Economics chap 20

Question 1

Inflation

Answer 1

Is defined as a continuous and considerable rise in prices in general

Question 2

Neutral definition

Answer 2

does not attempt to define inflation in terms of specific causes
allows for all possible causes of inflation to be taken into account. It also provides a sounder basis for anti-inflation policy

Question 3

Casual definition

Answer 3

Such definitions highlight a particular cause of inflation and therefore exclude all other possible causes. They can result
in the formulation of inappropriate policies for fighting inflation

Question 4

Inflation as a process

Answer 4

Continuous increase in prices. Inflation refers to a process in which the prices of most goods and services are increasing from year to year (or even from month to month).

Question 5

Considerable

Answer 5

Inflation is concerned with a considerable increase in prices

Question 6

General

Answer 6

Inflation refers to an increase in prices in general. An increase in the price of a particular good is not inflation

Question 7

Consumer price index

Answer 7

The most commonly used indicator of the general price level is the consumer price index (CPI). The CPI is an index which reflects the cost of a representative basket of consumer goods and services. The unadjusted CPI for all urban areas is referred to as the headline CPI.

Question 8

The producer price index measures:

Answer 8

Measures the average changes in prices received by domestic producers for their output
Measures prices when manufactured goods leave the factory
PPI measure the rate of changes in prices of products sold as they leave the producer

Question 9

CPI vs PPI

Answer 9

Whereas the CPI measures the cost of a representative basket of goods and services to the consumer, the PPI measures prices at the level of the first
significant commercial transaction. For example, manufactured goods are priced when they leave the factory, not when they are sold to consumers

Question 10

PPI

Answer 10

it includes capital and intermediate goods, but excludes services (which account for half of the CPI basket).
measures the cost of production rather than the cost of living. It can therefore not be related directly to consumers’ living
standards.

Question 11

Main differences between the CPI and PPI

Answer 11

CPI:Pertains to cost of
living
Basket consists of
consumer goods and
services
Capital and intermediate
goods excluded
Prices include VAT

PPI:Pertains to cost of
production
Basket consists of goods only
(no services)
Capital and intermediate
goods included
Prices exclude VAT

Question 12

Five different PPIs:

Answer 12

one each for
final manufactured goods( headline PPI)
intermediate manufactured goods
electricity and water
mining and agriculture
forestry and fishing.

Question 13

Intermediate goods vs capital goods

Answer 13

Intermediate good is a good or service purchased by a manufacturer to be used as an input in another product. Capital goods are goods used to produce other goods.

Question 14

The implicit GDP deflator

Answer 14

can be used to calculate an inflation rate
It is an implicit index since it is a side-effect of the calculation of economic growth. The CPI and PPI, on the other
hand, are explicit indices that are specifically designed to measure price increases
PPI, the basket consists of various consumer, capital and intermediate goods. The CPI basket contains consumer goods and services.
Economists want to know what happened, on average, to the prices of all goods and services included in GDP

Question 15

How to calculate the form of change in the general prices regularly

Answer 15

GDP is first measured at current prices. By using a variety of techniques the national accountants at Statistics South Africa and the South African Reserve Bank then transform GDP at current prices (or nominal GDP) to GDP at constant prices (or real GDP). This is done to eliminate the effects of inflation. The transformation which is the difference between nominal GDP and real GDP leads to an implicit inflation rate.

Question 16

Calculations

Answer 16

Nominal GDP=Current year quantities x current year prices
Real GDP=Current year quantities x based year prices
GDP Deflator=Nominal/Real x100

Question 17

Distribution effects

Answer 17

Inflation affects the distribution of income and wealth among the various participants in the economy. The first
significant distribution effect is the redistribution between creditors and debtors. The basic rule is that inflation
benefits debtors (borrowers) at the expense of creditors (lenders).The real value (or purchasing power) of money falls when prices increase. The difference between the nominal interest rate (10 per cent in this case) and the inflation rate is called the real interest rate. If the nominal interest rate is lower than the inflation rate, then the real interest rate is negative

Question 18

Distribution effects(2)

Answer 18

This redistribution of wealth naturally applies to all assets whose nominal value is fixed, such as money, government securities, bonds, certain insurance policies and certain pensions.
Anyone who holds money in a bank account or who has a savings or fixed deposit is a creditor and therefore loses. On the other hand, many people live in homes financed by bonds
(called mortgage bonds), the nominal value of which is fixed. People with mortgage bonds are debtors who benefit from inflation because the real value of their loans decreases as prices increase. Similarly, people who borrow money to purchase expensive consumer goods such as motorcars also benefit from inflation, because it reduces the real value of their debt.
However, since younger people are more likely to be net borrowers while old people tend to have relatively fixed nominal in comes (eg pensions or interest income), inflation tends to redistribute income and wealth from the elderly to the young

Question 19

Bracket creep

Answer 19

Results in a redistribution of income from taxpayers to the government. Bracket creep results from a com bination of inflation and a progressive income tax. It has the same effect as an increase in the tax rate

Question 20

Fiscal dividend

Answer 20

Increased government revenue from taxation through inflation

Question 21

Economic effects

Answer 21

Inflation has various economic effects which may result in lower economic growth and higher unemployment than would otherwise have occurred. For example, decision makers in the private sector tend to become more concerned with anticipating inflation than with seeking out profitable new production opportunities. Inflation also stimulates speculative practices that do not add to the country’s productive capacity .
Such speculative activity often occurs in place of productive investment in new factories, machines and other equipment.
By reducing the value of existing savings, inflation may also discourage saving in traditional forms such as fixed deposits and pension fund contributions. One of the most serious economic effects of inflation is that it can produce balance of payments problems. Inflation increases the costs of export industries and import-competing industries

Question 22

Social and political effects

Answer 22

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. Inflation creates a climate of conflict and tension which is not conducive to economic progress

Question 23

Expected inflation

Answer 23

An American economist, Gardner Ackley, once claimed that the greatest cost of inflation is the inflation it causes. The view that an increase in the rate of inflation often leads people to expect that it will increase further. They therefore try to be compensated for the expected higher inflation. If they succeed, this results in raising the actual rate of inflation. For example, unions may base their wage claims on the expected higher inflation. If these claims are granted, production costs and prices will rise more rapidly than during the previous period. Similarly,
firms may raise the prices of their products in anticipation of expected cost increases. They may also increase prices because of the need to raise sufficient funds to purchase materials which they expect to be more expensive in future. When the rate of inflation is expected to increase, consumers may also rush to buy things now instead of later. This will put further upward pressure on prices. If unchecked, such a process may eventually result in very high inflation or hyperinflation

Question 24

Hyperinflation

Answer 24

When the inflation rate becomes very high

Question 25

The causes of inflation

Answer 25

The demand-pull and cost-push approach
The structuralist approach
The conflict approach

Question 26

DEMAND-PULL INFLATION

Answer 26

Demand-pull inflation occurs when the aggregate demand for goods and services increases while aggregate supply remains unchanged. This type of inflation is often described as a case of “too much money chasing too few goods”. The excess demand pulls up the prices of goods and services

Question 27

Demand-pull inflation can be caused by any (or a combination) of the various components of aggregate demand:

Answer 27

1.Increased consumption spending by households (C), for example as a result of a greater availability of consumer credit or the availability of cheaper credit as a result of a drop in interest rates
2. Increased investment spending by firms (I), for example as a result of lower interest rates or an improvement in business sentiment and profit expectations
3. Increased government spending (G), for example to combat unemployment or to provide more or better services to the population at large
4. Increased export earnings (X), for example as a result of improved economic conditions in the rest of the world or because of increases in the prices of important export products (such as minerals).

Question 28

Causes of demand-pull inflation

Answer 28

Tend to be accompanied by increases in the money stock. Increases in the money stock do not simply happen – they are usually related to increases in one or more of the components of aggregate demand in the economy

Question 29

To combat demand-pull inflation

Answer 29

The authorities have to keep the aggregate demand for goods and services in check. This can be done by applying restrictive monetary and fiscal policies. Restrictive monetary policy entails raising interest rates and limiting the increase in the money stock. This raises the cost of credit and also reduces the availability of credit to the various sectors of the economy. Restrictive fiscal policy entails a reduction in government spending and/or in creased taxation. These policies will tend to reduce aggregate demand

Question 30

COST-PUSH INFLATION

Answer 30

Cost-push inflation is triggered by increases in the cost of production. Increases in production costs push up the price level

Question 31

There are five main sources of cost-push inflation

Answer 31

1. Increases in wages and salaries
2. Cost of imported capital and intermediate goods
3. Increase in profit margins
4. Decrease in productivity
5. Natural disasters

Question 32

To avoid cost-push inflation

Answer 32

measures have to be taken to avoid increases in the costs of production.
Increases in wages and salaries and profits therefore have to be kept under control. Increases in productivity can also help to avoid or combat cost-push inflation. One of the possible measures is to apply an incomes policy

Question 33

Demand-pull vs Cost-push

Answer 33

Demand-pull inflation thus has a positive impact on production, income and employment, provided that there are
still some unemployed resources and scope for increases in Y. When the economy is at full employment, further
increases in aggregate demand simply lead to price increases
An increase in the cost of production results in an increase in the price level (P) and a decrease in production
and income (Y). Cost-push inflation thus has a negative impact
on production, income and employment

Question 34

The distinction between demand-pull and cost-push inflation has a number of drawbacks, mainly the following

Answer 34

It ignores possible linkages between aggregate demand and aggregate supply in the economy
It can only explain changes in the price level and does not deal with the dynamic process of inflation

Question 35

The structuralist approach

Answer 35

According to the structuralist approach the inflation process is the result of the interaction between three interrelated sets of factors:
1. underlying factors, which provide the background against which the inflation process occurs
2. initiating factors, which trigger or intensify a particular inflation process
3. propagating factors, which transmit the initiating impulse(s) through the economy and over time, and in so doing generate or sustain the process of rising prices

Question 36

Underlying factors

Answer 36

Traditions, values and norms of society
Degree of conflict (or cohesion) between different groups in society
Political strength and bargaining power of trade unions
Degree of competition in the goods market
Degree of protection from international competition
Extent of administered pricing
Extent of formal and informal indexation
Size of the public sector
Degree of fiscal discipline
Degree of independence of the monetary authorities
Openness of the economy
Exchange rate regime

Question 37

Initiating factors

Answer 37

Demand-pull factors (eg exogenous increases in C, I, G or X)
Cost-push factors (eg exogenous increases in wages, profits or import prices)
Other price increases (eg as a result of natural disasters or increases in indirect taxes)

Question 38

Propagating factors

Answer 38

The various wage-price, price-price, price-wage and wage-wage interrelationships in the economy
Inflationary expectations
Interaction between domestic prices, the balance of payments and the exchange rate
Endogenous increases in the money stock

Question 39

The conflict approach to inflation

Answer 39

According to the conflict approach, inflation is a symptom of a fundamental disharmony in society which results
in a continuous imbalance between the rate of growth in the real national income and the rate of growth of the total effective claims on this income. There is no consensus on the appropriate division or distribution of the national income. Neither the market mechanism nor the political process works with sufficient authority to balance the contributions and the claims of the various groups in the economy and society

Question 40

Figure A

Answer 40

Suppose that there is no economic and/or political mechanism which guarantees a balance between the claims on the national income and the contributions to the national income. Put differently, there is no mechanism which guarantees exante equilibrium between the total effective claims and contributions at the existing price level

Question 41

Figure B & C

Answer 41

Since there is no reason why contributions should increase in response to such an ex ante imbalance, there
are only two possible equilibrating forces (ex post): an increase in net imports (to supplement the domestic contributions) and/or an increase in prices (ie inflation). Any increase in imports will have to be financed through an equivalent net inflow of foreign capital, decrease in net foreign reserves or a combination of the two

In other words, in the first case the value of the product is inflated by price increases and in the second case the value of the claims is deflated by price increases. In the latter case, the interest groups still receive the nominal amounts they claimed, but the real value of those amounts is eroded by inflation

Question 42

Diagram summary

Answer 42

To summarise: According to the conflict approach, inflation is the symptom of a lack of effective economic and/or political mechanisms to achieve a prior (ex ante) reconciliation of the conflicting claims on the national income
The broad policy implication of this approach is that the only real remedy for inflation lies in the creation of an effective mechanism to achieve an ex ante reconciliation of the competing claims on the national income. This points to the need for some form of anti-inflationary incomes policy

Question 43

Anti-inflation policy

Answer 43

Monetarists want the central bank to control inflation by controlling the rate of
increase in the money stock. They believe that inflation can be avoided by restricting the rate of increase in the money stock
to a rate approximately equal to the growth in real output.how ever, is that
the money stock is not exogenously determined or controlled by
the central bank

Question 44

Anti-inflation policy in terms of demand-pull inflation

Answer 44

The appropriate response would be to apply contractionary (or restrictive) monetary and fiscal policies, raising the interest rate and tax rates and reducing the rate of increase in government spending. Such an approach would
succeed in reducing inflation (or even the price level), but this would be achieved at the cost of lower production and income,
and therefore higher unemployment

Question 45

The costs of anti-inflation policy

Answer 45

1. The nature of the inflation being experienced
2. The possible interrelationships between inflation and other objectives or problems such as economic growth and unemployment
3. The possible costs of failing to achieve other objectives such as economic growth and full employment
4. The benefits of a reduction in the inflation rate (bearing in mind that a marginal reduction is often the only realistic possibility)
5. The possible costs or side-effects of the policy measures that are to be implemented in the attempt to reduce inflation rate to the desired level

Question 46

Indexation

Answer 46

Indexation means that prices, wages, pensions and so on are linked to price indices (for example, the CPI) to eliminate the distribution effects of inflation.
Formal indexation has been applied in countries like Brazil and Israel.
Formal indexation can help communities to cope with high inflation or hyperinflation in the short run.Unfortunately, it simultaneously impedes the fight against inflation since indexation means that today’s price increases serve as the basis for tomorrow’s price increases. It also reduces the pressure on government to take effective steps against inflation. Indexation should therefore only be resorted to in emergency conditions

Question 47

Inflation targeting has five essential feautures

Answer 47

The first is the public announcement of quantitative inflation targets. Before the target can be announced, a number of decisions have to be taken, for example: Who should determine the target? What index should be used to calculate the target? Should the target be a specific inflation rate (ie a point target) or should the aim be to achieve an inflation rate within a certain range of possible rates (ie a target range)? Over what period should the target be achieved?

Question 48

2nd

Answer 48

The second feature of an inflation-targeting framework is the acceptance by government that the primary goal of
monetary policy (and therefore of the central bank) is to achieve price stability (ie to combat inflation). Coupled with this, the central bank should be operationally independent, that is, it should have the freedom to use the instruments of monetary policy as it deems fit in its attempt to achieve the inflation target

Question 49

3rd

Answer 49

The third feature is the use of a wide range of variables, and not just monetary aggregates or the exchange rate, to decide on the appropriate setting of the policy instruments (eg the repo rate).

Question 50

4th

Answer 50

The fourth feature is increased transparency, which implies that the central bank should regularly inform the
public and the markets about its plans, objectives and decisions

Question 50

5th

Answer 50

The fifth feature is that the central bank should be held accountable (eg to parliament and the public at large)
for attaining its inflation objectives.

Question 51

The case for inflation targeting

Answer 51

The case for inflation targeting is essentially based on the view that the complex transmission mechanism of
monetary policy, the varying lags and strengths of effects through different channels, unpredictable shocks and inherent uncertainty combine to prevent the use of monetary policy for fine-tuning.

Question 51

The key features are thus:

Answer 51

The announcement of quantitative targets
The primary of price stability as the objective of monetary policy
A broad-based, pragmatic approach to the analysis of inflation
Transparency
Accountability

Question 52

Advantages have been ascribed to inflation targeting:

Answer 52

1. Easy to understand-framework extremely transparent
2. The monetary policy is set clearly(price stability)-reduces uncertainty and enhances sound planning
3. Explicit benchmark-improves accountability
4. Eliminates reliance on a stable relationship between changes in the MS and inflation
5. Enhance coordination of economic policy both government and central bank are publicly committed to the same inflation target

Question 53

potential disadvantages should also be noted

Answer 53

1. It is a complicated approach which relies heavily on forecasts in an uncertain economic environment
2. If forecasts turn out to be incorrect, the central bank’s credibility could be hampered
3. The reaction to external economic shock-it may be too stringent thereby reducing economic growth and employment or may choose not to act therefore adversely affecting its credibility if inflation exceeds pre-determined target
4. Many elements of the inflation process are beyond the bank’s control. Hence all stakeholders need to be on board.