Inflation

Question 1

Inflation

Answer 1

A persistent rise in the general level of prices, or alternatively a persistent falls in the value of money.

Question 2

Deflation

Answer 2

A persistent downward movement in the general price level overtime for an aggregate of goods and services.

Question 3

Types of inflation

Answer 3

Creeping
Galloping/hyperinflation
Trotting
Open
Suppressed
Stagflation

Question 4

Creeping inflation

Answer 4

Occurs when there is a sustained mild rise in the price level per year i.e. between one and six per cent.

Question 5

Galloping inflation

Answer 5

It develops at a rapid pace, perhaps only for a brief period of time.
Such form of inflation is dangerous for the economy as it mostly affects the middle and low-income classes of population.
Importantly, the galloping inflation can precipitate an economic depression.

Question 6

Trotting inflation

Answer 6

Occurs when prices increase at intermediate rates (between the two types above)

Question 7

Open inflation

Answer 7

Inflation is open when “markets for goods or factors of production are allowed to function freely, setting prices of goods and factors without normal interference by the authorities.” Thus open inflation is the result of the uninterrupted operation of the market mechanism.

Question 8

Suppressed inflation

Answer 8

It describes a situation in which, at existing wages and prices, the aggregate demands for current output and labor services exceed the corresponding aggregate supplies. In suppressed inflation, purchases of goods and labor services are rationed.

Question 9

Stagflation inflation

Answer 9

A situation in which the inflation rate is high, the economic growth rate slows, and unemployment remains steadily high.
It presents a dilemma for economic policy, since actions intended to lower inflation may exacerbate unemployment.

Question 10

Measurements of inflation

Answer 10

The Consumer Price Index
The Producer Price Index
GDP deflator index

Question 11

Consumer Price Index (CPI) - MAIN

Answer 11

Measures the relative changes in the prices of a specified set of market basket of consumer goods, which are bought by a typical urban household regularly.

Question 12

The producer price index (PPI)

Answer 12

Measures relative changes in the prices of raw materials, intermediate and finished goods i.e. at all stages of the productive process rather than at the stage of the ultimate user.

Question 13

GDP deflator index

Answer 13

Measures the level of prices of all new, domestically produced, final goods and services in an economy

Question 14

Steps followed in Calculating Consumer Index

Answer 14

1. Determine which prices are the most important to a typical consumer.
2. Find the prices of each of the goods and services in the basket at each point in time
3. Use the data in prices to calculate the cost of the basket of goods and services at different times.
4. Designate one year as the base year- the benchmark against which other years are compared.
5. Use the CPI to calculate the inflation rate which is the percentage change in the price index from the preceding period

Question 15

CPI =

Answer 15

CPI = price of basket in current year/price of basket in base year *100
Inflation in Yr 2 = CPI in Yr 2 - CPI in Yr 1/CPI in Yr 1 *100

Question 16

Causes of inflation

Answer 16

Demand pull inflation

Cost push inflation

Question 17

Demand pull inflation

Answer 17

It arises from a situation in which aggregate demand persistently exceeds aggregate supply at current prices.
In this case, the aggregate demand (C + I+ G) line is too high, resulting to inflationary pressure.

Question 18

Causes of demand pull inflation

Answer 18

• Increases in the level of demand for goods and services in a situation of near employment
• A general shortage of goods and services in times of disaster like floods and earthquake.
• Export surplus leading to foreign currency inflows that cause increases in the money supply. These inflows become a source of inflationary pressure.
• Expansion of government spending by borrowing from the banking system where this is not marched by an increase in output.

Question 19

Cost push inflation

Answer 19

While GDP is below its potential level, costs are increased, perhaps because unions push up wages, and in an attempt to protect their profit margins firms push up prices.
This price increases affects the cost of other firms and the consumer’s cost of living.
As the cost of living goes up, laborers feel entitles to, and obtains higher wages to offset the higher living costs.
Firms again pass on the cost increase to the consumer in the form of a price increase.
The so-called wage – price spiral is at the heart of cost-push inflation.

Question 20

Causes of cost push inflation

Answer 20

• Labor unions asking for higher wages without a corresponding increase in productivity.
• Manufactures fixing high profit margins
• An increase in import price of an essential commodity like crude oil that leads to escalation of prices in the economy
• Government imposing new taxes of higher taxes
• Structural rigidities in production that leads to increasing average costs.

Question 21

Internal Effects of inflation

Answer 21

1. Income and wealth are redistributed arbitrarily, for inflation imposes a tax on those who hold money as opposed to those holding real assets. Inflation reduces the standard of living of persons dependent on fixed incomes, for example, pensioners. It benefits debtors and penalizes lenders.
2. Interest rates rise, both because people require a higher reward for lending money which is falling in value and also because the government is forced to take anti-inflationary measures.
3. Investment is discouraged by government anti-inflation policy. In practice, controls imposed on prices are more effective than those on costs, particularly those on wages. The result is discouraged because postponing consumption
   simply means that goods cost more if bought later.
4. Inflation encourages speculation by the purchase of real assets by borrowing rather than investment by the use of resources in production. Indeed inflation discourages investment in long-term projects because possible government anti-inflation policies are difficult to forecast.
5. Inefficiency is encouraged because a buoyant seller’ marked blunts competition as higher prices obtained for their products allow even inefficient firms to survive.
   Inflation generates industrial and social unrest since there is competition for higher incomes. Thus, because of rising prices, trade unions ask for annual wage rises.
6. Often demands exceed the rate of inflation, anticipating future rises or seeking a larger share of the national cake to improve their members’ real standard of living. Those with the most ‘muscle’ gain at the expense of the weaker groups.
7. Additional administrative costs are incurred in offsetting go-slow and work to rule disruptions, allowing for inflation in negotiating contracts and wage rates, revising price lists and labels, among others.
8. The rate of inflation tends to increase, largely because high wage settlements in anticipation of higher future price help to bring about the very rise in which people fear.

Question 22

External effects of inflation

Answer 22

1. Exports tend to decline because they are relatively dearer in foreign markets.
2. Imports tend to increase because foreign goods are relatively cheaper compared to Kenyan goods.
3. Higher money incomes in the economy increase the demand for imports and tend to decrease exports because the buoyant home market makes it less vital for manufacturers to seek outlets abroad for their goods.
4. An outward movement of capital may take place if price rises continue since foreign traders and financiers lose confidence in the shilling maintaining its current rate of exchange

Question 23

Remedies of inflation

Answer 23

Fiscal and monetary policies

Question 24

Fiscal policy

Answer 24

• A cut in government spending
• Lowering government borrowing
• An increase in taxation
• Introduction of new taxes
  These measures directly reduce aggregate demand.

Question 25

Monetary policy

Answer 25

The monetary policy refers to actions that aim at a reduction in money supply or a reduction in its rate of growth. The measures include:

• Restricting direct lending to government
• Increasing cash or liquidity ratio requirement on commercial banks and financial institutions thereby reducing their ability to create credit.
• Rising interest rate i.e. the cost of borrowing
• Increasing the cost of overnight borrowing by commercial banks

Question 26

Prices and incomes policy

Answer 26

• Government exhortations to firms to avoid unjustified price rises and to unions to avoid unjustified wage claims
• The setting up of a prices and incomes board to examine proposed price increases and to contribute to collective bargaining between employers and unions.
• Bringing together of employers’ and unions’ organizations in an attempt to obtain some voluntary agreement from both parties to keep prices and incomes down.
• The impositions of legislation to regulate or even freeze wages and prices.

Question 27

Indexation

Answer 27

• This policy is sometimes called index linking.
• It works by linking economic variables for example wages, salaries, and interest payments to an index of inflation like the consumer price index.
• This means that as the price index rises, wages, salaries and interest payment rises simultaneously.