INFLATION

Definition
Inflation is a continuous and considerable rise in prices in general. Four important aspects of this definition have to be considered. First, it is a neutral definition which does not attempt to define inflation in terms of specific causes. Inflation is often defined in the media as “excessive increases in the money supply” or as “too much money chasing too few goods”. Such definitions highlight a particular cause of inflation and exclude all the possible causes. These so-called causal definitions of inflation can result in the formulation or adoption of inappropriate policies for fighting inflation. Second, the definition describes inflation as a process. Inflation does not refer to a once-and-for-all increase in prices. What is at issue here is a continuous increase in prices. Inflation is a process in which the prices of most goods and services are increasing from year to year (or even from month to month). Third, the definition emphasises that inflation is a considerable increase in prices. If prices are, on average, increasing by only 1 or 2 percent per year, it is debatable whether or not this should be described as inflation. Such price rises could, for example, have resulted from increases in the quality of the goods and services concerned, in which case it would be wrong to describe them as inflation. Fourth, inflation is an increase in prices in general. An increase in the price of a particular good (eg petrol or meat) is not inflation. Even when the overall level of prices remains constant some prices will increase while other will decrease, in response to changes in supply and demand. There is inflation only when the prices of most goods and services are increasing. Economists therefore often refer to inflation as increases in the general (or average) price level.

Measurement

The measurement of inflation requires some yardstick for the general price level. The most commonly used indicator of the general price level is the consumer price index (CPI) which is discussed separately as the next topic. Another frequently used indicator in this regard is the production price index (PPI) which is also discussed separately below.

Effects

Everyone is perturbed about inflation, but does it hurt everyone? The effects (or costs) of inflation are not immediately obvious. Generally speaking there are three sets of effects: distribution effects, economic effects and social and political effects.

As far as the distribution effects are concerned, inflation tends to redistribute income and wealth from creditors to debtors. In other words, debtors (borrowers) tend to gain, while creditors (lenders) tend to lose. If you borrow say R100 and repay it a year later, the R100 that you repay is worth much less than the R100 you borrowed. You will have to pay interest, of course, but the interest is simply the price you have to pay to have access to the funds for the period concerned. If the interest rate is lower than the inflation rate, the debtor (borrower) gains in this respect as well.

The difference between the nominal interest rate and the inflation rate is called the real interest rate. If the nominal interest rate is lower than the inflation rate, the real interest rate is negative. An example would be if the interest rate is 5% and the inflation rate is 7%. However, if the real interest rate is significantly positive (eg if the nominal rate is 15% and the inflation rate is 5%) there is no redistribution of income (interest) from the lender to the borrower.

Generally speaking, inflation tends to redistribute income and wealth from the elderly (who are usually creditors) to the young (who tend to be debtors (borrowers)) and from the private sector to the government (the largest debtor in the country).

The distribution effects benefit certain participants at the expense of others. More important, however, are the economic effects, that is, those effects that impact on the performance of the economy as a whole. Inflation tends to encourage speculative activity, at the expense of productive activity, and tends to discourage saving. Moreover, inflation can also give rise to balance of payments problems, particularly if the domestic inflation rate is higher than the rates in the economies of the country’s main trading partners.

Apart from its distribution and economic effects, inflation also has social and political consequences which can further undermine the performance of the economy. Price increases make people unhappy and different groups in society start blaming one another for increases in the cost of living. When rents, service charges, bus fares or taxi fares are raised, the frustration often causes social and political unrest. Inflation tends to create a climate of conflict and tension which is not conducive to economic progress.

Causes

Inflation is a complex, dynamic process which cannot be ascribed to a single cause. It can, for example, originate from the demand side or the supply (or cost) side of the economy. On the demand side, prices can be pulled up as it were by, for example:

All these causes of so-called demand-pull inflation are the result of, or are accompanied by, increases in the money supply.

From the supply or cost side prices can be pushed up as it were by, for example: