1 INFLATION LO 4

LO4 AS1: Analyse and investigate inflation and explain he policies hat are used to combat it.  Definition of inflation - is sustained and significant increase - in the general price level - over a period of time - results in a decrease in the buying power of money  Characteristics of inflation - it is not a once price rise but a continuous process of price increases - refers to a rise in prices in general than in one or more products - it is concerned with a considerable increase in prices - causes a decline in the purchasing power and value of money

KINDS OF INFLATION  Two main types of inflation Demand-Pull Inflation  Demand for goods is higher than the supply  Or demand increases much faster than supply  Which results in price increases  Aggregate demand increases an this pulls up the prices Cost-Push Inflation  Caused by an increase in the production costs  The increased price pushes up the price level  Eg. The increase in wages, Increase in fuel prices etc

OTHER TERMS/CONCEPTS  Hyperinflation Most extreme form of inflation Defined as runaway inflation During this condition the national currency is worth almost nothing and the exchange of goods for goods and not for money is widespread  Stagflation When both the inflation and unemployment rate increases This occurs in economies that lose the ability to create new jobs Here economic growth is stagnated because of strong monetary and fiscal policy to cub inflation  Deflation This a continuous decrease in prices and a simultaneous increase in the purchasing (buying) power of money This a deliberate attempt to decrease demand, production and prices This is a result of a strict monetary and fiscal policy to decrease the inflation rate

How inflation is measured  Consumer Price Index (CPI) This reflects the cost of a representative basket of consumer goods and services. This shows how the average price level of goods and services bought by a household/consumer changes over time The inflation rate is the annual percentage change in the CPI  CPIX (CPI excluding interest rates on mortgage bonds) Derived by excluding interest rates on mortgage bonds from the basket of goods and services used to compile the CPI  Production Price Index (PPI) The PPI measures prices at the level of the first significant commercial transaction The prices of imported goods are measured at the point of entry to a country and not when they are sold Likewise, manufactured goods are priced when the leave the factory The PPI, like CPI, is estimated and published on a monthly basis by Stats SA, but it measures the cost of production rather than the cost of living

THE CAUSES OF INFLATION  Increase in the money supply Excessive extension of credit may lead to increase in the demand for G and S If there is no increase in supply of these G and S a shortage will occur “Too much money chasing too few goods Demand will pull the prices of G and S upwards  Increase in the input costs When input costs increase, the selling price of these goods will increase Costs will therefore push prices upward If there is no increase in production this will result in cost-push inflation

THE CAUSES OF INFLATION (Cont)  Market failures Inflation occur when the normal interaction between demand and supply is not in balance If D and S is not in equilibrium it will result in a change in the price of consumer G and S If D > S then prices will increase  Weaker exchange rates If SA has a weaker exchange rate it will be more expensive for people in SA to buy G and S. The price of these goods imported will increase. This is called imported inflation

THE CAUSES OF INFLATION (Cont)  Decline in productivity In a free market economic, workers are paid based on productivity’ Should salaries and wages increase with an increase in productivity, prices will increase to compensate for the loss  Trade Unions Excessive wage demands will increase cost-push inflation If demands are not met resulting in strikes and lower productivity Shortages occur in the market resulting in higher prices.

Consequences of Inflation  A decrease in the buying power of the currency  Most important consequence of inflation  Consumer buys less with the same amount of money  More Rands to be given for the same product  An increase in poverty levels  Poverty levels increase because money is worth less and they can buy less G and S  People are unable to buy and satisfy their basic needs.  Lead to lower living conditions and increased poverty levels  People dependent on a fixed income  People with fixed income are hit hard by inflation (Pensioners)  It decreases their realm income  Low-income workers cannot keep pace with inflation  Inflation impoverishes these workers

Consequences of Inflation  Psychological influence  This normally influences investor confidence in the country  Consumers tend to spend more when they become aware that prices may increase (Purchasing power decreases)  This may lead to higher prices due to demand pulling prices higher  Negative influence on savings  If the interest on savings is less than the inflation rate the real value of money decreases  Investors will be worse off if they save  On the other hand people paying loans will benefit because they pay less than they borrowed  This may interest to rise.  Increased unemployment  Higher inflation rate higher unemployment  Higher prices decrease in demand for G an S  Production levels decrease  Business may therefore decrease staff to compensate Production losses

Consequences of Inflation  Balance of payments problems  Trade between countries effect the prices levels in one of these countries  If the inflation rate in SA increases then it will be difficult to sell our products – becomes too expensive  SA exports will decrease and shortages will occur on the BOP (M will increase)  Increase in tax income for government  Higher inflation, higher salaries and wages, resulting in higher personal tax to the state.  If tax brackets are not adjusted, then people will pay higher taxes  Business compensate workers with higher wages because of higher seller prices leading to higher profit margins on which businesses pay tax.

The Inflation problem in South Africa  Short term problems Demand  Production capacity  The MPC uses increases in the GDP as a way to calculate level of demand and employment  If manufacturers have little capacity to increase output and employment, inflationary pressures develop  Borrowing  Household debt as a % to disposable income has increased over the years and this indicates an increase in demand  Sales of durable goods  Increase in motorcar sales and an increase in house prices  Strong domestic demand  Money supply and credit  M3 increased from 2004 by 18% to 19%, whilst bank loans to the private sector grew by 20%

The Inflation problem in South Africa Cost  World inflation  If the rate is higher it puts pressure on domestic prices  If it is lower it reduces the pressure on inflation  Labour costs  Wage settlements were in most years below productivity increases  Key inputs  Key inputs such as fuel plays a role in increasing or slowing inflation  Administered prices  Theses prices wee below inflation, the cost of education has been slightly higher  Market prices  Goods such as food, clothing, medical aid, etc are continuously mentioned by the MPC  Exchange rates  These rates have not yet stablised. They still fluctuate

The Inflation problem in South Africa  Long-term problems  Logistical infrastructure  Asgisa announced a plan to spend on physical infrastructure  In the meantime there is inadequate port capacity, airport limitations, rail cargo and road restrictions and congestion  Energy  Liquid fuels, fuel stock and electricity (Costs, capacity and disruptions)  Skilled labour  Private and public sectors have severe shortages of skilled and highly skilled workers  Too much red tape to recruit skills from abroad  Escalations in the costs of labour  Exchange rate depreciation  Increased deficit financed by loans from abroad  These investments may be repaid quickly “hot money”  Thus rand will depreciate (too much Rands in circulation)  Social spending  Increase social spending, especially on cash grants  Taxes for this has been increased  Increases in taxes fuel inflation

Inflation – Combating measures  Fiscal Measures Steps taken through policies for taxation and expenditure  If there is excessive demand, this can be lessen by increasing direct taxation – personal income tax  Indirect taxation – VAT, customs and excise duties can be increase  Loan levy can be introduced or increased  The state can cut back on its expenditure by postponing or cancelling government projects  Financing of the budget deficit must be undertaken on non inflationary basis by loans from non-banking sector (SELLING BONDS)  A surcharge on imported goods to control inflation  Another method is stimulating supply side economy  Reduce taxation for people to work harder  Reduce company tax to encourage investment and capital formation, etc  Reducing government spending

Inflation – Combating measures  Monetary Measures  A fine balance must be maintained between goods and services and the monetary sector. Therefore it is the responsibility of the monetary authorities to adjust the quantity of money to the needs of the economy  Inflation caused by excess demand can be curbed if the monetary authorities reduce the money supply  The monetary authorities can raise the bank rate (repo rate). An increase encourages savings  Excessive inflation causes inflation. To reduce this restrict the granting of credit by banks  Monetary authorities can apply moral pressure on financial institutions – more careful when granting credit  Relaxing exchange controls is used as a measure to combat inflation

Inflation – Combating measures  Other (non monetary) measures  Increasing productivity to reduce inflation  Price control as a direct method to combat inflation  A wage policy to break the inflationary spiral  Stricter condition for consumer credit can restrict excessive demand  Encouraging personal savings as a means to combat inflation  Import control to be relaxed to allow more goods to enter the country to avoid an increase in prices  A floating exchange rate that will automatically adjust depending on international trade/conditions  Inflation targeting as a policy measure to curb inflation