PROJECT REPORT ON INFLATION

Submitted to: Submitted by:

Dr. Prabhat Kr. Pankaj Ajeet Yadav (FT-09-709)

Adarsh Tyagi (FT-09- 707 )
Monmee Das (FT-09- 773)
Omshyam (FT-09-789)
Sandeep Yadav (FT-09-835)

CONTENTS

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 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

Inflation can be defined as a rise in the general price level and therefore a fall in
the value of money. Inflation occurs when the amount of buying power is higher
than the output of goods and services. Inflation also occurs when the amount of
money exceeds the amount of goods and services available. As to whether the fall
in the value of money will affect the functions of money depends on the degree of
the fall. Basically, refers to an increase in the 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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 2. HOW INFLATION IS MEASURED?
Inflation is normally given as a percentage and generally in years or in some
instances quarterly and is derived from the Consumer Price Index (CPI).
However, there are two main indices used to measure inflation. The first is the
Consumer Price Index, or the CPI. The CPI is a measure of the price of a set group
of goods and services. The "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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The second measure of inflation is the Producer Price Index, or the PPI. While the
CPI indicates the change in the purchasing power of a consumer, the PPI
measures the change in the purchasing power of the producers of those goods.
The PPI measures how much producers of products are getting on the wholesale
level, i.e. the price at which a good is sold to other businesses before the good is
sold to a consumer. The PPI actually combines a series of smaller indices that
cross many industries and measure the prices for three types of goods: crude,
intermediate and finished. Generally, the markets are most concerned with the
finished goods because these are a strong indicator of what will happen with
future CPI reports. The CPI is a more popular measure of inflation than the PPI,
but investors watch both closely.

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

When there is a general rise in prices at very low rates, which is usually between
2-4 percent annually, this is known as creeping inflation.

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Whereas, trotting inflation occurs when the percentage has risen from 5 to
almost percent. At this level it is a warning signal for most governments to take
measures to avoid exceeding double-digit figures.
Another type of inflation is the galloping inflation, where the rate of inflation is
increasing at a noticeable speed and at a remarkable rate, usually from 10-20
percent.
However, when the inflation rate rises to over 20% it is generally considered as
hyper inflation and at this stage it is almost uncontrollable because it increases
more rapidly in such a little time frame.
The main difference between the galloping and hyper inflation, is that

hyperinflation occurs when prices rise at any moment and there is no level to
which the prices might rise.

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During World War II certain countries experienced a hyperinflation, where the
price index rose from 1 to over 1,000,000,000 in Germany during January 1922 to
November 1923.

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

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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 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.

On the other hand, when firms attempt to increase their profit margins by
making the prices more responsive to supply of a good or service instead of the
demand for that said good or service. This is usually done regardless to the state

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of the economy. This can be seen in monopolistic economies where the firm is the
only 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 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

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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:

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).

Increased risk - Higher uncertainties (uncertainties in business always

exist, but with inflation risks are very high, because of the instability of
prices).

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 Income diffusion effect (which is basically an operation of income
redistribution).

Existing creditors will be hurt (because the value of the money they will
receive from their borrowers later will be lower than the money they gave
before).

Fixed income recipients will be hurt (because while inflation increases,

their income doesnt increase, and therefore their income will have less
value over time).

Increased consumption ratio at the early stages of inflation (people will be

consuming more because money is more abundant and its value is not
lowered yet).

Lowers national saving (when there is a high inflation, saving money

would mean watching your cash decrease in value day after day, so people
tend to spend the cash on something else).
Illusions of making profits (companies will think they were making profits
while in reality theyre losing money if they dont take into consideration
the inflation rate when calculating profits).

Causes an increase in tax bracket (people will be taxed a higher percentage

if their income increases following an inflation increase).

Causes mal-investment (in inflation times, the data given about an

investment is often deceptive and unreliable, therefore causing losses in
investments).

Causes business cycles (many companies will have to go out of business

because of the losses they incurred from inflation and its effects).

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 Currency debasement (which lowers the value of a currency, and
sometimes cause a new currency to be born)

Rising prices of imports (if the currency is debased, then its purchasing
power in the international market is lower).

"POSITIVE" EFFECTS OF INFLATION ARE:

It can benefit the inflators (those responsible for the inflation)

It be benefit early and first recipients of the inflated money (because the
negative effects of inflation are not there yet).

It can benefit the cartels (it benefits big cartels, destroys small sellers, and
can cause price control set by the cartels for their own benefits).

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.

Many economists favor a low steady rate of inflation, low (as opposed to
zero or negative) inflation may reduce the severity of economic recessions

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 by enabling the labor market to adjust more quickly in a downturn, and
reducing the risk that a liquidity trap prevents monetary policy from
stabilizing the economy. The task of keeping the rate of inflation low and
stable is usually given to monetary authorities. Generally, these monetary
authorities are the central banks that control the size of the money supply
through the setting of interest rates, through open market operations, and
through the setting of banking reserve requirements.

Tobin effect argues that: a moderate level of inflation can increase

investment in an economy leading to faster growth or at least higher
steady state level of income. This is due to the fact that inflation lowers the
return on monetary assets relative to real assets, such as physical capital.
To avoid 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.

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 5. METHODS TO CONTROL

A high inflation rate is undesirable because it has negative consequences.

However, the remedy for such inflation depends on 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

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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.

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.

In a developing economy there is always an increasing need for credit. Growth

requires credit expansion but to check inflation, there is need to contract credit.
In such an encounter, the best course is to resort to credit control, restricting the
flow of credit into the unproductive, inflation-infected sectors and speculative
activities, and diversifying the flow of credit towards the most desirable needs of
productive and growth-inducing sector.

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It should be noted that the impression that the rate of spending can be controlled
rigorously by the contraction of credit or money 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.
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

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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.

As a result, this may lead to a further rise in prices of goods and services, and
inflation can spread from one sector of the economy to another and from one
type of goods and services to another.
Therefore, a reduction in public expenditure, and an increase in taxes produces a
cash surplus in the budget. Keynes, however, suggested a programme of
compulsory savings, such as deferred pay as an anti-inflationary measure.
Deferred pay indicates that the consumer defers a part of his or her wages by
buying savings bonds (which, of course, is a sort of public borrowing), which are
redeemable after a particular period of time, this is sometimes called forced
savings.
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

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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.

Fiscal policy by itself may not be very effective in combating inflation; therefore a
combination of fiscal and monetary tools can work together in achieving the
desired outcome.

DIRECT MEASURES OF CONTROL

Direct controls refer to the regulatory measures undertaken to convert an open
inflation into a repressed one.

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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In times of the severe scarcity of certain goods, particularly, food grains,
government may have to enforce rationing, along with price control. The main
function of rationing is to divert consumption from those commodities whose
supply needs to be restricted for some special reasons; such as, to make the
commodity more available to a larger number of households. Therefore,
rationing becomes essential when necessities, such as food grains, are relatively
scarce. Rationing has the effect of limiting the variety of quantity of goods
available for the good cause of price stability and distributive impartiality.
However, according to Keynes, rationing involves a great deal of waste, both of
resources and of employment.

Another control measure that was suggested is the control of wages as it often
becomes necessary in order to stop a wage-price 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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In overpopulated countries like India, it is also essential to check the growth of
the population through an effective family planning programme, because this
will help in reducing the increasing pressure on the general demand for goods
and services. Again, the supply of real goods should be increased by producing
more. Without increasing production, inflation just cannot be controlled.

Some economists have even suggested indexing in order to minimise certain ill-
effects of inflation. Indexing refers to monetary corrections through periodic
adjustments in money incomes of the people and in the values of financial assets
such as savings deposits, which are held by them in relation to the 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.

In general, monetary and fiscal controls may be used to repress excess demand
but direct controls can be more useful when they are applied to specific scarcity
areas. As a result, anti-inflationary policies should involve varied programmes
and cannot exclusively depend on a particular type of measure only.

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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.

Incidentally, Keynes mentions the following four related terms while discussing
the concept of inflation:
Deflation
Disinflation
Reflation
Stagflation

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.

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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
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 economic policies such
as reducing taxes, changing the supply of money or adjusting the interest rates;

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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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