A month or so ago one of our readers posed a number of economics-related questions, and asked if we would consider them as the subject of an article.  Ever willing to oblige, this month we present an introduction to the thorny problem of inflation.  In the interests of clarity we will take a rather broad-brush approach to the theory, rather than bore you with too much nit-picking theory and detail.

In the long run, inflation is essentially a monetary phenomenon.  It occurs if the amount of money circulating in the economy grows faster than the gross domestic product (GDP – the market value of the final goods and services produced within a country in a given period - usually a year).  There are essentially two sources of inflation:
•    Demand-pull inflation
•    Cost-push inflation

Demand-pull inflation

In the case of demand-pull inflation, inflation starts if the aggregate (total) demand for goods and services increases.   An increase in demand can be triggered off by any of the factors that increase aggregate demand, such as a cut in the interest rate, an increase in the quantity of money in circulation (which central banks can achieve in various ways other than interest rate cuts), an increase in exports, or an increase in investment triggered off by an increase in expected profits.  Each of these puts more money into the hands of consumers, and as they spend more you have a short-term situation of “too much money chasing too few goods.”  As a result, the price of those goods increases.

If you were a property owner in South Africa some years back, when interest rates were cut steadily over a period of months, you will know what that did to the price of your home.  As interest rates fell people could suddenly afford bigger, more expensive homes for the same monthly bond payment.  As a result a lot of people upgraded their homes, but the sudden increase in demand for these homes quickly drove the price up.

A once-off increase in the money supply can stimulate demand and increase prices, but this is not inflation.  For inflation to begin there must be a persistent increase in aggregate demand.

To better understand the demand-pull inflationary cycle, let us consider the example of a small beer-bottling plant in Cape Town.  Initially, as aggregate demand increases (for one of the reasons mentioned earlier), the demand for beer rises and the price of beer rises as well.  (The price rises due to the law of supply and demand – if the supply of a product is limited and demand rises, people are prepared to pay more for the product.  In the same way, if demand for the product falls while supply remains the same, prices of the product will fall).

As a result of the higher (demand-driven) beer price, the bottling plant works overtime and increases production.  Things are good for workers in the beer industry, and the plant finds that some of its best people are leaving to go to other bottling plants for more money.  So to hang on to its people the plant increases their wages.  A rise in the wage rate, however, has the effect of increasing the plant’s total production costs.

What happens next depends on aggregate demand.  If aggregate demand remains constant, the firm’s costs increase but the price of beer does not increase as quickly as its costs.  As a result the plant cuts back on production (by working less or no overtime, for instance).  Eventually, the percentage increase in the wage rate is equal to the percentage increase in the price of beer.  So, in real terms, the bottling plant is in the same position as it was before the increase in demand – it produces the same amount of beer, and employs the same number of workers.

However, if aggregate demand continues to increase, so does the demand for beer.  The price of beer then rises at the same rate as the wages of the workers, and the factory continues to operate at above its “full employment” level.  Shortages of labour occur (as a result of the demand for the limited pool of skilled workers in the beer industry), and prices and wages chase each other in an upward demand-pull inflation spiral.

Cost-push inflation

An inflation that is triggered by an increase in costs is called cost-push inflation.  The two main sources of cost-push inflation are an increase in the wage rate, or an increase in the prices of raw materials.  Let us take the example of an increase in raw material prices, and see what the effect is on our Cape Town beer bottling plant.
Let us say that hops producers suddenly increase the price of their products.  This has the effect of increasing the cost of bottled beer.  To cut back on total production costs the plant buys fewer hops, and therefore produces less beer.  As a result it has to lay off some of its workers.

If the increase in the price of hops is a once-off event it is known as a supply shock, and on its own cannot cause inflation.  For a supply shock to be converted into a process of ongoing inflation, the quantity of money circulating in the economy must persistently increase.  This sometimes happens, for the following reason:
When real GDP decreases, unemployment levels rise.  This often puts pressure on the government, and so to stimulate the economy the Reserve Bank may cut interest rates.  This increases the amount of money in circulation, and aggregate demand duly increases as well.  Employment levels rise again, but so does the price of beer (as explained in the demand-pull example).

An increase in prices generally could cause the hops producers to increase the price of their product again, which could lead to lower demand for hops and unemployment in the beer industry, which in turn could lead to further money creation by the Reserve Bank....So, if the government keeps responding to cost increases (and increased unemployment) by increasing the money supply, an inflationary spiral will be triggered.  However, if it does not, unemployment levels will rise.

Forecasting inflation

If economists expect inflation and can accurately forecast the annual inflation rate, an inflationary spiral will not kick in.  This is because aggregate demand will increase by the expected rate, but so will the percentage increase in the wage rate, because wage increases will be limited to the forecast inflation rate.  So, in real terms, firms will be in the same position as before, and employment levels will neither increase nor decrease.  (This is the same position as occurred in the demand-pull scenario after a once-off increase in demand).

Inflation management is essential in a well-run economy.  The effects of inflation in a poorly-run economy, on the other hand, can be horrendous. We have only to look north, to Zimbabwe, to see what has occurred as a result of the reckless expansion of the money supply.  The bankrupt Zimbabwean government has increased the money supply by literally printing more bank notes, even as their GDP is shrinking.

As a result Zimbabwe is experiencing the greatest hyperinflation in world history, with an inflation rate estimated at a mind-boggling 231 million percent per year in 2008. To translate this into more practical terms, a cup of coffee that cost $3 in Zimbabwe in January would sell for $10 in February, $117 in April and $4,560 in July!

Inflation is a very real phenomenon, and along with economic growth and full employment, low inflation rates remain one of governments’ prime economic objectives.