economic environment unit4

THE UGANDA INSTITUTE

OF BANKING &

FINANCIAL SERVICES

UIBFS

ISO 9001:2008 CERTIFIED

Introduction to Basic Economic Theory and Concepts

The Banking Economic Systems

Pricing and Price Mechanism

Inflation

The Government and Economy

Types of Business Organizations

MODULE COVERAGE

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International Trade and Regional Groupings


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Definition of inflation• Inflation is the rate at which the general level of prices for goods

and services in an economy rises over a period of time andsubsequently, purchasing power falls. The overall general upwardprice movement of goods and services in an economy (often causedby an increase in the supply of money), usually as measured by theConsumer Price Index and the Producer Price Index.

• Inflation also reflects erosion in the purchasing power of money – aloss of real value in the internal medium of exchange and unit ofaccount in the economy. When the general price level rises, eachunit of currency buys fewer goods and services.

• Most frequently, the term "inflation" refers to a rise in a broad priceindex representing the overall price level for goods and services inthe economy. The Consumer Price Index (CPI), the PersonalConsumption Expenditures Price Index (PCEPI) and the GDP deflatorare some examples of broad price indices.

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Measures of Inflationi) Price indices or “Price indexes”A price index is a normalized average / a weighted average of prices for a given class of

goods or services in a given region, during a given interval of time. It is a statisticdesigned to help to compare how these prices, taken as a whole, differ betweentime periods or geographical locations.

Price indices have several potential uses. For particularly broad indices, the index canbe said to measure the economy's price level or a cost of living. More narrow priceindices can help producers with business plans and pricing. Sometimes, they canbe useful in helping to guide investment.Notable price indices include:• Consumer price index• Producer price index• GDP deflator• Commodity price index• Core price index

A consumer price index (CPI) measures changes in the price level of consumer goodsand services purchased by households. The CPI is a statistical estimate constructedusing the prices of a sample of representative items whose prices are collectedperiodically.

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To find the CPI, sub-indexes and sub-sub-indexes are computed for different categoriesand sub-categories of goods and services, being combined to produce the overallindex with weights reflecting their shares in the total of the consumerexpenditures covered by the index. It is one of several price indices calculated bymost national statistical agencies.

The annual percentage change in a CPI is used as a measure of inflation. A CPI can beused to index (i.e., adjust for the effect of inflation) the real value of wages,salaries, pensions, for regulating prices and for deflating monetary magnitudes toshow changes in real values.

Inflation is usually estimated by calculating the inflation rate of a price index, usuallythe Consumer Price Index. The Consumer Price Index measures prices of aselection of goods and services purchased by a "typical consumer". The inflationrate is the percentage rate of change of a price index over time.

Assuming the Consumer Price Index for Uganda in January 2007 quoted in dollars at202.416, and in January 2008 it was 211.080. The formula for calculating theannual percentage rate inflation in the CPI over the course of 2007 is

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ii) The GDP deflator• This is a measure of the level of prices of all new, domestically produced,

final goods and services in an economy. GDP stands for gross domesticproduct, the total value of all final goods and services produced withinthat economy during a specified period.

• Commodity price indices - These measure the price of a selection ofcommodities. In the present commodity price indices are weighted by therelative importance of the components to the "all in" cost of an employee.

• Core price indices - Generally, food and oil prices can change quickly dueto changes in supply and demand conditions in the food and oil markets, itcan be difficult to detect the long run trend in price levels when thoseprices are included. Therefore most statistical agencies also report ameasure of 'core inflation', which removes the most volatile components(such as food and oil) from a broad price index like the CPI.

• Because core inflation is less affected by short run supply and demandconditions in specific markets, central banks rely on it to better measurethe inflationary impact of current monetary policy.

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ii) Other economic concepts relatedto inflation include:

• deflation – a fall in the generalprice level;

• disinflation – a decrease in therate of inflation;

• hyperinflation – an out-of-controlinflationary spiral;

• stagflation – a combination ofinflation, slow economic growthand high unemployment;

• Reflation – an attempt to raisethe general level of prices tocounteract deflationarypressures.

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Causes of inflation:• Cost Push InflationCost-push inflation, that is, a rise in cost of production, such as, raw materials, causes

prices to rise. Since costs of production have risen, producers pass this burden onconsumers, by charging higher prices.

Higher indirect taxes imposed by the government – for example a rise in the rate ofexcise duty on alcohol and cigarettes, an increase in fuel duties or perhaps a rise inthe standard rate of Value Added Tax or an extension to the range of products towhich VAT is applied. These taxes are levied on producers (suppliers) who,depending on the price elasticity of demand and supply for their products, can optto pass on the burden of the tax onto consumers

• Demand pull inflationCaused by an increase in aggregate demand in this case, demand for all products rise,

causing the demand curve to shift upwards, hence increasing the general pricelevel.

• Imported inflationThis is when a country is importing materials from another country, in which inflation

is high.

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• Increase of money supply in an economy.It is a situation of too much money chasing too few goods, hence increasing the price

of goods. This could be due to an increase in demand due to increase ingovernment and private spending; decrease in supply due to increase in inputprices or increase in wages of workers resulting in higher prices by the employers.

Common factors that cause a rise or fall in the price of goods and services are:a) a change in the value or production costs of the good,b) a change in the price of money which then was usually a fluctuation in the

commodity price of the metallic content in the currency,c) Currency depreciation resulting from an increased supply of currency relative to

the other currencies.• Currency Depreciation is the decrease in the value of a currency with respect to

other currencies. This means that the depreciated currency is worth fewer units ofsome other currency. While depreciation means a reduction in value, it can beadvantageous as it makes exports in the depreciated currency less expensive. Forexample, suppose one unit of Currency A is worth one unit of Currency B. IfCurrency A depreciates such that it becomes worth half of one unite of Currency B,then exports denominated in Currency A are only half as expensive when tradingin a Currency B market.

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Effects of Inflation an economyThese can be positive and negative. Negative effects of inflation include a decrease in

the real value of money and other monetary items over time, uncertainty overfuture inflation may discourage investment and savings, and high inflation maylead to shortages of goods if consumers begin hoarding out of concern that priceswill increase in the future.

Positive effects include ensuring central banks can adjust nominal interest rates(intended to mitigate recessions), and encouraging investment in non-monetarycapital projects.

Economists generally agree that high rates of inflation and hyperinflation are causedby an excessive growth of the money supply. Views on which factors determinelow to moderate rates of inflation are more varied. Low or moderate inflation maybe attributed to fluctuations in real demand for goods and services, or changes inavailable supplies such as during scarcities, as well as to growth in the moneysupply. However, the consensus view is that a long sustained period of inflation iscaused by money supply growing faster than the rate of economic growth.

Today, most mainstream economists favor a low, steady rate of inflation. Low (asopposed to zero or negative) inflation may reduce the severity of economicrecessions by enabling the labor market to adjust more quickly in a downturn, andreduce the risk that a liquidity trap prevents monetary policy from stabilizing theeconomy.

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Controlling Inflation:• Monetary policyThis is the primary tool for controlling inflation. Most central banks are tasked with

keeping their funds lending rate at a low level; normally to a target rate around 2%to 3% per annum, and within a targeted low inflation range, somewhere fromabout 2% to 6% per annum.

A low positive inflation is usually targeted, as deflationary conditions are seen asdangerous for the health of the economy.

High interest rates and slow growth of the money supply are the traditional waysthrough which central banks fight or prevent inflation, though they have differentapproaches.

Monetarists emphasize keeping the growth rate of money steady, and using monetarypolicy to control inflation (increasing interest rates, slowing the rise in the moneysupply).

Keynesians emphasize reducing aggregate demand during economic expansions andincreasing demand during recessions to keep inflation stable. Control of aggregatedemand can be achieved using both monetary policy and fiscal policy (increasedtaxation or reduced government spending to reduce demand).

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Examples of monetary policies to control inflation are:1. Central Bank selling high yielding Treasury Bills to “mop-up liquidity”2. Increase in the base lending rates by the Central bank, which causes

commercial banks to also raise their lending rates, thus loweringborrowing and overall money supply in the economy

3. Raising reserve requirements of commercial banks at the Central bank• Fiscal policyThese fiscal policies reduce injections into the circular flow of income and will

reduce demand pull inflation at the cost of slower growth andunemployment. Examples of fiscal policies to control inflation are:

1. Higher direct taxes (causing a fall in disposable income)2. Lower Government spending3. A reduction in the amount the government borrows each year

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economic environment unit4

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