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Topic: Inflation and Deflation
Lesson Objectives: At the end of the lesson, learners should be able to;
i. Define inflation
ii. State the types of inflation
iii. List the causes of inflation
iv. State the effects of inflation
v. Explain the various ways for controlling inflation
vi. List out the terminologies associated with inflation
vii. Define deflation
viii. State the causes of deflation
ix. List the effects of deflation
x. State the ways of controlling deflation
Inflation may be defined as a persistent rise in the general price level of goods and services. Inflation occurs when the volume of purchases is permanently running ahead of production and too much money in circulation chasing too few goods.
Types of Inflation
There are three main types of inflation. These are;
i. Demand-pull inflation: Demand-pull inflation occurs when consumers have high purchasing power leading to increases in aggregate demand without a corresponding increase in supply. In other words, this inflation occurs when the demand for goods and services is greater than their supply. The factors responsible for this type of inflation may be due to population increase, increase in workers’ salaries and wages.
ii. Cost-push inflation: Cost-push inflation occurs when increases in cost of production are passed on to consumers in the form of high prices for the goods and services on sale. The prices of goods and services are pushed up by rising costs.
iii. Hyper-inflation: Hyper-inflation, also known as galloping or run-away inflation, occurs when a persistent inflation becomes uncontrollable and the value of money keeps declining rapidly. Prices of goods and services rise at a fast rate leading to money losing its value or its ability to buy goods. War, budget deficits, etc are the major causes of hyper-inflation.
iv. Persistent or creeping inflation: Persistent or creeping inflation, also known as chronic inflation, occurs when there is a slow but steady rise in the volume of purchasing power and a fall in supply of goods and services. In other words, when inflation involves a slow but steady rise in the general prices of goods and services, it is known as creeping inflation.
Causes of Inflation
i. Increase in demand: When the demand for goods and services is greater than supply, this results in inflation (demand-pull inflation).
ii. Low production: Low production of goods and services can lead to their scarcity and when supply cannot meet up with high demand, inflation sets in.
iii. War: War is a major cause of inflation as people no longer produce, resulting in high volume of money pursuing fewer goods.
iv. Increase in salaries and wages: When salaries and wages are increased, without corresponding increase in supply of goods and services, it can lead to excess money in circulation chasing few goods.
v. High coat of production: When there is high Cost of production, manufacturers build in this high cost into the cost per unit and pass it to consumers leading to cost-pull inflation.
vi. Budget deficit: When government expenditure is more than its income, it results in budget deficit and this leads to inflation.
vii. Population Increase: A sudden rise in the population will result in a corresponding rise in demand for goods and services and if there is no corresponding rise in supply, it will result in inflation.
viii. Excess bank lending: This can lead to excessive money in circulation chasing few goods and services.
ix. Level of importation: High cost of importing raw materials can lead to high cost of goods, which is passed to consumers leading to cost-pull inflation.
x. Inadequate storage facilities: When goods purchased cannot be stored, for future use, it can lead to scarcity resulting in inflation.
Effects of Inflation
Inflation has both positive and negative effects:
(a) The positive effects of Inflation
i. Reduction in burden of debt: During inflation, debtors gain because there is too much money in circulation, which will enable them to pay their debts with ease.
ii. Higher profit margin: Because producers are selling their goods at higher prices, this will lead to higher profits.
iii. Higher tax yield: As a result of high volume of money in circulation, government is able to realise high yield from taxes.
iv. Higher output: Higher prices of goods and services during inflation encourage producers to embark on large scale production resulting in greater output.
(b) The negative effects of inflation
v. It discourages savings: During inflation, people spend more money leading to low or no savings.
vi. Increase in interest rate: The rate at which banks give loan to customers increases during inflation.
vii. Income redistribution: Inflation redistribution income haphazardly. There is a fall in real income, especially of those on fixed income, e.g pensioner.
viii. Creditors lose: The value of money received is far less than the value of money lent out.
ix. Loss of value of money: Money loses in value generally during this period of inflation.
x. Fall in standard of living: Inflation brings lots of problem to salary earners as they spend it on costly goods and services leading to a falling standard of living.
Control of Inflation
i. Use of contractionary monetary measures: The use of contractionary monetary measures such as increase in bank rate, open market operation, deposit ratio and moral persuasion can help to control inflation.
ii. Use of fiscal measures: Inflation can also be controlled with the use of fiscal policies or measures to reduce the amount of money in circulation, e.g increase in direct taxation.
iii. Effective price control system: Inflation can also be controlled through the use of effective price control system, e.g price control board by government officials and the application of rationing to maintain price level.
iv. Reduction in government expenditure or surplus budget: The government should reduce expenditure and it will go a long way toward reducing the amount of money in circulation.
v. Industrialisation: Industrialisation will reduce over reliance on imported goods and bring about increase in output which will reduce prices.
vi. Checking the activities of hoarders: The activities of hoarders should be checked to prevent increase in prices of goods.
vii. Increased production: Inflation can be controlled by increasing production or output in order to bring down the prices of goods.
viii. Granting of subsidy to enterprises: Inflation can also be controlled by granting subsidy to enterprises and companies producing essential products to reduce cost of production and the products prices.
Reasons Why Price Control System May Not Be Suitable For Controlling Demand-pull Inflation
i. Goods generally are in short supply
ii. Buyers will prefer buying at higher prices rather than going home without any goods.
iii. The interaction of the forces of demand and supply will work against price control system
iv. Price control system is prone to a lot of malpractice.
v. The existence of black market will contribute a lot in making price control not suitable in checking demand-pull inflation.
Terminologies Associated with Inflation
i. Inflationary gap: Inflationary gap refers to an economic situation in which the total demand in the economy exceeds the total supply of goods and services available to satisfy demand. Inflationary gap is calculated as the difference between the total amount of money available for spending and the total money value of the actual goods and services available to meet the demand. The greater the inflationary gap, the greater the rate of inflation in the economy and vice versa.
ii. Inflationary spiral: Inflationary spiral is caused by an interaction of income factors, especially wages and prices, such that an increase in the price level causes workers to demand higher wages which causes the price level to still rise higher, thereby increasing the cost of production.
When prices rise, workers demand for higher wages, and so the wages increase. But this increases the cost of production, so prices increase again and the condition continues in this spiral manner.
iii. Disinflation: Disinflation refers to a set of measures by which the inflationary pressure in an economy is removed so as to maintain the value of money. The essence of disinflation is to control inflation by direct control of consumer expenditure. This is done by reducing the supply of money and increasing interest rates, etc.
iv. Reflation: Reflation refers to an economic state of affairs in which prices, employment, output, etc are picking up again as a result of conscious government policy to that effect. When deflation has had too drastic effect on the economy, reflation is a period of recovery from the slump. While reflation is directed against deflation, disinflation is directed against inflation.
v. Stagflation: Stagflation refers to a high rate of inflation which exists at the same time as industrial production is slowing down. It refers to high increases in the price level which are not accompanied by any increases in industrial production.
vi. Slumpflation: Slumpflation refers to an economic condition in which much reduced economic activity co-exists with inflation. In other words, slumpflation is marked by the idleness and underutilization of resources such as capital and labour, at the same time as the general price level is rising and the value of money falling.
Inflation in Nigeria
Inflation has been a major problem facing Nigeria right from the period of civil war (1966 – 1970). Prior to this period, the Nigerian economy was in steady growth. This condition continued till the time of the first military intervention in 1966 when there was a deliberate policy of fiscal and monetary discipline. There was a balanced budget and there was no inflation.
Due to increase in government expenditure, budget deficit became acceptable to the government and inflation started to set in. By 1973, inflation had risen to about 6%. In that same year, the naira was devalued and the prices of imported commodities increased. In 1974, the Udoji salary award took the inflation figure from 13.8% that year to about 34% in 1975 due to increase in salaries and wages of workers. However, there have been fluctuations in the level of inflation in Nigeria. For example, the inflation figure in 1982 was just about 7% but rose to 24% in 1983 and to 39% in 1984 and it became worse in 1986 when the Second-tier Foreign Exchange Market (SPEM) was introduced. The Inflationary figure stood at 40%. In any case, inflation has been controlled by successive governments but it has not yet been eliminated.
Deflation may be defined as a continuous fall in the price level of goods and services as a result of decrease in the volume of money in circulation. Since prices fall, the value of money rises during deflation. A given sum of money can purchase more goods and services. It should be noted that deflation is the opposite of inflation.
Causes of Deflation
i. Budget surplus: Budget surplus serves as a device by which the rate of injecting money into circulation was reduced.
ii. Increase in bank rate: This serves to discourage commercial banks from borrowing from the Central Bank and by so doing reduces the banks’ ability to lend money, leading to a reduction in the volume in circulation.
iii. Increase in production: Increase in production of goods without corresponding Increase in the volume of money in circulation can lead to deflation.
iv. Increase in taxation: When taxation is increased, it will definitely reduce the volume of money in circulation thereby causing deflation to occur.
Effects of Deflation
i. Decline in profits: Deflation causes a decline in profits as a result of low volume of money in circulation.
ii. It results in unemployment: Deflation brings about unemployment in the labour market.
iii. Fall in prices of goods: As a result of decline in the volume of money in circulation, the prices of goods and services tend to fall.
iv. Reduction in investment: As a result of low savings, the level of investment tends to be reduced.
v. Creditors gain: Creditors gain because money has added value during the period of deflation.
vi. It encourages exports: Goods that are to be expected are generally very cheap during deflation.
vii. It discourages imports: Goods imported are generally more expensive and there is no hope of selling such goods in an economy that is experiencing deflation.
viii. It encourages savings: Savings is encouraged because the value of money increases during deflation.
Control of Deflation
i. Reduction in taxation: This practice enables people to have more money thereby increasing their purchasing power and controlling deflation.
ii. Use of deficit budgeting: An increase in government expenditure helps to inject more money into circulation by curbing the effects of deflation.
iii. Reduction in bank rate: This will assist investors to borrow more money from banks thereby increasing the volume of money in circulation.
iv. Increase in wages and salaries: This will help to inject more money into circulation thereby controlling deflation.
v. Use of open market operation: The Central Bank does this by purchasing securities from commercial bank. This makes it possible for the commercial banks to be able to lend money out and increase the volume of money in circulation.
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Take a quick lesson for this lesson
i. What is Inflation?
ii. Describe the types of inflation
iii. Explain the causes of inflation
iv. List and explain five terminologies associated with Inflation
v. Define deflation
vi. Explain four causes, effects and control of deflation
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