Causes of Inflation

Inflation means there is a sustained increase in the price level. The main causes of inflation are
either excess aggregate demand (economic growth too fast) or cost push factors (supply side
factors)
1. Demand pull inflation
If the economy is at or close to full employment then an increase in AD leads to an increase in
the price level. As firms reach full capacity, they respond by putting up prices, leading to
inflation. Also, near full employment, workers can get higher wages which increases their
spending power.

AD can increase due to an increase in any of its components C+I+G+X-M

We tend to get demand pull inflation, if economic growth is above the long run trend rate of
growth. The long run trend rate of economic growth is the average sustainable rate of growth and
is determined by the growth in productivity.
Example of demand pull inflation in the UK

In the 1980s, the UK experienced

rapid economic growth. The government cut interest rates and also cut taxes. House prices rose
by up to 30% fuelling a positive wealth effect and a rise in consumer confidence. This increased
confidence led to higher spending, lower saving and an increase in borrowing. However, the rate
of economic growth reached 5% a year well above the UKs long run trend rate of 2.5 %. The
result was a rise in inflation as firms could not meet demand. It also led to a current account
deficit. You can read more about this inflation at the Lawson Boom of the 1980s
2. Cost Push Inflation
If there is an increase in the costs of firms, then firms will pass this on to consumers. There will
be a shift to the left in the AS.

Cost push inflation can be caused by many factors

1. Rising wages

If trades unions can present a common front then they can bargain for higher wages. Rising
wages are a key cause of cost push inflation because wages are the most significant cost for
many firms. (higher wages may also contribute to rising demand)
2. Import prices
One third of all goods are imported in the UK. If there is a devaluation then import prices will
become more expensive leading to an increase in inflation. A devaluation / depreciation means
the Pound is worth less, therefore we have to pay more to buy the same imported goods.

In 2011/12, the UK experienced a rise in cost-push inflation, partly due to the depreciation in the
Pound against the Euro. (also due to higher taxes)
3. Raw Material Prices
The best example is the price of oil, if the oil price increase by 20% then this will have a
significant impact on most goods in the economy and this will lead to cost push inflation. E.g. in
early 2008, there was a spike in the price of oil to over $150 causing a temporary rise in
inflation.

4.

Profit Push Inflation

When firms push up prices to get higher rates of inflation. This is more likely to occur during
strong economic growth.
5. Declining productivity
If firms become less productive and allow costs to rise, this invariably leads to higher prices.
6. Higher taxes
If the government put up taxes, such as VAT and Excise duty, this will lead to higher prices, and
therefore CPI will increase. However, these tax rises are likely to be one-off increases. There is
even a measure of inflation (CPI-CT) which ignores the effect of temporary tax rises/decreases.

CPI-CT is less volatile because it ignores the effect of taxes. In 2010, some of the UK CPI
inflation was due to rising taxes.
What else could cause inflation?
Rising house prices
Rising house prices do not directly cause inflation, but they can cause a positive wealth effect
and encourage consumer led economic growth. This can indirectly cause demand pull inflation
Printing more money
If the Central Bank prints more money, you would expect to see a rise in inflation. This is
because the money supply plays an important role in determining prices. If there is more money
chasing the same amount of goods, then prices will rise. Hyperinflation is usually caused by an
extreme increase in the money supply
However, in exceptional circumstances such as liquidity trap / recession, it is possible to
increase the money supply without causing inflation. This is because in recession, an increase in
the money supply may just be saved, e.g. banks dont increase lending but just keep more bank
reserves.

See: The link between money supply and inflation

Inflation expectations
Once inflation sets in it is difficult to reduce it For example, higher prices will cause workers to
demand higher wages causing a wage price spiral. Therefore, expectations of inflation is
important. If people expect high inflation, it tends to be self-serving.
The attitude of the monetary authorities is important for example if there was an increase in AD
and the monetary authorities accommodated this by increasing the money supply then there
would be a rise in the price level
paul-bourne
Inflation: Causes and influences on the Jamaican Economy
Published on October 1, 2006 By Paul Bourne In Blogging
By Paul Andrew Bourne, M.Sc.; B.Sc.; Dip. Edu.

Inflation is a monetary phenomenon (Mishkin 2003: 11), which is created when more money is
chasing too few goods. In a situation where goods and services are scarce, an increase in money
supply will only fuel a higher valuation of the same commodities without a corresponding
change in the production function (i.e. capital formation- materials, stocks, work-in-progress,
finished goods). With this reality, businesses and government are forced to pay higher prices for
products; and so, this further amplifies cost increases throughout the general economy.
Economists refer to this phenomenon as the multiplier effect of changes throughout the economy.
This project seeks to examine price index in Jamaica between 1987 and 2004 in order to evaluate
the inflation rates, changes and its effect on other macroeconomic indicators.
An increase in the cost of a certain product affects the cost structure of other related products
and/or non-related commodities. Wilson (1982: 118) forwards a perspective that explains this
economic force, which concurs with Mishkins position that governments monetary policies
directly influence general prices throughout the economy, and that this is not only related to
government services and/or expenditures. Wilson summarizes this aptly in a relatively length
quotation that best explains the interrelatedness of price increases and other macroeconomic
variables. He writes that:
Inflation is a persistent rise in some general index of prices that, due to expectations, becomes
self-supporting. Yet not all prices rise, or do they raise by the same extent. Inflation therefore
results in a form of income and wealth redistribution totally unrelated to any desirable goal of
either economic or social policy Wilson (1982: 118)
Governments in for many years have tried (and continue to attempt) to combat the scourge of
inflation and its consequences on the populace, but this is to no avail. Mishkin (2003) in his book
titled The Economics of Money, Banking and Financial Markets asked the question, "What

explains inflation?" and this forms the basis upon which this paper analyzes the issue of inflation
on the Jamaican economy. He posits that one clue to this issue is money supply. Generally, it is
because of changes in the price levels. He writes that, "[The] continuing increase in the money
supply might be an important factor in causing the continuing increase in the price level that we
call inflation" (p. 11). Hence, inflation is inextricable linked to the continuous increase in money
supply. Mishkin (op cit) posits that, governments concern about inflation is its monetary policy
given the direct influence between money supply and price levels.
In order to grasp the complexities and consequences of the inflation phenomenon in Jamaica, it
must be contextualized within the broad space of other societies compared to what exists in this
society (Jamaica). With that been said, I will quote a number of instances from Hanke and
Schulers monograph:
Loans in Jamaican dollars are a big gamble for lenders and borrowers because inflation is so
unpredictable. For example, if the nominal interest rate on a loan is 5 percent a year and inflation
is 1 percent, the borrower pays 4 percent real interest. But if inflation is 5 percent, the borrower
pays zero real interest, and if inflation exceeds 5 percent, the borrower pays back less in real
value than he borrowed (Hanke and Schuler, 1995, 3).
Nominal interest rates for Jamaican dollar loans to good borrowers are approximately 42 to 45
percent a year today, compared to approximately 11 to 14 percent for U.S. dollar loans in
Jamaica. That is not the end of the story, of course; we need to adjust for inflation. Suppose that
inflation will be 20 percent in Jamaica and 3 percent in the United States this year. Real interest
rates are therefore 18 to 21 percent for Jamaican dollar loans and 8 to 11 percent for U.S. dollar
loans.1 The gap of 10 percentage points in real interest rates mainly represents the difference in
credibility between the Bank of Jamaica and the U.S. Federal Reserve System, which issues the
U.S. dollar (Hanke and Schuler, 1995, 3).
Monetary policy in Jamaica today faces a dilemma that may last for quite some time. On the one
hand, high real interest rates for Jamaican dollar loans are stifling business activity and economic
growth. They also imply a future crisis for government finances, which would sow the seeds for
further high inflation. Continuing the current monetary policy condemns Jamaica to low
economic growth until the Bank of Jamaica has more credibility. On the other hand, reducing
real interest rates by increasing inflation would destroy the credibility that the Bank of Jamaica
gained in 1994. Economic activity might increase temporarily, but lenders of Jamaican dollars
would demand even higher real interest rates in the future. To offset the higher interest rates the
Bank of Jamaica would have to create even more inflation, leading to a vicious cycle (Hanke and
Schuler, 1995, 4).
One might be tempting to argue that Hanke and Schuler may be biased in their presentation of
the fact, hence a research done for the Inter-American Development Bank by Zahler and
Desmond (2003) that a number of issues that concur with those perspective forwarded by Hanke
and Schuler. They (Zahler and Thomas, 2003) say that:
Despite some successes in the second half of the 1980s, the Jamaican economy has shown

enormous difficulties to achieve stable GDP growth and low inflation. In fact, average output
growth over the last 25 years has been dismal and total measured output in real terms has been
practically unchanged. The first half of the 1990s showed stagnant economic growth, which was
followed by contractions in Jamaicas economic activity during the second half of the 1990s.
Only in 2000 and 2001 has economic growth resumed, at very low rates, averaging less than
1.5% per year. In 2002, GDP growth was less than 0.5%. On the other hand, inflation was
reduced significantly during the 1990s and since 1997 has been maintained at one-digit levels,
despite external price shocks and exchange rate adjustments (Zahler and Thomas, 2003, 3).
The maintenance of price stability is one of the main objectives of governments throughout the
world, ever since the dawn of finance; this observable fact affects the lives of everyone. One
economist, states "the absence of fiscal and monetary discipline breeds inflation, which in turn
stifles growth" which is why this issue is of fundamental importance to all. As was previously
stated by Wilson (1982), inflation is the general rise in prices and so any movement in this
phenomenon influences social and economic policies, for example, incomes, wealth and peoples
lives. As such, this issue cannot be left to the wind as is importance is positively related to mans
welfare and so must be adequately analyze in order that we will be able to effectively deal with
its effects, influences and consequences (Mishkin, 2003).
According to Wilson (1982), in his article titled Inflation: Causes, Consequences and Cures,
inflation will not persist unless it is accommodated by sustained increase in money supply.
Inflation, therefore, is fundamentally a monetary phenomenon (see for example Mishkin, 2003).
Milton Freidman also forwarded this theorizing. Inflation is a major factor in the choice of
monetary policies by governments. Ever since the early 1990s, when Jamaica experienced annual
inflation rates as high as 80.2 percent (see Table 1), the issue of inflation has become
everybodys concern. This was severely felt by the average person.
Table 1: AVERAGE ANNUAL GROWTH RATE OF PRICES4
(By the Moving average from December of one yr. to December of next yr.)
YEAR %
1987 8.4
1988 8.8
1989 17.2
1990 29.8
1991 80.
1992 40.2
1993 30.1

1994 26.8
1995 25.6
1996 15.8
1997 9.2
1998 7.9**
1999 6.8
2000 8.2
2001 7.0
2002 7.1
2003 10.3
2004 13.6
Source: Statistical Digest, 2000 and Economic and Social Survey Jamaica, 2004, p. 5.4
* The highest inflation figure ever recorded in Jamaica
** Revised figure in 2000, i.e. 7.9 accepted figure, and 7.2 was discarded

Jamaica gained independence in 1962 and was enjoying strong economic growth (i.e. increase in
the production of goods and-or services of one year over another), so much so that economists
and peoples worldwide thought it would become a first world country, as America and Europe.
Imagine that! This, therefore, means that Jamaicas economy was stronger than that of all the
other developing countries in the Caribbean and Latin America (ECLAC). In the 1950s, the
country had an income per capita that was higher than that of entire Latin America. According to
one group of scholars "In the 1950s and 1960s it seemed that Jamaicans would slowly catch up
to the standard of living that West Europeans or Americans enjoy" (Hanke and Schuler, 1995, 2).
Statistics revealed that between 1952 and the 1962, GDP on an average grew by 6 percentage
points. This sparkling revelation means that, the growth rate was the highest in the Western
Hemisphere (World Facts Now Data-Maps and World Bank Group, statistical data).
However, in the last 25 years, Jamaica has almost no economic growth per person, while
developed countries (i.e. first world economies) have grown by 2 percent or more on an average

(see for example Hanke and Schuler, 1995). Countries that were, economically (using
macroeconomic variables such as National debt, GDP, NI, employment rate, inflation, standard
of living and/or cost of living) far behind Jamaica in the 1960s, for example, Singapore,
Barbados, and the Cayman Islands, presently have stronger economies. Those states are now
removed from the plague of high unemployment, high inflation, and huge debts (both external
and internal). The government of those countries has been able to bolster their economies, and
maintain price stability, a target Jamaica has been unable to do.
Since independence, between 1962 and 1973, the strong economic growth that Jamaica enjoyed
(Gross Domestic Product (GDP) growth) averaged 5 percent per annum, this has deteriorated to
negative growth between 1996 and 1999 (see Table 2). From the years 1973 to 1980, the
economy experienced a severe contraction due to negative external shocks and inappropriate
domestic policies . This contraction reiterates the macroeconomic vulnerability of the economy,
which is highly responsive to international price changes, external political decision, climatic
changes, demand shifts and other socio-economic and political variables.
Between the years 1987 to 1980, Jamaicas inflation rate averaged 17 percent2. Following the
previously mentioned periods, despite that actuality, one of the main objectives of the
governments was to lower this phenomenon. The macroeconomic policies of the then
government do not seem to support price stability. Nevertheless, in 1991, the rate of inflation
rose to an alarming 80.2 percent and as such, the government of the day had to implement
numerous policies to reduce this reality. This is seen in 1992 as the level of inflation left to 40.2
percent, a reduction of approximately 100 percent compared to 1991. In 1997, the average
annual growth in prices (rate of inflation) was 9.2 percent falling from 15.8 percent in 1996, and
further reduce to 7.2 percent in 19983 (see Table 1). The lesson learnt in 1991 concerning
monetary policies has meant a change in policies. This may account for the non-teen inflation
valuation after 1996 and leading up to 2004. Since1991, the social realities have taught us a
serious lesson in regards to better money management. Those inflation actualities created
hardship for countless peoples. In that, the cost of purchasing goods and-or services became
higher and so less was bought with the same original dollar.
According to Desmond Thomas (1998), the maintenance of price stability is due to a
combination of factors, including the tight monetary policy pursued and the sluggish level of
economic activity. At the same time that the government is pursuing policies to lower inflation,
they are also engaging in other activities to increase it. In that, they have: the growth in the
money supply of over 40 percent per year, the increase in public spending which includes large
wage increases to government employees every two years, the accumulation of unprecedented
levels of international reserves in 1992 and 1994, a policy of sterilization and the doubling of the
stock of domestic debts.
The substitutability of short-term debt with money showed up in an increase in the money supply
during the year 1991 and 1995. Wage awards in 1993 (demand pull inflation) and the latter part
of 1995, and government intervention in 1995 in support of troubled financial institutions
increased public expenditures5. All of the above arguments have contributed to
Jamaicas inflationary problems, but the most expansionary and therefore inflationary method of
financing a deficit is for the government to borrow money directly from the Central Bank.

According to Schuler (1998), throughout most of the Bank of Jamaicas history, it has merely
been "the printing press of the Ministry of Finance, with no ability to resist the ministries orders
to finance government deficits by creating inflation". Because of this constant inflation creation,
Jamaica was ranked at number 90 out of 108 countries in average annual inflation from 1971 to
19916 (Hanke and Schuler, 1995).
The Jamaican government has had a complex time maintaining inflation at a relatively low
percent; nevertheless, the economy is growing at a sluggish rate. Hanke and Schuler (1995)
believe that the governments policies are primarily responsible for this stagnation. They state
that a good monetary policy is necessary, but not sufficient for sustained economic growth. Their
reasoning is clear; that the government has tightened its monetary policy (contraction policy),
lower inflation and still has not succeeded in stimulating production (i.e. capital formation). The
economy experiences stagnant growth of GDP of 0.4 percent. This is evident in GDP rate of
growth over the four-year period 1996 to 19998. Hanke and Schuler (1995) posits that an
exceptionally good monetary policy cannot offset the growth-destroying effects of high taxes,
insecure property rights, excessive regulation and fear of the future cause of economic policy.
This affords an explanation for the stagnation within the economy despite the governments
efforts to curtail money supply.
The Jamaican economy shwinked in 1996 and 1997 (-1.3 and 2.0 respectively see Table 2). The
reductions in GDP meant that companies profits were less. This meant that businesses had to
reduce their productive capacity; many companies collapsed under their debts and went into
receivership or were closed down9. For some companies in garment manufacturing it became too
expensive to export and returns (i.e. profits) were minute. Many banks had to close for example,
the Century National Bank (CNB), and the Union Bank now owns by Royal Bank of Trinidad
and Tobago (RBTT) either because of the economic climate or because of poor management. All
of this led to many Jamaicans being without jobs and many more lose their jobs by the end of the
year. Those redundancies coupled with the high inflationary climate contribute to the continually
increased unemployment and change in many governmental social policies.
The high interest rates in both nominal and real terms that were experienced by the economy
placed a damper on economic activity. Meaning, high interest rates continue to be persistently
higher than the rate of growth of government taxes, which means that the government has to use
more and more of its revenue to repay its debts and less and less to other activities. The debts
cannot be financed by taxes alone, because it is too small, so the government has three options
available to them: (1) to further reduce spending on everything except repaying debts. (2)
Default, and (3) to create inflation10.
According Hanke and Schuler (1995), default is unnecessary because the government can make
the Bank of Jamaica print all the money it needs to repay its bills. Consequently, inflation has
been the usual result in the past, and the chance of it happening in Jamaica's future is close to
99.9 percent. It is 99.9 percent likely because, both intentional and domestic debts continue to
increase yearly, to the point where Jamaica probably will not be able to repay all of its debts in
the near future. The question arises then, how will Jamaica be able to lower inflation with the
government's implementation of tight monetary policies, without having to create more inflation

to finance its debts? Where is the solution?

If the government continues current monetary policies, Jamaica will be condemned to low
economic growth until the Bank of Jamaica has more credibility, on the other the hand, reducing
real interest rates by increasing inflation would destroy the credibility that the Bank of Jamaica
gained in1994. Hanke and Schuler (1995) believe that the only way out of Jamaica's dilemma of
'high interest rate verses high inflation is to reform current arrangements for monetary policy in
Jamaica. They believe that the best options for return are most far-reaching. In the case of
Jamaica, it means 'stripping' the Bank of Jamaica of its power to issue the Jamaican dollar.
Jamaica will then have to change its monetary policy to have a strong economy.
The main reason for Jamaica's dilemma is the type of monetary policy it uses. There are two
types. 1) A market led monetary regime - which relies on market forces to determine the supply
of money and credit and the effects of the exchange rate and 2) A managed monetary regime.
This regime is a system of rules governing who issues money and credit, and how domestic
currency is to be treated in foreign exchange, while a managed monetary regime relies heavily o
regulations to determine those things (Hanke and Schuler, 1995). The type of monetary regime
that Jamaica's monetary authority have been practicing is the managed monetary regime, while,
some countries such as America uses the market led monetary regime. The regime has caused
more harm than good as is shown in the poor performance of the Jamaican economy over the
years.
Table 2: Annual Growth Rate of Gross Domestic Product at Constant Prices7
YEAR %
1988 2.9
1989 6.8
1990 5.6
1991 0 .9
1992 1.6
1993 1.7
1994 1.1
1995 0.7
1996 -1.3
1997 -2.0

1998 -0.5
1999 -0.4
2000 0.8
2001 1.5
2002 1.1
2003 2.3
2004 1.2
Source: Balance of Payment of Jamaica, 1999 and PIOJ (2004) - ESSJ

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