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Macroeconomics: Definition of Inflation, Measuring Inflation Rate (CPI), and Causes and Effects of Inflation

Updated on November 2, 2015

Definition of Inflation

  • Changes in price always happen.
    • However, if the change is due to an overall increase of price in the market, the decrease of the value of money (purchasing power), and there is a negative effect on the people, this economic condition is a result of inflation.
  • The Economics Glossary – inflation is the increase of the overall price of selected products part of the basket of goods
  • Parkin & Bade’s Economics (2010) – inflation is the increase in price while deflation is the decrease in price.
  • This affects the quantity of products a consumer is willing and able to buy (Law of Demand, Income effect)
  • Hyperinflation – the price continues to rise every hour, day, and week, like what happened in Germany during the 1920s.
    • This also happened in the Japanese regime in the Philippines when money lost its value
  • Even at the present time, inflation cannot be stopped.
    • Primary products such as rice, sugar, chicken, meat, fish, and others are not safe from price increase.

Measuring the Increase in Price

  • The Consumer Price Index is commonly used
  • The government selects products as part of the basket of goods which would represent the primary needs and wants of the members of the society
    • This is used as the basis in measuring the degree and speed of price change
    • The market basket determines the price index which represents the overall and average change in price of all goods
  • The price index changes depending on the type of good that is to be analyzed

Types of Price Index

  1. GNP Implicit Price Index or GNP Deflator – average price index used in order to reduce the value of the current GNP and measure the real GNP. Measures the overall price of products and services produced by an economy within a year.
  2. Wholesale or Producer Price Index (PPI) – index for prices payed by the stores that buy in bulk from suppliers and resell to consumers
  3. Consumer Price Index (CPI) – measures the change in price of products and services used by a consumer. The price and quantity of products that are usually consumed by a family that is within the market basket is considered in computing for the CPI. The market basket also measures the quality of life of the consumer.

Activity

CPI = (Total weighted price of current year / Total weighted price of base year) (100)

Inflation rate = ((CPI of current year - CPI of last year) / CPI of last year) (100)

Purchasing power = (CPI of base year / CPI of current year) (100)

Guide Questions 1

  1. What is the importance to you, as a member of the family, to understand the true value of the peso?
  2. How would you describe the normal reaction of your parents whenever there is an increase in price of goods? Explain.

Reasons Behind Inflation

  • Demand-pull inflation
    • Increase in the consumption of the households, firms, government, and external sectors (aggregate demand) but does not coincide with the increase in overall production
    • Shortage occurs in the market, resulting to an increase in price
    • Monetarists like Milton Friedman – having too much money in circulation results into an increase in demand. Because there is too much money, there is a greater possibility that consumers will continue to buy many products and would result to an increase in price
  • Cost-push inflation
    • Increase in the costs of production
    • For instance, if minimum wage is increased, this may affect the overall cost of the products made.
      • The producer will pass on the increase in the price of labor to the consumer.
    • The same happens when the price of raw materials increase.
    • The increase in these costs will increase the overall price of the products because naturally, the producer would not want to take the burden of the increase in the price of production.

Causes and Effects of Inflation

Causes
Effects
Increase of supply of money in circulation
There will be an increase in demand or consumption, leading to an overall increase in price.
Dependence on importation for raw materials
When the peso to dollar exchange increases, or the price of materials imported increase, the products dependent on importation increase in price.
Increase of peso to dollar exchange
Due to a lack of dollar, the value of peso decreases. This would result to the increase of price of products.
Condition of exportation
When the supply in the local market is short because products are exported, this would lead to an increase in price. When the demand exceeds supply, it would result to an increase in price.
Monopoly/oligopoly
Price can be controlled in this system. When the price and quantity is controlled, there is a great possibility of high prices.
Paying debts
Instead of using money in order to be used in production, which is part of the national income, it is only used as a payment for debt.

Activity

Identify whether the following is a cause of inflation or an effect of inflation.

  1. A huge part of the budget of the country is used for paying debts.
  2. There is greater spending in the military than in agriculture.
  3. Many products cannot be bought by the citizens.
  4. Many students cannot go to school because their parents don’t have the resources.
  5. The labor force asks for higher wages.
  6. There is an increase in the cost of production.
  7. Higher interest is placed on loans.

Effects of Inflation to Citizens

Those who benefit from inflation
Example
Borrowers
A person borrows P1,000 at 10% interest (interest already included). However, due to the 15% inflation, the value of the total paid is only P935. Thus, it is the borrower who benefited from borrowing.
Businesspeople / owners of companies
A retailer of gasoline has a huge stock of gasoline. When the price of gasoline increases, his income would also increase without him expecting it.
Speculators
Real estate brokers, sellers of jewellery, and others that speculate that prices would increase in the future.
Those who get affected negatively by inflation
Example
Employees with fixed pay
Employees like teachers, police, clerks, nurses, and others that receive fixed pay every month are greatly affected by increase in price. What they could buy before is reduced due to the reduction in the actual value of the money they receive.
Lenders
In the same example as above, the lender actually lost money due to higher inflation than interest.
Savers
Savers would be negatively affected when the interest their savings earn in the bank is less than the inflation rate. The real value of the money that is stored in the bank is reduced.

Guide Questions 2

  1. How will you associate the images with the concept of inflation?
  2. What are the negative effects of the images?
  3. As a student, what can you suggest as your contribution in facing and responding to the effects of inflation in the economy?

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