This document discusses various topics related to inflation including: 1. Definitions of inflation, real vs nominal GDP and interest rates, and different indices used to measure inflation like the GDP deflator, CPI, and PPI. 2. Causes of inflation including demand shocks, supply shocks, and increases in the money supply from a Keynesian and monetarist perspective. 3. Costs of inflation such as its impact on savers, wage-price spirals, arbitrary redistributions of income, and disruption to business planning.

1. 1
UNIT TWO: MODULE TWO, TOPIC ONE:
INFLATION
1. Inflation: general price level.
2. Real and money wages:
(a) real and nominal GDP;
(b) Real and nominal interest rate.
3. The GDP deflator; the retail price index; the
producer price index. Calculations and
limitations of the indices.
4. Demand shocks, supply shocks, increase in
the money supply growth rate.
5. The costs and benefits of inflation: the
impact of redistribution of wealth; impact of
business activity and growth, impact on the
balance of payments.
6. Income policy, monetary policy, fiscal
policy and supply side measures.
7. Trade-off between inflation and the rate of
unemployment: Phillips curve – stagflation.

2. 2
1)Definition of inflation:
Inflation is the general upward price movement of goods and
services in an economy. Over time, as the cost of goods and
services increase, the value of a dollar is going to fall because a
person won’t be able to purchase as much with that dollar as he/she
previously could.
General inflation is a fall in the market value or purchasing power
of money within an economy, as opposed to currency devaluation
which is the fall of the market value of a currency between
economies. General inflation is referred to as a rise in the general
level of prices.
There are several degrees of inflation to which it is categorized:
DEGREE OF INFLATION DESCRIPTION
1) Creeping inflation Going up slowly (<5%)
2) Trotting inflation Changes by approximately 10%.
When this occurs, there is need
for concern. Government puts
policies in place to control
inflation.
3) Galloping inflation This is where inflation jumps in
the 20% to 40% range.
4) Runaway inflation Almost hyper inflation.

3. 3
5) Hyper inflation Inflation exceeds 1000%. Money
loses its value so rapidly; nobody
wants to use it as a means of
exchange. E.g. Zimbabwe in the
2000’s.
2)Real and money wages: a) real and nominal GDP
Nominal GDP is calculating the GDP using current prices. This
means that each year’s GDP is calculated using that year’s prices.
E.g. 2008’s GDP is calculated with 2008’s prices. On the other hand,
real GDP is calculated using constant prices. For example, a base
year is chosen, 2008. From that year onward, each year’s GDP is
calculated using 2008’s prices. This method shows the true picture
of what is actually going on in the economy.
NOMINAL
GDP
YEAR QUANTITY PRICE GDP
2008 10 £2 £20
2009 10 £4 £40
Based on the graph above, there was a nominal change in
GDP. In 2008, GDP was £20 and in 2009, prices rose but quantity
produced remained the same. This resulted in a substantial increase
in nominal GDP. However, if real GDP used and the constant price
used was £2 and as shown below, the GDP didn’t actually increase.
REAL GDP YEAR QUANTITY PRICE GDP
2008 10 £2 £20
2009 10 £2 £20

4. 4
b) Real and Nominal interest rates:
What Is a Nominal Interest Rate?
The nominal interest rate is the actual percentage used to
calculate the interest that a financial product such as a savings
account or certificate of deposit will yield. For example, if a savings
account has an interest rate of 5 percent, then the money in that
savings account will grow by 5 percent per year.
What Is the Real Interest Rate?
The real interest rate is the nominal interest rate minus
inflation; if the nominal interest rate is 5 percent per year and
inflation is 3 percent per year, then the real interest rate will be 2
percent per year. This real interest rate is the actual increase in
buying power an investor gets after both the nominal interest rate
and inflation are taken into account.
______________________________________________________
3) The GDP deflator; the retail price index; the producer
price index. Calculations and limitations of the indices.
I) THE GDP DEFLATOR
This measure the level of newly domestically produced goods
and services in an economy compared to previous prices. It is
calculated using the following formula:
X 100 = GDP deflator.
Think of the price deflator as the ratio of the current year price
of a good to its price in some base year. The price in the base year

5. 5
is normalised to 100. A price deflator of 200 means that the
current-year price of the good is twice its base year price [price
inflation]. A price deflator of 50 means that the current year price
is half the base year price [price deflation].
II)Retail Price Index (RPI):
The Retail Price Index1
(RPI), commonly referred as the
Consumer Price Index (CPI), is an economic formula that measures
the increase or decrease in the price of goods. The retail price index
(RPI) is an inflation measurement used to determine the price
increase in a market basket of goods. The common name for this
formula is the Consumer Price Index (CPI) and is issued on a
monthly basis.
The procedure for calculating the RPI is given in the following steps:
 A base year is recorded and the prices of the basket items are
recorded.
 Following this first step, a weighting is then assigned to each
item in the basket which reflects its importance to the average
household.
 A price relative for each item is then determined. This is
governed by the formula:
Price relative: X 100
 The RPI is then found by the formula:
RPI:

6. 6
EXAMPLE OF THE RETAIL PRICE INDEX:
 Basket of goods and services: Food, transport, clothing,
housing.
 Base year prices (2009):
 Food - $20
 Transport - $25
 Clothing - $15
 Housing - $30
 Prices in 2010 changed to:
 Food -$25
 Transport -$30
 Clothing -$20
 Housing -$40
The RPI can now be calculated by using the given data:
BASKET ITEMS WEIGHTING PRICE
RELATIVE
WEIGHTINGS X
PRICE RELATIVE
FOOD .45 $25/$20 X 100= 125 56.25
TRANSPORT .20 $30/$25 X 100= 120 24.00
CLOTHING .05 $20/$15 X 100= 133 6.65
HOUSING .30 $40/$30 X 100= 133 39.90
TOTAL 1.0 126.8
RPI = 126.8

7. 7
Limitations of the Retail Price Index:
The retail price index is a thorough indicator of consumer price
inflation but there are some weaknesses in its usefulness for some
groups of people.
 It does not take into account the changes in taxes, health
care, consumer safety, crime levels, water quality, air quality,
and educational quality.
 It also sticks to the experiences of people living in the urban
area.
 Psychological behavioural patterns of the buyer are not
considered.
 The RPI is not fully representative: Since the RPI represents
the expenditure of the ‘average’ household; it may be
inaccurate for the ‘non-typical’ household. Single people have
different spending patterns from households that include
children, young from old, male from female, rich from poor
and minority groups. We all have our own ‘weighting’ for goods
and services that does not coincide with that assigned for the
retail price index.
 Housing costs: Housing costs vary greatly from person to
person, from the young house buyer, mortgaged to the hilt, to
the older householder who may have paid off his or her
mortgage.
 The determination of which items should be included in or
excluded from the basket of goods.

8. 8
 The determination of the weighting to be applied to each item
in the basket.
iii) Producer Price Index:
The Producer Price Index (PPI) is a weighted index of prices
measured at the wholesale, or producer level. ThePPI shows trends
within the wholesale markets (the PPI was once called the
Wholesale Price Index), manufacturing industries and commodities
markets. All of the physical goods-producing industries that make
up the U.S. economy are included, but imports are not.
The PPI release has three headline index figures, one each for
crude, intermediate and finished goods on the national level:
1. PPI Commodity Index (crude): This shows the average price
change from the previous month for commodities such as
energy, coal, crude oil and the steel scrap.
2. PPI Stage of Processing (SOP) Index (intermediate): Goods
here have been manufactured at some level but will be sold to
further manufacturers to create the finished good. Some
examples of SOP products are lumber, steel, cotton and diesel
fuel.
3. PPI Industry Index (finished): Final stage manufacturing, and
the source of the core PPI.
4) Causes of inflation:
a) Keynesian View - demand pull inflation (demand shock):

9. 9
Keynesians believe the level of real GDP depends on AD. If the
economy is at full employment then an increase in AD leads to an increase in
the price level (as shown below).
AD can increase due to an increase in any of its components C+I+G+(X-M).
The link between output and inflation suggests that there will be a similar link
between inflation and unemployment.
According to J.M Keynes, inflation can be caused by increase in
demand and/or increase in cost. Demand-pull inflation is a situation
where aggregate demand persistently exceeds aggregate supply
when the economy is near or at full employment. Aggregate
demand could rise because of several reasons:
 A cut in personal income tax would increase disposable income
and contribute to a rise in consumer expenditure.
 A reduction in the interest rate might encourage an increase in
investment as well as lead to greater consumer spending on
consumer durables.
 A rise in foreigners' income may lead to an increase in exports
of a country.
Demand-pull inflation is caused by excess demand, which can
originate from high exports, strong investment, rise in money
supply or government financing its spending by borrowing. If firms
are doing well, they will increase their demand for factors of
production. If the factor market is already facing full employment,

10. 10
input prices will rise. Firms may have to bid up wages to tempt
workers away from their existing jobs.
It is most likely that during full employment conditions, the rise
in wages will exceed any increase in productivity leading to higher
costs. Firms will pass the higher costs to consumers in the form of
higher prices. Workers will demand for higher wages and this will
add fuel to aggregate demand, which increases once again. The
process continues as prices in the product market and factor market
are being pulled upwards.
b) Cost Push Inflation (supply shock):
Cost push inflation occurs when firms increase prices to
maintain or protect profit margins after experiencing a rise in their
costs of production.There will be a shift to the left in the aggregate
supply (as shown below). This can be shown by an inward shift of
the short run aggregate supply curve which leads to a contraction in
aggregate demand and a fall in real output, but an increase in the
general price level.

11. 11
The main causes of cost push inflation are:
 Rising imported raw materials costs perhaps caused by
inflation in other countries or by a fall in the value of the TTD
in the foreign exchange markets.
 Rising labour costs - rising labour costs are caused by wage
increases, which are greater than productivity increases this, is
especially important in industries, which are labour-intensive.
 Higher indirect taxes imposed by the government - for
example a rise in the specific duty on alcohol and cigarettes,
an increase in fuel duties or a rise in the standard rate of Value
Added Tax. These taxes are levied on producers who,
depending on the price elasticity of demand and supply for
their products can opt to pass on the burden of the tax onto
consumers.
c) Monetarist Theory of Inflation:
Monetarist Theory
Monetarists argue that if the Money Supply rises faster than the rate of growth
of national income then there will be inflation.
· If money supply increases in line with inflation then there will be no inflation.
Milton Friedman stated:
“Inflation is always and everywhere a monetary phenomenon”
Quantity theory of Money (Fisher Version) MV=PT,
Where, M = Money Supply, V= Velocity of circulation, P= Price Level and T =
Transactions.
T is difficult to measure so it is often substituted for Y = National Income
Therefore MV = PY, where Y =national output.

12. 12
The above equation must hold the value of expenditure on goods and
services must equal the value of output. However, they argue it is
unwarranted increases in the money supply which cause inflation.Monetarists
believe that in the short term velocity (V) is fixed. This is because, the rate at
which money circulates is determined by institutional factors e.g. how often
workers are paid does not change very much.Milton Friedman admitted it may
vary a little but not very much so it can be treated as fixed. Monetarists also
believe Output Y is fixed. They state it may vary in the short run but not in the
long Run (because LRAS is inelastic). Therefore an increase in the Money
Supply will lead to an increase in inflation.
Monetarist inflation in the AD and AS model:
i) Following a rise in the MS, consumers have more money so spend more
goods, this shifts AD to the right
ii) Firms respond by increasing output along SRAS, from A to B
iii) National output now exceeds the equilibrium level of output; therefore there
is an inflationary gap.
iv) Firms need to hire more workers so wages rise leading to an increase in
costs and hence prices. Initially workers agree to work more hours because
they see an increase in nominal wages.
v) As prices rise money can buy less therefore there is a movement to the left
along the new AD.
vi) Also workers realize the increase in nominal wage is not a real wage
increase. Therefore, workers also demand higher nominal wages to produce
more output and to compensate them for rising prices, therefore SRAS shifts
to the left.
vii) The economy has returned to the equilibrium level of output, but at a
higher price level.
Therefore the rise in the Money Supply cause a rise in AD, But because the
LRAS is inelastic there is no increase in therefore this is known as demand
pull inflation.

13. 13
5) Consequences of inflation:
High and volatile inflation is widely seen by economists to have a range of
economic and social costs – hence the continued importance attached to the control
of inflationary pressure in an economy by both the government and also the central
bank.
Why does inflation matter?
The impact of inflation on individuals and businesses depends
in part on whether inflation is anticipated or unanticipated:
 Anticipated inflation: When people are able to make
accurate predictions of inflation, they can take steps to
protect themselves from its effects.
 Unanticipated inflation: When inflation is volatile from year
to year, it becomes difficult for individuals and businesses to
correctly predict the rate of inflation in the near future.
Unanticipated inflation occurs when economic agents (i.e.
people, businesses and governments) make errors in their
inflation forecasts.
5) The Main Costs of Inflation
i) Impact of Inflation on Savers:

14. 14
Inflation leads to a rise in the general price level so that
money loses its value. When inflation is high, people may lose
confidence in money as the real value of savings is severely
reduced. Savers will lose out if nominal interest rates are lower than
inflation – leading to negative real interest rates. For example a
saver might receive a 3% nominal rate of interest on his/her deposit
account, but if the annual rate of inflation is 5%, then the real rate
of interest on savings is -2%.
ii) Inflation Expectations and Wage Demands
Inflation can get out of control because price increases lead to
higher wage demands as people try to maintain their real living
standards. Businesses then increase prices to maintain profits and
higher prices then put further pressure on wages. This process is
known as a ‘wage-price spiral’. Rising inflation leads to a build-up
of inflation expectations that can worsen the trade-off between
unemployment and inflation.
iii) Arbitrary Re-Distributions of Income
Inflation tends to hurt those employees in jobs with poor
bargaining positions in the labour market - for example people in
low paid jobs with little or no trade union protection may see the
real value of their pay fall. Inflation can also favour borrowers at the
expense of savers as inflation erodes the real value of existing
debts. And, the rate of interest on loans may not cover the rate of
inflation. When the real rate of interest is negative, savers lose out
at the expense of borrowers.
iv) Business Planning and Investment
More generally, inflation can disrupt business planning.
Budgeting becomes difficult because of the uncertainty created by
rising inflation of both prices and costs - and this may reduce
planned capital investment spending. Lower investment then has a
detrimental effect on the economy’s long run growth potential
v) Competitiveness and Unemployment

15. 15
Inflation is a possible cause of higher unemployment in the
medium term if one country experiences a much higher rate of
inflation than another, leading to a loss of international
competitiveness and a subsequent worsening of their trade
performance. If inflation inTrinidad and Tobago is persistently above
their major trading partners, TT exporters may struggle to maintain
their share in overseas markets and import penetration into the TT
domestic market will grow. Both trends could lead to a worsening
balance of payments.
The Advantages of Inflation:
1. Business Growth
Controlled growth of Inflation can become part of business growth,
simply because savings are often invested, because of the net loss if
they are kept in a Bank.During times of controlled Inflation, people
in the past tended to spend, as they feared prices could rise, saving
on buying now, rather than paying more later.
2. Falling Debt Values
Higher Inflation eats away at the real value of a currency. This could
mean that the actual value of debts decrease, benefiting indebted
businesses and private individuals.
3. Higher Stock Values
Stocks bought at an earlier value, could rise in price and sold off at
a higher price bringing higher profitability.
4. Rising asset Values
Values of fixed assets could rise, making some Companies more
financially secure. Traditionally higher Inflation often leads to higher
prices; therefore fixed assets in theory should rise in value.

16. 16
6) Remedies for inflation: Income policy, monetary policy, fiscal policy
and supply side measures.
The control of inflation has become one of the dominant
objectives of government economic policy in many countries.
Effective policies to control inflation need to focus on the underlying
causes of inflation in the economy. For example if the main cause is
excess demand for goods and services, then government policy
should look to reduce the level of aggregate demand. If cost-push
inflation is the root cause, production costs need to be controlled for
the problem to be reduced.
i) Monetary Policy:
Monetary policy is a policy that influences the economy through
changes in the money supply and available credit. Monetary policy
is adopted by the Central Bank of Trinidad and Tobago. Monetary
policy can control the growth of demand through an increase in
interest rates and a contraction in the real money supply.
The effects of higher interest rates:
Higher interest rates reduce aggregate demand in three main ways;
• Discouraging borrowing by both households and companies.

17. 17
• Increasing the rate of saving (the opportunity cost of spending
has increased).
• The rise in mortgage interest payments will reduce homeowners'
real 'effective' disposable income and their ability to spend.
Increased mortgage costs will also reduce market demand in the
housing market.
• Business investment may also fall, as the cost of borrowing funds
will increase. Some planned investment projects will now become
unprofitable and, as a result, aggregate demand will fall.
• Higher interest rates could also be used to limit monetary
inflation. A rise in real interest rates should reduce the demand for
lending and therefore reduce the growth of broad money.
ii) Fiscal policy:
Fiscal policy is the deliberate change in either government
spending or taxes to stimulate or slow down the economy. It is the
budgetary policy of the government relating to taxes public
expenditure, public borrowing and deficit financing. Fiscal policy is
based upon demand management i.e. raising or lowering the level
of aggregate demand by controlling various expenditures,
government expenditure, consumption expenditure and investment
expenditure.
Higher direct taxes (causing a fall in disposable income)
Lower Government spending
A reduction in the amount the government sector borrows
each year
These fiscal policies increase the rate of leakages from the circular
flow and reduce injections into the circular flow of income and will
reduce demand pull inflation at the cost of slower growth and
unemployment.

18. 18
iii) Direct wage controls - incomes policies
Incomes policies (or direct wage controls) set limits on the rate of
growth of wages and have the potential to reduce cost inflation. The
Government tries to influence wage growth by restricting pay rises
in the public sector and by setting cash limits for the pay of public
sector employees.In the private sector the government may try
moral suasion to persuade firms and employees to exercise
moderation in wage negotiations. This is rarely sufficient on its own.
Wage inflation normally falls when the economy is heading into
recession and unemployment starts to rise. This causes greater job
insecurity and some workers may trade off lower pay claims for
some degree of employment protection.
Long-term policies to control inflation
i) Labour market reforms
The weakening of trade union power, the growth of part-time
and temporary working along with the expansion of flexible working
hours are all moves that have increased flexibility in the labour
market. If this does allow firms to control their labour costs it may
reduce cost push inflationary pressure.
ii) Supply-side reforms
If a greater output can be produced at a lower cost per unit,
then the economy can achieve sustained economic growth without
inflation. An increase in aggregate supply is often a key long term
objective of Government economic policy. In the diagram below we
see the benefits of an outward shift in the long run aggregate
supply curve. The equilibrium level of real national income increases
and the average price level remains relatively constant.

19. 19
Conclusion:
The key to controlling inflation in the long run is for the authorities to keep
control of aggregate demand (through fiscal and monetary policy) and at the same
time seek to achieve improvements to the supply side of the economy.
7) Phillips Curve:
The essence of the Phillips Curve is that there is a short-term trade-off
between unemployment and inflation.