Inflation

Inflation• Coulborn: it is a state of “too much money chasing too few goods”.

• Two broad categories:

– price inflation

– money inflation.

Both have cause and effect relationship, i.e. money inflation leads to price inflation.

Money inflation is increase in the amount of currency in circulation.

– Deficit financing : direct cause is printing of additional currency on demand of the government to meet its needs.

– FDI and FII: Additional money supply through foreign exchange inflows in the form of capital, such as foreign direct investment and foreign institutional investment tourism and other incomes from abroad.

Price inflation is a persistent increase in the general price level or a persistent decline in the real income of people.

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.

• Inflationary Spikes: occurs when a particular section of the economy experiences a sudden price rise, possibly due to external factors.

• Hyperinflation: – prices increase at such a speed that the value of money

erodes drastically and the economy is trapped between rising prices and wages.

– This is also known as galloping inflation or runaway inflation.

Concepts of Inflation

• Stagflation:

– a typical situation when stagnation and inflation coexist.

– India faced stagflation in the decade of 1970s, when industrial production was at its lowest, accompanied by mounting prices.

– Current situation if not controlled may result in stagflation.

• Suppressed Inflation:

– when inflationary conditions exist, but the government makes such policies which temporarily keep prices under check

– as soon as these checks are removed, inflation bursts out.

Concepts of Inflation• Disinflation:

– a process of keeping a check on price rise by deliberate attempts.

– It is a well planned process to bring down prices moderately from a very high level.

• Deflation: – just opposite to inflation; – a state when prices fall persistently.

Inflationary Gap

• Inflationary Gap represents rise in price due to a gap between effective demand and supply.

• The term was coined by Keynes to describe a situation when there is an ‘excess of anticipated expenditure over available output at base prices’.

• When money income in the hands of people exceeds the supply of goods and services, a gap is created between demand and supply resulting in inflation.

Wage Price Spiral

“Wages chase price and prices chase wages” and create a wage price spiral.•Workers attempt to protect their real wages by pushing for higher money (or nominal) wages.

Prices Rise

Cost of living rises

Wages rise

Cost of production rises

Another kind of Inflationary Spiral

• Cost of higher education is soaring every year and the phenomenon is global. – In USA the overall inflation rate since 1986 increased 92.32% in 2007,

whereas, tuition increased a whopping 343.81%.  – As per an estimate the cost of attending state colleges will soar to

$120,000 by 2015. – A direct link can be found between tuition hikes and government-backed

student loans without parent income restrictions started in 1992. – Today the average undergraduate student loan debt is nearing

$20,000.  • Those who go on to graduate school often end up with an additional

$30,000. • Law and medical students report an average accumulated debt from all

years (undergraduate and graduate study) of $91,700.

• This combination of high tuition and education loan created a tuition loan spiral.

Causes of Inflation

• Excess Money Supply:. Money supply is the most important cause of price rise, it can be directly linked with increase in aggregate demand.

• Demand Pull Inflation: when aggregate demand level 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 in the cost of production, i.e. cost pushes prices up.

Causes of Inflation

• Low Increase in Supply: if supply falls short of demand, prices will increase. – Obsolete technology

– Deficient machinery

– Scarcity of resources

– Natural calamities

– Industrial disputes and external aggressions

• Built in Inflation: Built in inflation is a type of inflation that has resulted from past events and persists in the present.

– It is also known as hangover inflation.

Causes of Inflation in India

• In the medium to long-term, the movement and outcome of monetary aggregates such as the money supply and reference interest rates of the financial systems have influenced aggregate demand and consequently changes in price levels in the economy.

• The influence of global commodity prices on the domestic prices have become more important with the opening and growing integration of the Indian economy with the rest of the world.

• With huge surge in capital inflows, the liquidity management with its underlying implications for inflation has been a major challenge for the policymakers.

Measuring Inflation

• A price index is a numerical measure designed to help 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 that base year are assumed to be equal to 100.

Price Index = 100Price sYear' Base

Price sYear'Current

Measuring Inflation

• Wholesale Price Index (WPI): measures on the basis of wholesale prices of a wide variety of goods (including consumer and capital goods). In India, WPI is available on a weekly basis, and is the most popular measure.

• Producer Price Index (PPI): measures average changes in prices received by domestic producers for their output. It measures the pressure being put on producers by the costs of their raw materials.

– USA has replaced WPI with PPI

Measuring Inflation• Consumer Price Index (CPI): measures the price of a selection of

goods purchased by a "typical consumer.“– CPI differs from PPI in that price subsidization, profits, and taxes may

cause the amount received by the producer to differ from what the consumer paid.

• In India four types of Consumer Price Indices (CPls) are issued that are specific to different groups of consumers– CPI-IW for industrial workers; – CPI-UNME for urban non manual employees; – CPI- AL for agricultural labourers; and, – CPI-RL for rural labourers

• CPI-IW is the most well known of these indices as it is used for wage indexation in Government and in the organized sectors

• Central Statistical Organization has initiated steps to compile CPI under two broad categories – CPI (Rural) and– CPI (Urban).

Measuring Inflation

• Cost of Living Indices (COLI): these are used to adjust fixed incomes and contractual incomes to maintain the real value of such incomes. In fact 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).

Inflation Rate 100Index sYear'Current

Index sYear'Current -Index syear'Last

Wholesale Price Index (WPI) in India: A Brief History

• 1942 Beginning of the process of compilation of prices and converting them into comparative indices – published for the first time an index number of wholesale prices from the

week commencing January 10, 1942, with base week ended August 19, 1939 = 100.

– The WPI was calculated as the geometric mean of the price relatives of 23 commodities.

• 1947, the series included as many as 78 commodities, covering 215 individual quotations classified into five groups: food articles; industrial raw materials; semi-manufactures; manufactures; and miscellaneous.

• 1952-53 a new series was issued with 1952-53 as base price and 1948-49 as weight base consisting of 112 commodities and 555 quotations. – The commodities were reclassified into new set of five groups: food

article; liquor & tobacco; fuel, power, light & lubricants; industrial raw materials; and manufactures.

– The weighted arithmetic average replaced the weighted geometric mean.

Wholesale Price Index (WPI) in India: A Brief History

• Since then the base year has changed four times and number of articles/commodities increased substantially.

• July 1969: A new series of WPI with base 1961-62 = 100 covering 139 commodities and 774 quotations.

• January 1977 a new series with wider coverage of items (360 commodities) and 1295 quotations and a new base year 1970-71. – the commodities were divided into three major groups: i. primary

articles; ii. fuel, power, light & lubricants; and iii. manufactured products.

– Weights were assigned on the basis of the entire wholesale transactions in the economy and the values of transactions of the non-selected commodities were assigned to selected commodities whose nature and price trends were similar.

Wholesale Price Index (WPI) in India: A Brief History

• 1989:The WPI series underwent another restructuring with 1981-82 as the base year, 447 distinct commodities and 2,371 price quotations. – The method of compilation and assigning of weights, as well as

the classification into three major groups continued.

• The latest WPI series with the new base year 1993-94 follows the same methodology as earlier however now there are altogether 435 articles/items in the new series, comprising of 98 'primary articles', 19 items of 'fuel, power, light and lubricants'; and 318 'manufactured products'.

• The new series is constructed with 2004-05 as the base year.

Inflation and Decision Making

Impact on Consumers:– Consumer makes a tentative budget based on monthly

(or weekly) income and expenses.

– increase in prices brings the value of money down and upsets the whole budget.

Impact on Producers (or Suppliers): – Producers are generally benefited by inflation;

– higher the prices, higher are their profits.

But – when they have to buy raw material, hire workforce,

buy technology or machine, they are adversely affected by inflation.

Inflation and Decision Making

Impact on Government: – Government takes responsibility to take care of the

interest of all the sections of the society.– At one end it is committed to take the economy to

higher levels of growth by encouraging production and investment,

– At the other end, the government is duty bound to see that taxpayers’ money is not eroded by hyperinflation.

– Thus government has to act as the balancing force between consumers and sellers.

•A. W. H. Philips studied the relationship between unemployment and rate of changes in money wages in UK, taking statistics for a period spanning almost a century from 1862 to 1957. •Philips postulated that the lower the rate of unemployment, the higher is the rate of change of wages. •Hence the government must choose between the feasible combinations of unemployment and inflation.

Inflation and Employment

Inflation and Employment

• Labours accept jobs at lower pay if they are unemployed and firms being more willing to hire due to low wages.

• 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.

Philips’ Curve

Unemployment %

2 4 6 8

Philips’ curve

O

Δ P/P

2

4

68

Annual Price Rise %

4

68

ΔW/W

Annual Wage Rise %

10

2

1

• 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.

Control of Inflation

• Inflation erodes the value of money and discourages savings

• But zero inflation is undesirable as it discourages investment in productive activities.

• There is a need to control inflation• Two broad categories of inflation control

– monetary policy measures (proposed by those who believed money supply is the major culprit)

– fiscal policy measures (proposed by Keynes and his followers).

Monetary Policy Measures

• Excessive money supply may bring about inflation, therefore to control inflation it is necessary that a curb is put on money supply.

• The central bank of the country uses various methods of credit control to keep a check on inflation.

– Increasing the discount rate– Higher reserve ratios– Open market operations– Selective credit control

Monetary Policy Measures

• Increasing the discount rate: The central bank rediscounts the eligible papers offered by commercial banks. This is also called bank rate. – Increase in discount rate will leave less

money with the banks– High cost of money to the banks; hence

interest rates will increase• Loans will be discouraged• Savings will increase

Monetary Policy Measures

• Higher reserve ratios:– Cash Reserve Ratio (CRR)– Statutory Liquidity Ratio (SLR)

• Open market operations: – Central bank may directly sell government

securities to general public and thus 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

– Increasing public revenue• Major source of government revenue is various

types of taxes • Increase in income tax leaves less disposable

income in the hands of consumers and reduces effective demand

Fiscal Policy Measures

– 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.

• Monetary and Fiscal measures hit the demand side and ignore the supply side of prices.

Other Measures

Increasing Supply– Effective public distribution system, – administered pricing of essential commodity groups– increase imports and decrease exports of the items which are

short in supply. – Economic Survey 2007-08 states that government has decided

to maintain price stability of food grains, reduction in import duties and custom duties on edible oils and other oils and ban on export of wheat and pulses.

The government has to adopt an appropriate combination of all of these measures after thorough examination of the causes of inflation.

Indexation

• It is automatic linkage between monetary obligations and price levels.

• Indexation reduces the effect of inflation. • Applies to wages, interest and taxes

– employers are forced to index wages against prices so that the gap between money income and real income may be minimized.

– Interest of long term loans is so determined that the borrower would have to pay the loan in real terms.

– For example • National Savings Certificates are index linked. • The purchasing power parity theory of exchange rate

determination in international economics is an example of indexation