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1. SS2 ECONOMICS 3RD
TERM.
BY MRS JUDITH AKHIDENOR & MISS YVONNE IBRAHIM.

2. INFLATION AND DEFLATION
•
KEY TAKEAWAYS
•Inflation is an increase in the general prices of goods and
services in an economy.
•Deflation, conversely, is the general decline in prices for
goods and services, indicated by an inflation rate that falls
below zero percent.
Both can be potentially bad for the economy, depending on
the underlying reasons and the rate of price changes.

3. Inflation
Inflation is a quantitative measure of how quickly the
price of goods in an economy is increasing. Inflation is
caused when goods and services are in high demand,
thus creating a drop-in availability. Supplies can
decrease for many reasons; a natural disaster can
out a food crop, a housing boom can exhaust
supplies, etc. Whatever the reason, consumers are
willing to pay more for the items they want, causing
manufacturers and service providers to charge more.

4. Inflation can be defined as a general increase in the
prices of goods and services in an economy over
some period of time.

5. TYPES OF INFLATION
Creeping Inflation
Creeping or mild inflation is when prices rise 3% a year or
less. According to the Federal Reserve, when prices
increase 2% or less, it benefits economic growth. This
kind of mild inflation makes consumers expect that prices
will keep going up. That boosts demand. Consumers buy
now to beat higher future prices. That's how mild inflation
drives economic expansion. For that reason, the Fed sets
2% as its target inflation rate.

6. Walking Inflation
This strong, or destructive, inflation is between 3-10%
a year. It is harmful to the economy because it heats-
up economic growth too fast. People start to buy
more than they need to avoid tomorrow's much
higher prices. This increased buying drives demand
even further so that suppliers can't keep up. More
important, neither can wages. As a result, common
goods and services are priced out of the reach of
most people.

7. Galloping Inflation
When inflation rises to 10% or more, it wreaks
absolute havoc on the economy. Money loses value
so fast that business and employee income can't
keep up with costs and prices. Foreign investors
avoid the country, depriving it of needed capital. The
economy becomes unstable, and government
leaders lose credibility. Galloping inflation must be
prevented at all costs.

8. Hyperinflation
Hyperinflation is when prices skyrocket more than 50%
a month. It is very rare. In fact, most examples of
hyperinflation occur when governments print money to
pay for wars. Examples of hyperinflation include
Germany in the 1920s, Zimbabwe in the 2000s, and
Venezuela in the 2010s. The last time America
experienced hyperinflation was during its civil war.

9. STAGFLATION
Stagflation is when economic growth is stagnant,
there still is price inflation. This combination seems
contradictory, if not impossible. Why would prices
up when there isn't enough demand to stoke
economic growth?
It happened in the 1970s when the United States
abandoned the gold standard. Once the dollar's value
was no longer tied to gold, it plummeted.

10. At the same time, the price of gold skyrocketed.
Stagflation didn't end until Federal Reserve Chairman
Paul Volcker raised the fed funds rate to the double-
digits. He kept it there long enough to dispel
expectations of further inflation. Because it was such an
unusual situation, stagflation probably won't happen
again.

12. Causes of Inflation
Demand-Pull Effect
Demand-pull inflation occurs when the overall
demand for goods and services in an
increases more rapidly than the economy's
production capacity. It creates a demand-
gap with higher demand and lower supply,
which results in higher prices. For instance,
when the oil producing nations decide to cut
down on oil production, the supply diminishes.
It leads to higher demand, which results in
rises and contributes to inflation.

13. Additionally, an increase in money supply in an economy
also leads to inflation. With more money available to
individuals, positive consumer sentiment leads to higher
spending. This increases demand and leads to price rises.
Money supply can be increased by the monetary
authorities either by printing and giving away more
money to the individuals, or by devaluing (reducing the
value of) the currency. In all such cases of demand
increase, the money loses its purchasing power.

14. Cost-Push Effect
Cost-push inflation is a result of the increase in the
of production process inputs. Examples include an
increase in labor costs to manufacture a good or offer a
service or increase in the cost of raw material. These
developments lead to higher cost for the finished
product or service and contribute to inflation.

15. Built-In Inflation
Built-in inflation is the third cause that links to adaptive
expectations. As the price of goods and services rises,
labor expects and demands more costs/wages to
maintain their cost of living. Their increased wages
in higher cost of goods and services, and this wage-
spiral continues as one factor induces the other and
versa.

16. Theoretical, monetarism establishes the relation
between inflation and money supply of an
economy. For example, following the Spanish
conquest of the Aztec and Inca empires, massive
amounts of gold and especially silver flowed into
the Spanish and other European economies. Since
the money supply had rapidly increased, prices
spiked and the value of money fell, contributing to
economic collapse.

18. EFFECTS OF
INFLATION

19. (1) Government:
Inflation affects the government in various ways. It
helps the government in financing its activities
through inflationary finance. As the money incomes
of the people increase, government collects that in
the form of taxes on incomes and commodities. So
the revenues of the government increase during
rising prices.

20. Moreover, the real burden of the public debt
decreases when prices are rising. But the
government expenses also increase with rising
production costs of public projects and
enterprises and increase in administrative
expenses as prices and wages rise. On the whole,
the government gains under inflation because
rising wages and profits spread an illusion of
prosperity within the country.

21. (2) Balance of Payments:
Inflation involves the sacrificing of the
advantages of international specialisation and
division of labour. It affects adversely the
balance of payments of a country. When prices
rise more rapidly in the home country than in
foreign countries, domestic products become
costlier compared to foreign products.

22. This tends to increase imports and reduce
exports, thereby making the balance of
payments unfavourable for the country. This
happens only when the country follows a fixed
exchange rate policy. But there is no adverse
impact on the balance of payments if the
country is on the flexible exchange rate system.

23. (3) Exchange Rate:
When prices rise more rapidly in the home
country than in foreign countries, it lowers
the exchange rate in relation to foreign
currencies.

24. (4) Collapse of the Monetary System:
If hyperinflation persists and the value of
money continues to fall many times in a day,
it ultimately leads to the collapse of the
monetary system, as happened in Germany
after World War I.

25. (5) Social:
Inflation is socially harmful. By widening the gulf between
the rich and the poor, rising prices create discontentment
among the masses. Pressed by the rising cost of living,
workers resort to strikes which lead to loss in production.
Lured by profits, people resort to hoarding, black
marketing, adulteration, manufacture of substandard
commodities, speculation, etc. Corruption spreads in every
walk of life. All this reduces the efficiency of the economy.

26. (6) Political:
Rising prices also encourage agitations and protests
by political parties opposed to the government. And if
they gather momentum and become unhandy they
may bring the downfall of the government. Many
governments have been sacrificed at the altar of
inflation.

27. CONTROL OF
INFLATION

28. 1. Monetary Measures:
Monetary measures aim at reducing money incomes.
(a) Credit Control:
One of the important monetary measures is monetary
policy. The central bank of the country adopts a
number of methods to control the quantity and quality
of credit. For this purpose, it raises the bank rates, sells
securities in the open market,

29. Monetary policy may not be effective in
controlling inflation, if inflation is due to cost-
push factors. Monetary policy can only be
helpful in controlling inflation due to demand-
pull factors.
raises the reserve ratio, and adopts a number
of selective credit control measures, such as
raising margin requirements and regulating
consumer credit.

30. (b) Demonetisation of Currency:
However, one of the monetary measures is to
demonetise currency of higher denominations.
Such a measures is usually adopted when there is
abundance of black money in the country.

31. (c) Issue of New Currency:
The most extreme monetary measure is the issue of
new currency in place of the old currency. Under
this system, one new note is exchanged for a
number of notes of the old currency. The value of
bank deposits is also fixed accordingly.

32. Such a measure is adopted when there is an excessive
issue of notes and there is hyperinflation in the
country. It is a very effective measure. But is
inequitable for its hurts the small depositors the most.

33. 2. Fiscal Measures:
Monetary policy alone is incapable of controlling
inflation. It should, therefore, be supplemented by
fiscal measures. Fiscal measures are highly
effective for controlling government expenditure,
personal consumption expenditure, and private
and public investment.

34. (a) Reduction in Unnecessary Expenditure:
The government should reduce unnecessary
expenditure on non-development activities in order
to curb inflation. This will also put a check on
private expenditure which is dependent upon
government demand for goods and services. But it
is not easy to cut government expenditure.

35. Though this measure is always welcome
but it becomes difficult to distinguish
between essential and non-essential
expenditure. Therefore, this measure
should be supplemented by taxation.

36. (b) Increase in Taxes:
To cut personal consumption expenditure, the rates
of personal, corporate and commodity taxes should
be raised and even new taxes should be levied, but
the rates of taxes should not be so high as to
discourage saving, investment and production.
Rather, the tax system should provide larger
incentives to those who save, invest and produce
more.

37. Further, to bring more revenue into the tax-
net, the government should penalise the tax
evaders by imposing heavy fines. Such
measures are bound to be effective in
controlling inflation. To increase the supply
of goods within the country, the government
should reduce import duties and increase
export duties.

38. (c) Increase in Savings:
Another measure is to increase savings on the
part of the people. This will tend to reduce
disposable income with the people, and hence
personal consumption expenditure. But due to
the rising cost of living, people are not in a
position to save much voluntarily.

39. Keynes, therefore, advocated compulsory
savings or what he called ‘deferred
payment’ where the saver gets his money
back after some years. For this purpose, the
government should float public loans
carrying high rates of interest, start saving
schemes with prize money, or lottery for
long periods, etc.

40. It should also introduce compulsory provident
fund, provident fund-cum-pension schemes, etc.
All such measures increase savings and are likely
to be effective in controlling inflation.

41. (d) Surplus Budgets:
An important measure is to adopt anti-
inflationary budgetary policy. For this
purpose, the government should give
up deficit financing and instead have
surplus budgets. It means collecting
more in revenues and spending less.

42. (e) Public Debt:
At the same time, it should stop repayment of
public debt and postpone it to some future date
till inflationary pressures are controlled within
the economy. Instead, the government should
borrow more to reduce money supply with the
public.
Like monetary measures,

43. fiscal measures alone cannot help
in controlling inflation. They
should be supplemented by
monetary, non-monetary and non-
fiscal measures.

44. 3. Other Measures:
The other types of measures are
those which aim at increasing
aggregate supply and reducing
aggregate demand directly.

45. (a) To Increase Production:
The following measures should be
adopted to increase production:
(i) One of the foremost measures to control
inflation is to increase the production of
essential consumer goods like food, clothing,
kerosene oil, sugar, vegetable oils, etc.

46. (ii) If there is need, raw materials
for such products may be imported
on preferential basis to increase
the production of essential
commodities,

47. (iii) Efforts should also be made to
increase productivity. For this purpose,
industrial peace should be maintained
through agreements with trade unions,
binding them not to resort to strikes for
some time,

48. (iv) The policy of rationalisation of
industries should be adopted as a
long-term measure. Rationalisation
increases productivity and
production of industries through
the use of brain, brawn and bullion,

49. (v) All possible help in the form of latest
technology, raw materials, financial help,
subsidies, etc. should be provided to
different consumer goods sectors to
increase production.

50. (b) Rational Wage Policy:
Another important measure is to adopt a
rational wage and income policy. Under
hyperinflation, there is a wage-price
spiral. To control this, the government
should freeze wages, incomes, profits,
dividends, bonus, etc.

51. But such a drastic measure can only be
adopted for a short period as it is likely to
antagonise both workers and industrialists.
Therefore, the best course is to link increase
in wages to increase in productivity. This
will have a dual effect. It will control wages
and at the same time increase productivity,
and hence raise production of goods in the
economy.

52. (c) Price Control:
Price control and rationing is another
measure of direct control to check
inflation. Price control means fixing an
upper limit for the prices of essential
consumer goods. They are the maximum
prices fixed by law and anybody charging
more than these prices is punished by law.
But it is difficult to administer price
control.

53. (d) Rationing:
Rationing aims at distributing consumption
of scarce goods so as to make them available
to a large number of consumers. It is applied
to essential consumer goods such as wheat,
rice, sugar, kerosene oil, etc. It is meant to
stabilise the prices of necessaries and assure
distributive justice.

54. But it is very inconvenient for
consumers because it leads to queues,
artificial shortages, corruption and black
marketing. Keynes did not favour
rationing for it “involves a great deal of
waste, both of resources and of
employment.”

55. Deflation can lead to an economic recession or
depression, and the central banks usually work to stop
deflation as soon as it starts.
Deflation can be defined as the general decline in prices
for goods and services.
Deflation
Deflation occurs when too many goods are available or
when there is not enough money circulating to
purchase those goods. As a result, the price of goods
and services drops. For instance, if a particular type of
car becomes highly popular, other manufacturers start
to make a similar vehicle to compete. Soon, car
companies have more of that vehicle style than they can
sell, so they must drop the price to sell the cars.

56. Deflation is caused by a drop in demand. Fewer
shoppers mean businesses have to lower prices,
which can turn into a bidding war. It's also caused by
technology changes, such as more efficient computer
chips. Deflation can also be caused by exchange
rates. For example, China keeps its currency's value
low compared to the U.S. dollar. That allows it to
underprice U.S. manufacturers, lowering prices on its
exports to the United States.

57. Causes of deflation
Economists determine the two major
causes of deflation in an economy as
(1) fall in aggregate demand and (2)
increase in aggregate supply.
The fall in aggregate demand
a decline in the prices of goods and
services. Some factors leading to a
decline in aggregate demand are:

58. Fall in the money supply
A central bank may use a tighter monetary
policy by increasing interest rates. Thus,
people, instead of spending their money
immediately, prefer to save more of it. In
addition, increasing interest rates lead to
higher borrowing costs, which also
spending in the economy.

59. Decline in confidence
Negative events in the economy, such as recession,
may also cause a fall in aggregate demand. For
example, during a recession, people can become
more pessimistic about the future of the economy.
Subsequently, they prefer to increase their savings
and reduce current spending.

60. An increase in aggregate supply is another
trigger for deflation. Subsequently,
producers will face fiercer competition and
be forced to lower prices. The growth in
aggregate supply can be caused by the
following factors:

61. Lower production costs
A decline in price for key production inputs (e.g., oil)
will lower production costs. Producers will be able to
increase production output, which will lead to an
oversupply in the economy. If demand remains
unchanged, producers will need to lower their prices
on goods to keep people buying them.

62. Technological advances
Advances in technology or rapid application
of new technologies in production can cause
an increase in aggregate supply.
Technological advances will allow producers
to lower costs. Thus, the prices of products
will likely go down.

64. Effects of deflation
Frequently, deflation occurs during recessions. It is
considered an adverse economic event and can
cause many negative effects on the economy,
including:

65. Increase in unemployment
During deflation, the unemployment rate will rise.
Since price levels are decreasing, producers tend to
cut their costs by laying off their employees.

66. Deflation spiral
This is a situation where decreasing price levels
trigger a chain reaction that leads to lower
production, lower wages, decreased demand, and
even lower price levels. During a recession, the
deflation spiral is a significant economic challenge
because it further worsens the economic situation.

67. Increase in the real value of debt
Deflation is associated with an increase in interest
rates, which will cause an increase in the real value of
debt. As a result, consumers are likely to defer their
spending.

68. CONTROL OF
DEFLATION

69. 1. Monetary Policy:
To control deflation, the central bank can
increase the reserves of commercial
banks through a cheap money policy.
They can do so by buying securities and
reducing the interest rate. As a result,
their ability to extend credit facilities to
borrowers increases.

70. But the experience of the Great
Depression tells us that in a serious
depression when there is pessimism
among businessmen, the success of
such a policy is practically nil.

71. • In such a situation, banks are helpless in
bringing about a revival. Since business activity
is almost at a standstill, businessmen do not
have any inclination to borrow to build up
inventories even when the rate of interest is very
low. Rather, they want to reduce their
inventories by repaying loans already drawn
from the banks.

72. • Moreover, the question of borrowing for
long-term capital needs does not arise
during deflation when the business activity
is already at a very low level. The same is the
case with consumers who faced with
unemployment and reduced incomes do not
like to purchase any durable goods through
bank loans.

73. • Thus all that the banks can do is to make
credit available but they cannot force
businessmen and consumers to accept it. In
the 1930s, very low interest rates and the
piling up of unused reserves with the banks
did not have any significant impact on the
depressed economies of the world. Thus the
success of monetary policy in controlling
deflation is severely limited.

74. 2. Fiscal Policy:
Fiscal policy through increase in public
expenditure and reduction in taxes tends to raise
national income, employment, output, and
prices.

75. An increase in public expenditure during
deflation increases the aggregate demand for
goods and services and leads to a large
increase in income via the multiplier process,
while a reduction in taxes has the effect of
raising disposable income thereby increasing
consumption and investment expenditures of
the people.

76. • The government should increase its
expenditure through deficit budgeting and
reduction in taxes. The public expenditure
includes expenditure on such public works as
roads, canals, dams, parks, schools, hospitals
and other buildings, etc. and on such relief
measures as unemployment insurance,
pensions, etc.

77. • Expenditure on public works creates demand
for the products of private construction
industries and helps in reviving them while
expenditure on relief measures stimulates the
demand for consumer goods industries.
Reduction in such taxes as corporate profits
tax, income tax, and excise taxes tends to
leave more income for spending and
investment.

78. • Borrowing by the government to finance budget
deficits utilises idle money lying with banks and
financial institutions for investment purposes. But
the effectiveness of public expenditure primarily
depends upon the public works programme, its
importance in the economic system, the volume
and nature of public works and their planning and
timing.