Rs rises the price paid for imported products

will fall.

#Inflation #Economics