Price, the amount of money that has to be paid to acquire a given product

Economic price theory asserts that in a free market economy the market price reflects interaction
between supply and demand: the price is set so as to equate the quantity being supplied and that
being demanded

INFLATION

Plenty of us have, at some point or another, heard a grandparent talk about the days of
their childhood when a candy bar cost barely anything. In 1908, a Hershey's chocolate
bar cost a mere 2 cents. Today that same chocolate bar costs $1.34 at Walmart. How
does such a massive increase happen? Through inflation.

Inflation, is a general and ongoing rise in the level of prices in an entire economy.

Kinds of Inflation

There are many different types of inflation, depending not only on what good is being
priced but what the inflation rate actually is. For example, what happens if the inflation
rate is well above the Central Bank’s intended target? At a higher rate, yet still in the
single digits, that's known as walking inflation. It is seen as concerning yet manageable.

(Our country have been experiencing walking inflation:

The Philippines' annual inflation rate eased to 3.8 percent in February of 2019 from 4.4
percent in the previous month and below market expectations of 4 percent. It was the
lowest inflation rate since February last year, due to a slowdown in cost of food, housing
and transport.

Inflation Rate in Philippines averaged 8.38 percent from 1958 until 2019, reaching an all
time high of 62.80 percent in September of 1984 and a record low of -2.10 percent in
January of 1959.)

Once the rate hits double digits and ends up in the 10%-20% range, it becomes running
inflation. This is of much greater concern for a country's citizens, as the currency is
devaluing much faster than it needs to be. Prices going up that drastically can have a
devastating effect on the lower and working class populations, who were already
struggling financially. Incomes don't rise in tandem with prices, and fewer goods are
purchased, throwing the economy into chaos.

Hyperinflation is the rarest, but most disastrous iteration of inflation within an economy.
A totally unmanageable rise of 50% or more within a month, this can send an economy
plummeting. Recessions turn to depressions. People lose faith in fiat currency and
begin hoarding gold instead, leading to a significant decrease in an exchange of goods.
Financial institutions, with their money now essentially worthless, fail. Hyperinflation is
very rare, but has happened before.
There can also be a form of inflation known as "stagflation," where inflation rates rise
despite the fact that the economy is in a stagnant period. Special circumstances cause
stagflation, such as the U.S. in the 1970s, when despite high unemployment rates and
negative economic growth the price of oil skyrocketed.

How is Inflation Measured in the Philippines?

The inflation target-setting in the Philippines is based on the existing framework for
coordination between government economic agencies under the Development Budget
Coordinating Committee (DBCC).3 The national government, through the DBCC, sets
the inflation target based on the consumer price index (CPI) two years ahead in
consultation with the Bangko Sentral ng Pilipinas (BSP). The BSP has full powers over
and responsibility for the announcement of the inflation target and the determination of
appropriate monetary policy to achieve the target.

The price index used as the basis for determining the inflation target is the CPI.

How is the CPI computed?

The formula used to calculate the Consumer Price Index for a single item is as follows:

Cost of Market Basket in Given Year

CPI = _______________________________ X 100

Cost of Market Basket in Base Year

a. Base Period. This is a reference date or simply a convenient benchmark

The base period is a year. A month is deemed unwise to use as a base period
because it often reflects accidental or seasonal influences. The present series uses
2006 as the base year. The year 2006 was chosen as the base year because it is
the year when the Family Income and Expenditure Survey (FIES) was conducted.
The FIES is the basis of the CPI weights.

b. Market Basket. Since it is virtually impossible to have periodic measures on the

changes in the prices of all the thousands of varieties of goods purchased for
consumption and services availed of by households in the country, a sample of
these items, known as the `CPI market basket’, was selected to represent the
composite price behavior of all goods and services purchased by consumers.
There are 82 provincial market baskets including the National Capital Region
(NCR) and the cities of Isabela and Cotabato.

c. Weighting System. A desirable system that considers the relevance of the

components of the index. For the CPI, the weighting pattern uses the
 expenditures on various consumer items purchased by households as a
proportion to total expenditure.

The weights of the eleven COICOP divisions used in the computation, which
were derived from the 2006 FIES of the CPI are shown in the following table
d. Geographic Coverage. CPI values are computed at the national, regional, and
provincial levels, and for selected cities. A separate CPI for NCR is also
computed.

Causes of Inflation

So what exactly causes inflation in an economy? There is not a single, agreed-upon

answer, but there are a variety of theories, all of which play some role in inflation:

1. The Money Supply

Inflation is primarily caused by an increase in the money supply that outpaces economic
growth.

When the Central Bank decides to put more money into circulation at a rate higher than
the economy’s growth rate, the value of money can fall because of the changing public
perception of the value of the underlying currency. As a result, this devaluation will force
prices to rise due to the fact that each unit of currency is now worth less.

One way of looking at the money supply effect on inflation is the same way collectors
value items. The rarer a specific item is, the more valuable it must be. The same logic
works for currency; the less currency there is in the money supply, the more valuable
that currency will be. When a government decides to print new currency, they
essentially water down the value of the money already in circulation. A more
macroeconomic way of looking at the negative effects of an increased money supply is
that there will be more dollars/pesos chasing the same amount of goods in an economy,
which will inevitably lead to increased demand and therefore higher prices.

2. The National Debt

We all know that high national debt in the U.S./Philippines is a bad thing, but did you
know that it can actually drive inflation to higher levels over time? The reason for this is
that as a country’s debt increases, the government has two options: they can either
raise taxes or print more money to pay off the debt.

A rise in taxes will cause businesses to react by raising their prices to offset the
increased corporate tax rate. Alternatively, should the government choose the latter
option, printing more money will lead directly to an increase in the money supply, which
will in turn lead to the devaluation of the currency and increased prices (as discussed
above).

3. Demand-Pull Effect

The demand-pull effect states that as wages increase within an economic system (often
the case in a growing economy with low unemployment), people will have more money
to spend on consumer goods. This increase in liquidity and demand for consumer
goods results in an increase in demand for products. As a result of the increased
demand, companies will raise prices to the level the consumer will bear in order to
balance supply and demand.

4. Cost-Push Effect

Another factor in driving up prices of consumer goods and services is explained by an

economic theory known as the cost-push effect. Essentially, this theory states that when
companies are faced with increased input costs like raw goods and materials or wages,
they will preserve their profitability by passing this increased cost of production onto the
consumer in the form of higher prices. (Mo increase ang mga raw materials)

A simple example would be an increase in milk prices, which would undoubtedly drive
up the price of a cappuccino at your local Starbucks since each cup of coffee is now
more expensive for Starbucks to make.

5. Exchange Rates

Inflation can be made worse by our increasing exposure to foreign marketplaces.

When the exchange rate suffers such that the PESO has become less valuable relative
to foreign currency, this makes foreign commodities and goods more expensive to
Filipino consumers while simultaneously making Filipino goods, services, and exports
cheaper to consumers overseas.

The Effects of Inflation

1. Effects on Distribution of Income and Wealth:

The impact of inflation is felt unevenly by the different groups of individuals within the
national economy—some groups of people gain by making big fortune and some others
lose.

We may now explain in detail the effects of inflation on different groups of people:

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(a) Creditors and debtors:

During inflation creditors lose because they receive in effect less in goods and services
than if they had received the repayments during a period of low prices. Debtors, on
other hand, as a group gain during inflation, since they repay their debts in currency that
has lost its value (i.e., the same currency unit will now buy less goods and services).

(b) Producers and workers:

Producers gain because they get higher prices and thus more profits from the sale of
their products. As the rise in prices is usually higher than the increase in costs,
producers can earn more during inflation. But, workers lose as they find a fall in their
real wages as their money wages do not usually rise proportionately with the increase in
prices. They, as a class, however, gain because they get more employment during
inflation.

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(c) Fixed income-earners:

Fixed income-earners like the salaried people, rent-earners, landlords, pensioners, etc.,
suffer greatly because inflation reduces the value of their earnings.

(d) Investors:

The investors in equity shares gain as they get dividends at higher rates because of
larger corporate profits and as they find the value of their shareholdings appreciated.
But the bondholders lose as they get a fixed interest the real value of which has already
fallen.

(e) Traders, speculators, businesspeople and black-marketers:

They gain because they make more profits from the persistent rise in prices.

(f) Farmers:

Farmers also gain because the rise in the prices of agricultural products is usually
higher than the increase in the prices of other goods.

Thus, inflation brings a shift in the pattern of distribution of income and wealth in the
country, usually making the rich richer and the poor poorer. Thus during inflation there is
more and more inequality in the distribution of income.

2. Effects on Production:

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The rising prices stimulate the production of all goods—both of consumption and of
capital goods. As producers get more and more profit, they try to produce more and
more by utilising all the available resources at their disposal.

But, after the stage of full employ¬ment the production cannot increase as all the
resources are fully employed. Moreover, the producers and the farmers would increase
their stock in the expectation of a further rise in prices. As a result hoarding and
cornering of commodities will increase.

But such favourable effects of inflation upon production are not always found.
Sometimes, production may come to a standstill position despite rising prices, as was
found in recent years in developing countries like India, Thailand and Bangladesh. This
situation is described as stagflation.

3. Effects on Income and Employment:

Inflation tends to increase the aggregate money income (i.e., national income) of the
community as a whole on account of larger spending and greater production. Similarly,
the volume of employment increases under the impact of increased production. But the
real income of the people fails to increase proportionately due to a fall in the purchasing
power of money.

4. Effects on Business and Trade:

The aggregate volume of internal trade tends to increase during inflation due to higher
incomes, greater production and larger spending. But the export trade is likely to suffer
on account of a rise in the prices of domestic goods. However, the business firms
expand their businesses to make larger profits.

During most inflation since costs do not rise as fast as prices profits soar. But wages do
not increase proportionate with prices, causing hardships to workers and making more
and more inequality. As the old saying goes, during inflation prices move in escalator
and wages in stairs.

5. Effects on the Government Finance:

During inflation, the govern¬ment revenue increases as it gets more revenue from
income tax, sales tax, excise duties, etc. Similarly, public expenditure increases as the
government is required to spend more and more for administrative and other purposes.
But the rising prices reduce the real burden of public debt because a fix sum has to be
paid in instalment per period.

6. Effects on Growth:
A mild inflation promotes economic growth, but a runaway inflation obstructs economic
growth as it raises cost of develop¬ment projects. Although a mild dose of inflation is
inevitable and desirable in a developing economy, a high rate of inflation tends to lower
the growth rate by slowing down the rate of capital formation and creating uncertainty.

The Good Aspects of Inflation

In a fact that is surprising to most people, economists generally argue that some
inflation is a good thing. A healthy rate of inflation is considered to be approximately 2-
3% per year. The goal is for inflation (which is measured by the Consumer Price Index,
or CPI) to outpace the growth of the underlying economy (measured by Gross Domestic
Product, or GDP) by a small amount per year.

A healthy rate of inflation is considered a positive because it results in increasing wages

and corporate profitability and keeps capital flowing in a presumably growing economy.
As long as things are moving in relative unison, inflation will not be detrimental.

Another way of looking at small amounts of inflation is that it encourages consumption.

For example, if you wanted to buy a specific item, and knew that the price of it would
rise by 2-3% in a year, you would be encouraged to buy it now. Thus, inflation can
encourage consumption which can in turn further stimulate the economy and create
more jobs.

Inflation also makes it easier on debtors, who repay their loans with money that is less
valuable than the money they borrowed. This encourages borrowing and lending, which
again increases spending on all levels.

DEFLATION

Deflation is the persistent fall in the general price level of goods and services occurring
when the inflation rate falls below 0%.

Example: the general price level is falling and the purchasing power of say £1,000 in
cash is increasing

 Some countries have experienced periods of deflation in recent years; perhaps

the most well-known example was Japan during the late 1990s and in the current
decade. In Japan, the root cause of deflation was slow growth and a high level of
spare capacity that was driving prices lower.
  Greece and a number of Euro Area countries are now experiencing price
deflation as are countries such as Switzerland and Denmark

What Causes Deflation?

Deflation can be caused by a number of factors, all of which stem from a shift in the
supply-demand curve

Although there are many reasons why deflation may take place, the following causes
seem to play the largest roles:

1. Change in Structure of Capital Markets

When many different companies are selling the same goods or services, they will
typically lower their prices as a means to compete. Often, the capital structure of the
economy will change and companies will have easier access to debt and equity
markets, which they can use to fund new businesses or improve productivity.

However, after they have utilized this new capital to increase productivity, they are
going to have to reduce their prices to reflect the increased supply of products, which
can result in deflation.

2. Increased Productivity
Innovative solutions and new processes help increase efficiency, which ultimately leads
to lower prices.

For example, after the Soviet Union collapsed in 1991, many of the countries that
formed as a result struggled to get back on track. In order to make a living, many
citizens were willing to work for very low prices, and as companies in the United States
outsourced work to these countries, they were able to significantly reduce their
operating expenses and bolster productivity. Inevitably, this increased the supply of
goods and decreased their cost, which led to a period of deflation near the end of the
20th century.

3. Decrease in Currency Supply

As the currency supply decreases, prices will decrease so that people can afford goods.
How can currency supplies decrease? One common reason is through central banking
systems.

For instance, when the Federal Reserve was first created, it considerably contracted the
money supply of the United States. In the process, this led to a severe case of deflation
in 1913.
4. Deflationary Spiral
Once deflation has shown its ugly head, it can be very difficult to get the economy under
control for a number of reasons. First of all, when consumers start cutting spending,
business profits decrease. Unfortunately, this means that businesses have to reduce
wages and cut their own purchases. In turn, this short-circuits spending in other sectors,
as other businesses and wage-earners have less money to spend. As horrible as this
sounds, it continues to get worse and the cycle can be very difficult to break.

Effects of Deflation

Deflation can be compared to a terrible winter: The damage can be intense and be
experienced for many seasons afterwards. Unfortunately, some nations never fully
recover from the damage caused by deflation. Hong Kong, for example, never
recovered from the deflationary effects that gripped the Asian economy in 2002.

Deflation may have any of the following impacts on an economy:

1. Reduced Business Revenues

Businesses must significantly reduce the prices of their products in order to stay
competitive. Obviously, as they reduce their prices, their revenues start to drop.
Business revenues frequently fall and recover, but deflationary cycles tend to repeat
themselves multiple times.

Unfortunately, this means businesses will need to increasingly cut their prices as the
period of deflation continues. Although these businesses operate with improved
production efficiency, their profit margins will eventually drop, as savings from material
costs are offset by reduced revenues.

2. Wage Cutbacks and Layoffs

When revenues start to drop, companies need to find ways to reduce their expenses to
meet their bottom line. They can make these cuts by reducing wages and cutting
positions. Understandably, this exacerbates the cycle of inflation, as more would-be
consumers have less to spend.

3. Changes in Customer Spending

The relationship between deflation and consumer spending is complex and often
difficult to predict. When the economy undergoes a period of deflation, customers often
take advantage of the substantially lower prices. Initially, consumer spending may
increase greatly; however, once businesses start looking for ways to bolster their
bottom line, consumers who have lost their jobs or taken pay cuts must start reducing
their spending as well. Of course, when they reduce their spending, the cycle of
deflation worsens.
4. Reduced Stake in Investments
When the economy goes through a series of deflation, investors tend to view cash as
one of their best possible investments. Investors will watch their money grow simply by
holding onto it. Additionally, the interest rates investors earn often decrease significantly
as central banks attempt to fight deflation by reducing interest rates, which in turn
reduces the amount of money they have available for spending.

In the meantime, many other investments may yield a negative return or are highly
volatile, since investors are scared and companies aren’t posting profits. As investors
pull out of stocks, the stock market inevitably drops.

5. Reduced Credit
When deflation rears its head, financial lenders quickly start to pull the plugs on many of
their lending operations for a variety of reasons. First of all, as assets such as houses
decline in value, customers cannot back their debt with the same collateral. In the event
a borrower is unable to make their debt obligations, the lenders will be unable to recover
their full investment through foreclosures or property seizures.

Also, lenders realize the financial position of borrowers is more likely to change as
employers start cutting their workforce. Central banks will try to reduce interest rates to
encourage customers to borrow and spend more, but many of them will still not be
eligible for loans

Tools to Fix Deflation

Fortunately, it is possible to reduce the impact of deflation. However, fighting deflation

requires a disciplined approach, as it will not fix itself. Prior to the Great Depression, it
was commonly believed that deflation would eventually run its course. However,
economists suggested government intervention was necessary to break a deflationary
spiral.

What economic policies might be used to avoid a period of price deflation?

The main approach to avoiding deflation is to use macro-stimulus policies either by

loosening monetary policy and/or fiscal policy

Low interest rates and quantitative easing

 In some countries, policy interest rates have become negative e.g. Switzerland
and Japan
 Cheaper loans for businesses and households
  Expanding the supply of credit in banking system
 QE used by many central banks including BoE and European Bank

Fiscal stimulus measures

 Higher government spending (e.g. capital projects)

 A rise in government borrowing to inject demand into the circular flow
 Lower direct taxes to increase disposable income and spending

Other measures to stimulate aggregate demand

 Attempts to lower (devalue) the value of the exchange rate (perhaps via central
bank intervention to sell their currency in the market)
 Higher taxes on savings to encourage consumption
