ECONOMICS TOPIC 12 NOTES NKANGALA DISTRICT/2022

ECONOMICS NOTES

TOPIC 12: INFLATION

GRADE: 12

YEAR: 2022

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 ECONOMICS TOPIC 12 NOTES NKANGALA DISTRICT/2022

TOPIC 12: INFLATION

UNIT 1: DESCRIPTION OF INFLATION

 Inflation refers to a sustained and a significant increase in the general price level
over a period of time.
 It reduces the value of money which means a specific amount of money will buy
fewer goods and services as inflation increases.

WAYS TO MEASURE INFLATION

 Indexes
 The average price level in the economy is measured in the form of an index number.
 Prices index is compiled by recording the prices of a representative range of goods
and services a regular basis.
 Two price indexes are Consumer Price Index and Producer Price Index.

 Weighting
 To overcome the problem of differences in the importance of items in an index, a
weighted index number makes the figures directly comparable.

 Inflation rate
 The inflation rate can only be calculated once the Consumer Price Index figures has
been recorded.
 The recorded prices of the representative goods are calculated to get the percentage
increase in general price level.

UNIT 2: TYPES OF INFLATION

 CONSUMER INFLATION
There are three types of consumer inflation, headline, core and administered
Headline inflation:
 Represents the cost of the shopping basket of goods and services of a typical or
average South African household.
 Currently in 2021, the number of goods and services that make up the average
household’s shopping basket is 412. This means to calculate headline inflation the
change in prices of 412 goods and services are used.
 Headline inflation is measured by CPI.
 It is also referred to as an unadjusted CPI inflation rate.
 It is used by the SARB in inflation targeting.

Core inflation:
 It excludes items from the CPI basket that have highly volatile prices (prices that
changes too often) e.g. perishable products, fuel etc.
 It also excludes items with prices that are affected by state intervention and policies
(administered prices).
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Administered prices inflation

 The increase in prices of goods and services that are set by the government or
controlled by government appointed authorities. Example of goods with administered
prices are: electricity, fuel, municipal rates etc.

 PRODUCERS INFLATION

Producer Price Index (PPI) the cost of producing goods and service in the country.

Differences between PPI and CPI

PPI CPI
It measures cost of production It measures cost of living

Basket consist of goods only Basket consists of consumer goods and

services
Capital and intermediate goods are Capital and intermediate goods are
included excluded
Prices exclude VAT Prices include VAT
Interest rates are excluded It includes interest rates
Prices of imported goods are shown Prices of imports are not shown clearly
clearly

 ALL INCLUSIVE INFLATION; measures the changes in prices for all final goods and
services, (not only the goods and services in the selected basket).
 HYPERINFLATION: when there is an extremely high and a rapid increase in the general
price level (inflation rate at 50% or higher per month).
 STAGFLATION: when a country experiences a situation of low economic growth, high
unemployment and high unemployment.

UNIT 3: CAUSES OF INFLATION

1. DEMAND-PULL INFLATION
 It is an inflation that occurs when total demand of goods and services is more than
total supply.

Causes of demand pull-inflation

 Demand-pull inflation can be caused by any of the various components of aggregate
demand which are:
Increase in household consumption
 The disposable income of households can increase at a faster rate than aggregate
supply due to:
 Less savings – if consumers change their savings habits and start spending their
current and accumulated savings, growth in aggregate demand can outstrip growth
in aggregate supply.

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 Reduction in taxes – this applies more to personal income tax than indirect taxes.
When income tax is reduced, consumer spending increases.
 Access to credit – there is greater availability of consumer credit or the availability of
cheaper credit as a result decreases in lending rates.
Investors expenditure
 Lower interest rates may result in an improvement in the sentiment and profit
expectations of businesses.
 Businesses invest more and this may lead to an increase in the demand of the goods
and services that are part of the investment e.g. if there is an increase in investment
in the building industry, demand of capital goods used in such an industry will rise.
 If aggregate demand increases at a faster rate than aggregate supply, price increases
will follow

Government expenditure
 An increase in government’s spending without a corresponding rise in aggregate
supply, leads to increase in prices.
 Government can use three channels for increased spending (i.e. infrastructure,
consumption spending and social spending)
 Infrastructure – a government may embark on capital projects whose sizes outstrip the
economy’s immediate supply capacity.
 Consumption spending – most governments will at times increase expenditures in
education, health, protection and safety.
 Social spending – Governments sometimes feel they have to do something
substantive about unemployment and poverty.
 They then borrow money and spend it on public works programmes or raise the level
of social grants at a higher rate that the inflation rate.

Export services
 Increase in earnings from exports can come from foreign growth and commodities
demand.
 Foreign growth: growth of the economies of trading partner countries may create
demand for a variety of locally produced goods.
 The sale of exports bring money into the country.
 If demand increases without a corresponding increase in supply, it often results in
increase in prices.
 Commodities demand: the world’s demand for commodities expands and contracts as
business cycles do.
 During an expansionary period, foreign demand increases and this leads to greater
volume of exports.
 The income earned from these exports adds to aggregate demand and prices
increase.

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2. COST-PUSH INFLATION

 Cost-push inflation is a general increase in prices caused by increases in production

costs as such increases are passed on to consumers.

Causes of cost push inflation

 Cost-push inflation can be caused by any of the various components of production
costs which are:

Higher wages
 This is the most important single cost item in any economy
 In South Africa the remuneration of labour constitutes almost 50% of gross value
added at basic prices.
 Increase in salaries and wages are therefore an important source of cost-push
inflation.

Key inputs
 When prices of key input goods that are imported increases, the domestic cost of
production are pushed upwards.
 In South Africa these goods are essential for the smooth performance and growth of
the domestic economy, particularly the manufacturing sector.

Exchange rate depreciation

 Exchange rate depreciations may be the cause of price increases.
 If the rand depreciates in terms of the US dollar, all imported goods and services
become more expensive.
 Producers have to pay more money for the same quantity than before, therefore they
often would increase their prices.

Profit margins
 As with wages, interest and rent, profit is also a major cost to producers.
 When businesses push up their profit margins they increase the cost of production.

Productivity
 Wage increases that are not accompanied by similar productivity can cause inflation.
 If the various factors of production produce less while still receiving the same
remuneration, the cost of producing each unit of output increases.
 The prices of such goods will have to be increased to cover the cost.

Natural disasters
 Disasters such as droughts, floods and even global warming impact on the cost of
production.
 Food prices are one of the most volatile price items in inflation indexes as a result of
the effects of weather changes.

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UNIT 4: CONSEQUENCES OF INFLATION (possible essay)

 Debtors / creditors
 Creditors suffer due to price increase than debtors.
 This is because borrowers (debtors) receive money with relatively high purchasing
power and they repay the loan with money with low purchasing power.

 Wage and salary earners

 Inflation affects people whose income do not increase at the same rate as inflation.
 Pensioners, retired people and those who earn low income are affected highly.
 As prices increase, their almost fixed income purchases less goods and services.
 Investors and savers
 Assets with fixed nominal values give a fixed return if they are held until maturity.
 This means savers can be negatively affected by inflation as their returns often do not
grow as inflation increases.
 Assets with flexible market values increase more rapidly than increase in the general
price level.
 This means investors (e.g. property) are favoured by inflation.
 Tax payers
 South Africa uses the progressive tax system, the higher the consumer income is the
higher taxation will be paid.
 Taxes are levied on nominal income and not on real income.
 Industrial peace
 High inflation often disturbs industrial peace and makes consumers to demand higher
wages.
 Wage bargaining is often accompanied by strikes and mass actions which can be
destructive at times.
UNIT 5: THE EXPECTATIONS AND INFLATION
 During periods of inflation, consumers expect prices to rise.
 They often buy more goods before their expected prices increase, thereby add to
aggregate demand.
 Labour unions bargain for wage higher increases that will neutralise the effect of
future higher inflation.
 The expectation that wages will rise encourages some businesses to increase prices
in advance.
 The higher the expected rate of inflation, the higher the level of wage and price
increases will be.

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UNIT 6: MEASURES TO COMBAT INFLATION (possible essay)

 Monetary policy
 This is the use of monetary measures by the SARB to combat inflation.
 Increase in repo rate can lead to commercial banks increasing the prime interest rate
at which they loan money to their clients.
 The SARB can decrease money supply by selling government bonds.
 Monetary authorities can reduce the level of credit by instructing banks to apply stricter
lending criteria.
 Commercial banks can be required to keep larger amount of money in reserve.
 Reduce currency controls in order for the currency to float freely in the market.
 Fiscal policy
 These are steps taken by the minister of finance to control inflation through application
of tax and government spending.
 Restrictive fiscal policy involves a reduction in government spending and increased
taxation. This can reduce inflation as demand of goods and services will be reduced.
 Direct taxation means increasing personal income tax and business tax.
 Increase in indirect taxes such as VAT, customs and excise duties can be used to
influence inflation.
 A surcharge on imports can be levied.
 Reduce government spending on public goods and welfare payment
 The state can also cut back on its expenditure by postponing or even cancelling
government projects
 The government should implement policies that will increase productivity, competition
and innovation.
 Other measures
 Implementing a wage rate limit can control price levels.
 Increasing productivity through better education and training.
 Encouraging personal savings which can enable investments and supply.
 Reducing import control to make imported goods cheaper.
 Implementing inflation targeting policy.

UNIT 7: THE SUCCESS OF INFLATION TARGETING

 Inflation targeting is the most effective policy tool that can be used to break inflationary
expectations, which causes the continuation of inflation.
 South Africa formally introduced inflation targeting in February 2000
 South Africa’s target is to keep an inflation rate of between 3% and 6%.
 The target range rates are based on the CPI and are reconsidered every year.
 The target range has been reviewed several times since its introduction in 2000.
 Inflation targeting creates a more transparent monetary policy because policies can
be understood in relation to the target.