Module 2

Overview of
Macroeconomics
Inflation

Dr. Ajay Massand

 Inflation

– A general rise in prices. A persistent rise in the general price level rather than a
once-for-all rise in it.
– Inflation exists when money supply exceeds available goods and services.
– It is to be pointed out here that inflation is a state of disequilib­rium when there
occurs a sustained rise in price level. It is inflation if the prices of most goods go
up. Such rate of increase in prices may be both slow and rapid.
 Deflation/Disinflation

– As inflation is a state of rising prices, de­flation may be defined as a state of

falling prices but not fall in prices. Deflation is, thus, the opposite of inflation,
i.e., a rise in the value of money or purchasing power of money.
– Disinflation is a slowing down of the rate of inflation.
 How to Measure Inflation

– Inflation in India
– India calculates its inflation on two price indices, i.e., the wholesale price index
(WPI) and the consumer price index (CPI).

– WPI-Wholesale Price Index

– CPI-Consumer Price Index
 Wholesale Price Index

– The first index number of wholesale prices commenced in India for the week January 10,
1942. It was having the base week ending August 19, 1939 = 100, which was published by the
office of the Economic Adviser to the Government of India (Ministry of Industry).
– The base years are as given below:
– (i) 1952–53 Base Year (112 Commodities) issued from June 1952.
– (ii) 1961–62 Base Year (139 Commodities) issued from July 1969.
– (iii) 1970–71 Base Year (360 Commodities) issued from January 1977.
– (iv) 1981–82 Base Year (447 Commodities) issued from January 1989.
– (v) 1993–94 Base Year (435 Commodities) issued from July, 1999.
– (vi) 2004–05 Base Year (676 Commodities) released in September 2011.
– v) 2011-12 Base Year ( 697 Commodities) released in May 2017.
 WPI to PPI

– The Government has set up a working group under NITI Aayog member Ramesh
Chand to revise the current series of Wholesale Price Index (WPI) with base
2011-12 and devise a new Producer Price Index (PPI).
– PPI measures the average change in the price a producer receives for his goods
and services sold in the domestic market and exports.
 Consumer Price Index

– calculates inflation at the consumer level, similar to all the economies of the
world. As consumers in India show wide differentiation of their choice of
consumption, purchasing powers. etc., a single consumer price index (CPI) has
not been possible yet which can encompass all the Indian consumers.

– https://www.rbi.org.in/Scripts/PublicationsView.aspx?id=19029
CPI
CPI (last 25 years)
 CPI

– In 2013, the consumer price index replaced the wholesale price index (WPI) as a main
measure of inflation.
– In India, the most important category in the consumer price index is Food and beverages
(45.86 percent of total weight), of which Cereals and products (9.67 percent), Milk and
products (6.61 percent), Vegetables (6.04 percent), Prepared meals, snacks, sweets, etc.
(5.55 percent), Meat and fish (3.61 percent), and Oils and fats (3.56 percent).
– Miscellaneous accounts for 28.32 percent, of which Transport and communication (8.59
percent), health (5.89 percent), and education (4.46 percent). Housing accounts for 10.07
percent; Fuel and light for 6.84 percent; Clothing and footwear for 6.53 percent; and Pan,
tobacco and intoxicants for 2.38 percent.
WHY INFLATION OCCURS

– 1. Pre-1970s
– Demand-Pull Inflation: A mis-match between demand and supply pulls up
prices.
– The Keynesian School suggests cuts in spending as the way of tackling excess
demand mainly by increasing taxes and reducing government expenditure.
– Cost-Push Inflation: An increase in factor input costs (i.e., wages and raw
materials) pushes up prices. The price rise which is the result of increase in
the production cost is cost-push inflation.
– The Keynesian school suggested controls on prices and incomes as direct
ways of checking
 WHY INFLATION OCCURS

– 2. Post-1970s
– Demand-Pull Inflation: For the monetarists, a demand-pull inflation is creation
of extra purchasing power to the consumer over the same level of production.
– This is the typical case of creating extra money (either by printing or public
borrowing) without equivalent creation in production/supply.
– ‘too much money chasing too little output’—the ultimate source of demand-
pull inflation.
 WHY INFLATION OCCURS

– 2. Post-1970s
– Cost-Push Inflation: Similarly, for the monetarists, ‘cost-push’ is not a truly
independent theory of inflation—it has to be financed by some extra money
(which is created by the government via wage revision, public borrowing,
printing of currency, etc.).
– Monetarists suggested proper monetary policy (money supply, interest rates,
printing of currencies, public borrowing etc.), to check situations of inflationary
pressure on the economy.
 Types of Inflation
– A. On the Basis of Causes:
– (i) Currency inflation:
– This type of infla­tion is caused by the printing of cur­rency notes.
– (ii) Credit inflation:
– Being profit-making institutions, commercial banks sanction more loans and
advances to the public than what the economy needs. Such credit expansion leads to
a rise in price level.
– (iii) Deficit-induced inflation:
– The budget of the government reflects a deficit when expenditure exceeds revenue.
To meet this gap, the government may ask the central bank to print additional money.
– (iv) Demand-pull inflation:
– An increase in aggregate demand over the available output leads to a rise in the
price level. Such inflation is called demand-pull in­flation. But why does aggregate
demand rise? Classical economists attribute this rise in aggre­gate demand to
money supply.
– If the supply of money in an economy ex­ceeds the available goods and services,
DPI appears. It has been described by Coulborn as a situation of “too much money
chasing too few goods.”

Increased Additional Increase in Demand-

Income Demand Price Level Pull Inflation
– (v) Cost-push inflation:
– Inflation in an economy may arise from the overall increase in the cost of production.
This type of inflation is known as cost-push inflation.
– Cost of pro­duction may rise due to an increase in the prices of raw materials, wages,
etc. Higher wage means high cost of production. Prices of commodities are thereby
increased.

Increased cost
Increase in Price Cost-Push
for inputs and
Level Inflation
raw materials
– B. On the Basis of Speed or Intensity:
– (i) Creeping or Mild Inflation:
– If the speed of upward thrust in prices is slow but small then we have creeping inflation. To
some, a creeping or mild inflation is one when annual price rise varies between 2 p.c. and 3
p.c.
– (ii) Walking Inflation:
– If the rate of annual price increase lies between 3 p.c. and 4 p.c., then we have a situation of
walking inflation. When mild inflation is allowed to fan out, walking inflation appears.
These two types of inflation may be described as ‘moderate inflation’.
– (iii) Galloping:
– Walking inflation may be converted into running inflation. Running inflation is danger­ous.
If it is not controlled, it may ulti­mately be converted to galloping. It is an extreme form of
inflation when an economy gets shatter­ed. Inflation in the double or triple digit range of 20,
100 or 200 p.c. a year is labelled “galloping inflation”.
B. On the Basis of Speed or
Intensity:
IV) hyperinflation
– This form of inflation is ‘large and accelerating’ which might have the
annual rates in million or even trillion. In such inflation not only the range
of increase is very large, but the increase takes place in a very short span of
time, prices shoot up overnight.
– https://www.imf.org/external/datamapper/PCPIEPCH@WEO/OEMDC/ADVEC/
WEOWORLD?year=2020
– https://www.stlouisfed.org/on-the-economy/2018/january/venezuela-address-
hyperinflation
Terminologies

– Core Inflation: core inflation shows price rise in all goods and services excluding
energy and food articles.
– Bottleneck Inflation-when the supply falls drastically and the demand remains
at the same level.
– Inflationary Gap: The excess of total government spending above the national
income (i.e., fiscal deficit) is known as inflationary gap.
Causes of Inflation:
– Inflation is mainly caused by excess demand/ or decline in aggregate supply or output.
Former leads to a rightward shift of the aggregate demand curve while the latter causes
aggregate supply curve to shift left­ward. Former is called demand-pull inflation (DPI), and
the latter is called cost-push infla­tion (CPI).

(i) Demand-Pull Inflation Theory:

– There are two theoretical approaches to the DPI—one is classical and other is the
Keynesian.
– According to classical economists or mon­etarists, inflation is caused by an increase in
money supply which leads to a rightward shift in negative sloping aggregate demand curve.
– According to Keynesians, aggregate demand may rise due to a rise in consumer demand or
investment demand or govern­ment expenditure or net exports or the com­bination of these
four components of aggregate demand.
– Given full employment, such in­crease in aggregate demand leads to an up­ward pressure in
• In Fig, aggregate demand curve is negative sloping
while aggregate supply curve before the full
employment stage is positive sloping and becomes
vertical after the full employ­ment stage is reached.
AD1 is the initial aggregate demand curve that
intersects the aggregate supply curve AS at point
E1.
• The price level, thus, determined is OP1. As ag­
gregate demand curve shifts to AD2, price level
rises to OP2. Thus, an increase in aggre­gate demand
at the full employment stage leads to an increase in
price level only, rather than the level of output.
Causes of Demand-Pull Inflation:

– An increase in nominal money supply shifts aggregate demand curve

rightward.
– by the printing of additional money (classical argument) which drives
prices up­ward.
– growth of population stimulates aggregate demand.
– Higher export earnings increase the purchasing power of the exporting
countries.
– Again, there is a tendency on the part of the holders of black money to
spend more on conspicuous consumption goods.
ii) Cost-Push Inflation Theory
– In addition to aggregate demand, aggregate supply also generates inflationary process.
As inflation is caused by a leftward shift of the aggregate supply, we call it CPI. CPI is
usu­ally associated with non-monetary factors. CPI arises due to the increase in cost of
produc­tion. Cost of production may rise due to a rise in cost of raw materials or increase
in wages.
– However, wage increase may lead to an in­crease in productivity of workers. If this hap­
pens, then the AS curve will shift to the right- ward not leftward—direction. We assume
here that productivity does not change in spite of an increase in wages.
– Such increases in costs are passed on to consumers by firms by rais­ing the prices of the
products. Rising wages lead to rising costs. Rising costs lead to rising prices. And, rising
prices again prompt trade unions to demand higher wages. Thus, an inflationary wage-
price spiral starts. This causes aggregate supply curve to shift leftward.
– AS1 is the initial aggregate supply curve. Below the
full employment stage this AS curve is positive
sloping and at full em­ployment stage it becomes
perfectly inelastic.
– Intersection point (E1) of AD1 and AS1 curves
determine the price level (OP1). Now there is a
leftward shift of aggregate supply curve to AS 2. With
no change in aggregate demand, this causes price
level to rise to OP2 and output to fall to OY2.
– With the reduction in output, employment in the
economy de­clines or unemployment rises. Further
shift in AS curve to AS3 results in a higher price level
(OP3) and a lower volume of aggregate out­put (OY3).
Thus, CPI may arise even below the full employment
(YF) stage.
Causes of Cost-Push Inflation:

– rise in price of raw materials.

– hike in the price of petrol or diesel or freight rate.
– wage-push inflation or profit-push inflation. (Trade unions demand)
– Fiscal policy changes, such as increase in tax rates i.e. GST
– Natural disaster, gradual exhaustion of natural resources, work stop­
pages, electric power cuts, etc.,
– Inefficiency, corruption, mismanagement of the economy may also
be the other reasons.