1. InflationDefinition, Causes, Measurement,Consequences and Corrective Actions

2. Some definitionsThe state in which value of money is falling, i.e.price is rising. Prof CrowtherCriticisms: Every increase in price level is inflationary and hasharmful consequences. Emphasized the symptom rather than the cause of thedisease fails to explain why price level increases 3. Other Definitions Issue of too much money Prof Hawtrey Too much currency in relation to physical volume ofbusiness being done. Prof Kermmerer Inflation is too much money chasing too few goods. Prof Coulbourn 4. Therefore, increase in average price levels isreferred to as Inflation.Problem Prices rise faster than income Standard of living declines 5. Deflation Defined Declining price levels Associated with recession 6. Types of Inflation 7. Based on speedCreeping inflation: mildest form of inflation makes the economy dynamic. Prices rise slowly Industry and trade receive stimulus and thecountry develops economically. According to some economists, price levelshould rise by approx. 2% annually undercreeping inflation. 8. Walking:Rate of increase of price-level gets further accelerated rises byapprox 5% annually. If proper control is not exercised, it caneasily 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 itmay 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 WorldWar, and Great Chinese Inflation after the Second World War. 9. Theories of Inflation 10. Demand-Pull InflationInflation is caused by an excess of demand (spending)relative to the available supply of goods and services atexisting prices. The Classical - the key factor is the money supply. The quantitytheory of money => only an increase in money supply is capableof raising the general price level. In Modern income theory, means an excess of aggregatedemand relative to the economys full employment output level. Prices rise in response to an excess of aggregate demand overexisting supply of goods and service => caused by an increase inquantity of money May also be caused when MEC or MPC goes up causing anincrease in expenditures and hence prices. 11. Demand Pull Inflation S Price level D2D1 P2D0 P1 P0 S Y0 Real Income 12. Cost Push Inflation This theory maintains that prices, instead of beingpulled-up by excess demand, are pushed-up as aresult of a rise in the cost of production. Prices rise on account of a rise in the cost of rawmaterials, especially wages. Some producers, group of workers, or both,succeed in raising the prices for either theirproduct or services above the levels that wouldprevail under more competitive conditions 13. Inflation of the cost-push type originates inindustries, which are relatively concentrated,and in which, sellers can exercise considerablediscretion in the formulation of both prices andwages. It may not be possible in an economycharacterized by pure competition. 14. S D2D1 D0P1P0 S1 S0Y2 Y1 Y0 15. MEASUREMENT OF INFLATION 16. General Price LevelWeighted average of individual goods prices.nPt = S wi Piti=1wi >= 0S wi = 1 17. ExampleSuppose there are only 3 goods in the economy, withtheir prices in 1999 and weights as follows:GoodsPrice WeightRice Rs. 15 / kg0.6ShirtRs. 200 / piece0.3House (room) Rs.1000 / mon0.1 18. General price in 1999P99 = 0.6 (15) + 0.3 (200) + 0.1 (1000) = Rs. 169Note: the general price is merely a concept. There is nothing particular that you can buy for Rs. 169. 19. WeightsThe weights for the various component items aredetermined by the relative significance of that itemin all the items during the base period.Qi0 Pi0 Wi = ------------------ Qi0 Pi0iwhere Qi0 and Pi0 are the quantity and price of thegood i in the base period. 20. Price Index A Price Index is expressed as the current pricein relation to its value in the base period. Thus, price index for period t is defined as: PIt = Pt / P0 21. ExamplePrice of shirt in base year, say 1991 was Rs. 120and in 1999 it was Rs.200, the price indexPI 99 = Rs. 200 / Rs. 120 = 1.67 22. About Price index An index helps to compare the data withoutworrying about the unit of measurement. Price Index of 1.67 indicates that between 1991and 1999, price of shirt has increased by 67 %. Index numbers are usually written with a basevalue = 100 (above number has to be multipliedby 100). 23. Price index of general price weighted average of various pricesPitPIt = Wi ------Pi0 24. Measuring the Inflation It means the rate of change in general price (P orPI) per year, expressed in percentages. Thus the simple inflation rate in period t (Pt) overthe last one year is given by:Pt P t-1Pt = ------------------ x 100Pt-1If it is compounded once in a year only. 25. If compounding is done on a continuous basis:PtPt = ln ------ x 100Pt-1Where ln stands for natural logarithm. 26. ExampleIf the general price index rises from, say, 150 in1998 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 oftenused. 27. Effects of Inflation 28. Effects on Production Mild inflation is beneficial to the economy. Hyperinflation disrupts the economy: discourages savings =>capital accumulation falls. Drives out foreign capital alreadyinvested in the economy. Volume of production will fall not only on account of fall incapital accumulation, but also due to the uncertainty. Pattern of production may change. Sellers market => result in deterioration of the quality of goodsproduced. Give impetus to speculative activities. Most serious: disrupts the smooth functioning of the pricemechanism. 29. Effects on DistributionResults 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 termsWage & 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. 30. Fixed income groups: hardest hit persons who live on pastsavings, pensioners, interest and rent receivers suffer most duringinflation. Entrepreneurs: Inflation is a boon whether manufacturers,traders, merchants and businessmen rising prices serve as a tonicfor business enterprise experience windfall gains as the prices oftheir 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 increasewith 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 tolose during inflation. Frequently, the value of their savings islargely, if not completely, wiped out as a result of depreciation inthe value of money. 31. Measures to Control Inflation 32. Monetary PolicyMeasures adopted by the Central Bank such asIncrease 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 andstatutory liquidity ratio; and Adjustments in selective controls: consumer creditcontrol and higher margin requirements, etc. 33. Fiscal Policy Government Expenditure: during inflation, effectivedemand increases far too much due to unregulated privatespending. To counteract this, the government should reduceits own expenditure to the minimum. Taxation: the problem is to reduce the size of the disposableincome in the hands of the general public The rates ofexisting taxes should be increased while new taxes should beimposed. Public Borrowing: the objective is to take away from thepublic excess purchasing power. Public borrowing may bevoluntary or compulsory. 34. Fiscal Policy (Contd) Debt Management: refers to public borrowing andrepayment the government borrowing may assume theform of borrowing from non-bank public through sale ofbonds and securities, which will curtail consumption andprivate investment. Overvaluation: of domestic currency in terms of foreigncurrencies will serve as an anti-inflationary measure as(i) it will discourage exports and thereby result in anincreased availability of good and services at home, (ii)encourage imports add to domestic stock of goods andservices, (iii) by lowering the price of foreign inputs, itwill help in checking the upward cost-price spiral. 35. Physical PolicyExpansion 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 tolay down the upper limit beyond which, the price of aparticular commodity will not be allowed to rise. Demandcan also be controlled through rationing of essentialcommodities. 36. Unemployment: Some Concepts 37. Unemployment In physical termsUp = Population employed people In economic termsU = workforce employed peoplewhereworkforce = population people not employed =population employable (15-58 yrs) 38. Kinds of UnemploymentVoluntary and Hidden Voluntary : willful unemployment may arise due to laziness, obsessionwith wealth and/or leisure notconsidered an economic threat Involuntary : forced unemployment caused by paucity of employmentopportunities an economic issue 39. Open and HiddenOpen Unemployment Frictional : unemployment when inbetween two jobs (for betterprospects) prevalent in developedcountries where jobs are verydemanding and they are available inplenty for capable persons healthy,not an economic problem. 40. Kinds (cont.) Cyclical : caused by business cycles andeconomic fluctuations serious problem Structural : mismatch between vacanciesand skills of unemployed people; mismatchbetween location of unemployed andvacancies requires retraining andadditional skill sets; mobility 41. Hidden Disguised : when several people share aparticular work at a given time and/or whensuch work is spread over time. Marginalproduct of withdrawn workers is zero. Seasonal : someoccupationsareseasonal, e.g. farming Underemployment : number of hoursworked is less than the full employmenthours norms. Part-time workers inindustries and services and full time workersin agriculture suffer from such a malady. 42. Full Employment Literally, it means zero unemployment. Economists regard voluntary unemploymentas no unemployment and the frictionalunemployment as not bad. Thus, when theunemployment rate is close to say 3-4%,economists call it a full employmentsituation. Voluntary unemployment is hard to quantifyand the full frictional unemployment isestimated to be around 3-4 %, particularly inthe developed countries. 43. Demand for and supply of labour aresensitive to the wage rate - fullemployment is also defined as thesituation where the demand for labourequals the supply of labour in theeconomy at a given wage rate. Full employment is a situation wherethe number of people unemployedequals the number of vacancies that isuntenable. 44. 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 govt.