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Project Report On Inflation: Submitted To: Submitted by
Project Report On Inflation: Submitted To: Submitted by
INFLATION
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Sandeep Yadav (FT-09-835)
CONTENTS
PARTICULARS PAGE
NUMBER
Inflation 3
How inflation is measured? 4
Causes of inflation 7
Effect of inflation 11
Methods to control 15
Other monetary phenomena 22
1. INFLATION
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supply of currency or credit relative to the availability of goods
and services, resulting in higher prices.
Therefore, inflation can be measured in terms of percentages. The
percentage increase in the price index, as a rate per cent per unit
of time, which is usually in years. The two basic price indexes are
used when measuring inflation, the producer price index (PPI) and
the consumer price index (CPI) which is also known as the cost of
living index number.
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"bundle," as the group is known, contains items such as food,
clothing, gasoline, and even computers. The amount of inflation is
measured by the change in the cost of the bundle: if it costs 5%
more to purchase the bundle than it did one year before, there
has been a 5% annual rate of inflation over that period based on
the CPI. You will also often hear about the "Core Rate" or the "Core
CPI." There are certain items in the bundle used to measure the
CPI that are extremely volatile, such as gasoline prices. By
eliminating the items that can significantly affect the cost of the
bundle (in either direction) on a month-to-month basis, the Core
rate is thought to be a better indicator of real inflation, the slow,
but steady increase in the price of goods and services.
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TYPES OF INFLATION:
Subsequently, when either the prices of goods or services or the
supply of money rises; this is considered as inflation. Depending
on the characteristics and the intensity of inflation, there are
several types, namely.
Creeping inflation
Trotting inflation
Galloping inflation
Hyper inflation
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uncontrollable because it increases more rapidly in such a little
time frame.
The main difference between the galloping and hyper inflation, is
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3. CAUSES OF INFLATION
Inflation comes in different forms and those at are familiar with
the economic matters would observe that there are trends in the
way that prices are moving gradual and irregular in relation to
aggregate sections of the economy. This suggest that there is
more than one factor that causes inflation and as different
sections of the economy develop it gives rise to different types
inflationary periods. The main causes of inflation are:
Demand-pull Inflation
Cost push Inflation
Monetary inflation
Structural inflation
Imported inflation
DEMAND-PULL INFLATION
Demand-pull inflation occurs when the consumers, businesses or
the governments demand for goods and services exceed the
supply; therefore the cost of the item rises, unless supply is
perfectly elastic. Because we do not live in a perfect market
supply is somewhat inelastic and the supply of goods and services
can only be increased if the factors of production are increased.
The increase in demand is created from in increase in other areas,
such as the supply of money, the increase of wages which would
then give rise in disposable income, and once the consumers have
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more disposal income this would lead to aggregate spending. As a
result of the aggregate spending there would also be an increase
in demand for exports and possible hoarding and profiteering from
producers. The excessive demand, the prices of final goods and
services would be forced to increase and this increase gives rise
to inflation.
COST-PUSH INFLATION
Cost-push inflation is caused by an increase in production costs. It
is generally caused by an increase in wages or an increase in the
profit margins of the entrepreneurs.
When wages are increased, this causes the business owner to in
turn increase the price of final goods and services which would be
passed onto the consumers and the same consumers are also the
employees. As a result of the increase in prices for final goods and
services the employees realise that their income is insufficient to
meet their standard of living because the basic cost of living has
increased. The trade unions then act as the mediator for the
employees and negotiate better wages and conditions of
employment. If the negotiations are successful and the employees
are given the requested wage increase this would further affect
the prices of goods and services and invariably affected.
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supplier or by entrepreneurs that are seeking a larger profit for
their own self interests.
MONETARY INFLATION
Monetary inflation occurs when there is an excessive supply of
money. It is understood that the government increases the money
supply faster than the quantity of goods increases, which results
in inflation. Interestingly as the supply of goods increase the
money supply has to increase or else prices actually go down.
When a dollar is worth less because the supply of dollars has
increased, all businesses are forced to raise prices just to get the
same value for their products.
STRUCTURAL INFLATION
Planned inflation that is caused by a government's monetary
policy is called structural inflation. This type of inflation is not
caused by the excess of demand or supply but is built into an
economy due to the governments monetary policy.
In developed countries they are characterized by a lack of
adequate resources like capital, foreign exchange, land and
infrastructure. Furthermore, over-population with the majority
depending on agriculture for their livelihood means that there is a
fragmentation of the land holdings. There are other institutional
factors like land-ownership, technological backwardness and low
rate of investment in agriculture. These features are typical of the
developing economies. For example, in developing country where
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the majority of the population live in the rural areas and depend
on agriculture and the government implements a new industry,
some people get employment outside the agricultural sector and
settle down in urban areas. Because there might be an unequal
distribution of land ownership and tenancy, technological
backwardness and low rates of investments in agriculture
inclusive of inadequate growth of the domestic supply of food
which corresponds with an increase in demand arising from
increasing urbanization and population prices increase.
Food being the key wage-good, an increase in its price tends to
raise other prices as well. Therefore, some economists consider
food prices to be the major factor, which leads to inflation in the
developing economies.
IMPORTED INFLATION
Another type of inflation is imported inflation. This occurs when
the inflation of goods and services from foreign countries that are
experiencing inflation are imported and the increase in prices for
that imported good or service will directly affect the cost of living.
Another way imported inflation can add to our inflation rate is
when overseas firms increase their prices and we pay more for our
goods increasing our own inflation.
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4. EFFECT OF INFLATION
Inflation can have positive and negative effects on an economy.
Negative effects of inflation include loss in stability in the real
value of money and other monetary items over time; uncertainty
about future inflation may discourage investment and saving, and
high inflation may lead to shortages of goods if consumers begin
hoarding out of concern that prices will increase in the future.
Positive effects include a mitigation of economic recessions, and
debt relief by reducing the real level of debt.
Most effects of inflation are negative, and can hurt individuals and
companies alike, below are a list of negative and positive effects
of inflation:
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NEGATIVE EFFECTS ARE:
Hoarding (people will try to get rid of cash before it is
devalued, by hoarding food and other commodities creating
shortages of the hoarded objects).
Distortion of relative prices (usually the prices of goods go
higher, especially the prices of commodities).
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dont take into consideration the inflation rate when
calculating profits).
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It might relatively benefit borrowers who will have to pay the
same amount of money they borrowed (+ fixed interests),
but the inflation could be higher than the interests, therefore
they will be paying less money back. (example, you borrowed
$1000 in 2005 with a 5% fixed interest rate and you paid it
back in full in 2007, lets suppose the inflation rate for 2005,
2006 and 2007 has been 15%, you were charged %5 of
interests, but in reality, you were earning %10 of interests,
because 15% (inflation rate) 5% (interests) = %10 profit,
which means you have paid only 70% of the real value in the
3 years.
Note: Banks are aware of this problem, and when inflation
rises, their interest rates might rise as well. So don't take out
loans based on this information.
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inflation, investors would switch from holding their assets as
money (or a similar, susceptible to inflation, form) to
investing in real capital projects.
The first three effects are only positive to a few elite, and
therefore might not be considered positive by the general
public.
5. METHODS TO CONTROL
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the cause. Therefore, government must diagnose its causes
before implementing policies.
MONETARY POLICY
Inflation is primarily a monetary phenomenon. Hence, the most
logical solution to check inflation is to check the flow of money
supply by devising appropriate monetary policy and carefully
implementing such measures. To control inflation, it is necessary
to control total expenditures because under conditions of full
employment, increase in total expenditures will be reflected in a
general rise in prices, that is, inflation. Monetary policy is used to
control inflation and is based on the assumption that a rise in
prices is due to excess of monetary demand for goods and
services by the consumers/households e because easy bank credit
is available to them. Monetary policy, thus, pertains to banking
and credit availability of loans to firms and households, interest
rates, public debt and its management, and the monetary
standard. Monetary management is aimed at the commercial
banking systems, and through this action, its effects are primarily
felt in the economy as a whole. By directly affecting the volume of
cash reserves of the banks, can regulate the supply of money and
credit in the economy, thereby influencing the structure of interest
rates and the availability of credit. Both these, factors affect the
components of aggregate demand and the flow of expenditure in
the economy.
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The central banks monetary management methods, the devices
for decreasing or increasing the supply of money and credit for
monetary stability is called monetary policy. Central banks
generally use the three quantitative measures to control the
volume of credit in an economy, namely:
1. Raising bank rates
2. Open market operations and
3. Variable reserve ratio
However, there are various limitations on the effective working of
the quantitative measures of credit control adapted by the central
banks and, to that extent, monetary measures to control inflation
are weakened. In fact, in controlling inflation moderate monetary
measures, by themselves, are relatively ineffective. On the other
hand, drastic monetary measures are not good for the economic
system because they may easily send the economy into a decline.
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supply is wrong in the context of modern economic societies. In
modern community, tangible, wealth is typically represented by
claims in the form of securities, bonds, etc., or near moneys, as
they are called. Such near moneys are highly liquid assets, and
they are very close to being money. They increase the general
liquidity of the economy. In these circumstances, it is not so
simple to control the rate of spending or total outlays merely by
controlling the quantity of money. Thus, there is no immediate and
direct relationship between money supply and the price level, as
is normally conceived by the traditional quantity theories.
When there is inflation in an economy, monetary restraints can, in
conjunction with other measures, play a useful role in controlling
inflation.
FISCAL MEASURES
Fiscal policy is another type of budgetary policy in relation to
taxation, public borrowing, and public expenditure. To curve the
effects of inflation and changes in the total expenditure, fiscal
measures would have to be implemented which involves an
increase in taxation and decrease in government spending. During
inflationary periods the government is supposed to counteract an
increase in private spending. It can be cleared noted that during a
period of full employment inflation, the aggregate demand in
relation to the limited supply of goods and services is reduced to
the extent that government expenditures are shortened.
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Along with public expenditure, governments must simultaneously
increase taxes that would effectively reduce private expenditure,
in an effect to minimise inflationary pressures. It is known that
when more taxes are imposed, the size of the disposable income
diminishes, also the magnitude of the inflationary gap in regards
to the availability of the supply of goods and services.
In some instances, tax policy has been directed towards
restricting demand without restricting level of production. For
example, excise duties or sales tax on various commodities may
take away the buying power from the consumer goods market
without discouraging the level of production. However, some
economists point out that this is not a correct way of combating
inflation because it may lead to a regressive status within the
economy.
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Additionally, private savings have a strong disinflationary effect on
the economy and an increase in these is an important measure for
controlling inflation. Government policy should therefore, include
devices for increasing savings. A strong savings drive reduces the
spendable income of the consumers, without any harmful effects
of any kind that are associated with higher taxation.
Furthermore, the effects of a large deficit budget, which is mainly
responsible for inflation, can be partially offset by covering the
deficit through public borrowings. It should be noted that it is only
government borrowing from non-bank lenders that has a
disinflationary effect. In addition, public debt may be managed in
such a way that the supply of money in the country may be
controlled. The government should avoid paying back any of its
past loans during inflationary periods, in order to prevent an
increase in the circulation of money. Anti-inflationary debt
management also includes cancellation of public debt held by the
central bank out of a budgetary surplus.
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Such regulatory measures involve the use of direct control on
prices and rationing of scarce goods. The function of price control
is a fix a legal ceiling, beyond which prices of particular goods
may not increase. When ceiling prices are fixed and enforced, it
means prices are not allowed to rise further and so, inflation is
suppressed.
Under price control, producers cannot raise the price beyond a
specified level, even though there may be a pressure of excessive
demand forcing it up. For example, during wartimes, price control
was used to suppress inflation.
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spiral. During galloping inflation, it may be necessary to apply a
wage-profit freeze. Ceilings on wages and profits keep down
disposable income and, therefore the total effective demand for
goods and services.
On the other hand, restrictions on imports may also help to
increase supplies of essential commodities and ease the
inflationary pressure. However, this is possible only to a limited
extent, depending upon the balance of payments situation.
Similarly, exports may also be reduced in an effort to increase the
availability of the domestic supply of essential commodities so
that inflation is eased. But a country with a deficit balance of
payments cannot dare to cut exports and increase imports,
because the remedy will be worse than the disease itself.
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degrees of price rise. Basically, if the annual price were to rise to
20%, the money incomes and values of financial assets are
enhanced by 20%, under the system of indexing.
Indexing also saves the government from public wrath due to
severe inflation persisting over a long period. Critics, however, do
not favour indexing, as it does not cure inflation but rather it
encourages living with inflation. Therefore, it is a highly
discretionary method.
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6. OTHER MONETARY
PHENOMENA
In Keynes view, rising prices in all situations cannot be termed as
inflation. In a condition of under-employment, when an increase in
money supply and rising prices are accompanied by the expansion
of output and employment, but when1here are bottlenecks in the
economy, an increase in money supply may cause cost and prices
to rise more than the expansion of output and employment. This
may be termed as semi-inflation or reflation till the ceiling of
full employment is reached. Once full employment level is
reached, the entire increase in money supply is reflected simply
by the rising prices - the real inflation.
DEFLATION
It is a condition of falling prices accompanied by a decreasing
level of employment, output and income. Deflation is just the
opposite of inflation. Deflation occurs when the total expenditure
of the community is not equal to the existing prices.
Consequently, the supply of money decreases and as a result
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prices fall. Deflation can also be brought about by direct
contractions in spending, either in the form of a reduction in
government spending, personal spending or investment spending.
Deflation has often had the side effect of increasing
unemployment in an economy, since the process often leads to a
lower level of demand in the economy. However, each and every
fall in price cannot be called deflation. The process of reversing
inflation without either creating unemployment or reducing output
is called disinflation and not deflation. Therefore, some perceive
deflation as an underemployment phenomenon.
DISINFLATION
When prices are falling due to anti-inflationary measures adopted
by the authorities, with no corresponding decline in the existing
level of employment, output and income, the result of this is
disinflation. When acute inflation burdens an economy, disinflation
is implemented as a cure. Disinflation is said to take place when
deliberate attempts are made to curtail expenditure of all sorts to
lower prices and money incomes for the benefit of the community.
REFLATION
Reflation is a situation of rising prices, which is deliberately
undertaken to relieve a depression. Reflation is a means of
motivating the economy to produce. This is achieved by
increasing the supply of money or in some instances reducing
taxes, which is the opposite of disinflation. Governments can use
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economic policies such as reducing taxes, changing the supply of
money or adjusting the interest rates; which in turn motivates the
country to increase their output. The situation is described as
semi-inflation or reflation.
STAGFLATION
Stagflation is a stagnant economy that is combined with inflation.
Basically, when prices are increasing the economy is deceasing.
Some economists believe that there are two main reasons for
stagflation. Firstly, stagflation can occur when an economy is
slowed by an unfavourable supply, such as an increase in the price
of oil in an oil importing country, which tends to raise prices at the
same time that it slows the economy by making production less
profitable. In the 1970's inflation and recession occurred in
different economies at the same time. Basically, what happened
was that there was plenty of liquidity in the system and people
were spending money as quickly as they got it because prices
were going up quickly. This gave rise to the second reason for
stagflation.
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