Inflation

Lecture Plan
• Inflation
• Causes of Inflation
• Inflation and Decision Making
• Measuring Inflation
• Inflation and Employment
• Control of Inflation
 Objectives
• To explore the realms of inflation and its different frontiers.
• To delve into concepts like wage price spiral, hyperinflation
and inflationary gap.
• To understand various measures of inflation and their role
in decision making.
• To analyze the reasons behind inflation, its impact on the
economy and the measures to curb it.
 Inflation
• Coulborn: it is a state of “too much money chasing too few goods”.
• Two broad categories:
– price inflation (generally called as inflation)
– money inflation.
– Money inflation is increase in the amount of currency in circulation.
Which may be due to:
Price inflation is a persistent increase in the general price level or a
persistent decline in the real income of people, i.e. decline in
value of money.
 Types of Inflation

• On the basis of
1. Speed
2. Inducement
3. Government reaction
4. Time
5. Reach
 Concepts of Inflation
• Headline Inflation: measure of the total inflation within an economy
– affected by the areas of the market which may experience sudden
inflationary spikes such as food or energy.
• Hyperinflation: prices increase at such a speed that the value of money
erodes drastically
– This is also known as galloping inflation or runaway inflation.
• Stagflation: a typical situation when stagnation and inflation coexist.
• Disinflation: a process of keeping a check on price rise by deliberate
attempts.
• Deflation: a state when prices fall persistently; just opposite to inflation
• Inflationary Gap (Keynes): Excess of anticipated expenditure over available
output at base price
– When money income exceeds the supply of goods and services, a gap is
created between demand and supply resulting in inflation.
 Wage Price Spiral
Wages chase prices and prices chase wages, thus create a wage
price spiral.

•When prices rise, workers

demand higher money (or Prices Rise
nominal) wages to protect their
real wages. This raises the costs Cost of
faced by their employers. production rises
Cost of
• To protect the real value of living rises
profits producers pass the higher
costs onto consumers in the form
Wages rise
of higher prices.
•Workers (who are also consumers
demand for higher money wages.
•
Causes of Inflation
Demand Pull Inflation: when aggregate demand increases due to any reason, and supply of
output is unable to match this increased demand; i.e demand pulls prices up.
– Increase in money supply/ Increase in disposable income
– Increase in aggregate spending
– Increase in population of the country
• Cost Push Inflation: An increase in price of any of the inputs will increase the cost of
production; i.e. prices pushed up by cost.
• Low Increase in Supply: if supply falls short of demand, prices will increase.
– Obsolete technology/Deficient machinery
– Scarcity of resources
– Natural calamities/ Industrial disputes/ external aggressions
 Causes of Inflation
Demand Side factors
• Increase in public expenditure
• Cheap monetary policy
• Increase in Income
• Black money
• Increase in investment
• Reduction in Taxes
• Increase in Population
• Paying off debts
• Increase in exports
• Increase in private expenditure
• Increase in exports
• Introduction of new products
 Supply side factors
• Less production
• Taxation
• Shortage of raw material
• Industrial disputes
• Natural calamities
• War
• Industrial policy
• Hoarding
• Scarcity of factors of production
• Trade union activities
• Law of diminishing returns
• Sectoral liquidity policy by RBI
• Increase in exports
• International causes
 Inflation and Decision Making
• Impact on Consumers
– increase in any price upsets the home budget.
• Impact on Producers (or Suppliers)
– Producers as sellers are benefited by inflation;
• higher the prices, higher are their profits.
– when as buyers of raw material, they are adversely affected by inflation.
Impact on Government:
– Government has to take the economy to higher levels of growth by encouraging production
and investment,
– At the other end, has to see that taxpayers’ money is not eroded by hyperinflation.
– Thus government has to act as the balancing force between consumers and sellers.
 Measuring Inflation
• A price index is a numerical measure designed to compare how the prices
of some class of goods and/or services, taken as a whole, differ between
time periods or geographical locations. (prices of the base year are
assumed to be equal to 100.)

Current Year' s Price

Price Index =  100
Base Year' s Price
• The most common term used to denote inflation is inflation rate, which is
annual rate of increase of prices.

Inflation Rate
Last year' s Index - Current Year' s Index
 100
Current Year' s Index
 Measuring Inflation
• Producer Price Index (PPI): measures average changes in prices received by domestic
producers for their output.
• Wholesale Price Index (WPI): measures wholesale prices of a wide variety of goods
(including consumer and capital goods.
– USA has replaced WPI with PPI
• Consumer Price Index (CPI): measures the price of a selection of goods purchased by a
typical consumer.
– CPI differs from PPI in that price subsidy, profits, and taxes may cause the amount
received by the producer to differ from what the consumer paid.
• Cost of Living Indices (COLI): used to adjust fixed incomes and contractual incomes to
maintain the real value of such incomes.
– wage indexation is based on such indices.
• Service Price Index (SPI): With the growing importance of service sector across the world,
many countries have started developing services price indices (SPI).
 Control of Inflation
• Inflation erodes the value of money and discourages
savings
• But zero inflation is undesirable
• Need to control inflation
– monetary policy measures (proposed by those who
believed money supply is the major culprit)
– fiscal policy measures (proposed by Keynes and his
followers).
– Other measures
• The government has to adopt an appropriate
combination of these measures after thorough
examination of the causes of inflation
 Monetary Policy Measures
• Increasing the discount rate: The central bank
rediscounts the eligible papers offered by commercial
banks. This is also called bank rate.
• Higher reserve ratios:
• Cash Reserve Ratio (CRR)
• Statutory Liquid Ratio (SLR)
• Open market operations: directly sell government
securities to public and restrain their disposable
income
• Selective credit control: discourages consumption but
not investment
 Fiscal Policy Measures
The government may reduce public expenditure or increase
public revenue to keep a check on inflation
• Reducing public expenditure
• When government spends on activities like health, transport,
communication, etc., income of individuals increases; this in
turn increases the aggregate demand.
– Therefore the reverse will also be true.
• Increasing public revenue
– Major source of government revenue is various types of taxes
– Increase in income tax leaves less of disposable income in the hands of
consumers
 Other measures
• Increase in production
• Encouragement to saving
• Proper wage policy
• Investment policy
 Inflation and Employment
•A. W. H. Philips studied the relationship between unemployment
and rate of changes in money wages in UK, taking statistics for a
period from 1862 to 1957.
•Philips postulated that the lower the rate of unemployment, the
higher is the rate of change of wages.
•labours accept jobs at lower pay if they are unemployed and firms are
more willing to hire due to low wages.
•But this effect dissipates as inflation becomes more expected with
workers demanding higher wages and firms being less willing to hire.
•the objectives of low unemployment and low rate of inflation may be
inconsistent.
•Hence the government must choose between the feasible
combinations of unemployment and inflation.
 Philips’ Curve
Δ P/P ΔW/W

8 10

Annual 6 8
Price Rise % Annual Wage
4 Philips’ 6 Rise %
2 curve 4

O 2 4 6 8
2
1
Unemploym
ent %
• Demand pull inflation refers to the effects of falling unemployment rates
(rising real national income) in the curve.
• Cost push inflation and built in inflation will lead to shifts in the Phillips
curve.