INFLATION Definition: Inflation versus Deflation Types of inflation: demand-pull and cost-push inflation Measuring inflation rate & effect of inflation on purchasing power The costs of inflation Measures to reduce the inflation rate Fiscal policy Monetary policy Direct measures

Inflation versus Deflation: Inflation occurs when there is an increase in the overall price level (consumer price index – CPI) of goods and services in the economy. Deflation occurs when there is a decrease in the overall price level (CPI) of goods and services in the economy. We measure overall price level by looking at all or a large number of goods and services in the economy. Types of inflation: demand-pull inflation and costs-push inflation.

Demand-pull Inflation Demand-pull Inflation = inflation that is initiated by an increase in aggregate demand. AD curve shifts to the right. AD curve can shift to the right for a number of reasons, including: An increase in money supply (Ms) – r↓ - I↑ an increase in G a tax cut – C↑ & I↑

Cost-push Inflation: Cost-push inflation = inflation caused by an increase in costs. AS curve shifts to the left. AS curve can shift to the left for a number of reasons, including: An increase in production cost: wages, prices of raw materials, rental, interest rates, water & electricity tariffs, sales tax, price of imported goods. Greed for profit: AS is reduced and prices can be increased. (profit-push inflation) A sudden decrease in AS caused by flood, tsunami, a severe frost. (supply-shock inflation)

1. DD-pull inflation 2. Cost-push inflation Gen. price level Gen. price level AS1 AS ASo Po P1 P1 Po AD1 ADo AD Yo Y1 Y1 Yo DD-pull inflation= inflation caused by increases in AD Cost-push inflation= inflation caused by a decrease in AS. Known as stagflation, i.e ↑P followed by ↓Y

Calculating consumer price index (CPI): CPI = a measure of the overall cost of goods & services bought by a typical consumer. Formula CPI (Lp) Assumption: consumers buy only noodles and fried rice. Step 1: determine a fixed basket of goods. 4 bowls of soup noodles, 2 plates of fried rice Step 2: find the price of each good in each year. Price of a bowl of soup noodles: RM1 (2009), RM1.50 (2010), RM2.00 (2011) Price of a plate of fried rice: RM2 (2009), RM2.50 (2010), RM3.00 (2012)

CPI cont. Step 3: compute the cost of the basket of goods in each year 2009: (4 x 1) + (2 x 2) = RM8 2010: (4 x 1.50) + (2 x 2.50) = RM11 2011: (4 x 2) + (2 x 3) = RM14 Step 4: using 2009 as a base year, compute CPI in each year CPI = (RM8/RM8) x 100 = 100 CPI = (RM11/RM8) x 100 = 137.5 CPI = (RM14/RM8) x 100 = 175

Measuring the rate of inflation Inflation rate = Example: Inflation rate in 2001 = [(101.4–100)/100]x100 =1.4% Inflation rate in 2004 = [(105.3–104.4)/104.4]x100 =0.86% Average inflation rate 2001 – 2004: CPI4 = CPIo(1+f)4: 105.3 = 100(1+f)4 1 + f = (1.053)1/4 = 1.013 Average inflation rate (f) = 0.013 = 1.3% per year. t Tahun CPI 1 2 3 4 2000 2001 2002 2003 2004 100 101.4 103.2 104.4 105.3

Inflation Rate in Malaysia Year Inflation rate Average 1970s 5.5% Average 1980s 3.6% Average 1990s 3.7% Average 1971 - 1990 4.3% Average 1991 - 2000 2006 2008 5.4% 2009 0.6% 2010 1.7% 2011 3.2% 2012 1.6% 2013 2.1% 2014 Source: Department of Statistics & Bloomberg Alliance Research

Effects of inflation on purchasing power ↑prices will↓consumer’s purchasing power & ↑cost of living. Example: The purchasing power of RM100 (1977) is reduced to RM80 (1982) and to RM31 (2000) Real income: inflation tends to reduce purchasing power of money. 1990:wage = RM2500 (CPI=100) 2000:wage RM4000 (CPI=135.5). Real income in 2000 = 4000x(100/135.5) = RM2952. Year CPI Purchasing power index (CPIo/CPIt) 1977 1982 1987 1992 2000 100 125.3 181.5 289.1 328.4 1 100/125.3 = 0.8 100/181.5 = 0.55 100/289.1 = 0.35 100/328.4 = 0.31

Effect/ costs of inflation Gainers and losers: Gainers: business; owners of real properties (land, houses and buildings); farmers and non-fixed income earners, debtors. Losers: fixed income earners (pensioners) and creditors. Inflation shrinks income: nominal income Vs real income. The greater the rate of inflation, the greater the decline in the quantity of goods we can purchase with a given nominal income. Savings and investment: inflation reduces the savings of consumers because of the increasing cost of living but it increases the savings of businessmen because of more profits. Inflation encourages businessmen to invest because the returns on investment are attractive.

Effects of inflation: cont. Trade union and wages: - Inflation tends to reduce the purchasing power of money and raise the cost of living. This will encourage the trade unions to demand for higher wages to compensate the rising cost of living. Inflation and international trade: Balance of trade: inflation means an increase in the prices of domestic products including exported products. The volume of exports will decrease. Inflation will make prices of imports relatively cheaper in the domestic markets. The volume of imports will increase. This will lead to a deficit in the balance of trade. Exchange rates: If Malaysia is having a deficit in balance of trade, the demand for the Malaysian Ringgit will fall against the USD. As a result the USD becomes more expensive than the Malaysian Ringgit.

Measures to Reduce Inflation Rate: Demand-pull inflation Fiscal policy: Using a contractionary policy -↓G, and/or ↑Tx. As a result, AD and spending will decrease AD approach (diagram) Monetary policy: Using a contractionary monetary policy to reduce the money supply and the level of AD and spending. A decrease in money can be achieved by: (a) making loans more expensive and difficult to obtain such as (i) increasing the interest rates on loan, (ii) increasing the cash, legal and liquidity ratios (↑reserve ratio), (iii) selling government securities through the open market operation, and (iv) restricting the hire purchase regulations. (b) reducing the amount of new money issued by Bank Negara Malaysia.

AD curve shift downwards and P↓. A contractionary fiscal policy and contractionary monetary policy will reduce AD and spending. AD curve shift downwards and P↓. General price ADo AD1 AS Po P1 P.N Yo Y1

Measures to Reduce Inflation Rate: Cost-push inflation Direct measures: Controlling prices by setting controlled items. Controlling wages Increasing the AS by improving the productivity of workers, giving subsidies to firms that produce necessities goods. Giving cash assistance to compensate the rising cost of living. For example, giving RM100 one off cash assistance to school children and RM500 for household with a monthly income of RM3000 and below.