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Inflation denotes a rise in the general level of prices.  The rate of inflation is the rate of change of the general price level and is measured as follows.
 
Rate of inflation (year t)
 
Price level (year t) - Price level (year t - 1) x 100
               Price level (year t - 1)
 
Price level is known as the consumer price index (CPI).
If year t is 2003, then year t - 1 is 2002.
How?  2003 - 1 = 2002.
 
A simplified formula to calculate the rate of inflation is as follows:
 
CPI(year 2) - CPI (year 1) x 100
               CPI (year 1)
 
CPI - Consumer Price Index
Year 2 - current year
Year 1 - previous year or base year.
 
The Consumer Price Index is the mose widely used measure of inflation.  The CPI measures the cost of buying a standard basket of goods at different times.  The market basket includes prices of food, clothing, shelter, fuels, transportation, medical care, college fees, and other goods and services purchased for day-to-day living.
 
There are three categories of inflation:(1) Moderate Inflation is characterized by prices that rise slowly and predictably.  We might define this as single-digit annual inflation rates.  When prices are relatively stable, people trust money.  They are willing to hold on to money because it will be almost as valuable in a month or a year as it is today.  People are willing to write long-term contracts in money terms because they are confident that the prices and costs of the goods they buy and sell will not get too far out of line. (2) Galloping Inflation is inflation in the double-or triple-digit range of 10, 100, or 300 percent a year. Many Latin American countries, such as Argentina and Brazil, had inflation rates of 50 to 700 percent per year in the 1970s and 1980s.  (3) Hyperinflation is a condition where prices are rising a million or even a trillion percent per year.  It has disastrous impacts.  The most thoroughly documented case of hyperinflation took place in the Weimar Republic of Germany in the 1920s.  From January 1922 to November 1923, the price index rose from 1 to 10,000,000,000.  If a person had owned $300 million in cash in early 1922, this amount would not have bought a piece of candy 2 years later!
 
Demand-Pull Inflation occurs when aggregate demand rises more rapidly than the economy's productive potential, pulling prices up to equilibrate aggregate supply and demand.  Simply put, demand is higher than supply thus pushing prices up.  In effect, demand ringgits are competing for the limited supply of commodities and bid up their prices.  As unemployment falls and workers become scarce, wages are bid up and the inflationary process accelerates. Cost-Push Inflation is inflation resulting from rising costs during periods of high unemployment and slack resource utilization.  Prices today travel a one-way street - up in recessions, up faster in booms.  And this is true for all the market economies of the world.  Prices and wages begin to rise before full employment is reached.  They rise even when 30 percent of factory capacity lies idle and 10 percent of the labour force is unemployed!  Expectations and Inertial Inflation--Most prices and wages are set with an eye to future economic conditions.  When prices and wages are rising rapidly and are expected to continue doing so, businesses and workers tend to build the rapid rate of inflation into their price and wage decisions.  High or low inflation expectation tend to be self-fulfilling prophecies (what we expect will indeed become a reality)
 
Effects of Inflation.  
Gainers:
Entrepreneurs--When goods are sold at higher prices, entrepreneurs make more profits.Debtors--the purchasing power of money will fall by the time they pay back their loans, so they gain.  For example, if you borrow RM100 from a friend today and promised to pay her next year at exacly the same amount, then you gain because the RM100 today can buy more than the same RM100 next year.  Property owners--the prices of property will increase in times of inflation and will benefit the owners.  Rental rates are also high during inflationary periods. Stockholders--the companies they invest in make more profits and they will in turn earn higher returns in the form of dividends.
 
Losers:
Creditors--they receive the same amount as borrowed by debtors but at the lower value (that is, at a lower purchasing power).  If your friend pays you back the RM100 she borrowed last year, the amount you can buy with the returned money is much less than the amount you can buy had you spent it last year.  Wage Earners--during inflationary times, the real value of income fall.  Usually the rate of increase in income for this group is lower than the rate of inflation.  For instance, if you earn RM1000 a month with a 10% increment each year, you will stand to lose if inflation rate is more than 10% a year.  Pensioners/fixed income earners--for these people, their income are almost fixed and if prices go up, they are badly affected.  With inflation, their real income falls.  Savers--if you save your money in the bank, and usually with very low interest rate, you will stand to lose if price level goes up.  Let's say thay you kept RM100,000 in the bank a year ago and this amount is enough for you to buy a nice house in Kuantan, but you decided not to buy the house yet.  With an interest rate of say 5%, the money you kept in the bank now amounts to RM105,000.  This year you decided to buy the house so you withdrew all your money and met the same person who wanted to sell the house to you last year.  The house is now sold at RM120,000!  You lose.
 
EXTRA NOTES ON INFLATION
Cost-Push Inflation vs. Demand-Pull Inflation
 

What are Cost-Push Inflation and Demand-Pull Inflation?

Inflation is caused by a combination of four factors. Those factors are:

  • The supply of money goes up.
  • The supply of goods goes down.
  • Demand for money goes down.
  • Demand for goods goes up.
Let's look at the definition of cost-push and demand-pull inflation and see if we can understand them using our four factors.

Definition of Cost-Push Inflation:  Inflation can result from a decrease in aggregate supply. The two main sources of decrease in aggregate supply are

  • An increase in wage rates
  • An increase in the prices of raw materials
These sources of a decrease in aggregate supply operate by increasing costs, and the resulting inflation is called cost-push inflation

Other things remaining the same, the higher the cost of production, the smaller is the amount produced. At a given price level, rising wage rates or rising prices of raw materials such as oil lead firms to decrease the quantity of labor employed and to cut production.

Aggregate Supply is the "the total value of the goods and services produced in a country" or simply, "The supply of goods". 

Of course, the next question would be "What caused the price of inputs to rise?". Any combinations of the four factors could cause that, but the two most likely are (1) Raw materials such as oil have become more scarce, or (2) The demand for raw materials and labor have risen

Definition of Demand-Pull Inflation: The inflation resulting from an increase in aggregate demand is called demand-pull inflation.  Inflation caused by an increase in aggregate demand is inflation caused by an increase in the demand for goods. The three most likely causes of an increase in aggregate demand will also tend to increase inflation:

  1. Increases in the money supply.
  2. Increases in government purchases .
  3. Increases in the price level in the rest of the world.  If the price of rice rises in Thailand, we should expect to see less Malaysians buy rice from the Thais and more Thais purchase the cheaper rice from Malaysian sources. From the Malaysian perspective the demand for rice has risen causing a price rise in rice.