Inflation: meaning, measurement and causes

In 2022 and 2023 Sierra Leone's shoppers watched the prices of rice, fuel and transport climb month after month, as the leone fell and world food and fuel prices rose. A general, continuous rise in prices is inflation. This lesson explains how it is measured and what causes it.

Learning objectives

By the end of this lesson you should be able to:

• define inflation and describe its types by speed
• construct a simple consumer price index and calculate the rate of inflation
• explain demand-pull, cost-push, imported and monetary causes of inflation
• show demand-pull and cost-push inflation on a diagram

What is inflation?

A rise in the price of one good (say, tomatoes in the dry season) is not inflation. Inflation means prices in general keep rising.

Types by speed:

Measuring inflation: the consumer price index

A price index shows the average change in prices of a "basket" of goods and services compared with a base year (index = 100). Each item gets a weight showing its importance in household spending.

where $I_1$ is this year's price index and $I_0$ is last year's.

If the index rises from 124 to 136.4, inflation $= \dfrac{12.4}{124} \times 100 = 10\%$.

In Sierra Leone the consumer price index is compiled by Statistics Sierra Leone (Stats SL).

Uses of price indices: measuring inflation; adjusting wages and pensions; finding real income and real GDP; guiding monetary policy.

Limitations: the basket may not match every household's spending; weights go out of date; quality changes are hard to measure; and price collection in markets can be inaccurate.

Causes of inflation

1. Demand-pull inflation

Causes: increased government spending (especially financed by borrowing from the central bank); rapid growth of bank credit; rising incomes and wages; a big increase in exports or remittances; a rapid rise in population.

2. Cost-push inflation

Causes: wage increases above productivity (often won by trade unions); higher fuel and transport costs; dearer imported raw materials; higher indirect taxes; higher interest rates on business loans.

Figure 1. Demand-pull inflation (left) and cost-push inflation (right). WASSCE Tutor diagram.

3. Imported inflation

When a country imports much of its food, fuel and manufactured goods, a rise in world prices or a fall in its own currency raises prices at home. Sierra Leone imports most of its fuel and much of its rice, so a weaker leone quickly pushes up local prices.

4. Monetary causes

An excessive increase in the money supply, for example when the government finances its deficit by borrowing from the central bank, raises spending and prices (see $MV = PT$ in Money and Banking).

5. Structural causes

In developing countries, bottlenecks such as poor roads, low farm output, power shortages and hoarding by traders mean supply cannot keep up with demand.

Key points

• Inflation is a persistent rise in the general price level and a fall in the value of money.
• Types by speed: creeping, walking, galloping, hyperinflation.
• A price index uses a weighted basket and a base year; inflation is the percentage change in the index.
• Causes: demand-pull, cost-push, imported, monetary and structural.

WASSCE examination focus

Quick check

1. Is a rise in the price of tomatoes in the dry season inflation? Why?
2. A price index rises from 150 to 165. What is the rate of inflation?
3. Distinguish demand-pull from cost-push inflation.
4. Why does a fall in the value of the leone raise prices in Sierra Leone?

Answers: 1. No. Inflation is a general, persistent rise in prices, not a seasonal rise in one good. 2. $\dfrac{15}{150} \times 100 = 10\%$. 3. Demand-pull: total demand exceeds supply. Cost-push: rising costs are passed on in higher prices. 4. Imports such as fuel and rice cost more leones, and firms pass these higher costs on to consumers (imported inflation).