University of Nigeria Research Publications OKAFOR, Chris Obi Author PG/MBA/88/7175 Title Effects of Inflation on Project Evaluation and Capital Budgeting in Nigeria (1980-1990) Faculty Business Administration Department Banking and Finance Date June, 1993 Signature
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University of Nigeria Research Publications
OKAFOR, Chris Obi
Aut
hor
PG/MBA/88/7175
Title
Effects of Inflation on Project Evaluation and Capital Budgeting in Nigeria (1980-1990)
Facu
lty
Business Administration
Dep
artm
ent
Banking and Finance
Dat
e
June, 1993
Sign
atur
e
EFFECTS OF INFLATION ON
PROJECT EVALUATION AND CAPITAL
BUDGETING I N NIGERIA (1980 'to 1990).
OKAFOR CHRIS OBI
PG/MBA/88/7175
DEPARTMENT O F BANKING AND FINANCE,
UNIVERSITY OF NIGERIA , ENUGU CAMPUS
JUNE, 1993.
EFFECTS OF fNFLATION ON
PROJECT EVALUATION AND CAPITAL
BUDGETING tN NIGERIA
(1980 to 1990)
OKAFOR CHRIS OBI
PGIMBAI8817175
A PROJECT REPORT submitted In Partial Fulfilment of the Requirements
for the award o f the Degree of Masters of Buslness Admlnkttration IMt3kl
i n Banking and Finance o f the University o f Nigeria.
Faculty of Business A d m i n i s i r d ~ ~ o r ~ , u e ~ d r L I W I ~ L of Banking and Finance
University of Nigeria
Enugu Campus
June, 1 9 9 3 .
C E R T I F I C A T I O N
OKAFOR CHRIS OBI, a post-graduate student in the Department of Banking
anf Finance, and wlth Registration Number PGIMBA/88/7175, has satisfactorily
completed t h e requirements for course and research work for the degree of
Master of Business Administration in Banking and Finance.
This dissertation i s an embodiment of original work and has not been submltted
in pa r t o r in full for any other diploma o r degree.of this o r any o ther University
Head of ~ e p a r t m e n t Dr. J. N. Ezikpe (Supervisor)
D E D I C A T T O N
This work is dedicated to my 'Squad'
Jayne - My darling wife
Ozioma - Tie. Commanding Officer
~ d e obi - Brain teaset
Lota - 1 ndefatigable
Kosa l u - M y twin intellect
Ka'etoo - Resilient power-pack
They made it a team a f f a i r .
A B S T R A C T
Capital Budge t ing and Proiect Evaluation both refate to.p1'anning investment
, expendi tures whose re tu rns are expected to extend beyond one year, and
assessing, a t the end o f
to i t s set objectives.
the period, the performance of the project, re la t ive
In this work, t he impacts o f Inf lat ion (a general r ise in prices) on b o t h key
aspects o f investment were studied, over an eleven year per iod (1980 - 1990).
To do this, in f la t ion data cbmputed from the Annual Consumer Pvfce indexes
were used t o analyze financial Items inseparate authenticated Balance Sheets
and Pro f i t and Loss Accounts of four Companies. Return on Investment, a
measure o f prof i tab i l i ty , was doubly ascertained f o r each company; (i) without
inf lat ion a n d (ii) w i t h inflation. The analyses o f data showed a pers is tent
percentage d r o p in Retrun on Investments that ranged from 0.99 in a low
inf lat ion year to 33.23 In a year o f relatively high inf lat ion. Results o f these
analyses and subsequent tests of: hypotheses revealed that:
1. In f la t ion reduced t he real value o f f ixed and total assets o f each of t h e
Companies investigated,
2 . In f la t ion h a d a negative influence on the p r o f i t performance o f each
company as it depressed the ra te o f turn-over o f assets,
Th i s revelat ion has re-lnforced the need t o include in f la t ion conslderatlons
white p rov i d i ng pro~ec2/investment capltal, and in evaluation o f project
pro f i tab i l i ty , especfally fo r projects whos gestation per iod would l ikely
exceed one year.
iii
He d ic ta ted it altogether, God the Almighty; I adore him inf in i te ly.
My supervisor, Dr. S.N. Ezike - Managing Director NAL Merchant Bank PIC.
He accommodated my lapses, rest ructured my inputs, t o produce th is i l luminat ing
piece o f work; I thank him immensely.
Mr. L.E. Okafor, erud i te banker, Managing Director and Chief Executive ,United
Bank fo r Afr ica Pic. He inst igated this study, motivated it and refused to take
'No' f o r a n answer. He remains an Pndlspensable inspiration. Brother, I d o f f my
hat. His wife (my wife), Mrs Vee Cee Okafor IAkanwezeJ, She too was desperate
f o r my success; Cod bless her.
S i r . (-Engr) A. I. Okafor (Okaaomee) ; ve ry benevolent elder brother, spent sleepless
n igh ts wo r r y i ng to see the end o f this study. I p r a y God to protect and gu ide
him.
Mr. ~ d n a Onwugharu, Dlrector (Computer] , National ~ o b u ~ a t i o n Commission,
Enugu Zone, my good fr lend. He v i r tua l ly served me w i t h many'queriest l o show
cause why th i s work should l inger on. 1 thank him ernest ly.
Bar r i s te r Emma Uyanwa, Secretary/Legal Adviser o f former Diamond Breweries Ltd,
Enugu. He prov ided the bulk of data from h is company a t a time when dear th
o f consistent data proved a n obstacle to th i s work, I owe him a lot.
My parents Chief and V r s J.A. E V.M. Okafor; My parents in-law, Ide D.C.
Odenigbo and lyom V. Odenlgbo; they formed a team o f Solicitors, request ing God
to successful ly complete th is work. May Cod soothe the i r aching knees and
reward t he i r many other supplications.
My good f r i end and bestman, Dr. J.U.J. Onwmere, Economist and Econonretrist;
he demonstrated the rarest quall t les o f g w d f r iendship by ca r r y i ng th is cross
wi th me, read and re-read my or ig inal draf ts. I cannat thank hfm enough.
My recurring decimal, my beloved wife Jayne; she proved more than a better-
half, encouraged thls study and worked tirelessly for thls. end. "Mmanrvanyi
bu diyal', I love you dearly.
Enugu, Nigeria
June, 1993.
Chris Obi Okafor
TABLE OF CONTENTS
CERTIFICATION
DEDICATION
ABSTRACT
ACKNOWLEDGEMENT
TABLE OF CONTENTS
LIST OF FIGURES
LIST OF TABLES
CHAPTER ONE: INTRODUCTION
1.1 Background t o the Study
1.2 Problem Identif icatfon
1.3 Objectives o f the Study
1.4 Hypotheses o f the Study
1.5 Significance of the Study
1.6 Limitations o f the Study.
CHAPTER TWO: REVIEW OF RELATED LITERATURE
Nature and Dimensions o f lnfal t ion
His tory o f lnf lat ion
lnf lat ion and War - A 'Since quanon'?
Def in i t ion o f lnf lat ion
Types o f lnf lat ion
Causes o f tnf lat lan
l nf lat ion or Unemployment?
Estimating lnf lat ion
Inf lat ion: The Nigerian Experience
in f la t ion and Project Evaluation
Inf lat ion and Capital Budget ing
Why Worry about Inf lat ion ?
CHAPTER THREE: RESEARCH METHODOLOGY
3.1 Preamble
3.1.1 Prof i tab i l i ty Measures
3.1.2 Earn ing Power
3.2 Sources of Data
3.2.1 l nf lat ion Rate
3.2.2 Prof i tab i l i ty
3.3 Sampling Procedure and Sample Size
Page
Page
3.4 Instruments for Data Collection
3.5 Techniques of Data Analysis
CHAPTER FOUR: PRESENTATION AND ANALYSIS' OF DATA
4.1 Data Presentation, Analysis and Results
4 .2 Test of Hypotheses
CHAPTER FIVE: SUMMARY OF FINDINGS, CONCLUSIONS AND RECOMMENDATIONS.
5.1 Summary of Findings
5.2 Conclusions
5.3 Recommendations
5.4 Area of Further Investigation
LIST OF TABLES Page
Consumer Price Index Levels 1979
The Phill ips Curve
R Coy L t d Balance Sheet as a t 31 ~ e c . 1980 11 I1 II 11 I1 I1 I! I1 11 1 98 1
X Coy L t d Balance Sheet as a t 31 Dec. 1982 II II II I1 11 I1 11 I1 11 1983
Y Coy L t d Balance Sheet as a t 31 Dec. 1984 If II 11 I1 I 1 I1 11 11 I1 1985
II I1 11 II 11. 11 I1 11 , 1 9 8 6
I 1 I1 I 1 I 1 I1 II I1 I 1 S 1987 11 I1 I1 11 11 11 11 I1 R 1988
II n PI M 11 II 18 II a 1989
Z Coy Ltd Balance Sheet as a t 31 Dec. 1990
APP.1 R Coy Ltd Prof l t and Loss Account 1980 - '8'1
APP.2 X Coy ttd Prof i t and Loss Account 1982 - '83
APP.3 Y Coy Ltd Prof i t and Loss Account 1984 - '85
APP.4 " II II II II 1986 - '87
APP.5 " I1 11 I f II II 11 1988 - '89
APP.6 ' Z Coy Ltd Prof i t and Loss Account 1990 '
LIST O F FIGURES
Fig. 2.1 - Differentiat ing Between Inflat ion Types
Fig. 2.9.1 - The Phlll ips Curve
v i i i
CHAPTER ONE
I N T R O D U C T I O N
1.1 . Backg round To The S t u d y
In f l a t i on has been def ined as a r ise in the average p r i c e level. In a
dynamlc economy, p r i c e changes take place constant ly . Sometimes, t h e pric
o f a pa r t i cu la r good o r service may exh ib i t a n u p w a r d o r downward t r e n d
t h a t can last f o r months, years or even decades.
I n i t i a l p r i c e changes as a resu l t o f sh l f t s in t h e supp ly a n d demand f o r
p a r t i c u l a r goods and services do n o t imply a n y change in t h e general p r i c e
level. A change in t h e average p r i ce level takes place i f the re i s a s t r o n g
tendency f o r a l l p r ices to move up or down in p ropor t i on to ane another.
Such r i s e in t h e average pr ice level is Inf lat ion.
Modern count r ies have all, almost wi thout exception, su f fe red p e r i ~ d s o f
inf lat ion. Generally, attempts have been made t o cont ro l these inflation,
both In s e v e r l t y and !in the l r d u h t i o n . In some o the r instances. t he
accelerat ion in t h e ra te of increase in pr ices had been seeming mrnanag-
eable. The German inf lat ion o f 1923 (Chu and Feltenstein, 1979) saw
p r i c e increases r i se t o a peak o f more than 30,000 percent a month, a n d
the economy was reduced t o funct ion on t he basis o f ba r te r .
A l though n o cases o f such violent in f la t ion has been recorded in the most
recent t h e , few cases have been where f o r a considerable l eng th o f time,
the ra te of p r l c e increases tended t o b e o u t o f contro l .
In Nigeria, t h e index o f pr ices has been cont inuously o n t h e increase since
1960 (A jay i a n d Ojo, 19811,although the p r i c e increases since 1976 have
however been o f more slgniflcance. The rate o f in f la t ion between 1969 and
1970 was about 10% which rose immediately a f t e r t he C iv i l War in 1970 to
about 74 p e r cent, and to 16.1 percent in 1971. A f t e r a itill' between 1972
and 1973, the consumer pr ices index rose again f r om 213.6 in 1974 to 286.4
in 1975 (Base 1 9 6 0 ~ 1 0 0 ) ;an increase in inf lat ion ra te o f about 34 p e r cent.
tn f ta t lon can emanate f rom a va r ie t y of sources. C h u a n d Feltenstein (1979)
repo r ted t h a t two studies on inf lat ion made t o cover betw.een 1963 a n d 1976 in
Argen t ina showed tha t t he re were essentially two main causes o f t h e in f la t ion in
t h a t c o u n t r y a t t h e time. T h e f i r s t cause was t he b u d g e t def ic i t o f t h e Centra l
Government, whi le the second was government p r i ce controls, which paradoxlcal ly
i s a n instrument used by government t o attempt t o check the r ise in prices.
In t h e opinion o f Ajayl and Ojo (1981) t he two major factors wh ich combined t o h(
inf luences on in f la t ionary t rends in Nigeria were 1. shlktage o f suppl ies ( t h e
coro l la ry o f excess demand], and 2. monetary factors, such as t h e r i s e in
government expendi ture; increases in money incomes a n d increases in money supp
These vfews seem to have been shared by(Ciroma (1976) when as Governor o f t h e
Cent ra l Bank o f Nigeria, he voluntered hfs opinion on t h e predisposing factors o f
t he Niger ian in f la t ion and stated; i n t e r slia:
I' t he banks have substantlel funds - f o r wh ich they a re
apparent ly not f i nd ing as much investment out let as t h e y
would wish, and t h i s v e r y h i g h liquidity o f t h e commercial
bank ing system could be a source o f f u r t h e r monetary instabl l l ty l l
[ Ciroma, 19761 ,
One major resu l t o f t he r a p i d bui ld-up o f purchas ing power in the Niger ian econol
a t t h e tlme, was the acute in f la t lonary pressures which had been the experience
of several years. Again, in the vlews o f Ciroma ( i b id ) among the fac tors under -
lining t h e in f la t ion inc luded insuf f ic ient p roduct ion o f t h e domestic market, added
t o inadequate capacity t o augment th rough iinpwtdtion and compounded by p o r t
congestion which had done severe damage to the economy.
One disadvantage o f an unstable p r i ce level i s t ha t it makes t h e task of appropr ia
te l y analyz ing the economic advantages and disadvantages o f d i f f e ren t investment
a l ternat ives more d i f f i c u l t and complex. Capital budget ing, a n inherent aspect o f
investment decisions i s a many-sided ac t lv l ty t h a t includes searching f o r new
a n d more pro f i t ab le investment proposals. Of ten times, i t involves i nves t i ga t i ng
engineer ing a n d inarketirrg consldesatlon to p r e d i c t t he consequences o f accept ing
t h e fnvesitment a n d making economic analyses t o determine the p r o f i t potent ia l of
each investment proposal. By assuming tha t t he consequences of a n investment
can be descr ibed In terms o f cer ta in o r unce r ta in cash flows it w i l l genera te in
each tlme interval , one c a n thence exclude many investments. A l t h o u g h not all
investlrnent decisions in a n organization can be descr ibed l n Naira terms, importal
decisions descr ibable in these terms, nonetheless, w c u r In most modern organiza-
t ions.
The cent ra l focus o f a n investment analysis there fore i s the comparison between z
si tuat ion w i t h the Investment and that wi thout it. T h e net e f fec t o f the invest-
ment Is found by deduct ing the flow o f costs a n d benef i ts w i thout t h e investment
f rom the same f low represent ing the s i tuat ion wlth the investment. A l though
t h e pr inc ip les of capl ta l budgeting a r e applicable when there i s a r i s k o f in f la t ion
as well a s when t h e r i s k Is.neglible, these pr lnc lp les however, become d i f f i c u l t
to apply when t h e r i s k o f in f la t ion essurnes a pr l rnary importance a n d the i n f l a t i o ~
I s significant. In that case, f u t u r e cash flows may d i f f e r , no t on l y in the i r t imir
b u t also In t h e l r purchas ing power.
1 . 2 Problem identification
Most comparisons o f project ( investment] p ro f l tab l l l t y , l i qu id i t y a n d n e t w o r t h are
o f t e n done on the assumption tha t the value o f t h e monetary u n i t remalned stable
during the yea rs u n d e r consideration. Experience has shown, however, t ha t a
cont i r iu ing high level o f inf lat ion has so reduced the purchas ing power o f t he
Naira from year to year, thet the monetary values tn successive f l na l accounts
a n d capital budge ts do n o t g i ve real ist ic up-to-date values f o r p r o p e r assessment
o f ne t ~ 4 t h and pro f i tab i l i t y . The implication is t ha t , in per iods of inf lat ion,
holders o f monetary sssets could lase purct7ase pwr w h i l e owners o f physical
assets improve t h e i r wealth base.
In evaluat ing capi ta l budget decisions therefore, a businessman o r business
analyst Must consrder n o t on l y the possible ef fects o f inf lat ion, but also the
e f fec t of long term t rends In the re lat ive pr ices o f h i s a n d o the r products .
Repor t ing I r v i n g Fisher, Farna a n d Schwert (1977) had noted t h a t t h e nominal
y ie ld o n a n asset can b e expressed as t h e sum o f a n expected rea l r e t u r n and
an expected i n f l a t i on rate. In the i r views, i f t h e market was a n e f f i c i en t processc
o f informat ion available a t time t-1 , it wi l l se t the p r i ce o f any asset, j, such tha i
t he expected nominal r e t u r n o f t he asset f rom t-1 t o t . w o u l d be t h e sum o f t h e
appropr ia te equ i l ib rum expected real r e t u r n a n d the best possible assessment o f
t h e expected in f la t ion rate, f rom t-1 t o t. Represented in the fo rm o f a n equatior
E(Rjt/Ot-1) = E(Tjt/t-1) .t E(Dt/O-t-l 1 . . . . . l e i
Where R j t = Nominal r e t u r n o n asset j f rom
t - 1 t o t
E ( T j t / B j t ) = appropr ia te equi l ibrum expected real r e t u r n
on t he asset implied by t h e set o f in format ion €bt -1
avai lable at t-1
E(&/Qt-1) = T h e best possible assessment o f the expected value o f in f la t ion
rate , Dt, tha t can be made on the basis o f Ot -, The message belng conveyed b y Equation 1 . 1 above i s tha t t he market uses
B t - 1 co r rec t l y assess t h e inf lat ion rate a n d t o determine the appropr ia te
equ i l ib r ium expected real r e t u r n on asset j, inc lud ing perhaps, a r i s k adjustment
which d i f fe rent ia te t h e expected r e t u r n on asset j, f rom tha t on o the r assets.
T h e market t hen sets the p r i ce of the asset so t h a t i t s expected nominal r e t u r n
becomes the sum o f t he equi l ibrum expected rea l r e t u r n a n d the c o r r e c t l y
assessed expected [nf la tion.
From t h e foregolng, It becomes apparent that t he issue at stake I s whether
In f la t ion Improves a r reduces the pro f i tab i l i t y and n e t wor th o f a p ro jec t o r
Investment.
1.3 Objectives of t h e Study
T h e fundaniental mechanism for economk evaluation o f investment opt ions
i s t h e Net Present Value [NPV) formular. T h i s states t h a t t h e present
value o f an investment option i s the sum of the discounted cash f lows
associated w i t h t h a t option. Present va lue is a stock concept. T h u s
t h e re levant cash f lows are equated w i t h a stock of new wealth by Caplta-
l izat ion a t t he cos t o f capital approprate to that investment. Bussey (1978
put it in a n equat ion form thus:-
Where
Po = t h e Net Present Value
Y t = t h e net cash flow at the end of per iod t.
N = t h e l i fe o f the project.
i = t h e discount ra te fo r t h e period.
t = t h e po in t i n tlme under considerat ian
,i.e. t = 0,1 ,2 , ; .....,.. N
Underthese conditions, the NPV is a po in t estlmafe, a s ingle value a t a
par t icu lar in teres t (discount] ra te i . In practise, for the f irm, once
t h e NPV is positive, t he pq'ect i s accepted, but rejected i f otherwise.
Inc idental ly t h e NPV method does no t p rov ide for t h e v ic iss i tudes o f
in f la t ionary pressures and seems to re late more to a n "a prlori" pro jec t
evaluation.
T o determine the pro f i tab i l i t y of an itwestment, one o f t h e most widely
used measures i s t h e r e t u r n on Investments (where investments i s to ta l
assets ( less in tang ib le f i xed assets) + V i cke ry [I9731 had maintained t h a t
W W W t he na tu re o f f ixed assests, t h e y a r e he ld solely f o r t h e pu rpose0
earn ing revenue a n d not pu re l y for sale. They a r e usua l ly valued a t cost
and: the amount o f f i xed assets whlch a r e shown in the Balance sheets
does not represent the i r realisable value, but usually historic record o f th ier
cost.
it wi l , b e the objectives o f this s tudy therefore:
1. Use In f la t ion data to analyze assets financial values i n successive
Balance Sheets and present them in uniform, inflaflon-adjusted
monetary values.
2 . Discover t he effect of lnf laiton on Capital Budgeting by comparison
o f the adjusted assets values with the unadjusted values and thence
3. State more reallstlcally the real prof i tabHlty and wealth o f an Investment.
1.4 Hypotheses of the Study
For the purpose o f th is study, we state two hypotheses, namely:
Hypotheses1 : l nf lat ion negatively affects the real r e r u r n on a project
investment.
Stated mathematically, we have that
Where
Ho = Null Hypotheses
HA = Al ternat ive hypotheses
~ r t incorporat ing inf lat ion on asset values a t time t.
f t = Return on Investment with inf lat ion-neutral
asset values a t time t.
Decision Rule
I f N - J j t ) , f t
accept null hypotheses
4 N T t < f f
accept t h e al ternat ive hypotheses
Hypotheses I I : Inf la t ion reduces the values o f investment assets
Stated mathematically
Ho: NWt - - W t
Ha: NWP # W t
Where
NWt = Adjusted value of assets under Inf lat ion a t time t.
W t = Hts tor ic value o f assets a t time t.
Decision Rule
If NWt 4 W t
accept u i l hypotheses
I f NWt > Wt
accept t h e s l terna t i ve hypotheses
1.5 Siqni f icance o f the S tudy
T h e s t u d y i s s ign i f i cant because i t would emphasize the need to acknowledge
in f l a t i on considerat ions in estimating o f investment p ro f i t ab i l i t y a n d v iab i l i t y .
F o r "a p r i o r i " pro ject evaluation, i t would encourage a more real is t ic assessment
of a project 's chances o f success. I n most cases recently, companies have had
t o r e p o r t huge levets o f p r o f i t only to d iscover t h a t such jumbo p r o f i t s f izzle
out in asset maintenance and replacement costs prec ip i ta ted by in f la t ion .
6.1 L imi tat ions o f the S tudy
T h i s s t u d y i s notal l embracing, fo r many reasons:
1. Risk adjustment, which di f ferent iates the expected r e t u r n s o n one asset
from tha t on another was not introduced, and as such, on l y t h e general
7
' effects.of inf lat ion are highlighted with respect to each asset or .pro ject
investigated.
2 . Inf lat ion data a re o f tern retrospective. The analysis i s essential ly l i ke
a post-mortem. It can therefore only prescr ibe fo r the f u t u r e by implication
Besides, since inf lat ion Is time variable, the respective effects determined in
th is s tudy relate on ly to the periods covered by the investigation. More
so, inf lat ion data used in th is work are the A l l i tem composite Consumer
Price index, not those of specific assets,.
3 . The work did no t compare the effects o f Inf lat ion on one company relative
t o the other. Al though this i s outside the scope o f the present study,
pauci ty o f consistent and regular data on any one company dld no t allow
f o r any such comparison,
CHAPTER TWO
REVIEW OF RELATED LITERATURE
Nath-e and Dimensions o f Inf lat ion
Inf lat ion, bo th now and in the past has cont inued t o confront policy-makers
throughout the wor ld as a dominant economic problem, Developing c0uh.t r ies
exper iencing g row th are often inundated w i th inf lat ion. Developed count r ies
usual ly have some form o f inf lat ion which i s inevi table for growth.
Inflation, which i s manifested by a general increase In the pr ices o f goods and
services var ies bo th in sever i ty and duration. I t can also resu l t f rom a var ie ty
o f causes and the main consequence is that i n f fa t i i causes a reductionin:& purchasing
power o f t he local cur rency.
2.1.1 H is to ry o f In f la t ion
Inf lat ion has now been proclaimed the cr i t ica l problem o f the indust r ia l ised society
and probably, I t s obsession(~evinson, 1971). Th is applies to a l l economiers
irrespective o f the i r levels o f Industriaiisatioh o r development. It i s ,not a new
phenomenon.
Throughout the ancient periods, the M.editerranean civ i l i ret lons f requen t l y experi-
enced h igher pr ices In terms of metallic currency, due to t he discoveries o f new
mines. The ear ly Mediterranean wars also caused lnf lat lon as a resu l t af the
release of hoards o f metallic money accummulated th rough pillage. Acquis i t ion
o f substant ia l quant i t ies o f gold and si lver by conquer ing Roman Emperors had
in f la t ionary fmpacts in the Kingdom, and f requent debasements [devaluation) o f
the coins in ancient China, Greece and Rome resul ted in inf lat ion.
in f la t ion i s n o t a ra re phenomenon In economic h'lstory. In the mlddle ages, it
was not unknown, despite the constra!nts of a general scarci ty o f t h e prec ious
metals. The discovery o f the New World produced a prot racted in f la t ionary
episode o f a t least West European extent, and each of the World Wars has been
known to b r i n g in f la t ion on an international scale. A fa i r number o f local
occurencies of inflation have also been known.
The inflation of u p till 1980 had been both extensive and sever, judging from the
consumer price index level as shown .on Table 2.1.
Table 2.1 Consumer Pr ice Index (CPI) Levels 1979
(Base 1950 =I)
COUNTRY
Argent ina
Uruguay
Bol iv ia
B raz i l
South Korea
l srael
Iceland
Paraguay
Ghana
PerO
T u r k e y
. Colombia
Yugoslavia
Spain
Mexico
Portugal
l re land
Fin land
Greece
I r a n
Un i ted Kl ngdom
New Zealand
I t a l y
Japan
France
Aust ra l ia
Denmark
CPI
100,000.0
12,000.0
719.0
275.0
183.0
80.5
60.4
54.0
50.0
45.3
40.3
29.2
15.0
10.6
9.7
7 .9
7.0
6.7
6.6
6.5
6.3
6.2
5.9
5.7
5.7
5.5
5.5
COUNTRY
Phillipin'es
Sweden
Norway
South A f r i c a
l ndia
Aust r ia
Morocco
Costa Rica
Netherlands
E l Salvador
Burma
Canada
Tunis ia
Belgium
Uni ted States
Dominican Refxlbli
Egyp t
Malta
Guatemala
S r i Lanka
Switzerland
West Germany
Malaysia
CPI
5.5
5.0
4.9
4.9
4.3
4.1
4.1
3.6
3.4
3.4
3.4
3.2
3.2
3.1
3.0
3 .O
2.9
2.7
2.7
2.6
2.5
2.4
2.1
Source: B r o w n a n d Darby 119851 p.2.
In their opinion (Brown and Darby 1985) no market economy avoided the inf lat ion
o f the per iod and none.seemed. t o have escaped w i t h less than a doubl ing o f i t s
consumer p r i ce index. Cnly the off icial price.s o f some central ly - planned economies
[ the USSR, (&echoslbvak'ii :as a t that time- and Bulgar ia) show2d v i r t ua l l y no
increase; and those o f some others (Poland Hunga ry ] showkidonly a small one.
The ilnternational Monetary Fund (IMF) gave a wor ld (weighted] average increase o f
5.3 fold, and the median count ry increase (see Table 2.1.) i s about the same figure
The United Nations indices for United States doll,ar pr ices o f internat ional ly t raded
goods showed a 3.6 fo ld increase in the case o f manufactures and a 4.8 fold in tha t
of pr imary products. A greater number o f market economies showed increases
between two and seven fold; Not many (mexico, 9.7; Spain, 10.6; Yugosslavia 15.0)
showed higher increases than that un t i l one go t to the v e r y much h igher ones o f
between 30 and 80 fo ld (Col.ombia,Chana, Israel, Peru and ~ u r k e ~ ) , t o 12,000 fo ld
(Uruguay) and 100,000 fold (Argentina).
Compared wi th World War periods however, Brown and Darby (1985) maintained
tha t recent lnf lat idns have produced larger p r i ce Increases f o r e t h e general i ty
of countries, but no truly hyper-inf lat ionary f i reworks, 'Cagan ( 1 956) def ined
hyper- inf lat ion a rb f t r a i i l y as a sett ing in whlch pr ices rose 50 percent in a month).
G r i f f i t h C1976) repor ted that one o f the earl iest records o f a rap id r i se in the
pr ice level was in ancient Greece around 330 BC, fol lowing Alexander the Great's
conquest o f Persia and h is t ransfer o f newly acquired go ld to Greece. Gold thus
replaced si lver as money and prices and wages rose throughout the whole Hellenic
Empire. lnsp i te o f this, the Greek States, even on t he verge o f b a r k r q t k y
did not have a h is to ry o f coinage debasement.
In Rome, the experience was qu l te different. Two hundred years before the
pirnic wars, t he copper coinage o f the Roman Empire was debased, and two
hundred years thereafter, both si lver and copper were debased by mint ing coins
wi th an Increased propotion o f alloys. W i t h the In t roduct ion of go ld as a p a r t
of coinage b y Augustus in about 30 BC till the decline o f the empire, the re was a
succession o f debasement and inflation.
2.1.2. I n f l a t i o n a n d War - A 'Sine Qua non' ?
T h e o r i g i n of t h e Pr ice Revolut ion of t he 16 th a n d ea r l y 17 th cen tu r i es
h a d been a m a t t e r of con t rove rsy among economic historians.. While one
school o f ( t h o u g h t he ld t h a t t h e basic cause was t h e increase in t h e s u p p l y
of g o l d a n d s i l v e r f rom' the Spanish colonies of t h e New World, t h e o t h e r
h e l d t h a t t h e i r i f la t ion was caused by non-monetary- factors,. y j t i r t i cu la r l y by
t h e increased demand f o r Spanish e x p o r t s
Many per iods of s h a r p l y r i s i n g p r i ces have been connected w i t h t h e
increased demand f o r resources r e s u l t i n g f rom wars: t h e b e g i n n i n g o f
t h e H u n d r e d years' war (1327);the Eng l i sh C i v i l War (1642 -'48); t h e War
w i t h France [ I689 - 971; t h e w a r o f Spanish succession (1701 - 13); t h e
seven years t War (1793 - 1SOb); t h e Crimean w a r (1854 - 56); t h e B o e r
War (1899 - 79021 ; t h e F i r s t Wor ld W a r (1939 - 451, t h e Korean War
(1950 - 53J a n d t h e Vietnam War, (Heichclheim, 1968; C r i f f i t h , 1976).
D u r i n g t h e Napoleonic Wars, p r i ces rose very sharply. Between 1793 a n d
1813 t h e y mare t h a n doub led and over t he two years, 1799 - 1801, p r i ces
rose by more t h a n fifty percent. Between 1914 a n d 1918, p r i c e s more t h a n
doub led a n d by 1920, t h e y t r ip led . Between 1939 a n d 1941 a t t h e beginning
a t t h e b e g i n n i n g o f t h e Second World War, t h e r e was a f u r t h e r r a p i d b o u t
o f i n f l a t i on as t h e p r i c e level n e a r l y doubled.
One fac t wh ich emerges f rom t h e s t u d y o f behav iour of p r i ces over s u c h a
l o n g p e r i o d o f time, is t h e increased magn i tude o f t h e p resen t i n f l a t i o n
by con t ras t w i t h ear l ier ones. D u r i n g Henry V l l l ' s Great Debasement
(1548 - 51), t h e r a t e o f in f la t ion averaged n e a r l y t h i r t y p e r c e n t ( G r i f f i t h ,
1976).
Ano the r i n t e r e s t i n g fea ture o f p r i ces in European count r ies up t o t h e 19th
C e n t u r y a n d of Europe a n d America since t h e n has been t h e coinc idence
in t im ing o f t h e major per iods of r i s i n g pr ices. In t h e h a l f c e n t u r y be fore
t h e Napoleonic Wars, p r ices rose g radua l l y [abou t one pe rcen t p e r annurn)
About AD214, t h e denan'us.: had approximately a f o r t y percent s i l ve r content.
In the same year, Emp&-or Caracella replaced it as the means of payment by
a double denarius which was only one a ha l f times t h e value o f a s ingle denar ius
(~eichi$lhe)m,1968).
Another indicator o f t he d i f ferent rates o f inf lat ion in Greece and Rome was t h e
d i f ferent levels o f in terest on normal loans (Gr i f f i th , 1976; Brown and Darby,
1985). In Greece, t he interest ra te rose from a level o f 4 percent in 550 BC
t o 6 percent and remained v i r tua l ly constant till about 50 BC.
In the Roman Empire, the interest ra te rose from a level o f 4 percent in AD50,
t o over 12 percent In ADZSO. These variable rates, were not inconnected w i th
qu i te d i f ferent under l y ing t rends in the rates o f inf lat ion. (Gr i f f i t h , 1976;
Rostow, 19781.
Following t he decline o f the Roman Empire, Europe sank in to t h e Dark Ages.
The tmpi re dis integrated i n t o a set o f barbar ian kingdoms which - invaded .and
p lundered each other. A t th is time, l i t t l e was known about t he behaviour o f
wages, prices o r interest rates.
From mid-thir teenth century, a number of features o f B r i t i sh in f la t ion came to
the open [Brown and Hopklns, 1956). Wen- two long periods, each approximately
one hundred and t h i r t y years (1380 - 1510 and 1630 - ?760), the re was a
remarkable s tab i l i ty o f the pr ice level. Throughout these per iods however,
t he p r i ce level did no t remain the same from year to year. Two o ther perlods,
1270 - 1380 and 1815 to 1914, intervening pr ice fluctuations were not iced than
a t the extremes. In the f i r s t o f these periods, t he re were rap id inf lat ions
associated w i t h the misgovernment of Edward 11; the outbreak of t he hundred
years War; the Black Death o f 1348 - 49 and the per iod immediately preceding
the Peasants' Revolt of 1381. Each o f these was followed by per iods o f deflat lon
which were sometimes severe.
For instance, between 1284 and 1289, 1370 and 7379, the p r i ce level fe l l by
near ly one half, In the second, of these periods, there were long per iods o f
fa l l ing p r i ces fol lowed by s h o r t per iods of f a i r l y sha rp p r i c e increases.
T h e p r i c e Revo lu t ion o f T u d o r a n d ea r l y Stuar t p e r i o d (1500 - 1650) reco rded
small p r i ces increases o f n o more than 2 percent p e r annum. (Heichelheim,
19683 . Agalns t t he backd rop o f p r i ce s tab i l i t y o f t h e 14th a n d 15 th Centur ies
it was a substant fA l i Increase. 8y the 1550's the average level o f a g r i c u l t u r a l
p r i ces was about two a n d 8 h a l f times t h e level o f f o r t y years prev ious ly .
Even i n d u s t r i a l p r i ces wh ich rose less rap ld l y t h a n ag r i cu l tu ra l p r i ces were in th
1550'6 - n i n e t y f i v e pe rcen t above t h e level of twen ty years ear l ier . T h e most
r a p i d a n d notor ious In f la t ion of t h i s pe r iod occurred between mid 1542 a n d mid 15
when H e n r y V I I ! a n d h l s son, Edward V I c a r r i e d o u t a substant ia l debasement o'
t h e gold a n d s i l v e r coinage, l a rge ly because of t he f i sca l p ressures t o wh ich
t h e y were subject. Over these n ine years, t h e money s u p p l y more t h a n double
a n d p r i ces rose by about s i x t y - f i ve percent.
Vals'h (1982) also r e p o r t e d t h a t the metall ic i n f l a t i on wh ich fol lowed t h e
d i scove ry o f America const i tu ted one o f t h e most impor tan t instances o f infat t ion
In h i s to ry . He observed that ' w i th t h e adoption o f paper money towards t h e ,
e n d o f t h e 17th C e n t u r y in t h e Un i ted States o f America a n d France, in f la t lon
began to occur a t regu la r Intervals. In 1775, t he USA exper ienced substant ia l
in f la t ion due t o t h e issue o f continental dol lars b y t h e government t o f inance
t h e War o f independence CTUttle and Perry, 7970) .
T h e d i scove ry of gold crlshes In Australia, Alaska, South A f r i ca a n d t h e Yukon
resu l ted in inf lat ion, The hyper - in f la t ion that occured Fn Germany In about 192:
( C h u a n d Feltenstein, 1977; Vaish , 1982) was the wors t in l i v i n g memory. In
Canada, r a p i d i n f l a t i on occured during 1914 t o 1920 a n d between 1947 e n d 1948.
T h e r e occured a r e t u o n t o double digit ln f la t fon In 1951, when N o r t h American
economy became o v e r st imulated b y the demands o f t h e Korean War, In t h e
subsequent f i f teen year per iod up to 1965, the Canadian economy [ f r o m 1966
t o 19761 saw t h e average p r i c e increase by 4 percent p e r annum.
inf lat ionary wi th inf lat ion averaging near ly three percent in Great B r i t a i n and j u ~
ove r three percent in the United States and Germany.
The f i r s t half o f the 19th Century was a general per lod of deflation, w i th pr ices
fa l l ing in Br i ta in between 1815 and 1850, and in the United States o f America b y
average of jus t over two percent, (Tuttle and Perry, 1970); in Cermany b y nearll
two percent and in France, b y one percent. The per iod 1850-73 was a per iod o f
r i s i ng pr ices followed, till the end of the cent rury , by fal l ing prices. The lnflat
before and during the War was qu i te general a l though t h e per iod immediately
following, when there was a r e t u r n t o f loating exchange rates, was no t= Some
countr ies notably Austria, Germany, Hungary, Poland and Russia experienced
hyper-inflation, while others such as Br i ta in experienced a sharp deflat ion.
Between 1920 and 1922, prices fe l l b y a total o f f i f t y - f i ve percent. The deflat ion
accompanying t he Great Depression was however, general and since t h e end of t h
S e c o n d ! ~ o r l d War, a l l Western Countries have experienced continuous inf la i ton.
In f la t ion accelerated in almost all countries following the Vietnam War.
Vaish 1982) are no t qu i te in agreement on a s ingle def l f i i t lon o f the term, :nf lat io
According t o Levinson (1971), it was not possible to approach in f la t ion as a
relat ively homogenous and easily defined phemomenon, identical, in al l periods of
time and In d i f fe ren t economic environments. In th is opinion, in f la t ion has remai
a n indetermlnate, unresolved chapter In economic h is tory .
There seems to b e as many dafin.itions o f inf lat ion as there a re economists IA j ay i
and Ojo, 1981). Levy and Sarnat (1978) described inf lat ion as a substant ia l and
sustained increased in the general level o f prices. Using the reciprocal o f the
I. It in t roduced r a t h e r two variables namely, general p r i ce level o r general
wage level, as t h e thing tha t i s in f la ted a n d
ii. It restr:icted i n f l a t i on t o s i tuat ions in which t h e general output i s incapable
of be ing increased, even Dnthe sho r t run.
A l though a l l t he above meanings of in f la t ion d o hwe something t o recommcmd each,
Hagger (19771 l ns i t ed t h a t tliey were al l too much o f economists def in i t ions, a n d thr
did n o t descr ib. t h e in f la t ion t h a t wor r i ed t h e o r d i n a r y man, and as s u c h was
no t o f in teres t to t h e po l icy makers. In .his book therefore, he d e f i n e d in f l a t i on
much in t h e same way as did Johnson (1972) , by descr ib ing in f la t ion as
I1a s i tua t ion in which there
i s a pers is tent upward
movement in t h e general p r i c e
level, o r in which there cou ld
b e s u c h pers is tent u p w a r d
movement but fo r the presence
o f d i r e c t contro ls over
price1' [Hagger 1977) .
Bal l (1973) had ear l ie r recognized t h e d i f f i c u l t y o f advanc ing a c lear-cut
de f i n i t i on o f inf lat ion, but nonetheless maintained t h a t one cond i t ion wh ich was
necessary f o r a s i tua t ion t o b e descr ibed as i n f l a t i ona ry was t h a t p r l ces nus st
b e r i s i ng . T h e thing w o r t h y o f note in the genera l p r i c e increases during
in f la t ion i s t ha t t h e pr ices o f a l l goods a n d serv ices must n o t b e i nc reas ing by
t h e same propor t ions (Gr i f f i t h , 1976, Levy a n d Sarnat, 1978). T h e impoptant
thing i s tha t although re la t ive pr ices v a r y f o r var ious reasons, t h e average level
o f a l l p r i ces cont inues t o rise, sustainedly. T h e change in p r i ces can b e
def ined as
so t h a t t h e propor t iona l r a t e of in f lat ion i s adopted as a n empir ical measure o f the
ra'te o f in f la t ion thus,
Where Pi = Change in p r i c e
P = Pr ice level o r p r i c e i ndex
t = t ime
Usually, in f la t ion i s measured ove r time per iods t h a t a r e su f f i c ien t ly l o n g t o el imin
a n y bias a r i s i n g f rom s h o r t te rm phenomena.
2.3 T y p e s of In f l a t i on
A p a r t f rom t h e many d e f i n i t i o m o f the term, i n f l a t i on has also been v a r i o u s l y
categorised. Words such as creeping, t r o t t i n g , galloping,rapid, chronic, explosive
runaway a n d hyper, have a l l been used t o descr ibe t h e pace o f t he va r ious
' in f la t ionary tendencies (Gr i f f i t h , 1976; Hanson, , 1 9 7 8 a n d Coxon, 1981). ,
Vaish (1982) h a d descr ibed a sustained almost impercept ib le r i se in p r i c e s o f
about 2 percent p e r annzrrn, ascreeping inf lat ion. ln h i s view th is can be d i s t i n -
gu i shed from gal loping o r hyper- inf lat ion wh ich occu rs when the p r i c e ris,e i s
o f t h e o r d e r o f 50 o r 60 percent , and f rom t r o t t i n g in f la t ion in wh ich t h e p r i c e
r i s e occurs a t intermediates, b r milder sustained p r i c e rises, economists have
used t h e terms, walk ing; running o r run-away in f l a t i on t o descr ibe them. T h e
content ion i s t h a t in t h e case o f walk ing inf lat ion, a sustained p r i c e r i s e may b e
about 8-10 pe rcen t p e r annum, while f o r h ighe r t w o d i g i t s sustained p r i c e rise,
t h e te rm r u n n i n g in f la t ion may be used. Vaish (1982) had said t h a t a l t hough
the re may sometimes b e over lapp ing between these terms, t h e pecu l i a r i t y o f each
r a t e o f p r i ce r i s e just i f ied t h e descr ib ing o f a n y p a r i t i c u l a r s i tuat ion, as such . Diagrampatic d i s t j n c t i o n of these terms revealed t h a t in hyper - in f la t ion ,
c u r r e n c y f l i g h t became SO fantast ical ly h i g h t h a t t h e veloci ty of money in
c i r cu la t i on approaches in f i n i t y .
Pr ice
Rise
Hyper- l nf lat ion . . I . Running /
Walking / Inflat ion
5 10 15
Years
Pr ice
l ndex
Fig 2.1. D i f ferent ia t ing between Inflation Types
(Va ish, 1982, P. 180)
Gr i f f i fh (1976) noted that one paticularly common euphemism for in f la t ion was
deflat ion which i n t he context i t was used, s h ~ u l d describe. ' a situation o'F
increased real ou tpu t in the short r u n p l us a greater ra te o f in f la t ion over the
s l ight ly longer r un . Iii the realm o f fa l l ing prices, dis-inf laiton is used to
re fe r to the reduct ion o r elimination o f inf lat ion and should not be confused wi th
demon which re fe r s to a reduction in the level o f real economic ac t i v i t y in an
economy. A depression should not be confused w i t h inf lat lonary situations.
Hanson (1978) was o f the opinion that a depression existed when unemployment
is high and capi ta l is unused for a substaintial per iod o f time. Less severe
than a depression is a recession, although the term i s of ten used emphemi'stically
f o r the former.
Inf lat ion in an economy Is open when there are no barr iersor controls t o p r i ce
increases. The reverse i s suppressed inf lat ion. In th is case, policies of p r i ce
controls, rat ioning o f essential goods, a re p u t in place, to suppress p r i ce
increases. I t was in th is regard that Florence (1975) observed tha t one obvious
d is t inc t ion between open and repressed/ suppressed inf lat ion i s that in the
former instance, pr ices which enter the p r i ce index are as determined by market
7 1
fo rce whi le in repressed inf lat ion, pr ices a n d wages a r e determined admin is t ra t ive ly
so t h a t t h e i r rea l increase Is a d is tor ted estimate o f t r u e i n f l a t i ona ry pressure .
Suppressed in f l a t i on i s subject t o many Il ls; F i r s t l y it creates many d i f f i c u l t
administ rat ive ' problems. In bad ly managed situations, suppresed in f l a t i on 500n
e r u p t e d a f t e r sometime, resu l t i ng in open inf lat ion.
I n f l a t i ona ry sp i ra ls r e f e r t o wages chasing pr ices a n d p r i ces chas ing wages.
T h e re la t ive ly recent 'Staglation' i s a te rm used t o r e f e r t o a cond i t i on o f
' in f la t ion a n d low g r o w t h in real Cross National product , In t h i s case, Stagnat ion
i s usua l ly coupled w i t h i n f l a t i on [Florence, 1975). l n f l a t i ona ry gap came in vogue
in t h e pos t Second World War years t o descr ibe t h e d i f fe rence between money GNP
a n d full employment CNP, w i t h constant p r i c e level ( B r o w n a n d Coxon 19'76).
T h e o t h e r t ypes o f i n f l a t i on w i t h respect t o cause i s t h e Demand Pu l l I n f l a t i on
Demand Pul l i n f l a t i on theo ry explains t h a t when t h e supp ly o f goods a n d services
fe l l sho r t o f t h e demand f o r them, an excess demand was stimulated. T h i s excess
'demand leads t o comper'itive bidding, which in tu'rn would lead t o high& pr ices.
w h i c h pers ist ing, became in f la t ionary (A jay i a n d Ojo,1981). In t h e v iew o f Hanson
( 1 978), Demand Pul l in f la t ion i s a term used t o descr ibe a n d in f l a t i on main ly induce1
b y excessive demand, because supp ly o f goods a n d services con tan t l y fa i led t o
keep pace w i t h demand. Us ing o u r now famil iar paraphrase a demand pull
i n f l a t i on ex is ted in a s i tua t ion where "too much money was chasing too few good".
Technical ly, it occurs when there was al ready full employment, a n d aggregate
demand expands beyond t h e ou tpu t which can b e supp l ied a t full employenlent
(Means, 1975) .
T h e o t h e r t y p e o r t h e Cost-Push theory o f in f la t ion associated t h e r i s e in pr ices
w i t h p r i o r r i s e in wages a n d other costs. T h e t h e o r y deposes t h a t i n f l a t i on
occu red d u e t o t h e increase in the imput costs. Acco rd ing to t h i s explanat ion,
r a p i d l y r i s i n g wage levels, unaccompanied by cor respond ing increase in labout
p r o d u c t i v i t y became ref lected in h ighe r pr ices. (We shal l examine t h i s la t te r
detai l , subsequent ly ) . 2 2
2.4 Causes of l n f l a t i o n
l n f l a t i on has also been classed w i t h respect t o cause. Causes o f i n 4 a t i o n
a n d in f la t ionary processes cannot genera l ly b e unders tood w i t h o u t r e g a r d
t o expectat ions t h a t a r e en ter ta ined abou t t h e f u t u r e course of pr ices.
B r o w n a n d Da rby (1985) ident i f ied f o u r k i n d s o f i n f l a t i ona ry impuls je~,
namely: Wage impulses, expend i tu re pull, cost-push a n d money-inject ion.
T h e y h a d maintained, whi le examining these impulses, t h a t changes in in te res
r a t e b e used as conf i rmatory evidence o f monetary impulses . Rut ledge 119741 h a d observed t h a t s ince the .Second World War, t h e po l i cy
problems associated w i t h ln f la t ion h a d g i v e n r i s e t o renewed In te res ts in
t h e re la i tonsh ip between t h e r a t e o f i n f l a t i on a n d t h e market r a t e o f in te res t .
T h i s i s exp la ined l a rge l y by t h e fac t t h a t i nves to rs form forecas ts o f
f u t u r e ra tes o f i n f l a t i on wh ich e n t e r as exp lanatory variables, i n t o t h e i r
demand a n d s u p p l y schedules f o r real capital . H i cks (1939) h a d eal-lier
no ted t h a t t h e r e were a na tu ra l r a t e a n d a t r u e money r a t e o f i n t e r e s t
b o t h o f which, h e he ld ,would be i d e t h c a l o n l y if t h e f u t u r e p r i c e s s f
the economists commodity remained the same as spot pr ices. T h i s v iew
is in l ine w i t h t h e Keynesian system wh ich o f ten assumes a cons tan t p r i c e
level o f s t i c k y pr ices. Many economists, p a r t i c u l a r l y t h e m o n e t a ~ i s t s , based
on p rev ious exper iences , had he ld t h a t p rec ise measurement a n d u n d e r -
s tand ing of i n f l a t i o n expectat ions deserve much analys is a n d t h o u g h i .
Accord ing ly , var iables represent ing expected r a t e o f i n f l a t i on have been
i n t roduced i n t o e x i s t i n g theories t o adapt them t o a World o f c h a n g i n g pr ices.
U n t i l t h e Grea t Depression o f t h e in te r -war years a n d t h e publ icat io i? by
Keynes In 1936 of h i s classic analysis o f t he problem o f mass unempl3yment
in advanced cap i ta l i s t economies, t h e accepted explanat ion o f t h e causes
o f i n f l a t i on was t h e Quant i ty theory o f money. In t h i s wise, i n f l a t i o ~ was
expla ined o n l y in monetary terms.
The quant i ty theory has a long and dist inguished h is tory . It was t h e theory o f
Dav id Hume, Adam Smith. David Ricardo, A l f red Marshall, Knu t Wicksell and
I r v i n g Fisher (Gri f f i ths, 1976). This quant i ty theory was or ig ina l ly propounded
to prov ide the theor i t ical basis f o r the observed tendency f o r *p r i ces t o increase .
when the quant i ty o f money was r is ing a t a faster ra te than the product ion of
goods and services. In the original form o f the theory, var iat ions in t he quant i ty
of money and the p r i ce level were said to be proport ionately related.
' elements o f th i s view were set out b y Dav id Hume in h is Essay o f 1.752 (Rotwein
1955) in which it was observed that the p r i ce o f commodities a re always proport ion
e d t o the p lenty o f money and that the high pr i ce o f commodities be a necessary
consequence o f the increase o f gold and si lver. Many 18th and 19th centur ies
wr i ters cont r ibuted to t he discussion o f the quan t i t y theory o f money.
In the late 18th and ear ly 19th centuries, Ricardo (1951) rested the theory again
in the context o f a n international economy, not ing as previous wr i te rs h a d done
the di f ference between the in i t ia l and ultimate ef fects o f an increase in the money
supply. Said Ricardo (1951), "if b y the discovery o f a new mine, b y t he abuse
o f bank ing o r b y any other cause, the quant i ty o f money be great ly increased
i t s ult imate ef fect is always t o raise the pr ices o f commodities in p ropor t ion to
the increased quan t i t y o f money; but there is probably always a n intervial
during which some effect i s aways produced on the ra te o f interest .
By the late T9th Century Knu t Wicksell (Cr i f f i th , 1976) showed t h e way in which
money af fected expendi ture and inturn pr ices under two extreme k i nds o n
monetary systems;
(a) a p u r e cash system in which money was e i ther metal o r else bank deposit
backed b y hundred percent reserves and (b) a pu re cred i t system in wbich
money was bank deposits backed by hundred percent credi t . The d is t inc t ive
feature o f Wicksells contr ibut ion was to show how in a wor ld o f c red i t and
interest rates, a change in the stock o f money affected.
pr ices ind i rect ly by I t s effects on market rates o f interest.
The quant i ty theory reached a high level o f sophistication in the work o f
Irving Fisher. In h i s book, the Purchasing Power o f money, Fisher (1911)
l a i d ou t the quan t i t y theory in terms o f t he now famous quant i ty equation ( o r
equation o f exchange I where
in nhich
M = total Money Stock
V = transactlon velocity o f c i rcu la t ing money (o r
the ra te of turn-over o f money in t he process
o f exchange for goods).
P = Price index o f the aggregate p r i ce level
T = the total number of transactions
(o r quant i ty, Q, o f goods sold).
What th is equation o f exchange d i d was to summarise the pr imary factors that
inf luenced pr ice level determination, namely:
...... P = M V l T = MV/Q. . (2.4)
Within th is framework, Fisher (1911) concluded tha t on the assumptidn tha t
increase In money supply (m) wil l general ly not af fect the veloci ty o f
c i rculat ion (V) o r quan t i t y o f transactions(Q) a t full employment level, the
p r i ce level (PI wil l va r y d i rect ly wi th the quant i ty o f money [MI. In h i s v e r y
words : -
"Money supply is seen as the important causal
...... factor in inf lat ion The normal effects o f a n
increase in the quant i ty o f money i s an exactly
proport ional increase in the general p r i ce level "
(Fisher, 1911).
According t o th is classical economic analysis, inf lat ion occurs when the
quan t i t y of money increases, and comes to a ha l t when the quan t i t y of ,
money becomes stable. To that extent, the ra te o f inf lat ion
wil l depend upon the ra te at which new money was created,that i s upon
demand f o r money.
A s a resu l t o f t h e g rea t depression a n d the revo lu t ion b r o u g h t abou t by
Keynesian ideas; t h e q u a n t i t y t heo ry fe l l i n t o g rea t d i s repu te a n d d isuse
in t h e 1940's a n d 1950's. It was g ra te fu l l y re labi l i ta ted d u e t o t h e work of
Mi l toh Fr iedman o f t h e Un ive rs i t y o f Chicago in the Un i ted States o f America,
in what was popu lar ly known as ~ o n e t a r i s h . T h i s thought asser ted tha t t h e
s ign i f i cant determinant o f aggregate spending was t h e supp ly o f money. Thus,
increases in money s u p p l y were seen as the important causal.: f ac to r in
in f l a t i on (Friedman, 1956) . Another, more recent theo ry wh ich attempted t o exp la in t h e o r l g i n o f i n f l a t i on
i s knownas t h e Cost p u s h o r Wages p u s h theo ry o f i n fa l t i on ( w h i c h we s a y
b r i e f l y in t h e conc lud ing paragraphs o f Chapter 2.3). In t h i s theory , g rea t
emphasis i s put on t h e ro le o f t rade unions t o secure increased wages, so
increasing t h e money value o f nat ional income, and w i t h it, in f la t ion .
Most ecwlom i c w r i t e r s a n d decision makers believe tha t t h e cause o f post-war
B r i t i s h inf lat ion, lay, n o t i n excess creation of money, but in t h e monopoly
power o f t rade unions and the i r attempt to ra ise t h e i r share o f wages in t h e
GNP. Said Reginald Maulding, a once chancel lor o f t he B r i t i s h Exchequer,
"The last two decades have
seen p ro found changes, bo th
economic a n d polit ical, in the
whole cap i ta l i s t system. T h e major
change has been a n a r i s ing
consciousness o f t he power o f organized
labour wh ich in a complex modern
economy possesses the power to b r i n g
a n y modern capi ta l is t economy t o
a halt . We see the resu l t o f a l l t h i s
in t h e prob lem o f cost in f la t ion wh ich
has bedevilled th is c o u n t r y fo r many
years ... . T h i s i s a new problem;
it i s a pol i t ica l problem. The o l d
t rad i t iona l economies cannot
beg in to cope w i th i t " (Maulding 1972) .
A r t h u r Burns, then Governor o f the Uni ted St?
sytem, made statements, ap t enough, to descr i t
r v e
stion:-
He said,
"The ru les o f econor;lics are no t work ing in
qu i te t he same way as they used to, Despite
extensive unemployment in o u r coun t r y wage
ra te increases have no t moderated. Despite
id le indus t r ia l capacity commodity pr ices
cont inue t o r ise rapidly (Burns 1971) .
Thus, it i s argued t ha t t rade unions are in a posi t ion to demand h igher wages
from the i r employers and put considerable pressure o n governments. Altogether,
the addit ion o f a l l union's successful demands f o r pay r i se may be g rea le r than
the increase in product ion following increase in wages. Under such situations,
pr ices wi l l r ise,
Alternatively, the r i se in wages may be seen as a n increase in costs pf product ion
which i s passed un to consumers b y way of h igher pr ices o f goods and services.
Another version o f th i s cost push theory of inf lat ion i s the p ro f i t - push. In this
case, an oligopolistic o r monopolistic firm induced a p ro f i t margin o r mark-up
designed to of fset any increases in cost of product ion. Th is m a r k - ~ p or p ro f i t
margin becomes a n important stimulus of inf lat ion.
2.4.1 In f la t ion o r Unempfoyment?
No discusslan on the causes o f inf lat ion would be deemed complete wi thout
reference to the relat ionship between inf lat ion and unemployment, r e f e r r d to as thl
Phillip:' Curve. Originated b y Professor A.W. Phil l ips of thelr>r& School of
Economicsand Political Science, the curve traced the existence of a negat ive but
non-linear relat ionship between the percentage increases in wages and the percent;
o f the labour force unemployed.,.
Phi l l ips (1958) also argued that wages would be affected by the ra te a t
which demand for labour was changing and t he ra te o f change o f re ta i l
prices. Thus, i f .one considered a situation in whlch the average level o f
unemployment was the same but in which the demand fo r labour rose rapidly,
we would expect tha t wages would r ise more rapidly.
Shor t l y a f ter the introduct ion o f the phl l l ips curve, it was hai led by most
economists and policy-makers as one of the greatest empirical laws of economics.
The curves appeared to offer a t rade-of f between inf lat ion and unemployment.
Al though in Gr i f f i t h ts (1978) vlew, the trade-off was of ten presented in terms
of a relat ionship between unemployment and the ra te o f p r i ce inf lat ion, ra ther
than wage inf lat ion. To support the existence o f a t rade-of f f rom which
policy-makers can make a choice between inf lat ion and unemployment, Ajayi and
Ojo (7981) opined tha t It was necessary to show that the r a te o f change o f
money wages (o r prices) was a stable funct ion o f unemployment tha t does no t
sh i f t from one per iod to another. If one assumed that pri-ce increases were
equal to wage increases, less p roduc t i v i t y increases, such a cu r ve would be
paral lel to,but below the original phi l l ips relationship b y a n amount e q ~ a l t o the
percentage increase in product iv i ty.
Another reason for the popular i ty o f the .Phillips curve was t ha t it seemed to
have of fered society a range o f choices. Because It was impossible t o achieve
ei ther fu l l employment o r lwfect pr ice stabil i ty, the best that soclety could
do was to move along the !?hillips curve. Here, the choice was less in f la t ion
( t o the r i g h t ) a t the cost o f h igher unemployment o r less unemployment [ t o
the le f t ) a t t he cost o f more inflation. The chosen combination f o r any count ry
depended on i t s previous h is tory o f Inf lat ion and unemployment.
In the late 1960's and early 1970'5, the Phil l ips cu rve was presented wi th a
major challenge as more and more developed capital ist economies became faced
wi th a n experience o f r is ing inf lat ion accompanied b y a h i g h level o f unemploy-
ment [Griffith. 1976; Ajayi and Ojo, 1981). These experiences, to ta l ly
unexpected as they were, led economists t o question, no t only t he s tab i l i t y
o f the Phi l ips relationship, b u t also i t s ve r y existence.
One dissent ing school o f throught he ld that inf lat ion was synonymous w i t h cost
inflation, Th is g r o u p observed that wage inf lat ion and unemployment were
atween the determined b y separate factors and tha t any empirical connection be.
two, was explained by random forces. For instance, wage in f la t ion was said
to be the , resu l t of conflict between labour and capital over the size o f the i r
respective shares in the CNP and of the attempt b y t rade un ion to charge wage
differentials t o the i r own advantage. Secondly, p r i ce inf lat ion was bel ieved
t o depend o n wage increases, d i rect and ind i rect tax r ises and upward
movement in import pr ices (in the Nigeria case, upward movement in fore ign
exchange rates] .
The other schools of thought based the i r explanations o f the perverse behaviour
o f the Phi l ips c u r v e on effects of expectations o f f u t u re pr ice increases on
cu r ren t economic behaviour. The general concensus seemed t o be tha t if trade-
of f existed between un-employment and wage (pr ice) increases, It was on ly in
the shor t run; and that no permanent t rade-of f existed in the long run
between in f la t ion and unemployment as the economic climate was subject to
change, and as there existed market imperfections, thus making the Phi l ips
relationship a shor t - run phenomenon.
Estimating ln f la t ion
An in f la t ionary r i se In prices must be concerned mostly wi th the concept o f the
general p r i ce level. It i s therefore appropr iate to consider r i s i ng pr ices in
terms o f some measure o f the general p r i ce level. Ris ing pr ices must o f
necessity be thought of as reflected in some average o f al l prices, and t h i s
chosen average o f the general pr ice level i s used t o define an inf lat ionary
situation.
Three main problems thus emerge in an e f f o r t t o measure the ra te of inf lat ion
namely;
1 . Choice of an index o f prices t o represent the genera1 pr ice level.
2 . Measuring the extent o f the upward movement in the chosen index ove r a
specif ied per iod o f time, and
3 . measuring variat ions in the speed o f the upward movement in the chosen indc
over the specif ied time period,
The general p r i ce level must be regarded as a n average p r i ce o f some klnd, which
then raises the quest ion as t o what pr ices t o use and how they are t o b e summed
together. In t r y i n g t o measureinflatiorione(of the man problems remains t h a t o f
choosing the p r i ce index which would represent the general pr ice level. Accordin
t o G r i f f i t h (1976), the ra te o f inf lat ion in a modern economy was measured by Ind
numbers. The Austral ian possibilit ies (Haggs, 1977) come qu i te handy in t r y i n g
to determine an appropr iate measure of a r ise in the general pr ice level. These
possibilit ies, including the i r merits and demerits consist--of:
i. The Consumer Price lndex (CPI)
ii. Some component o f the CPI
... III The Wholesale Pr ice lndex (WPI)
v lmpl ic i t Deflator o f some Category of the Gross National Expendi ture ( G N E )
vi . lmpl ic i t Deflator o f the Non-farm GNP a t Cost.
i. The consumer p r i ce lndex (CPI] . Th is i s intended to measure only var iat io
in the retai l pr ices o f those goods and services which at t rac t a substaint ia l
po r t ion o f the aggregate expendi ture o f wage errrers ; It Cove6 a l l important
raw foods and a l l commodities whose pr ices are subject to s igni f lcant var iat io
th rough fiscal action. The CPI i s no t however comprehensive as it c'oes no t
cover al l foods and commodities.
ii. Some component of the CPI
In th is case, instead of using the CPI, one could use one o f the f i ve compo!:
indexes from which theCPl is bu i l t up, namely :-
the indexes f o r food, c lothing and draper.^, housing, house-hold supplies
and equipment and miscellaneous. Like the CPI, these components lack
comprehensiveness.
iii. The Wholesale Pr ice lndex
While the CPI represent retai l pr ice indexes, the WPI considers Wholesale
p r i ce indexes o f materials used in house-building o r the index o f materials
used In bui ld ing, o ther than house building. Again the WPI i s no t
comprehensive.
iv. T h e lrnplidt Def lator of t he GNP
Thls i s not, s t r i c t l y speakitkg , a p r i ce index, I t Is calculated f o r any
quar te r b y d iv id ing the GNP in cur ren t pr ices f o r that qua r t e r b y the
CNP in constant pr ices f o r t he same period. Al though it i s no t a gennuine pd
index, It can specifically be thought o f as one re la t ing t o a l l good:; and
servlces comprising GNP.
v. The Impl ic i t Deflator o f Some Category o f GNE
The GNE def lator measures the movement in the general p r i ce level o f some
component o f C N E f o r instance the implicit deflator o f personal con!;umptlon
expendi ture. It on ly lacks the advantages o f the GNP def lator and also
shares its disadvantages.
vi . The Impl ic i t def lator fo r non-farm CNP a t Cost
Th l s p r i ce index is obtained f o r any g iven quar te r by d i v i d i ng t he f i gu re
fo r non-farm CNP a t factor cost, in terms o f cu r ren t pr ices by the f i gu re
fo r non-farm GNP at constant prices. Th is lndex al though satisfact9t-y in
some respects, is no t total ly acceptable.
In a b i d t o determining which o f these indexes was the most appropr iate, Hagger
(1971) approached the problem b y f i r s t o f a l l l i s t l ng the character ist ics o f a pr ice
index ideal fo r measuring inflation. The f i r s t characterist ic requi res tha t the
index relate to. t h e commodities produced within the economy.
o r economies for which inf lat ion i s being measured. The second requi res tha t the
index be comprehensive w i th respect t o the goods and services produced w i th in
the economy. Th i rd ly , the index should take proper account o f Improvements in
the qual i ty o f t h e various commodities covered by the Index. The f o u r t h and final
character ist ic requi res that the Ideal index should no t b e affected by temporary
p r i ce increases l ike ly t o reverse in the immediate future.
Af ter th is review, Hagger (1971) observed t ha t none of the l is ted s i x indexes was
en t i re l y sat isfactory and that in any actual situation, serial p r i ce indexes could b e
legitimately used t o measure inf lat ion.Gri f f i th (1976) in apparent agreement had
ear l ier noted t ha t al l o f these pr ices indexes "have cer ta in biases, contain defects
and over shor t per iods o f time, these indexes behave qu i te d i f ferent ly" . Often, in
practise, during inf lat ionary periods, these indexes moved closely together.
With time, pract ise and experience it became obvlous tha t the most convenient mode
of represent ing a single p r i ce over tlme, in many respects, was to. express it as a
percentage o f i t s value in some g iven year. Thus, if a par t icu lar p r i ce was g iven
the number 100, it i s implied that It was 100 per cent o f the p r i ce obtaining i n
that g i ven base year. For instance, if the value was 100 in 19-X and 115 In the
year 19-Y, then it could b e said tha t the p r i ce had r isen 15 pe r cent between the
years 19-X and 19 - Y.
Ba,ll. (1973) r i g h t l y noted that w i th the general p r i ce level, complications arose
because it was a ref lect ion of the behaviour o f many pr ices and some way must be
found to add them up. However, since all pr ices were no t equally important, it
was usual ly felt necessary to represent the general p r i v e level as a weighted
average, so tha t the movement of an ind iv idua l pr ice cont r ibuted t o the movement
o f the whole in propor t ion to the importance wi th which i t was regarded.
In theory, matters got complicated b y the fact that the choice ofweights was no t
general ly unique. While d i f ferent sets o f weights lead to d i f ferent numerical
assertions about how much the general p r i ce level has a altered between two ~ o i n t s
3 4
In time, in practise, t h i s i s ' no t unduely t'estrictive. The reason i s because
even the d i f f e ren t methods of weighting o f ten had t i t t le ef fect on t he b road
. qual i tat ive coirclusions rcachcd about p r i ce behaviours.
2.6 Inf lat ion : T h e Niger ian Experience
In Nigeria, the index o f pr ices has been continuously on the increase :since
1960, al though ths p r i c= increases since 11970 have ,been of more significance.
The World Bank C o u n t r y Ec~nornic ~ i ~ o t - t o f 1979 had A that in: t h e two years ,
endirig December 1971, the money supply in Nigeria ' incieased b y 52 p e r cent.
The report. bttmed some o f the increases o n the remonltization in the t h e n Eastern
States o f N iger ia a f t e r the Civ i l War, most o f whlch however stemmed f rom
government's rel iance o n shor t t e r n bor tow ing from the bank ing 'system and
thus con t r ibu ted to the rap id rate o f u rban inf lat ion.
Ajayi and 'Ojo (1982) had it that the r a te o f 1nflatio.n between 1969 a n d 1970 was
about 1.0 p e r cent, but that it rose immediately a f te r the c i v i l war in 1970 tp
about It4 p e r cent, and thence to. 16.1 p e r cent in 1971, mainly a t t r i bu tab le to
food pr ices whlch increased b y 24 p e r cent and 27 per cent respect lvely.
Import l iberal izat ion measures o f 1971 eased demand pressure on manufactured
goods b u t ant i - in f la t ionary effects had l i t t l e ef fect on food prices. A f t e r a l u l l
between 1972 a n f 1973, the consumer p r i ce index rose again from 213.6 in 1974
to 286.4 in 1975 (Base 1965 = 100) ,an Increase in inf lat ion ra te o f 34.0 p e r cent.
N w a n k w o [ 1 9 0 0 ) was of thc oplnlon that t f ~ c per iod sincc 1374 could bc regarded
as inf lat ion era. He said that although in f la t ion had been plaguing t h e Niger ian
economy well before then, it got so serious tha t in 1974 the then Head o f State
described the phenomenon as Public Enemy Number 1. Nwankwo ( i b i d ) t ~ e n t - P ---
ahead to d iv ide the inf lat ion era in to two. The f i r s t per iod o f T974 t o 1976 was
characterised b y the short- l ived oil boom which created the euphoria t ha l a l l was
well w i th the economy as there was a ve r y healthy balance o f payment pclsition
and a considerably improved Government revenue position. Dur ing t h i s
period, the bank ing system had an unsual
excess l i qu id i t y as a resul t of the heavy spending by government, o f i t s o i l
revenues. Terminat ing this period was the launching o f the T h i r d Nil t ional
Development Plan invo lv ing a planned expendi ture o f a whopping 30 b i l l ion
naira. Th is set t ing o f the f i r s t period, launched what NwankwoC1980) referrec
t o as the second era, from 1976, a time in which t he balance o f payments r a n
i n t o huge def ic i ts which have recalc i t rant ly persisted, till date.
As the prospects f o r o i l production and sales became unfavourable, governmen
revenues slumped and a period o f aus te r i t y and acute inf lat ion whose end
remained unforeseeable set in.
Ciroma (1976) as governor o f the Central Bank o f Nigeria (CBN) blamed the
acute Inf lat ionary pressures at the time, on excess l i qu id i t y in the bank ing
system. In h is opinion, the banks had substantial funds f o r which they were
no t finding as much investment out let as they would wish. Among the several
o ther factors tha t under l ined the in f la t ion included insuff ic ient product ion f o r
t he domestic economic market, added to a n inadequate physical capacity t o
augment th rough importation,compounded, as it were, b y p o r t congestion al l
o f which together did severe damage to the economy.
l nf la t ion pressures intensif ied during 1983 following the general scarc i ty of
consumer goods which was made worse b y hoarding and the sharp increase i n
the money supply situation. There was a rap id r ise in consumer pr ices as
revealed b y the Federal Office o f Statist ics (FOS) all-item Composite (?PI
which averaged 328.5 (base 1975 = 100) an increase o f 23.2 p e r cen l above
the prev ious year's level. The major factors responsible fo r the high pr ices
was the fal l in food production and the d rop in importation due t o import
res t r ic t ions and low foreign exd7ange.
Ahmed (1986), seemingly towing the l ine o f Ciroma (1986) observed tha t the
oi l g l u t o f the late 1970's and ear ly 1980's resul ted i n a sharp decl ine in the
Federal and State governments' revenues which was not matched by a corres-
ponding reduct ion in publ ic sector expenditures. Consequently, la rge
b u d g e t a r y de f ic i ts -red, f inanced mainly by t h e b a n k i n g system. T h i s
cons t i t u ted substant ia l l y t o excess demand p ressu re in t h e economy a n d t h e
accelerat ion in t h e r a t e o f in f la i ton from 9.9 pe rcen t in 1980 t o 39.6 percen t .
in 1984.
It was also r e p o r t e d (CBN Annua l Report, k c . 198Y) t h a t s u p p l y sic'e factors
were dominant i n r~exe r t i ng u p w a r d pressures o n p r i c e s In 1984. Severe shortages
in consumer goods a n d serv ices markets, caused mainly by low ' leve l domestic
ou tpu t , h o a r d i n g act iv i t ies; l ong cha in d i s t r i b u t i o n ne tworks a n d i m p o r t
res t r i c t ions , l e d t o t h e h i $ b s t in f la t ion r a t e as t h e al l- i tem composite CPI rose
f rom 328.5 in 1983 t o 458.4 in 1984 (Base 1975 = 100) . O t h e r c o n t r i b u t o r y
fac tors blamed f o r t h i s s t r o n g u p w a r d movement o f p r i c e s were r e d u c e d level
o f impor t s o f complementary commodities a n d Inadequate storage fac i l i t ies.
T h e i n f l a t i ona ry p ressu res wh ich reached a peak in 1984 subs ided cons iderab ly
in 1985. Foli lowing t h e f igures pub l ished by t h e FOS (CBN Annua l Repor t ,
December 1985) , t h e r a t e o f i n f l a t i on decl ined s h a r p l y t o 8.5 p e r c e n t in 1985
f rom a peak 39.6 p e r c e n t in 1984. Al though t h e a l l i tem composite CPI s t i l l
mainta ined a n u p w a r d t r e n d (1984 CPI = 458.4, 1955 CPI = 483.7) , t h e r a t e
o f domestic p r i c e increase decelerated cons iderab ly in 1985 ,in re la t i on to t h e
p rev ious year. Compared w i t h t h e 39.6 percen t i n f l a t i on r a t e in 1984, t h e CPI
increase in 1985 was o n l y 5.5 percent . T h i s re la t ive r e d u c t i o n was r e p ~ t e d
t o b e a t t r i b u t a b l e main ly t o a n Improved domestic s u p p l y s i t ua t i on a n d t h e
r e s t r a i n t o n expans ion o f aggregate demand, especial ly in areas o f government
spending. These v iews were also expressed by t h e U n t e d B a n k f o r A f r i ca
Chairman (Bus iness Times Monday 5 t h May, 1986) in h i s Annual R e p o r t f o r t h e
yea r ended Dec. 1985. He ascr ibed t h e re la t i ve dec l ine in in f l a t i on r a t e
between 1984 a n d 1985 t o increased domestic p roduc t i on in t h e ag r i cu l t u r3e a n d
manufac tur ing sectors , assisted b y low levels o f monetary expansion.
Looking a t t h e f i g u r e s quoted by Ahmed (1985), government cap i ta l expend i tu re
in 1986 was 5445.9 mi l l ion naira, decreasing f rom 6,096.4 mil l ion n a i r a in 1985.
Correspondingly,data suppl ied by the FOS (CBN Annua l Repor t o f DEc. 1986)
showed t h a t i n f l a t i on moderated in 1986, d u e la rge ly t o improved food supp ly ,
A t 509.7 (Base: 1975 = loo), the all-item CPI in 1986 fo r a l l income g r o u p s in
u r 5 a n and r u r a l areas rose by 5.4 percent , compared w i th a n increase o f 5.5
percent in 1985. T h e decl ine again, was a t t r i b u t e d t o t h e increase i n food
p roduc t ion a n d reduc t i on in personal income which severely c u r t a i l e d consumer
demand. Also con t r i bu to ry , was t h e tight monetary and f iscal po l i cy .
2.7. I n f l a t i on a n d Project Evaluation
Wil loughby (19771. observed tha t t h e te rm tevaluationl has tended ' in English,
t o take o n t h e sense o f a re t rospect ive rev iew o f something a t least 01 going.
R o m t h e p o i n t o f v iew o f economic, method, t h e di f ference betweenter:-ante'
(a ~ r i o r ; ) o r lex-post t (a poster ior i ) p ro jec t evaluat ion i s o n l y one o f perspect i \
T h e Central f o c u s o f a n y investment analys is usua l ly invo lves a c ~ m p ~ r i s o n o f
t he s i tuat ion w i t h : ! t k inwstment and tha t w i thout t he investment.
Goodman a n d Love (1979) def ined Project Evaluat ion as the appraisal o f t h e
overal l ab i l i t y o f a pro jec t t o succeed. Such an appraisal i s usua l l y clone by
compar ing t h e expected benef i t from t h e project , w i th the amount o f resources
t o b e committed in execut lng the project . A l though th i s sounds v e r y much
l i k e an 'a!prior i lproject evaluation, t he o n l y fea ture considered pecu l i a r t o
ex-post analys is i s t h a t quoted f inancia l f i g u r e s may need ad jus tment by a p r i c t
index, in o r d e r t o eliminate the ef fects o f Inf lat ion, made appra ten t by a gener?
change in t h e p r i c e level o f goods a n d services. Accord ing t o Wil loughby,
(19771, a charac ters t ic weakness o f expost pro jec t evaluation, from t h e World
Bank's exper ience, i s t ha t at tent ion was usua l l y d r a w n to issues a n d cases
o f p ro jec ts approved f o r t he Banks s u p p o r t u n d e r pa ides t h a t were n o t necessa
s t i l l c u r r e n t . He there fore saw i t as a n " i n t r i n s i c problem o f eva luat ion t o avoi
a n ar id historicisrrlt whi le re ta in ing the ob jec t i v i t y a n d independent v iew po in t
which a re I t s p r imary strengths.. , The implication here i s that i t i s necessary,
a t t he f i r s t instance, and to make more meaningful the c0n ten . t~ o f pro ject
appraisal, to Include in the projectjons, a condi t ion tha t accomodates inf lat ionary
pressures .
Harbergc r il972) d i f f e red sl ight ly wi th t l ~ e s c view when he said that most
discus&ons o f project evaluation ('ex-ante'), note tha t expected p r i ce changes . ,
should b e talcen In to account. What th is sought to 'suggest was t ha t techniques
o f project evaluation' were ready made to accomodate inf lat ion- induced changes in
the general p r i ce levels.
- Olashore ( 1987) apparent ly echoed th is po in t when he observed t h a t Acc:auntants,.
th rough t he ages, have no t been ind i f ferent t o changes in general p r i ce levels. H
maintained that . under t h e subject o f .Account ing fo r inf lat ion, cbnsiderable at tent io
was g iven t o the concept o f changes in specif ic general p r i ce levels. Consequent
upon th is was the formulation o f a series o f guidelines classif ied as Statements.of
Standard Accounting Practises, each o f which endeavoured to reconcile the d.iverge
views o f accoun'tants in repor t ing financial statements. Writing 'on the ef fect of SF
on Accounting Methods and procedures bo th Olashore and Randle ( 1 987) ~ecognisec
tha t the d ive rgen t views inherent in al ternat ive accounting methods. For repor t in !
financial statements would not reflect the impact o f SFEM. Olashore's views:
"Considerable f lex ib i l i ty allowed ind iv idua l f r ims in
t he application o f alternative accounting methods fo r
repor t ing f inancial statements would usual ly no t re f lec t
the impact o f SFEM. One serious impact o f SFEM i s
that o f unbr id led inflation". (Olashore 1987)
Again, Olashore ( 1987 ) observed that the aspect o f accounting repor ts l i ke ly t o
be af fected in the presentation of operational act iv i t ies i n d u d e Valuation o f Assets,
among others. Randle (1987) also had noted tha t another problem which SFEM
created f o r accountants and auditors related to the revaluation o f f ixed assets,
especially plants and machinery. In his opinion, companies were right to sc?ek
to revalue the i r assets in order to reflect the vas t l y increased ( in f la ted?)
replacement costs. St i l l w i th in the SFEM era, Randle ( ib id ) noted t h a t when
it came to stock valuation,while opening stock may have been calculated o n
p r e SFEM histor ical cost,closing stock may be closelyreflectt ive o f pos t SFEM
purchas ing cost. He therefore cautioned that l i ke be always compared w i t h l ike,
since vas t l y d i f fe ren t resul ts could emerge depending o n whether closing stock
i s calculated o n f i rst- In- f i rst-out (FIFO) o r Last-In-First-Out (LIFO) basis.
In essence, wha t 'a l l these point to is to say that one aspect o f a cornpa;?yls
revaluation, most l ike ly t o bring ou t t he effects o f a general p r i ce increase, i s
the aspect o f Assets Valuation.
2.8 In f la t ion and G p i t a l Budget ing
Oneaspect o f business enterpr ise whose siamese twin i s Project Evaluation could
be said t o b e Capital Budget ing .Weston and Brigham (1980) explained Capital
Budget ing to involve the ent i re process o f p lanning expendi tures whose re tu rns
a re expected t o extend beyond one year. They maintained tha t the optimium
Capital budget i s simultaneously determined by the interact ion o f supp ly and
demand forces under conditions o f uncertainty.
Naslund (1971) he ld that the area o f capi ta l budget ing was ve ry large and
d ivers i f ied and that there existed i n l i terature, discussion on the proper.
criterion t o use t o evaluate investment projects. Weingartner (1965 and '19661
approached the problem from various points o f views and came up w i t h a va r ie ty
o f formal techniques. Lorie and Savage (1955) seemed concerned about the
problem o f allocating f i xed funds among a specified set o f investment. projects.
Thei r problem was to set budget cei l ings proper ly and t o determine the discount
rate. Chaines et a l (1959), reformulated the warehouse model o f Kahn (19493
and augmented it w i th financial constraints, thus determing b o t h the b u d ~ e t
constraints and the discount rate inside the model.
Al l i n al l , choices among feasible investment projects der ive d i rect ly from
t h e goals o f t h e firm. T h e d i rec t economic goal o f a p r i v a t e f i rm i s t o maximise
t h e weal th o f t h e f i rm's stockholders [Boness, 1972). In t h i s sense, whatever
inves tment p l a n was good enough. for t h e stockholders, was assumed t o b e good 1
t h e f i rm. In t h i s perspective; t he success ( o r role) o f f inanc ia l management was
o f t e n ~ b s c u r e d by t h e const ra in ts t o .which weal th maximization was subjected.
One s u c h c o n s t r a i n t i s t h a t o f i n f l a t i ona ry pressures.
A l t h o u g h Cap i ta l b u d g e t i n g decisions o f ten i nvo l ved d i scoun t i ng in advance, stocl
p r i c e s a r e a lways in a f lux, such t h a t it 'becomes techn ica l ly impossib le f o r
management t o maximize t h e p r i ce o f common s tock w i thou t i d e n t i f y i n g t h e rea l
in f luence o f non-corporate forces o n common s tock values.
T h a t i n f l a t i o n was o n e s u c h fac tor was imp l ied by Holsen (19781 when he said
that t h e f i r s t thing usua l l y tione b y t h e Wor ld Bank when ana lyz ing a c o u n t r y ' s
c r e d i t wo r th iness f o r k i nk loan was t o ascer ta in t h e e x t e n t t o w h i c h p g b l i c
e x p e n d i t u r e was f inanced by pub l i c sector savings, g r a n t i n g somk i n t e r n a l
b o r r o w i n g f r o m non- inf la t ionary sou-rces. T h e impression deduceable f r o m t h i s
asser t ion i s t h a t in f la t ionary pressures h a d t h e capaci ty t o reduce the monetary
va lue of inves tment p ro jec t s . Bonnes (1972) h a d said t h a t t he p r i m a r y subject in Capi ta l B u d g e t i n g i s tnves t -
ment Decis ion process. Bierman a n d smidt (1980) pos i ted t h a t in eva lua t i ng
.Capital b u d g e t i n g decisions, a businessman mus t consider n o t o n l y t h e possib le
e f fec t s o f in f la t ion , but also the e f fec t of l ong run t r e n d s in t h e r e l a t i v e pr ices
o f h i s p roduc ts . Generally, a r i s e in p r i c e level b r i n g s about a d r o p in t h e
p u r c h a s i n g power o f money, in th i s case t h e Naira. I t t h u s I s impor tan t t o
measure t h e cost a n d benef i ts o f a n ivnes tment in terms of Na i ra o f cons tant
p u r c h a s i n g power (Randle, 1987).
We h a d ear l ie r seen t h a t t h e fundamental mechanism o f analys is in eva lua t i ng
inves tment p ro jec ts was t h e Net Present va lue (NPV) Formular. In u s i n g t h e
NPV method o f Pro jec t Evaluation, t h e app rop r ia te Cost o f Capi ta l in a n y g i v e n
p e r i o d i s t h a t r a t e o f i n t e r e s t which when u s e d t o d iscount t h e expec ted va lue o f
t h e f i r m a t t h e e n d o f t h e pe r iod t o t h e beg inn ing , exac t ly equates t h e d iscount
expected e n d i n g va lue w i t h t h e g i ven b e g i n n i n g value. B y accept ing t h e p ro jec t s
w i t h pos i t i ve NPV values, t h e expectat ion i s t h a t t h e PV o f t h e i nves tmen t is
maximized, a n d th is ; ce te r i s paribus; implements t h e goals o f t h e f i rm. Un fo r tuna t l
however, a l l t h i n g s a r e n e v e r always equal. F o r one thing, t h e cos t o f cap l ta l i s
n o t necessar i ly cons tan t o v e r time periods.
Nonetheless, Boness (1972) h e l d tha t t h i s PV method o f eva lua t ing p r i v a t e Investme'
proposals c a n fo rmal ly b e c a r r i e d o v e r i n t o t h e ana lys is o f p u b l i c investments,althou
d l f f i cv l t ies pecu l ia r t o p u b l i c sector investments wou ld arise; re la ted main ly, t o t h e
non -p ro f i t n a t u r e o f col lect ive governmental act iv i t ies, a n d t o t h e non-marketable
n a t u r e o f p u b l i c goods. Because b o t h bene f i t s a n d costs o f many p u b l i c investment
a r e multi-dimensional, t h e y a re inappropr ia te subjects f o r a s t r a i g h t f o r w a r d evalua
t i o n in terms o f p r e s e n t values o f economic pr ices.
A l t h o u g h Capi ta l B u d g e t i n g decisions may b e u s i n g e i ther money o r rea l f low,
Bierman a n d Smidt (1980) noted tha t t h e r e may s t i l l b e d i f fe rences in es t imat ing
t h e necessary imputs, t h e costs a n d benef i ts o f a n investment p ro jec t . T h e y
maintained t h a t if revenues or costs were main ly determined by marke t forces in
t h e pe r iod in w h i c h t h e ou t l ays were made, o r e revenues received, t h a n estimates
in terms o f money f lows. O n t h e o t h e r hand, t h e y he ld t h a t i f f u t u r e costs a n d
revenues were determined by immediate decisions, by income cons idera t ions o r by
l o n g te rm con t rac tua l relat ionships, estimates in terms o f money f lows were l i k e l y tc
b e more accurate.
T o conve r t money values t o real values Bierman a n d Smidt (1980) chose t o d i v i d e
t h e monetary va lue by a n appropr ia te p r i c e i ndex re lat ive. T h e y supposecl an
investment t h a t p romised t o r e t u r n W l O O p e r year, f o r t h ree consecut ive years a n d
whose cash proceeds
measured in money values, were certain. Given that the discount ra te was 9 percen
the PV o f the monetary value was W 75.91. If it were assumed that the p r i ce index
(PI1 was 140 f o r t he cu r ren t year, 145.60 for t he nex t year and 151.42 the followir
year; and i f money values were to be converted to real values in al l th ree years in
terms o f the c u r r e n t year's pr ice level, then a p r i ce index relat ive must be
constructed fo r each o f t he three years.
The P I relat ive was the ra t io o f two p r i ce index values in which the numerator
was t he value o f t he P I fo r the cu r ren t year in which the cash flows occur red
and the denominator was the P1 for the base period. Having obtained these P I
relatives, money values were then converted t o real values, f o r a g iven period,
b y dividing the money value fo r the per iod by the P1 relat ive f o r that period.
Using the hypothet ical case above, Bierman and Smidt (1980) calculated t he P1
relat ive t o be 1401140 = 1 .OO f o r the cu r ren t period; 145.61140 = 1 .O4 f o r the
nex t year and 151.42/140 = 1 .O8 f o r t h e following year. To conver t money values
t o real values, for any given period,t hey went ahead t o d iv ide the money values
fo r the per iod by the P1 relative fo r tha t period. Thence, the .real [R ) o f
W100 t o be received in the base year was found be 10011.0 = R W 100/1.38 = RPI
92 -46.
Using th is premise, Blerman and Surd t (1 980) analyzed the inv-estment out lays
o f a f ic t i t ious company, under d i f ferent inf lat ionary any conditions, over ir
f ive year period. After the analysis, they came to the conclusion tha t real
cash flows (Cu r ren t Purchasing Power), were considerably d i f fe ren t from
money flows, In times o f inflation,
On t he use o f cu r ren t purchasing power, Rockley (1981) d l d observe t ha t the
Accounting S t a n d a r d Steering Committee of the Uni ted Kingdom had recommended
that conventional h istor ic costs be adjusted by a conversion index which
reflected a measured change i n the value of the monetaryunit'ln-whkh aoclcr~nts Wet-
expressea. I nrs measured change in the purchasing power o f the monetary unit
was to be taken from the movements in the consumer p r i ce index, calculated, in
the Nigerian case, b y the Federal Off ice o f Statistics.
2.9. Why Worry about In f la t ion?
Nagger (1977) did say tha t one main reason in trying t o prevent a pers is tent upward
movement in the general p r i ce level was tha t it led t o a red is t r ibut ion o f real income
which was a r b i t r a r y and which therefore may well be socially un just people whose
money income rose less rap id ly than the general p r i ce level, lost re la t ive ly in inflat ia
while those whose money rose more rapidly than t h e p r i ce levels, gained d u r i n g
inflation.
Duesenberry (19771 observed that losers in inf lat ion were more l i ke ly t o include
pensioners academics and other c i v i l servants w i t h a f i xed income. He insisted tha t
the red is t r ibut ive effects o f inf lat ion were no t conf ined to real income and said t h a t
people o r ins t i tu t ions whose wealth comprised mainly o f assets o f a f i xed pFesented
one who wished t o save wi th a d i f f i cu l t dilemma. I f the person s t i l l had something tc
save, he r a n the r i s k tha t inf lat ion would reduce t h e real value b f these sums to t h e
extent that he would find it di f f icul t to meet the needs f o r which the sav ing had bee
set out.
For government, inf lat ion could cause a balance o f payment (A jay i and Ojo, 1981).
Th is was particularly t r ue for countries in which forelgn trade palyed a major role
in the economy, because inf lat ion could weaken the balance o f payment posi t ion b y
st imulating imports and rest r ic t ing exports. Newmark (1977) was of the opinion t h a t
s t r i k i ng a balance between budgetary losses and ga ins from in f la t ionary proc:esses
was a ve r y d i f f i cu l t and complicated task, more so as resul ts o f theor i t ical and
emprical studies on these issues differed considerably. He nonetheless concluded
that wi th respect t o publ ic revenues, inflation-Induced losses were conf ined to
categories which in general were not ve r y important. In the f ie ld o f t a x e s , ~ p v e m m i
resu l ted on ly f rom taxes which were of smalf budge ta ry relevance, wh i le
progress ive persona l taxes prov ided governments w i t h considerable ga ins due t o
inf lat ion. On t h e exper id i ture side, Newmark (1977) noted tha t governmental
losses were combined w i t h gove.rnment gains a n d t h a t i t was v e r y difficult td clearl '
specify t h e co r rec t balance.
Some economists h a d a rgued that some form o f in f la t ion was inevi table f o r growth,
a l though Friedman (19731 reported tha t many count r ies h a d In f la t ion w i thou t g rowth
T h e general impression though had always been t h a t in f la t ion ' w a s e v i l a n d should
b e avoided. In t h e opin ion o f Kiein ( l 9 7 7 ) , t h e pub l i c seem to r e g a r d in f la t ion
as 'per set evi l . As had earl ier been observed, t h e greatest object ions l o inf lat ion
arose because o f i t s impact on wealth and income d is t r ibu t ion . D u r i n g inf lat ion,
t he grea,test losers were,usual ly people o f f i xed incomes; salary earners, pensioners
and wealth owners whose wealth was heav i ly dependent o n fixed-income assests.
T h e s i tuat ion seem s l i g h t l y improved when we considered fixed-income securi t ies.
T h e reason beh ind t h i s i s because, in add i t ion to a premium to, cover t h e f inancia l
r i s k of default, t h e y ie lds on f i xed Income secur i t ies also ref lect the r i s k o f
general r i se In consumer prices d u r i n g t h e life-time o f the contract . Such a
premium became necessary since credi tors (bond-holders) su f fe r a real economic 10s:
when consumer p r i ces r ise, Inf lat ion reduced the purchas ing power o f t h e f ixed
nominal amounts ( in teres t and r e t u r n on pr inc ipa1)which a bond-holder i s en t i t led
t o receive; t hus necessistat ing the need f o r a n addit ional premium t h a t wou ld induct
such ho lder t o g i v e up present money in r e t u r n fo r a promise t o receive a fixed
amount o f f u t u r e money.
Evident ly , when uncer ta in t y regarding t h e purchas ing power o f money becomes ver:
great, investors may become unwi l l ing t o acqu i re f i xed income-bearing secur i t ies
unless a n d exp l i c i t purchas ing power guarantee was added to t h e cont rac t . Thus
the world-wide i n f l a t i on during and a f te r t h e Second World-Warled a number of
countr ies to i n t roduce investments whose in te res t a n d l o r p r i nc ipa l were l i n k e d t o
vavious p r i c e indexes. In addition, purchas ing power guarantees, o r escalator
clause were be ing inc luded in wage the rnonetory unit in the which accounts were
cont rac ts a n d pension contracts in t h e Uni ted States a n d many European
Count r ies [Sarnat , 1973).
Bonowers ga ined in inf lat ionary per iods since a t t h e t ime t h e loan was due, t h e
rea l va lue o f money used t o repay t h e loan would b e less than t h e rea l value
when t h e money was borrowed.
T h e ro le o f pu rchas ing power r i s k c a n be c lar i f ied by u s i n g t h e known mdist inct ion
between t h e lmoney a n d 'real' rates o f interest,. \ ' M e the fo rmer ,measured the r a t e
o f i n te res t in terms o f money, t h e l a t te r measured t h e r a t e o f i n te res t in terms
o f t h e command o v e r commodities, t h a t is , in terms o f t h e pu rchas ing power o f
money. Unless t h e general p r i ce leve l remained stable during t h e d u r a t i o n of
a loan, t h e t w o aforesaid rates a r e n o t identical.
Hypothet ical ly , Sarnat (1973) pract ical ised t h a t i f t h e r a t e o f I n te res t on a
one-year b o n d was say. 80 percent , but in f la t ion ra ised p r i ces by 6 percent ;
t h e rea l r a t e o f in terest in terms o f t h e purchas ing power was o n l y 2 percdnt .
What thi; Impl ied i s t ha t if a n investor gave up N100 a t t h e beginning o f t h e
yea r a n d rece lved HI08 a t year end, such money (N108) cou ld o n l y have purchase(
W102 w o r t h o f goods in re lat ion t o t h e beg in ing year 's p r i ces - Thus, i f the generi
level o f consumer pr ices increased, the rea l ra te o f r e t u r n on f i x e d - income
secur i t ies was less than t h e money r a t e a n d vice versa.
Thus, f rom t h e foregoing we see t h a t in f la t ion impairs t h e usefulness o f money anc
in some cases, des t roys money completely, pa r t i cu la r l y +f t he r a t e o f in f ta t ion i s
v e r y high. Hicks (in Hagger, (1977)) summed up t h e ef fects o f i n f l a t i on more
succ i r i t l y when h e said:-
" T h e hab i ts - business hab i ts as well as personal habi ts-
wh ich a r e based on t h e assumption o f stable p r i ces a r e too
s t r o n g t o b e easily broken. Nor i s it jus t habits, it I s also
ins t i tu t ions . The account ing system, t h e t a x system, even
t h e legal system, a l l a r e based on assumption o f a stable va lue
o f money.
If the value o f money i s ser iously changeable, these a r e tw is ted
. 46
to be t r u e profits; the taxes that a r e Imposed a r e
different t o what was intended; the fines and penalties
imposed by the courts a s well a s compensations which
they award, all lose their proper effect".
Kahn [I9791 in his opinion maintained that inflation does more than just t ransfer
wealth and income. He said, "It increases risks; it creates distortions; It decrease
the efficiency of the system; it erodes morale, integrity and discipline; and it
destroys faith and confidencet1.
CHAPTER THREE
RESEARCH METHODOLOGY
3.1 Preamble
One o f t h e main problems in optimal f inancial management o f th,e f i r m or. individ~
i s t h e selection o f investments from among many possib le a l ternat ives. Some
methods o f d iscr iminat ion ex i s t to select t h e 'best1 se t o f projects. Select ion of
assets w i thout r e g a r d t o r i s k i s done w i t h considerat ion o f t h e b e n e f i t s t o b e
ga ined f rom t h e assets where a forecast o r reco rd o f t h e cash in f lows d u e t o
t h e asset i s avai lable.
In t h e slmplest form, the wor th t o t h e f i r m o r indiv idual , o f a n asset i s t h e
sequence o f cash in f lows generated by t h e asset. T h e sum o f t h e c a s h in f lows
minus t h e cash payments can b e cal led t h e 'accounting n e t p r o f i t " (Jean,1970).
A l though t h i s f i g u r e cou ld b e used as a measure o f benefi ts, it i g n o r s t h e
time p a t t e r n o f cash inf lows a n d there fore the time va lue o f money.
.A l though the set o f cash inf lows cou ld b e considered as t h e aggrega te bene f i t
from t h e asset, it i s desirable t o summarise t h e l i s t i n g o f cash in f l ows i n t o a
s ing le number such as t h e Account ing Rate o f r e t u r n , the I n t e m a l Rate o f
Return , t he Net Present Value, etc; when two o r more projects a r e u n d e r
select ion considerat ion, It may, o n t h e o t h e r h a n d b e auspicious t o use Ratio
analyses t o evaluate pro jec t o r asset performance against t h e i n d u s t r y o r f i r m
average when cons ider ing the benef i t o f a pro jec t o v e r a t ime per iod .
T o measure a f irm's financial posi t ion a n d performance, two p r i m a r y measures
read i l y come t o m ind - Prof i tab i l i t y a n d Liquidity. ( C h r i s t y a n d Roden, 1973).
These terms answer the two al l - important quest ions of:-
i. How much is t h e business making fo r i t s owners ? and
ii. How able i s t h e business t o pay i t s b i l l s ?
A f i rms business performance can be measured by t h e use o f ratios. Ratios
i n v o l v i n g f i gu res from the income statement, t h e Balance Sheet, o r b o t h
reveal qu i te a lot about a company's financial pos i t ion to i t s management,
A ra t i o i s a q u o t i e n t o f two numbers. Often, a r a t i o b y i t se l f i s meeningless
un less i t I s i n t e r p r e t e d against s0m.e standard. T w o main ways e x i s t to ana lyze
a rat io. T h e f i r s t i s time series analys is w h i c h invo lves seeing how t h e r a t i o
has behaVed o v e r time. T h e second i s t h e c ross - sectional ana lys is in wh ich
t h e f i r m i s obse rved a t a s ingle po in t in t ime re la t i ve t o o t h e r f i rms or parameter
T o measure p ro f i t ab i l i t y . we think o f p ro f i t . T h e accountants a n d economists
de f ine p r o f i t d i f f e ren t l y . Fo r t h e accountant a n d businessman, p r o f i t i s synomync
w i t h owners ' earnings, f o u n d by subtracting a l l cos t f rom t h e to ta l r evenue
accru i t ig ' t o t h e f i r m during the opera t ing per iod.
T o t h e economist, p r o f i t I s a d i f f e ren t i a l r e tu rn , a special r e w a r d f o r r i s k -bead
o r f o r be ing c leve re r o r more e n t e r p r i s i n g t h a n one's competi tors. In t h e
economists1 p o i n t o f view, the account lng p r o f i t l umps together two v e r y d i f f e re r
so r t s o f re tu rns . F i r s t is t h e basic r e t u r n d u e t o t h e owners rnoney(equa1 t o
t h e o p p o r t u n i t y r a t e they cou ld e a r n b y i n v e s t i n g it in v i r t u a l l y r i sk less i n s t r u -
ments such as, T r e a s u r y B i l l s o r high g r a d e bond) a n d the second is t h e t r u e l
economic p r o f i t (a r e w a r d f o r r i s k - bear ing, o r a reward f o r s u p e r i o r a b i l i t y
t o take,manage a n d outguess t h e r i s k s ) . Thus, f rom the economists v iewpoint ,
a firm's r a t e o f p r o f i t can be rep resen ted as
K = ip+r . ......................... (3.1)
where K = r a t e o f p r o f i t
&pure o r r i sk less
r a t e o f r e t u r n t o capi ta l
r = r i s k premium for t h e pa r t i cu la r f i r m
We acknowledge t h e economists' d i s t r u c t i o n In p r i n c i p l e b u t for o u r pu rpose
h e r e we shal l t ake K in totality t o s tand f o r t h e accountant p r o f i t .
3.1.1 P ro f i t ab i l i t y Measures
Profitabil ity i s t o p r o f i t what ra te is t o an amount ( C h r i s t y a n d Roden, 1973) .
p r o f i t i s t h e f i g u r e a t t he bottom o f t h e income statement, r e p r e s e n t i n g