Continuous increase in the demand for goods and services in an economy without a corresponding increase in supply will push prices up resulting in inflation.
LEARNING OBJECTIVES
By the end of this topic, you should be able to;
Inflation refers to a quantitative measure of the rate at which the average price level of certain baskets of goods and services in an economy increases over a certain period of time. It is the rise in the general level of prices where a unit of currency effectively buys less than it did in prior periods. It is often expressed as a percentage, inflation therefore indicates a decrease in the purchasing power of a nation's currency.
Inflation is measured as the rate of change of prices with time. Normally, prices rise over time, but prices can also fall, a situation known as deflation.
The most common indicator of inflation is the Consumer Price Index (CPI), which measures the percentage change in the price of a basket of goods and services consumed by households.
The formula for calculating inflation for a single item is:
Inflation= (price for year 2- price for year 1)/ (price for year 1) x 100
To better understand how inflation is calculated, we can use an example. We will calculate the inflation for a basket that has two items, books and shoes.
The price of book was $20 in 2019 (year 1) and the price increased to $20.50 in 2020 (year 2). The price of shoes was $30 in 2019 and increased to $31.41 in 2020.
Using the formula, inflation for each of the individual items can be calculated;
Books; (20.50 - 20)/20 x 100 = 2.5%
Shoes; (31.41 - 30)/30 x 100 = 4.7%
To calculate inflation for a basket that includes books and shoes, we need to use the CPI weights which are based on how much households spend on these items. Because households spend more on shoes than books, shoes have a greater weight in the basket. In this example, let us assume that shoes account for 73 per cent of the basket and books account for the remaining 27 per cent. Using these weights, and the change in prices of the items, annual inflation for this basket was (0.73 x 4.7) + (0.27 x 2.5) = 4.1%
TYPES OF INFLATION
Demand-pull inflation. This type of inflation is caused by excessive demand for goods and services without a corresponding increase in production. This results in a rise in the prices. This type of inflation can be caused by a number of things. They include;
Cost-push inflation. This type of inflation is caused by an increase in the cost of factors of production. This translates to increased prices of goods and services. This type of inflation can be caused by any of the following factors;
Imported inflation. This type of inflation is caused by the importation of high priced goods and services like crude oil, machines/technology, and skilled human resources. It can be caused by any of the following factors;
LEVELS OF INFLATION
Mild inflation. This refers to a slow rise in the price level of not more than 5% per annum. It is mainly associated with low unemployment levels and it has beneficial effects on an economy. It is a sign of a buoyant economy or an expanding economy. It also implies the generation of jobs, output, and growth.
Rapid/hyperinflation. This is a type of inflation that accelerates rapidly. It normally leads to the breakdown of the monetary system of a country. This is because a currency can be withdrawn and another one is introduced.
Stagflation. This refers to an economic condition where the rate of unemployment is high, the economy is stagnant and prices are rising.
Runway/galloping. This is when prices are rising at double or triple-digit rates of 20%, 100%, 200%
EFFECTS OF INFLATION TO AN ECONOMY
These effects can be positive or negative.
Positive effects
Negative effects
CONTROLLING INFLATION
Inflation can be controlled through different means;
Fiscal measures
Monetary policies
Other measures
