introduction

Inflation

Inflation
This is the process by which the price level rises and money loses value. There are two kinds of inflation: a) Demand pull b) Cost push

Demand pull inflation

Demand pull inflation may be due to : a) Increase in money supply b) Increase in government purchases c) Increase in exports

Cost push Inflation

Cost push inflation may arise because of : a) Increase in money wage rates b) Increase in money prices of raw materials.

Hyper inflation
Extremely rapid or out of control inflation. There is no precise numerical definition to hyperinflation. Price increases are so out of control that the concept of inflation is meaningless. The most famous example of hyperinflation occurred in Germany between January 1922 and November 1923. By some estimates, the average price level increased by a factor of 20 billion!

Money and Prices During Hyperinflations

(a) Austria Index (Jan. 1921 = 100) 100,000 10,000 1,000 100 Price level Money supply Index (July 1921 = 100) 100,000

(b) Hungary

Price level 10,000 1,000 100 Money supply

1921

1922

1923

1924

1925

1921

1922

1923

1924

1925

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Stagflation
A condition of slow economic growth and relatively high unemployment accompanied by inflation. This happened to a great extent during the 1970s, when world oil prices rose dramatically, fueling sharp inflation in developed countries. At least some central banks have expressed concern over inflation even as the global economy seems to be slowing down.

Money Supply, Money Demand, and the Equilibrium Price Level

Value of Money, 1 /P (High) 1 Price Level, P 1 (Low)

Money supply

/4

1.33

12

Equilibrium value of money

Equilibrium price level

14

4 Money demand

(Low)

Quantity fixed by the Fed

Quantity of Money

(High)

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The Effects of Excess Money Supply

Value of Money, 1 /P (High) 1

MS1

MS2

Price Level, P

1
1. An increase in the money supply . . . A

(Low)

2. . . . decreases the value of money . . .

/4

1.33 3. . . . and increases the price level.

12

14

B Money demand

(Low) 0
M1 M2

(High)

Quantity of Money

Copyright 2004 South-Western

How is inflation measured?

WPI (Wholesale Price Index) India- the only major country that uses WPI (1st published in 1902) What is WPI? The WPI number is a weekly measure of wholesale price movement for the economy

WPI- The Indian Example

Indian government constructed its present WPI way back in 1993-94 (1993-94 series replacing 1981-82 bases) by making a basket of 435 commodities Laspeyres formula employed The 100-point index is subdivided into three groups

Major Groups: I. Primary Articles (98 items)- 22.02 % Food Articles, Non-Food Articles, Minerals II. Fuel, Power, Light & Lubricants (19 items) - 14.23 % III. Manufactured Products (318 items) - 63.75 % Food Products Beverages, Tobacco & Tobacco Products Textiles etc

 The Office of the Economic Advisor (OEA) compile the WPI numbers on weekly basis On Friday inflation figures are announced The working group on WPI, headed by Planning Commission member Abhijit Sen, has worked out a new index The base year of the new index :2000-01 The basket of commodities- around 1200 To Reflect the post-liberalisation consumption pattern

Consumer Price Index (CPI)

A measure of the average price of consumer goods and services purchased by households (1st published in 1970) CPI indicates the change in the purchasing power of the consumer CPI for Industrial Workers (CPI-IW), CPI for Agricultural Labourers / Rural Labourers (CPI AL/RL), CPI for Urban Non-Manual Employees (CPI-UNME) Published on a monthly basis

 Producer Price Index (PPI)

Measures average changes in prices received by domestic producers for their output

Service Price Index (SPI)

The share of the service sector in the (GDP) gone up from 28% (1950) to over 50% Necessitates representation of Services in the price index

Discussion question
Why is inflation bad?

 Unanticipated inflation is bad because it makes the economy behave like a giant casino. Gains and losses occur because of unpredictable changes in the value of money. If the value of money varies unpredictably over time, the quantity of goods and services that money will buy will also fluctuate unpredictably. Resources are also diverted from productive activities to forecasting inflation. Unanticipated inflation leads to : a) Redistribution of income, borrowers and lenders b) Too much or too little lending or borrowing

The Economic Impacts of Inflation

Redistribution of Income and wealth among different groups Distortion in relative prices and outputs of different goods, or sometimes in output and employment for the economy as a whole.

THE COSTS OF INFLATION

Shoe leather costs Menu costs Tax distortions Confusion and inconvenience Arbitrary redistribution of wealth

Shoe leather costs

Shoe leather costs are the resources wasted when inflation encourages people to reduce their money holdings. Inflation reduces the real value of money, so people have an incentive to minimize their cash holdings. Less cash requires more frequent trips to the bank to withdraw money from interest-bearing accounts.

Menu costs
Menu costs are the costs of adjusting prices. During inflationary times, it is necessary to update price lists and other posted prices. This is a resource-consuming process that takes away from other productive activities.

Inflation-Induced Tax Distortion

The income tax treats the nominal interest earned on savings as income, even though part of the nominal interest rate merely compensates for inflation. The after-tax real interest rate falls, making saving less attractive.

Taming Inflation
Monetary policy- Bank rate policies, Open Market operations, Reserve requirement ratios Fiscal policy-taxation, public borrowing, public expenditure Direct Control-Fixing ceiling prices of the products, Rationing. Miscellaneous methods-Controlling Wages, Controlling population growth

The Effects of Monetary Injection

Value of Money, 1 /P (High) 1

MS1

MS2

Price Level, P

1
1. An increase in the money supply . . . A

(Low)

2. . . . decreases the value of money . . .

/4

1.33 3. . . . and increases the price level.

12

14

B Money demand

(Low) 0
M1 M2

(High)

Quantity of Money

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