UNIT 7 INFLATION UNIT 7 INFLATION Learning Objectives

UNIT 7 INFLATION

UNIT 7: INFLATION Learning Objectives � Distinguish between inflation, disinflation and deflation with the help of a numerical example. � Distinguish two indices of inflation: the CPI and the GDP deflator. � Assess their effectiveness in measuring cost of living and production cost accurately. � Describe the positive relationship between the two indices. � Distinguish between demand pulled and cost pushed inflation and explain how they are generated. � Compare and contrast how these two types of inflation affect the economy using the income identity AD = C + I + G + X – M. � Suggest practical ways by which the adverse effects of inflation can be reduced in the construction sector. � Analyze the effect of inflation on interest by distinguishing between the concepts of actual and expected inflation. �

INFLATION Inflation is defined as a sustained increase in the general (average) price level.

The consumer price index �The consumer price index or CPI measures the average level of the goods and services consumed by an urban family. �Inflation rate = CPI this year – CPI last year/CPI last year x 100 �Q Why is the CPI also known as cost of living index? �Q Is the CPI an accurate measure of the changes in the cost of living? Explain.

Causes of Inflation �DEMAND PULL �COST PUSH

Demand Pull Inflation �Excessive demand causes the price level (inflation) to rise. Consider the following: AD = C + I + G + X – M �Examples :

Diagram showing Demand Pull Inflation

Cost push inflation �Excessive increases in production costs push up the price level (inflation). �The major production costs are: wages, rent, raw materials and energy.

Diagram showing cost push inflation

Impact of inflation on borrowers and lenders Nominal interest rate = real interest + expected inflation rate. For the borrowers: For the lenders:

Assignment and Review �Q Consider the following: nominal interest rate = real interest + expected inflation rate. � If inflation is corrected predicted, what is the relationship between actual and expected inflation? Who gain: the bank or your firm? Use numerical values to illustrate. � Q If inflation is under predicted, what is the relationship between actual and expected inflation? Who gain: the bank or your firm? � Q If inflation is over predicted, what is the relationship between actual and expected inflation? Who gain: the bank or your firm?