Inflation - Business Studies Form 4 Notes

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  • Inflation is a situation where the general prices of goods and services in a particular country or region are rising. The opposite of inflation is deflation which refers to a situation where the general prices of goods and services to fall.
  • Inflation is measured using a consumer price index.

Consumer Price Index (C.P.I)

  • Consumer price index measures and allows comparison of prices of goods and services for two different periods.
  • It also measures the changes in the purchasing power of the consumers in the said periods.

Factors To Consider When Constructing The Consumer Price Index

  1. Selection of commodities
    - Commodities selected are those that are generally consumed by average consumers. This is because these commodities are more representative of the state of the economy
  2. Selection of the base year
    - The year selected for the base year should be a year when the prices were fairly stable.
  3. Determination of Average prices
    - In computing price index, the average of relative prices of the commodities need to be computed. Simple average may be calculated by adding the indices for all the commodities and then dividing y the number of the commodities. The index for each commodity is calculated by diving the current year‟s price with the base year's price and multiplying by 100.
    Thus, index of current year = p1/po × 100
    Where; p1 = price in the current year
    po = price in the base year

    commodities  Price per unit base year (21 – 0 ) Index of base year Price in current year (21 – 4 ) Index in current year
      Sh   Sh  
    Bread 16 100 20 125
    Sugar 40 100 60 150
    Salt 10 100 12 120
    Average = 500/5
    = 100
      Average = 720/5
    - Comparison of the consumer price index of the year 21 – 0 and that of the year 21-4 indicates that the purchasing power of sh.144 in the year 21-4 is the same as the purchasing power of sh.100 in the year 21- 0.
    - This means that the standard of living went down by 44% between the year 21 – 0 and year 21-4.

Types of Inflation

  1. Moderate/creeping/mild inflation
    - The general prices of commodities increases slowly. The percentage increase is usually less than 10.
  2. Galloping inflation/rapid inflation
    - The general price levels increases rapididy.The percentage rate of increase is in terms of tens or hundreds.
  3. Hyper- inflation/runaway inflation
    - The rise in price levels are extremely high. In this situation the inflation rates can be in thousands or even in millions per cent per annum

Causes of Inflation

Demand Pull Inflation

- This type of inflation is caused by excessive demand for goods and services leading to increase of prices.

  1. Increase in government expenditure
    - When the government spend more money it had borrowed from central bank or printed it increases the supply of money in the economy leading to increase in aggregate demand which may led to upward pressure on the prices of goods and services.
  2. Effects of credit creation
    - When commercial banks lend more money than the deposit they hold they increases the supply of money which leads to consumers purchasing ability. This increases consumer‟s ability to purchases more goods and services eventually leading to inflation
  3. Increase in money income
    - When money income increases, purchasing power will increase and this will have upward pressure on prices as the demand for goods and services increases
  4. General shortages of goods and services
    - If there is shortage of commodities supplied the demand will be high causing demand pull inflation because the demand pulls the prices of the commodities upwards.

Factors Causing Shortages Of Commodities

  • Adverse climatic conditions
  • Hoarding
  • Smuggling
  • Withdrawal of firms from the industry
  • Decline in level of technology

Cost – Push Inflation

- It is caused by an increase in the total production cost of goods and services leading to increase in prices of the commodities.

  1. Rise in wages and salary
    - An increase in wages and salaries which will be reflected in the increased prices of commodities, which will in turn cause inflation
  2. Increase in taxes
    - Increase in indirect taxes (e.g. VAT), can increase the cost of production which make firms to increase their prices.
  3. Increase in profit margin
    - Increase in profit margins by management and shareholders leading to an increase in prices. This is possible where there is no price control.
  4. Increase in cost of inputs other than labor.
    - Increase in cost of inputs (e.g. raw material) causes the price of finished goods to be high.
    - These inputs can either locally available or imported.
  5. Reduction in subsidies
    - Reduction in subsidies also lead to an increase in cost of production which will be reflected in an increase in the price of the commodities.

Effects of Inflation

- The effects can be divided onto;

  • Negative
  • Positive

Negative Effects of Inflation

  1. Loss of confidence in the monetary system
    - People lose confidence in local currency as it‟s difficult to use in transaction when it loses value very fast.
  2. Retardation of economic growth
    - Hinders implementation of development plans since the cost of projects increases, business people are also not willing to either take risks, invest in new ventures, expand production or hire more workers .This leads to retardation in economic growth.
  3. Reduction in profit
    - Rise in prices of commodities may lead to reduced sales volume for firms. This in turn may reduce the firm‟s profits.
  4. Wastage of time
    - During inflation individuals and firms waste a lot of time hopping around for reasonable prices. The time wasted can be an extra cost to the firm or individual.
  5. Increase in wages and salaries
    - During inflation firms are always forced by trade unions to raise employees‟ salaries to cope with inflation. This normally leads to conflict between the parties concerned.
  6. Decline in standards of living
    - During inflation consumers' purchasing power decreases especially for people who earn fixed income such as pensioners. The reduction in purchasing power bring about a decrease in standards of living.
  7. Loss to creditors
    - Creditors lose money when they lend out when the value is high but got paid when the value is less due to inflation.
  8. Discourages savings
    - Discourages savings/investments since people fear their money will loose value/as they have less disposable incomes.
  9. Adverse effects on the balance of payments.
    - Leads to balance of payment deficits as imports are highly demanded than exports because the exports are very expensive leading to fall in demand.
  10. Loss of confidence in the monetary system
    - High levels of inflation may lead to loss of confidence in money both as a medium of exchange and store of value. This may lead to collapse of the momentary system.

Positive Effects of Inflation

  1. Benefits to Debtors
     - Debtors will end up paying less in real terms. This is because the debtor end up paying for the old price of the commodity in the future after it would have increased.
  2. Benefit to sellers
    - Sellers will buy commodities at low prices and sell them later when the prices are high making more profits
  3. Motivation to work
    - People may be motivated to work harder to cope up with effects of inflation as the prices of the commodities goes up.
  4. Increased job opportunities
    - Inflation may cause increased job opportunities due to high level of resource use to cope up with inflation.

Controlling Inflation

  • Control of money supply
    - The government should ensure that increase in money is matched with supply of goods and services. The supply of money can be controlled by monetary policies carried out by the central bank which include:
    • Increasing commercial banks‟ lending interest
    • Restricting lending capacity by commercial banks
    • Selling of government properties through open market operations
    • Controlling the public sector
  • Control of the level of demand
    - Demand pull inflation can be controlled by reducing the level of demand in an economy as a whole. This is achieved by the following fiscal policies:
    • Change in taxation e.g. increase in tax such as income tax would reduce consumer demand for goods and services.
    • Reducing government spending. This will restrict the amount of money in circulation reducing demand for commodities.
    • Restricting terms of hire purchase and credit terms of sale. This will reduce demand for goods and services.
  • Cost controls
    - Cost push inflation can be controlled by controlling the factors that contribute to rise in costs. These factors include:
    • Increase in wages and salaries
      - To curb inflation brought by increase in wages and salaries the government may restrict the increase.
    • Reducing taxes
      - Taxes such as VAT are believed to be the cause of cost –push inflation, the government can reduce such taxes in order to control inflation.
    • Restricting imports
      - Where inflation is caused by increase in prices of imports, the importing country can control the inflation by reducing the of such imports.

Past KCSE Questions on the Topic

Paper 1

  1. A country‟s domestic currency has been depreciating over time highlight five disadvantages of this to the country
  2. State four negative effect of inflation to a country
  3. State any four causes of demand-pull inflation
  4. State four non-monetary methods of controlling inflation in a country
  5. Mention four desirable effects if inflation
  6. Highlight four negative effects of inflation in Kenya
  7. Highlight four negative effects of inflation in Kenya

Paper 2

  1. Explain five negative effects of inflation to an economy
  2. Explain five positive inflation effects of inflation to the economy.
  3. Explain five causes of inflation in an economy
  4. Write short notes on the following strains of inflation;
    1. Mild inflation
    2. Hyper inflation
    3. Demand-pull inflation
    4. Cost push inflation
    5. Imported inflation
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