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Concept of Inflation Rate of Inflation & Rate of Return Kinds of Inflation Causes of Inflation Measures to control Inflation
Jithin Prabhakaran Royston Martis Minal Khochare Nikhil Limaye Priyanka Patil & Chandra M
The word "inflation" covers two different concepts, and it's important to keep them separate. One concept is monetary inflation, which is when the supply of money increases faster than the supply of goods and services. According to Pigou, “Inflation exists when money income is expanding more than in proportion to increase in earning activity.” According to Coulborn, “Too much money chasing too few goods”.
CONCEPT OF INFLATION
The other concept is price inflation, which is an increase in the overall level of prices for goods and services. The relationship between the two is the relationship of cause and effect. Monetary inflation causes price inflation. But while almost everyone sees price inflation when it happens, few people notice the monetary inflation that is causing it. And so they tend to blame the producers of goods and services for higher prices - rather than the money-creating government that is the true culprit. For example: ➢ A movie ticket was for a few paisas in my dad’s time. Now it is worth Rs.50. ➢ My dad’s first salary for the month was Rs.400 and over his years it has now become Rs.75, 000. This is what inflation is, the price of everything goes up. Because the price goes up, the salaries go up. If you really thing about it, inflation makes the worth of money reduce. What you could buy in my dad’s time for Rs.10, now a days you will not be able to buy for Rs.400 also. The worth of money has reduced! If this is still not clear consider this, when my father was a kid, he used to get 50paise pocket money. He used to use this money to go and watch a movie (At that time you could watch a movie for 50paise!) Now, just for the sake of understanding assume that my dad decided in his childhood to save 50paise thinking, that one day when he becomes big, he will go for a movie. Many years pass. The year now is 2006. My dad goes to the theater and asks for a ticket. He offers the ticket-booth-guy at the theater 50paise and asks for a ticket. The ticket booth guy says, “I am sorry sir, the ticket is worth Rs.50. You will not be able to even buy a “paan” with the 50 paisa!!” The moral of the story is that, the worth of the 50paise reduced dramatically. 50paise could buy a whole lot when my dad was a kid. Now, 50paise can buy nothing. This is inflation. This tells us two important things.
Do not keep your money stagnant. If you just save money by putting it your safe it will loose value over time. If you have Rs.1000 in your safe today and you keep it
there for 10years or so, it will be worth a lot less after 10 years. If you can buy something for Rs.1000 today, you will probably require Rs.1500 to buy it 10 years from now. So do not keep money locked up in your safe. Always invest money. If you can’t think where to invest your money, then put it in a bank. Let it grow by gaining interest. But whatever you do, do not just lock your money up in your safe and keep it stagnant. If you do this, you will be loosing money without even knowing it. The more money you keep stagnant the more money you will be loosing.
When investing, you have to make sure that the rate of return on your investment is higher than the rate of inflation.
What is the rate of inflation?
As we said earlier, the prices of everything go up over time and this phenomenon is called inflation. The question is: By how much do the prices go up? At what rate do the prices do up? The rate at which the prices of everything go up is called the "rate of inflation". For example, if the price of something is Rs.100 this year and next year the price becomes approximately Rs.104 then the rate of inflation is 4%. If the price of something is Rs.80 then after a year with a rate of inflation of 4% the price go up to (80 x 1.04) = 83.2 So, when you make an investment, make sure that your rate of return on the investment is higher than the rate of inflation in your country. In our county India, for the year 2005-2006 the rate of inflation was 4% (Which is really low and amazing!). This rate keeps changing every year. The finance minister generally gives the official statement on the inflation rate of the country for a particular year.
What is the rate of return?
The rate of return is how much you make on an investment. Suppose you invest Rs.100 in the market and over a year, you make Rs.120, then you rate of return is 20%. If you invest Rs.100 in the market today and you make money at a 3% "rate of return" in one year you will have Rs.103. But now, since the rate of inflation is at 4%, an item costing Rs.100 today will cost Rs.104 a year from now. So what you can buy with today’s Rs.100, you will only be able to buy with Rs.104 a year from now. But the Rs.100 that you invested has grown only at a 3% rate of return and so it is
worth Rs.103. In effect, you are loosing money! So in conclusion, the rate of return on your investments, have to be higher than the rate of inflation. From the above paragraphs you can note how silently, inflation eats into your money. You would not even know about it and your money would sit loosing value for no fault of yours.
KINDS OF INFLATION
➢ Moderate Inflation ➢ Galloping Inflation ➢ Hyper Inflation
1. Moderate Inflation: A ‘single digit’ rate of annual inflation is called ‘moderate inflation’ or creeping inflation. During the period of moderate inflation price increases, but at a moderate rate. The moderate rate may vary from country to country. However an important feature of moderate inflation is that it is predictable and people hold money as a store of value. By this definition India has had a moderate rate of inflation during the post independence period except in few years. 2. Galloping Inflation: Very high rate of inflation is called galloping inflation. How high should be the rate of inflation to be called a galloping inflation is not defined precisely? According to Baumol and Blinder galloping inflation refers to an inflation that proceeds at an exceptionally high rate. They do not specify at what rate of inflation is exceptionally high. A country with 900 percent inflation will have devastating effects, whereas countries with 20-30 percent can mange without pressing the alarm bell. Some examples of galloping inflation, i.e., the annual average rate of inflation, during 1980-91 are as follows: ➢ Argentina- 416.9% ➢ Brazil- 327.6% ➢ Mexico- 66.5% ➢ Peru- 287.3% ➢ Yugoslavia- 123%
1. Hyper Inflation: Hyper inflation takes place when prices shoot up at more than three digit rate per annum. During the period of hyper inflation, paper currency becomes worthless. Germany had hyper inflation in 1922 and 1923 when wholesale price index shot up by ‘100 million percent between December 1922 and November 1923. In recent times, Argentina, Brazil and Peru had hyper inflation in 1989 and 1991 as shown below:
Country Argentina Brazil Peru
1989 3079.8% 1287.0% 3398.6%
1990 2314.0% 2937.8% 7481.7%
CAUSES OF INFLATION
1. Demand-pull inflation.
According to the demand pull theory price rise in response to an excess of aggregate demand over existing supply of goods and services. The demand pull theorists point out that inflation might be caused, in the first place, by an increase in the quantity of money, when the economy is operating at full employment level. As the quantity of money increases, the rate of interest will fall and, consequently, investment will increase. This increased investment expenditure will soon increase the income of the various factors of production. As a result, aggregate consumption expenditure will increase leading to an effective increase in the effective demand. With the economy already operating at the level of full employment, this will immediately raise prices, and inflationary forces may emerge.
2. Cost-push inflation
A group of economists holds the opposite view that the process of inflation is initiated not by an excess of general demand but by an increase in costs, as factors of production try to increase their share of total product by raising their prices. Thus, it has been viewed that a rise in prices is initiated by growing cost factors. Therefore, such a price is termed as “cost push inflation” as prices are being pushed up by the rising factor cost. Cost push inflation is induced by wage inflation process. It is believed that wages constitute nearly seventy percent of the total cost of production. This is specially true for a country like India, where labour intensive techniques are commonly used. Thus rise in wages leads to a rise in the total cost of production and a consequent rise in the price level, because fundamentally, prices are based on costs. Any autonomous increase in costs, such as rise in price of imported components or an increase in indirect taxes (excise duties, etc), may initiate a cist push inflation.
MEASURES TO CONTROL INFLATION
1. • Monetary Policy set by RBI CRR (Cash Reserve Ratio): Currently 5.50%. A cash reserve ratio (or CRR) is the percentage of bank reserves to deposits and notes. The cash reserve ratio is also known as the cash asset ratio or liquidity ratio. India's central bank ordered commercial banks to hold a larger share of deposits in cash, and raised a key short-term lending rate in a bid to curb high inflation that has stoked fears of overheating. • SLR (Statutory Liquidity Ratio): Currently 24% Statutory Liquidity Ratio (SLR) is a term used in the regulation of banking in India. It is the amount which a bank has to maintain in the form of cash, gold or approved securities. The quantum is specified as some percentage of the total demand and time liabilities ( i.e. the liabilities of the bank which are payable on demand anytime, and those liabilities which are accruing in one months time due to maturity) of a bank. This percentage is fixed by the Reserve Bank of India. The maximum and minimum limits for the SLR are 40% and 25% respectively.
Repo rate: Current 7.50% Whenever the banks have any shortage of funds they can borrow it from RBI. Repo rate is the rate at which our banks borrow rupees from RBI. A reduction in the Repo rate will help banks to get money at a cheaper rate. When the Repo rate increases borrowing from RBI becomes more expensive.
Reverse Repo rate: Current 6.00% Reverse Repo rate is the rate at which Reserve Bank of India (RBI) borrows money from banks. Banks are always happy to lend money to RBI since their money is in safe hands with a good interest. An increase in Reverse repo rate can cause the banks to transfer more funds to RBI due to these attractive interest rates. It can cause the money to be drawn out of the banking system. Due to this fine tuning of RBI using its tools of CRR, Bank Rate, Repo Rate and Reverse Repo rate our banks adjust their lending or investment rates for common man.
Fiscal Policy set by GOVERNMENT OF INDIA
TAXATION Government to ease liquidity may change the tax rate structure. An increase in tax rate may suppress the cash flow in the economy. Taxes like excise duties, octroi rate, income tax rate or the corporate tax.
GOVERNMENT EXPENDITURE Expenditure on public welfare schemes like infrastructure schemes like construction of roads, power generation plants, construction of dams etc. If more expenditure is on public welfare there is a possibility of rising inflation. Thus for curbing inflation lesser expenditure projects is a measure.
PUBLIC BORROWINGS A public borrowing is the money taken by the government from the people on which the government pays them interest. The money which is borrowed is used for public expenditure. The reason behind public borrowings is to stop /restrict the cash influx in the economy. More the public borrowings, the less influx of money in the economy so less the inflation and vice versa.
Top 10 nations with highest inflation (As on May 19,2008).
1. Zimbabwe: 355,000% The inflation in Zimbabwe for the month of March 2008 rose to 355,000%! Yes, 355,000 per cent! It more than doubled from the February figure of 165,000%. Economists say that it is a miracle that the Zimbabwean economy is still surviving and prices have been rising to unprecedented proportions. Inflation surged between February and March following the sudden rise in money supply that flooded the economy to finance the 2008 elections. Apart from this food and non-alcoholic beverages continued to drive up inflation. Almost 80% of the nation is unemployed. The Zimbabwean central bank has introduced $500 million bearer cheques (or currency notes) for the public, and $5 billion, $25 billion, $50 billion agro-cheques for farmers. Just last fortnight the nation had introduced $250 million bearer cheques. A sausage sandwich sells for Zimbabwean $50 million. A 15-kg bag of potatoes cost Zimbabwean $260 million. But then, Zimbabwean $50 million is roughly equal to US$ 1!
2. Iraq: 53.2%
War-torn Iraq is also facing a huge problem, not only on the political front but also on the economic one. Inflation in Iraq is running amuck. It currently stands at 53.2%.
Rising oil prices, political instability, terrorism and the other post-conflict dynamics have led to inflation in the nation rise to unmanageable proportions Some hurried counter-by the Iraqi central bank to curb inflation too have added fuel to the fire.
3. Guinea: 30.9%
Guinea is also one of the world's poorest countries. The inflation in the nation is at 30.9%. Although blessed with rich mineral wealth -- with huge iron ore, gold and diamond deposits -- Guinea has been languishing as one of the poorest nations on earth with large-scale unemployment, lack of industry and infrastructure dogging it.
4. San Tome and Principe: 23.1%
The mainstay of the economy of San Tome and Principe, an African nation, is agriculture. The main export from the nation is cocoa. It also exports coconut, coffee, etc. The current inflation rate in San Tome and Principe is at 23.1%. The country does not produce enough to meet domestic demand and thus is forced to import some essential commodities. With prices of food and other essential items rising in the global markets, imports for the nation have become almost unsustainable, leading to high prices and inflation. The nation has undertaken myriad measure to reform the economy, but it is still early days and the results of liberalisation will only be noticeable over a period of time.
5. Yemen: 20.8%
Yemen is going through terrible times. The Yemini economy is experiencing an inflation rate of 20.8%. More than 87% of Yemenis live for less than $2 a day. About 52% of children less than 5 years old suffer from malnutrition. Most of the people are engaged in agriculture, followed by the services and infrastructure sectors, while unemployment is rampant at 35 per cent.
6. Myanmar: 20%
Myanmar is one of the world's poorest nations. It has suffered immensely under military rule for decades and has been categorised as one of the 'least developed countries' in the world by the United Nations. Its inflation rate is at 20%. The economy of Myanmar is mostly controlled by the military junta leaving little room for private entrepreneurship or growth. The military regime has also decided to do away with all reforms suggested by economists, throwing the nation's economy into further turmoil.
7. Uzbekistan: 19.8%
Uzbekistan is slowly moving from a somewhat closed to a market-based economy. The economic reforms have helped achieve some growth, but not nearly as much as the nation would ideally like to enjoy. Also, lack of infrastructure, tight state control over the economy, occasional skirmishes with neighbouring nations, and an unstable political environment have seen inflation rise sharply here. The nation's inflation rate is at 19.8% currently.
8. Democratic Republic of Congo: 18.2%
Global investors do not feel that the Republic of Congo has a foreigner-friendly investment environment as it does not offer any incentive to the investor. Added to that a disorganized yet costly work force, high electricity costs, irregular supply of raw material, occasional civil unrest, political instability have only added to Congo's woes. And even as the nation grapples with its myriad problems, the Congolese economy has been going from bad to worse. And its current rate of inflation is 18.2%.
9. Afghanistan: 17%
Afghanistan has long been a theatre of conflict and that has affected its economy adversely. Perpetual battles, an environment of fear, lack of infrastructure, industry and services has led to a once-proud nation turn into one of the world's poorest. The inflation rate in Afghanistan is at 17%. The influx of billions of dollars of international aid has not really helped the economy much, although it is supposed to be much better now than it was in 2002.
10. Serbia: 15.5%
Serbia's fragile economy, which mostly rests on agriculture, services and some manufacturing activity, has been going through a reform process for a long time. However, economic sanctions that were imposed on the nations in the 1990s have hit Serbia's economy so hard that its myriad economic problems continue to this day. Unemployment is rampant, foreign investment is down to a trickle, foreign exchange reserves are low, and political instability are keeping good projects from taking off. Although the nation is growing at a robust pace, the rising inflation -- currently at 15.5% -- is hurting the Serbian economy.