Inflation

Definition, Causes, Measurement,

Consequences and Corrective Actions
 Some definitions

The state in which value of money is falling, i.e.

price is rising. Prof Crowther

Criticisms:
– Every increase in price level is inflationary and has
harmful consequences.

– Emphasized the symptom rather than the cause of the

disease – fails to explain why price level increases
 Other Definitions
 Issue of too much money
Prof Hawtrey
 Too much currency in relation to physical volume of business
being done.
Prof Kermmerer
 Inflation is too much money chasing too few goods.
Prof Coulbourn

Therefore, increase in average price levels is referred to as

Inflation. Sustained inflation occurs when the overall price level
continues to rise over some fairly long period of time.

Problem
 Prices rise faster than income
 Standard of living declines
 Deflation Defined

 Declining price levels

 Associated with recession

Types of Inflation
 Based on speed

Creeping inflation: mildest form of inflation – makes

the economy dynamic.

 Prices rise slowly

 Industry and trade receive stimulus and the country
develops economically.
 According to some economists, price level should rise
by approx. 2% annually under creeping inflation.
Walking:
Rate of increase of price-level gets further accelerated – rises by
approx 5% annually. If proper control is not exercised, it can
easily assume the form of running inflation.

Running:
• price-level rises by approx 10% annually.

Galloping or Hyperinflation:
Prices rise every minute and there is no upward limit to which it
may rise in course of time.
– Lord Keynes has called it true inflation.
– This type invariably occurs after the point of full employment.
Price rises by 16% and more.
Examples are the Great Inflation of Germany after First World
War, and Great Chinese Inflation after the Second World War.
Causes of Inflation
 Demand-Pull Inflation
Inflation is caused by an excess of demand (spending) relative to
the available supply of goods and services at existing prices.

– The Classical - the key factor is the money supply. The quantity
theory of money => only an increase in money supply is capable of
raising the general price level.

– In Modern income theory, means an excess of aggregate demand

relative to the economy’s full employment output level.

– Prices rise in response to an excess of aggregate demand over existing

supply of goods and service => caused by an increase in quantity of
money

– May also be caused when MEC or MPC goes up causing an increase

in expenditures and hence prices.
 Demand Pull Inflation

S
D2
Price level

D1
P2
D0
P1
P0 S

Y0

Real Income
 Cost Push Inflation
 This theory maintains that prices, instead of being
pulled-up by excess demand, are pushed-up as a
result of a rise in the cost of production.

 Prices rise on account of a rise in the cost of raw

materials, especially wages.

 Some producers, group of workers, or both,

succeed in raising the prices for either their
product or services above the levels that would
prevail under more competitive conditions
 Inflation of the cost-push type originates in industries,
which are relatively concentrated, and in which, sellers can
exercise considerable discretion in the formulation of both
prices and wages.

 It may not be possible in an economy characterized by pure

competition.
 S
D2
D1
D0
P1
P0
S1

S0

Y2 Y1 Y0
Shifts of the Short-Run Aggregate Supply Curve
Factors That Shift the Aggregate Supply Curve
Shifts to the Right Shifts to the Left
Increases in Aggregate Supply Decreases in Aggregate Supply
Lower costs Higher costs
lower input prices higher input prices
lower wage rates higher wage rates
Economic growth Stagnation
more capital capital deterioration
more labor
technological change
Public policy Public policy
supply-side policies waste and inefficiency
tax cuts over-regulation
deregulation
Good weather Bad weather, natural
disasters, destruction
from wars
MEASUREMENT OF INFLATION
 General Price Level

Weighted average of individual goods’ prices.

n
Pt = S wi Pit
i=1
wi >= 0
S wi = 1
 Example
Suppose there are only 3 goods in the economy, with their prices in 1999 and
weights as follows:

Goods Price Weight

Rice Rs. 15 / kg 0.6
Shirt Rs. 200 / piece 0.3
House (room) Rs.1000 / mon 0.1
 General price in 1999

P99 = 0.6 (15) + 0.3 (200) + 0.1 (1000) = Rs. 169

Note: the general price is merely a concept. There is

nothing particular that you can buy for Rs. 169.
Weights
The weights for the various component items are
determined by the relative significance of that
item in all the items during the base period.

Qi0 Pi0
Wi = ------------------
Σ Qi0 Pi0
i
where Qi0 and Pi0 are the quantity and price of the
good ‘i’ in the base period.
 Price Index
 A Price Index is expressed as the current price
in relation to its value in the base period.

 Thus, price index for period t is defined as:

PIt = Pt / P0
 Example

Price of shirt in base year, say 1991 was Rs. 120

and in 1999 it was Rs.200, the price index

PI 99 = Rs. 200 / Rs. 120 = 1.67

 About Price index

 An index helps to compare the data without

worrying about the unit of measurement.

 Price Index of 1.67 indicates that between 1991

and 1999, price of shirt has increased by 67 %.

 Index numbers are usually written with a base

value = 100 (above number has to be multiplied
by 100).
 Price index of general price

weighted average of various prices

Pit
PIt = Σ Wi ------
Pi0
 Measuring the Inflation

 It means the rate of change in general price (P or

PI) per year, expressed in percentages.

 Thus the simple inflation rate in period t (Pt) over

the last one year is given by:
Pt – P t-1
Pt = ------------------ x 100
Pt-1

If it is compounded once in a year only.

If compounding is done on a continuous basis:

Pt
Pt = ln ------ x 100
Pt-1

Where ln stands for natural logarithm.

 Example
If the general price index rises from, say, 150 in
1998 to 160 in 1999,

the simple inflation rate during 1998-99 = 6.67%

{(160-150)/150 x 100}
and the continuous compounded inflation rate =
6.45 % {ln (160/150) x 100}.

In practice, the annual compounding rate is often

used.
Effects of Inflation
 Effects on Production
 Mild inflation is beneficial to the economy.

 Hyperinflation disrupts the economy: discourages savings =>

capital accumulation falls. Drives out foreign capital already
invested in the economy.

 Volume of production will fall not only on account of fall in

capital accumulation, but also due to the uncertainty.

 Pattern of production may change.

 Seller’s market => result in deterioration of the quality of goods

produced. Give impetus to speculative activities.

 Most serious: disrupts the smooth functioning of the price

mechanism.
 Consequences of high inflation

• Inertial inflation: prices and wages adjust to past

inflation through contractual adjustment.
Hyperinflation: wages and prices anticipate future
inflation (and v rises). In both an underlying conflict
over income distribution.

• Supply shortages (e.g. droughts, wars) can cause

inflation. Serious redistributive consequences for the
poor. Price controls lead to shortages of essential goods
(rationing and black markets).

• Inflation also causes uncertainty, leading to hoarding

by households and no investment by firms; eventually
can lose to market collapse as money loses its
functions.
 Effects on Distribution
Results in redistribution of income and wealth.

 Debtors & Creditors: Debtors are gainers – they borrowed

when purchasing power of money was high and return the loans
when pp of money is low due to rising prices. Creditors are
losers – receive less in real terms

 Wage & Salary Earners: wages do not rise proportionally with

rise in cost of living. If they are well organized in trade unions,
they may not suffer much.

 Farmers: gain – prices of farm products go up while costs

incurred do not go up to the same extent – time lag between rise
in prices and costs. Farmers are generally debtors and can repay
their debts in terms of less purchasing power.
 Fixed income groups: hardest hit – persons who live on past
savings, pensioners, interest and rent receivers suffer most during
inflation.

 Entrepreneurs: Inflation is a boon – whether manufacturers,

traders, merchants and businessmen – rising prices serve as a tonic
for business enterprise – experience windfall gains as the prices of
their inventories (stocks) suddenly go up. Also gain as their costs
(on wages, raw materials, etc) do not go up as rapidly as prices.

 Investors: of two types

(a) Invest in equities (shares) – Dividends on equities increase
with increase in prices and corporate earnings.
(b) Invest in fixed interest- yielding bonds and debentures –
income from bonds remain fixed and as such they have much to
lose during inflation. Frequently, the value of their savings is
largely, if not completely, wiped out as a result of depreciation in
the value of money.
Measures to Control Inflation
 Halting inflation

• In the short run the only ‘cure’ for inflation is to reduce

expenditure – but whose? Wage contracts can be de-indexed,
interest rates raised and public expenditure cut. But with severe
political costs.

• In the medium term the only solution is increased supply.

Simulated in the short run by large-scale imports (aid, debt) to
reduce inertial inflation. But demand cuts in the short run reduce
investment required to increase supply in the long run.

• The current fashion for independent central banks (so politicians

cannot monetize fiscal deficits) is an institutional approach to
permanently altering market expectations.
 Monetary Policy
Measures adopted by the Central Bank such as
 Increase in re-discount rates: increases the cost of
borrowing for business and consumer spending and
discourages excessive activity based on borrowed
funds

 Sale of government securities in the open market:

mops up excessive purchasing power from the public

 Increase in reserve ratios: cash reserve ratio and

statutory liquidity ratio; and

 Adjustments in selective controls: consumer credit

control and higher margin requirements, etc.
 Fiscal Policy
 Government Expenditure: during inflation, effective
demand increases far too much due to unregulated private
spending. To counteract this, the government should reduce
its own expenditure to the minimum.

 Taxation: the problem is to reduce the size of the disposable

income in the hands of the general public The rates of
existing taxes should be increased while new taxes should be
imposed.

 Public Borrowing: the objective is to take away from the

public excess purchasing power. Public borrowing may be
voluntary or compulsory.
 Fiscal Policy (Contd…)
 Debt Management: refers to public borrowing and
repayment – the government borrowing may assume the
form of borrowing from non-bank public through sale of
bonds and securities, which will curtail consumption and
private investment.

 Overvaluation: of domestic currency in terms of foreign

currencies will serve as an anti-inflationary measure as
(i) it will discourage exports and thereby result in an
increased availability of good and services at home, (ii)
encourage imports – add to domestic stock of goods and
services, (iii) by lowering the price of foreign inputs, it
will help in checking the upward cost-price spiral.
 Physical Policy

Expansion of output: increased production is the best antidote to

inflation – steps should be taken to increase output of those
goods, which seem to be extremely sensitive to inflationary
pressures by shifting resources.

Wage Policy: wage increase has to be controlled – wages should

be allowed to rise only if there is an increase in the
productivity, i.e. output per worker. In such a situation,
higher wages will not give rise to higher costs and hence to
higher prices.

Price Control and Rationing: the objective of price control is to

lay down the upper limit beyond which, the price of a
particular commodity will not be allowed to rise. Demand
can also be controlled through rationing of essential
commodities.
Unemployment: Some Concepts
 Unemployment
 In physical terms
Up = Population – employed people

 In economic terms
U = workforce – employed people
where
workforce = population – people not employed =
population employable (15-58 yrs)
 Kinds of Unemployment

Voluntary and Hidden

 Voluntary: willful unemployment – may arise due to

laziness, obsession with wealth and/or leisure – not
considered an economic threat

 Involuntary: forced unemployment – caused by

paucity of employment opportunities – an economic
issue
 Open and Hidden

Open Unemployment

 Frictional: unemployment when in between two jobs

(for better prospects) – prevalent in developed
countries where jobs are very demanding and they are
available in plenty for capable persons – healthy, not
an economic problem.
 Kinds (cont….)

 Cyclical: caused by business cycles and economic

fluctuations – serious problem

 Structural: mismatch between vacancies and skills of

unemployed people; mismatch between location of
unemployed and vacancies – requires retraining and
additional skill sets; mobility
 Hidden
 Disguised:
when several people share a particular work at a given time
and/or when such work is spread over time. Marginal product
of withdrawn workers is zero.

 Seasonal:
some occupations are seasonal, e.g. farming

 Underemployment:
number of hours worked is less than the full employment
hours’ norms. Part-time workers in industries and services and
full time workers in agriculture suffer from such a malady.
 Full Employment

 Literally, it means zero unemployment.

 Economists regard voluntary unemployment as no

unemployment and the frictional unemployment as
“not bad.” Thus, when the unemployment rate is close
to say 3-4%, economists call it a “full employment”
situation.

 Voluntary unemployment is hard to quantify and the

full frictional unemployment is estimated to be around
3-4 %, particularly in the developed countries.
 Demand for and supply of labour are sensitive to the
wage rate - full employment is also defined as the
situation where the demand for labour equals the supply
of labour in the economy at a given wage rate.

 Full employment is a situation where the number of

people unemployed equals the number of vacancies that
is untenable.
 NK S
T H A
 MEASURING
 Consumer Price Index (CPI)
• Impact on household
• Basis of Cost-of-Living Adjustments (COLA)

 Producer Price Index (PPI)

• Impact on business

 GDP Deflator
• Impact on household, business, and gov’t.