Inflation

Learning Outcomes

After This Lecture, The Student Will Be Able To

Understand:

•Concept of Inflation
•Concepts Related to Inflation
•Types Of Inflation
•Inflationary Gap
•Wage Price Spiral
•Causes of Inflation
•Measurement of Inflation
•Wholesale Price Index
•Controlling Inflation (Monetary Policy / Fiscal Policy)
 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
production rises
Cost of living rises

Wages rise
 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%.
– per an estimate the cost of attending state colleges will soar to
As
$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 (outdated) 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.

Current Year's Price

Price Index = 100
Base Year's Price
 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  Last year's Index - Current Year's Index 100

Current Year's Index
 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.
 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 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
• 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
Δ P/P ΔW/W

8
10
6
Annual 8
Price Rise % 4 6 Annual
Philips’ Wage Rise %
2 curve 4

2
O 2 8 1
Unemployment

• 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
Inflation is the state in which ..............................

(a) The value of money decreases

(b) The value of money increases
(c) The value of the money increases first and then
decreases
(d) The value of money decreases first and increases
later
How inflation affects the price of the commodities?

(a) Price of the commodities decreases

(b) Price of the commodities increases
(c) No effect
(d) First the price decreases later on increases
When there is high inflation in the economy, how
will it affect the supply of money in the economy?

(a) No effect on the money supply

(b) Supply of money decreases
(c) Supply of money increases
(d) None of the above
Which of the following class will not be negatively
affected by the higher inflation?

(a) The consumer class

(b) The debtor class
(c) Pensioner class
(d) Business class