Topic 5: Inflation and Deflation

1. Inflation

Inflation is a persistent rise in the general level of prices, which reduces the value (purchasing power) of money.

Types

• Demand-pull: total demand exceeds supply (too much money chasing too few goods).
• Cost-push: higher costs of production (wages, fuel, raw materials) raise prices.
• Imported inflation: rising prices of imported goods.
• Creeping, galloping and hyperinflation: slow, fast and extremely rapid price rises.

Causes

1. Excess money supply.
2. High government spending and deficit financing.
3. Rising wages and production costs.
4. Shortages (poor harvests, supply disruptions).
5. High import prices and a weaker currency.
6. High demand from credit expansion.

Effects

2. Controlling Inflation

a) Monetary Policy (Central Bank of Kenya)

• Raise the Central Bank Rate and interest rates.
• Increase the cash reserve ratio.
• Sell government securities to remove money from circulation.
• Restrict credit.

b) Fiscal Policy (Government)

• Increase taxes.
• Reduce government spending.
• Run a budget surplus.

c) Other Measures

• Price controls and subsidies.
• Increase production and supply.
• Control wage increases.
• Reduce imported inflation by stabilising the currency.

3. Deflation

Deflation is a sustained fall in the general price level.

Causes

• Reduced demand and money supply
• Increased production efficiency
• High interest rates and tight credit

Effects

• Reduced business profits
• Unemployment
• Delayed consumer spending
• Debts become harder to repay

Control

• Lower interest rates
• Reduce taxes
• Increase government spending
• Increase the money supply

4. Stagflation and Reflation

• Stagflation: high inflation with high unemployment and slow growth.
• Reflation: policies used to raise output and prices after deflation.