INFLATION

Definition: Inflation versus Deflation Types of inflation: demand-pull and cost-push inflation Measuring inflation rate & effect of inflation on

purchasing power The costs of inflation Measures to reduce the inflation rate

Fiscal policy Monetary policy Direct measures

Inflation versus Deflation:Inflation occurs when there is an increase in the overall price level (consumer price index – CPI) of goods and services in the economy.Deflation occurs when there is a decrease in the overall price level (CPI) of goods and services in the economy.We measure overall price level by looking at all or a large number of goods and services in the economy.Types of inflation: demand-pull inflation and costs-push inflation.

Demand-pull Inflation

Demand-pull Inflation = inflation that is initiated by an increase in aggregate demand. AD curve shifts to the right.AD curve can shift to the right for a number of reasons, including:• An increase in money supply (Ms) – r↓ - I↑• an increase in G• a tax cut – C↑ & I↑

Cost-push Inflation:Cost-push inflation = inflation caused by an increase in costs. AS curve shifts to the left.AS curve can shift to the left for a number of reasons, including:• An increase in production cost: wages, prices of

raw materials, rental, interest rates, water & electricity tariffs, sales tax, price of imported goods.• Greed for profit: AS is reduced and prices can be

increased. (profit-push inflation)• A sudden decrease in AS caused by flood, tsunami,

a severe frost. (supply-shock inflation)

1. DD-pull inflation

AS

ADo

AD1

Po

P1

Yo Y1

2. Cost-push inflation

ASo

AS1

AD

Po

P1

Y1 Yo

Gen. price levelGen. price level

Cost-push inflation= inflation caused by a decrease in AS. Known as stagflation, i.e ↑P followed by ↓Y

DD-pull inflation= inflation caused by increases in AD

Calculating consumer price index (CPI):

CPI = a measure of the overall cost of goods & services bought by a typical consumer. Formula CPI (Lp)

Assumption: consumers buy only noodles and fried rice.Step 1: determine a fixed basket of goods. 4 bowls of soup noodles, 2 plates of fried riceStep 2: find the price of each good in each year. Price of a bowl of soup noodles: RM1 (2009), RM1.50 (2010), RM2.00 (2011) Price of a plate of fried rice: RM2 (2009), RM2.50 (2010), RM3.00 (2012)

100xPoQo

PnQoCPI

CPI cont.

Step 3: compute the cost of the basket of goods in each year 2009: (4 x 1) + (2 x 2) = RM8 2010: (4 x 1.50) + (2 x 2.50) = RM11 2011: (4 x 2) + (2 x 3) = RM14

Step 4: using 2009 as a base year, compute CPI in each year2009CPI = (RM8/RM8) x 100 = 1002010 CPI = (RM11/RM8) x 100 = 137.52011 CPI = (RM14/RM8) x 100 = 175

Measuring the rate of inflation

• Inflation rate = • Example:

Inflation rate in 2001 = [(101.4–100)/100]x100 =1.4%Inflation rate in 2004 = [(105.3–104.4)/104.4]x100 =0.86%Average inflation rate 2001 – 2004:CPI4 = CPIo(1+f)4: 105.3 = 100(1+f)4

1 + f = (1.053)1/4 = 1.013Average inflation rate (f) = 0.013 = 1.3% per year.

100)(

1

1 xCPI

CPICPI

t

tt

t Tahun CPI

01234

20002001200220032004

100101.4103.2104.4105.3

Inflation Rate in MalaysiaYear Inflation rate

Average 1970s 5.5%

Average 1980s 3.6%

Average 1990s 3.7%

Average 1971 - 1990 4.3%

Average 1991 - 2000 3.6%

2006 3.6%

2008 5.4%

2009 0.6%

2010 1.7%

2011 3.2%

2012 1.6%

2013 2.1%

2014 3.2%

Source: Department of Statistics & Bloomberg Alliance Research

Effects of inflation on purchasing power• ↑prices will↓consumer’s purchasing power & ↑cost of living.

Example:

• The purchasing power of RM100 (1977) is reduced to RM80 (1982) and to RM31 (2000)

• Real income: inflation tends to reduce purchasing power of money.– 1990:wage = RM2500 (CPI=100)– 2000:wage RM4000 (CPI=135.5). – Real income in 2000 = 4000x(100/135.5)

= RM2952.

Year CPI Purchasing power index (CPIo/CPIt)

19771982198719922000

100125.3181.5289.1328.4

1100/125.3 = 0.8100/181.5 = 0.55100/289.1 = 0.35100/328.4 = 0.31

Effect/ costs of inflation• Gainers and losers:– Gainers: business; owners of real properties (land, houses

and buildings); farmers and non-fixed income earners, debtors.

– Losers: fixed income earners (pensioners) and creditors.• Inflation shrinks income: nominal income Vs real income. The

greater the rate of inflation, the greater the decline in the quantity of goods we can purchase with a given nominal income.

• Savings and investment: inflation reduces the savings of consumers because of the increasing cost of living but it increases the savings of businessmen because of more profits. Inflation encourages businessmen to invest because the returns on investment are attractive.

Effects of inflation: cont.• Trade union and wages:

- Inflation tends to reduce the purchasing power of money and raise the cost of living. This will encourage the trade unions to demand for higher wages to compensate the rising cost of living.

• Inflation and international trade:– Balance of trade: inflation means an increase in the prices of

domestic products including exported products. The volume of exports will decrease. Inflation will make prices of imports relatively cheaper in the domestic markets. The volume of imports will increase. This will lead to a deficit in the balance of trade.

– Exchange rates: If Malaysia is having a deficit in balance of trade, the demand for the Malaysian Ringgit will fall against the USD. As a result the USD becomes more expensive than the Malaysian Ringgit.

Measures to Reduce Inflation Rate: Demand-pull inflation

• Fiscal policy: Using a contractionary policy -↓G, and/or ↑Tx. As a result, AD and spending will decrease– AD approach (diagram)

• Monetary policy: Using a contractionary monetary policy to reduce the money supply and the level of AD and spending. A decrease in money can be achieved by:

(a) making loans more expensive and difficult to obtain such as(i) increasing the interest rates on loan,(ii) increasing the cash, legal and liquidity ratios (↑reserve ratio),(iii) selling government securities through the open market

operation, and

(iv) restricting the hire purchase regulations. (b) reducing the amount of new money issued by Bank Negara Malaysia.

• A contractionary fiscal policy and contractionary monetary policy will reduce AD and spending.

• AD curve shift downwards and P↓.

General price

ADo

AD1

AS

Po

P1

P.NYoY10

Measures to Reduce Inflation Rate: Cost-push inflation

• Direct measures:– Controlling prices by setting controlled items.– Controlling wages– Increasing the AS by improving the productivity of

workers, giving subsidies to firms that produce necessities goods.

– Giving cash assistance to compensate the rising cost of living. For example, giving RM100 one off cash assistance to school children and RM500 for household with a monthly income of RM3000 and below.