• Key concepts
• Measuring inflation (define, explain, examine)
• Types and characteristics of inflation
• The causes of inflation
• The consequences of inflation
• Measures to combat inflation

Inflation occurs when there is a sustained and significant increase in the general price level over a period of time. At the same time, there is a decline in the buying power of money, i.e. the general price level increases more than the general increase in wages or salaries.

Overview

12.1 Key concepts

These definitions will help you understand the meaning of key Economics concepts that are used in this study guide. Understand these concepts well.

Monetary Policy in South Africa is formulated and implemented by SARB within an inflation targeting framework. SARB works closely with Treasury, but it has operational independence.

12.2 Measuring inflation (define, explain, examine)

Price indexes are used to measure the changes in the general price level.
The following are important concepts related to measuring inflation:

1. Indexes: A price index is compiled by using the prices of a representative range of goods and services which are recorded on a regular basis.
2. Weighting: The difference in the importance of items in an index is solved through a weighted index which reflects the relative importance of each item.
3. Inflation rate: The inflation rate is determined by using changes in the CPI and/or PPI index. The figures for each month are compared to the corresponding month in the previous year.
4. Inflation targeting: Forms part of monetary policy set by government and is managed by the Reserve Bank to keep inflation within the range as set by the Minister of Finance (between 3% and 6%). The aim of inflation targeting is to keep the inflation rate at low and more stable levels.

12.3 Types and characteristics of inflation

There are two main types of inflation – demand-pull inflation and costpush inflation. Their characteristics are explained below:
12.3.1 Consumer inflation

• Headline inflation: it is measured by the CPI and is calculated for urban areas only. It represents the cost of a shopping basket of goods and services of a typical SA household. Stats SA identifies 1 500 different consumer goods/services, assigns a weight to each, decides on a base year, on formula and on the collection of prices. The unadjusted CPI rate is known as headline inflation.
• Core inflation: it is published by Stats SA and excludes items from the CPI basket with highly volatile prices and those affected by government intervention and policy, e.g. fresh and frozen meat and fish, vegetables, interest rates on mortgage bonds, VAT and assessment rates.
• Administered prices: the prices are set by government or controlled by government through appointed authorities. Price changes must remain within the inflation target prescribed by the Minister of Finance.

12.3.2 Producer inflation
PPI is used to measure the prices of domestically produced goods. It also shows domestic output. When the rand depreciates it will first be reflected in the PPI.
Differences between CPI and PPI:
CPI:

• Pertains to cost of living
• Basket consists of consumer goods and services
• Capital and intermediate goods are excluded
• Prices include VAT
• Interest rates are taken into account
• Prices of imported goods are not shown

PPI:

• Pertains to cost of production.
• Basket consists of goods only.
• Capital and intermediate goods are included.
• Prices exclude VAT.
• Interest rates are excluded.
• Prices of imported goods are shown explicitly.

The main way in which inflation is measure are:
Changes in CPI; Changes in PPI; Changes in implicit GDP deflator

12.3.3 All-inclusive inflation

• Economists check what happened to prices of all final goods and services produced in a particular year.
• Use the calculated implicit GDP deflator.
• GDP figures at current and constant prices are used as published in the national accounts.
• GDP at constant prices measures economic growth and measures inflation.
• Measures the inflation rate for economy as a whole.
• Implicit GDP deflator is the ratio of GDP at current prices to GDP at constant prices.
• To determine inflation:     GDP deflator for next year     × 100.
                                      GDP deflator for previous year 

12.3.4 Hyperinflation

• Very high rate of inflation (more than 50%).
• Price levels rise so rapidly that people lose confidence in the value of money.
• Becomes difficult for the economy to operate.
• People resort to goods as medium of exchange – barter.

12.3.5 Stagflation
A low growth rate, high unemployment and high inflation rate.
12.3.6 Comparison of inflation rates

• Annual inflation rates of CPI, PPI and GDP deflation are provided.
• For policy purposes and forecasting all these indexes as well as other implicit deflators are considered.
• For the consumer the CPI is by far the most important indicator because it relates to their cost of living and the interest rate policy of the Reserve Bank.

12.4 The causes of inflation

Note that demand inflation is the same thing as demand-pull inflation. Cost inflation is the same thing as costpush inflation.
12.4.1 Demand-pull inflation
Demand-pull inflation occurs when aggregate demand in an economy outpaces (is faster than) aggregate supply, even though gross domestic product rises and unemployment falls. Effectively, too much money is spent chasing too few goods. Generally, an increase in the supply of demanded goods will reverse the inflationary trend. Some of the characteristics of demand-pull inflation are:

• Aggregate demand rises more than aggregate supply, causing an increase in the general price level.
• Groups that are responsible: Consumers, businesses and government.
• Foreigners’ contribution: They further increase the demand for our goods and services through an increase in exports.
• Relative increase in aggregate demand’s components: C (consumption spending), I (investment spending), G (government spending), M (cost of imports).
• Decline savings: if savings habits are changed and consumers start spending their current and accumulated savings, growth in aggregate demand can outstrip growth in aggregate supply
• Tax reduction: If personal income tax is reduced more money is available for private consumption expenditure.
• Access to credit: Ggreater availability of consumer credit (credit cards) and cheaper credit – credit multiplier kicks in and more credit is created.
• Figure 12.1 illustrates an increase in aggregate demand from AD1 to AD2 and a single aggregate supply AS1. As the aggregate demand increases, the price level and production output will also increase until full employment is reached. The initial increase in demand will have a positive influence on production, employment and income, but when full capacity is reached further increases in demand will lead to price increases.

Related Items

Causes of demand-pull inflation
There are many causes of demand-pull inflation.
Some of these are:

• Increase in household consumption: due to easily available credit, a reduction in taxes and less savings.
• Investors expenditure: may lead to higher profit expectations of businesses. They will invest more, this might lead to an increase in the demand for goods and services.
• Government expenditure: an increase in government spending leads to an increase in prices. More money comes into circulation due to an increase in spending on infrastructure, consumption spending and social spending.
• Export earnings: the growth in foreign countries might create an increased demand for locally produced goods without an increase in production.
• The Monetarist explanation: According to the monetarists sustained high rates of growth in the money supply cause high inflation, while low rates of growth cause low inflation. They base their view on the quantity theory of money (MV = PT). They make three basic assumptions: the velocity of circulation of money is stable; the quantity of money is exogenously determined by monetary authorities and real output is determined by the quantity and quality of various factors of production.

12.4.2 Cost-push inflation
Cost-push inflation is caused by an increase in the cost of goods or services that are very important to the economy, and for which no alternatives exist. Examples can be spikes in the oil price due to war, huge price rises in essential food products due to drought, or excessive increases in the cost of labour due to control of industries by trade unions. Some of the characteristics of cost-push inflation are:

• An increase in labour costs: Aggressive trade union negotiations push the price of labour up above the increase in productivity.
• Producers increase profits: Prices rise more than the rise in production costs.
• The state imposes a higher VAT rate.
• Expensive imported products (intermediate goods) cause an increase in the prices of locally finished goods.
• Lower productivity but the same remuneration: The cost of production increases.
• Natural disasters: Floods or droughts increase the cost of production.
• Increased total costs on the supply side.

Causes of cost-push inflation

• Wages: an increase in wages constitutes 50% of GVA at basic prices and is one of the major causes of cost-push inflation.
• Key inputs: When the prices of key input goods that are imported, increase, domestic cost of production increases especially in the manufacturing sector.
• Exchange rate depreciation: The depreciation in the rand will lead to more expensive imports.
• Profit margins: When businesses increase their profit margins, their cost of production and prices consumers must pay, will also increase.
• Productivity: Less productive factors of production will lead to increased cost per unit.
• Natural disasters: Prices will increase due to weather changes such as droughts, floods and global warming.

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Expectancy and inflation
The inflationary process is triggered by demand pull and cost push inflation.
The role of inflationary expectations:

• during inflation consumers expect prices to rice and start to buy more goods
• labour unions wish to protect their members’ income against erosion of purchasing power caused by inflation
• expectation that wages will rise encourages some businesses to increase prices in advance.

12.5 The consequences of inflation

• Debtors/Creditors: debtors benefit because they receive money with a high purchasing power and repay their debt with money with low purchasing power. Creditors on the other hand suffer.
• Wage and salary earners: people with a fixed income will be able to purchase less as prices are rising.
• Investors and savers: Assets with a fixed nominal value have a fixed return and lower purchasing power as prices increase. Real value of savings decreases.
• Tax payers: In South Africa income is taxed on a progressive system. We experience a bracket creep, resulting from inflation and progressive income tax and the government benefits.
• Disruption of industrial peace: Wage bargaining is accompanied by strikes and mass action.

SUMMARY: Monetary policy involves reducing money supply to combat inflation.

12.6 Measures to combat inflation

Policy makers can use various policy measures to fight inflation when it gets too high. Three types of policy measures are highlighted.
12.6.1 Fiscal measures
Fiscal measures are measures taken by the Minister of Finance regarding taxation and expenditure. Examples of measures that can be taken include:

• An increase in direct taxation (personal income tax) which will help to decrease demand.
• An increase in indirect taxation (VAT) causes spending to decrease because goods become more expensive.
• A loan levy. Reduces the disposable income of consumers.
• The state cuts back on expenditure by cancelling government projects like roads, hospitals and schools.
• The country’s finance budget deficit is non-inflationary (the government uses loans from the non-banking sector to limit inflation).
• The state imposes surcharges on imported goods. This increases the price of these imported goods, resulting in many people being unable to afford to buy these goods.
  SUMMARY: Fiscal policy makes use of tax increases and spending cuts to combat inflation.

12.6.2 Monetary measures
The South African Reserve Bank (SARB) and the government apply certain monetary measures to curb inflation:

• The SARB adjusts the quantity of money to the needs of the economy, (e.g. through open-market policy, thus maintaining a fine balance) between the supply of goods and services and money supply.
• The SARB curbs inflation caused by excess demand by reducing the money supply.
• The bank rate of the central bank (SARB) affects the interest rates in the economy (repo rate). The bank rate can be raised to encourage savings.
• Excessive credit can be reduced by restricting the granting of credit by banks.
• The SARB can apply moral pressure (moral suasion) on financial institutions to be more careful when granting credit.

12.6.3 Other measures
Additional measures that can be taken to combat inflation include:

• Increase productivity: This is a long-term measure generated through improved education and training which allows more people to be employed and ensures they are more productive.
• Price control: By fixing the price of certain essential goods, the government assures they remain affordable.
• Wage policy: The government takes a decision to break the inflationary spiral of increased wages and prices by keeping the increase in wages below or at the level of inflation.
• Stricter conditions for consumer credit: The government makes it harder for consumers to get credit in order to restrict their spending.
• Encourage personal savings: The government implements measures to encourage savings, e.g. by cutting taxes on savings. The imbalance between demand and supply is corrected by increased savings, as people save more and spend less.
• Import controls are relaxed.
• Floating exchange rate: Prices are automatically adjusted to international conditions.
• Indexation: A policy of linking prices of items such as wages, pensions and mortgage bond interest rates to price indices to eliminate the effects of inflation.

Use the following word acronyms to help you remember these additional measures to combat inflation:
W – Wage
I – Import
P – Productivity
E – Exchange rate

S – Savings
C – Credit
I – Indexation
P – Price

Activity 1
Study Figure 12.2 below and answer the questions that follow:

1. Define the concept inflation. (2)
2. When did the inflation rate peak? (2)
3. Do we adhere to the inflation target set by government from July 2010–Jan 2011? Supply figures. (4)
4. Explain what you would do to lower the inflation rate in our country? (4)
5. Which institutions in South Africa make inflation figures available? (2)
6. What, according to you, caused the double figures in April–July 2008? (4)
7. Why are these figures in the graph not a reflection of hyperinflation? (4)
   [22]

Activity 2
Study the cartoon below and answer the questions that follow:

1. What is the message behind the cartoon? (2)
2. What is happening to the purchasing power of the money? (2)
3. In which country is this woman a consumer? Motivate your answer. (4)
   [8]

Activity 3
Name any THREE fiscal measures to control inflation. (3 × 2) [6]