Price Stability

- Dr Vighneswara Swamy

1
Coverage
1. Inflation Vs. deflation
2. Measures of inflation
3. Types of inflation
4. Low inflation
5. Galloping inflation
6. Hyperinflation
7. Threshold inflation
8. Demand-pull Vs. Cost-push inflation
9. Stagflation
10. Expected Vs. unexpected inflation
11. Core inflation Vs. Headline inflation,
2
Coverage..
11. The role of
government
and RBI to
control
inflation
12. Economic
impacts of
inflation
13. Is a little
inflation is
good for the
economy?
14. Price in the
AD-AS
framework
15. The Phillips
curve
16. Short run
Philips curve
and Long run
Philips curve.

3
Inflation
Inflation is a pervasive and general rise in the average price level.
Inflation is an increase in the average level of prices, and a price is the
rate at which money is exchanged for a good or service.
Inflation measures how much more expensive a set of goods and
services has become over a certain period, usually a year.
Deflation is a fall in the overall level of prices.
Rate of Inflation shows the rate of change of prices over time.
Rate of inflation is the percentage rate of change in a price index
Rate of inflation = (PI2 – PI1) / PI1

4
Deflation
Deflation is the opposite of inflation.
Deflation is the fall in prices. It occurs when the inflation rate falls below 0%. When this
happens, the nominal prices of goods are falling on average and the purchasing power of
money is increasing.
Deflationary Spiral is a situation where decreases in price lead to lower production, which
in turn leads to lower wages and demand, which leads to further decreases in price.
It is generally caused when an asset bubble bursts.
Deflation can turn a recession into a depression.
During the Great Depression of 1929, prices dropped 10 percent a year. Once deflation
starts, it is harder to stop than inflation.

5
Deflation ..
When deflation occurs, the general price level is falling and the purchasing
power of money is increasing.
Deflation is a more serious problem because it increases the real value of debt
and may worsen recessions.
Deflation discourages consumption because consumers know that if they wait
to make a purchase, the price will likely drop.
Deflation discourages borrowing and investment because the real value of the
money to be repaid will be higher than the real value of the money borrowed.
Deflation is caused by a fall in the general level of demand, and sometimes
due to a fall in the money supply.
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Cause and Effect of Deflation
Causes
Deflation is caused by a shift in
the supply and demand curve for
goods and services.
According to monetarist
economists, therefore, deflation
is caused by a reduction in the
money supply, a reduction in the
velocity of money, or an increase
in the number of transactions
Effects
Deflation is a more serious problem
because it increases the real value of
debt and may worsen recessions.
Deflation is good for lenders and
bad for borrowers: when loans are
paid back, the cash is worth more.
Thus, deflation discourages
borrowing, and by extension,
consumption and investment today.
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Theories explaining Inflation
The Classical Theory of Inflation The Quantity Theory of Money
1. The classical theory of money is
used to explain the long-run
determinants of the price level
and the inflation rate.
2. Inflation is an economy-wide
phenomenon that concerns the
value of the economy’s medium of
exchange.
3. When the overall price level rises,
the value of money falls.
1. How the price level is determined
and why it might change over time
is called the quantity theory of
money.
2. The quantity of money available in
the economy determines the value
of money.
3. The primary cause of inflation is
the growth in the quantity of
money.
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The Classical Dichotomy
Classical dichotomy is the the theoretical separation of nominal and real
variables
Hume and the classical economists suggested that monetary developments
affect nominal variables but not real variables.
If central bank doubles the money supply, Hume & classical thinkers contend
Nominal variables are variables measured in monetary units.
Real variables are variables measured in physical units.
All nominal variables – including prices – will double.
All real variables – including relative prices – will remain unchanged.
9
The Classical Dichotomy
1. According to Hume and others, real economic variables do not
change with changes in the money supply.
◦ According to the classical dichotomy, different forces influence real and
nominal variables.
2. Changes in the money supply affect nominal variables but not real
variables.

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The Neutrality of Money
Monetary neutrality: the proposition that changes in the money supply do not
affect real variables.
Doubling money supply causes all nominal prices to double; what happens to
relative prices?
Initially, relative price of cd in terms of pizza is
Most price of cd $15/cd
economists = = 1.5 pizzas per cd
believe the price of pizza $10/pizza
classical
dichotomy and The relative price
neutrality of  After nominal prices double, is unchanged.
money
describe the price of cd $30/cd
economy in = = 1.5 pizzas per cd
the long run price of pizza $20/pizza

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The Neutrality of Money..
The irrelevance of monetary changes for real variables is called monetary
neutrality.
Neutrality of money is the idea that a change in the stock of money affects
only nominal variables in the economy such as prices, wages, and exchange
rates, with no effect on real variables, like employment, real GDP, and real
consumption.
Neutrality of money means that money is neutral in its effect on the fiscal
system. A variation in the money stock can have short-run forces on the
level of actual productivity, employment, rate of interest or the composition
of final productivity. The only lasting impact of a variation in the money
stock is to modify the normal price level.
12
Disinflation Around the World

13
 Measures of inflation
Price index level
Expresses the level of prices of goods traded in economy at the same
time
Price index is calculated for particular market basket for examined
periods.
The change of price index level within time is the rate of inflation.
1. Consumer price index
2. Producer price indexes
3. Wholesale price indexes
4. Commodity price indexes

14
Prices
According to the classical model of the price level,
the real quantity of money is always at its long-run
equilibrium level.

Prices play three roles:

1. Convey Information
2. Give Incentives
3. Provide Working Capital
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The Classical Dichotomy
Real Variables:
Measured in physical units—
quantities and relative prices, for
example:
• quantity of output produced
• real wage: output earned per
hour of work
• real interest rate: output
earned in the future by lending
one unit of output today
Nominal Variables:
Measured in money units, e.g.,
• nominal wage: Dollars per hour of
work.
• nominal interest rate: Dollars
earned in future by lending one
dollar today.
• the price level: The amount of
dollars needed to buy a
representative basket of goods.
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Real vs. Nominal Wage
The Real Wage is the wage rate divided by the price level.
Real Income is income divided by the price level.

An important relative price is the real wage:

W = nominal wage = price of labor, e.g., $15/hour

P = price level = price of gas, e.g., $5/unit of output

Real wage is the price of labor relative to the price

of output: W $15/hour
= = 3 units output per hour
P $5/unit of output
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Illustration 1
If inflation is 12% and you get a 7% raise, what has
happened to your money income? real income?
Ans:
Your money income has increased by 7% but your
real income has decreased by 12-7= 5%

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Illustration 2
If your income goes up from $30,000 to $35,000 and
inflation is 8%, are you better or worse off?
Ans:
Take the difference and divide by the original number
$5,000/$30,000 = 16.7%
You are better off because your real income has
increased by 16.7-8=8.7%
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Price Mechanism
The adjustment of prices in response to changing market
conditions
Is any increase in prices inflationary? The answer is ‘NO’ –
Because some prices will always increase because of the
price mechanism.

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Inflation and Indexation
•In counties where inflation rates are high and uncertain, long-term
borrowing using nominal debt becomes impossible: lenders are simply too
uncertain about the real value of the repayments they will receive
•Governments of such countries issue indexed debt
•An indexed debt is a bond indexed to the price level when either the
interest rate or the principle or both are adjusted for inflation
•The holder of the indexed bond will typically receive interest equal to the
stated real rate plus the actual inflation rate → risk reducing
•Some formal labor contracts include cost of living adjustment (COLA)
provisions
 Link increases in money wages to increases in the price level
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Inflation and Indexation..
1. In case real material prices increase, firms pass these cost increases
on as higher prices of final goods
1. Consumer prices will increase
2. Under a system of wage indexation, wages will also rise this leads to
further price, materials-cost, and wage increases
3. Indexation in this example feeds an inflation spiral
2. Economists argue that the governments should adopt indexation on
a broad scale, including bonds and the tax system because:
 Inflation would be easier to live with
 Costs of unanticipated inflation would disappear

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Price Index
Price index is a measure of relative price changes, consisting of a series of
numbers arranged so that a comparison between the values for any two
periods or places will show the average change in prices between periods
or the average difference in prices between places.
Price indexes were first developed to measure changes in the cost of living
in order to determine the wage increases necessary to maintain a constant
standard of living.
They continue to be used extensively to estimate changes in prices over
time and are also used to measure differences in costs among different
areas or countries.

23
Price Index..
The central problem of price-data collection is to gather a sample of prices
representative of the various price quotations for each of the commodities under
study. Sampling is almost always necessary.
Weighting is the next step is to combine the price relatives in such a way that the
movement of the whole group of prices from one period to another is accurately
described.
Adjusting For Biases is another problem of price index number construction that
cannot be completely resolved is the problem of quality change. In a dynamic
world, the qualities of goods are continually changing to such a degree that it is
doubtful whether anyone living in an industrialized economy buys many products
that are identical in physical and technical characteristics to those purchased by his
grandfather.
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Price Indices
Price indices are tools used to measure price changes for a specific subset of goods and services.
Price indices are often normalized and compared to a base year.
The basket of goods determines which prices are being compared.
The most commonly used formula is the Laspeyres price index, which determines a basket of goods during a
base period, finds the price of this basket, and then compares that to the price of the same basket of goods in a
later period of time.
An alternate type of index, the Paasche index, finds a basket of goods in the current period, determines it’s
total price, and compares that price to what the current basket of goods would have cost in the base period.
The Consumer Price Index (CPI) and the Producer Price Index (PPI) are commonly used inflation indices. The CPI
reflects changes in the prices of goods and services typically purchased by consumers.
The PPI reflects changes in the revenue that producers receive for goods and services.

25
Consumer Price Index (CPI)
1. The CPI measures the price increases of a particular basket of goods and services.
As people’s tastes and preferences change, what goes into the basket will change
2. CPI is the most often used index
3. Measures the price of a selection of goods purchased by a "typical consumer".
4. It is a statistical time-series measure of a weighted average of prices of a specified
set of goods and services purchased by consumers.
5. It is a price index that tracks the prices of a specified basket of consumer goods and
services, providing a measure of inflation.
6. The CPI reflects changes in the prices of goods and services typically purchased by
consumers, and includes price changes in imported goods. The CPI is often used to
measure changes in the cost of living.
26
How to measure CPI?
(1) Selection of the Base Year (CPI = 100)
(2) Selection of CPI basket, Example of Consumer Basket, weightage (to measure
the importance of one item in the basket)
(3) Collection of data on prices
(4) Calculation of CPI
Weighted CPI

The rate of inflation is determined as:

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Wholesale Price Index
Wholesale price index is a measure of changes in the prices
charged by manufacturers and wholesalers.
Wholesale price indexes measure the changes in commodity
prices at a selected stage or stages before goods reach the retail
level; the prices may be those charged by manufacturers to
wholesalers or by wholesalers to retailers or by some
combination of these and other distributors.

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Measuring Wholesale Price Index
In the United States, the index measures the price movements of all commodities
flowing into primary markets of the United States—whether domestically produced or
imported.
Primary markets are those in which a good in a given stage of fabrication is first sold in
substantial quantities. Because primary markets include goods of all degrees of
fabrication, the same commodity is often priced at several stages of processing. Cotton,
for example, is priced in the form of raw cotton, cotton yarn, cotton gray goods, cotton
piece goods, and cotton clothing.
Price data used to construct the indexes are usually gathered from business firms by
mail, less frequently from trade journals and trade associations, and also from
government purchasing agents. Weights are generally based on relative sales volume.
Data from censuses of production (manufacturing, mining, agriculture, etc.) are used for
weights when they are available.
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Producer Price Index
The PPI reflects changes in the revenue that producers receive in
return for goods and services.
The PPI, unlike the CPI, includes price changes for goods produced
within the US but exported abroad.
It also does not include sales and excise taxes, nor does it include
distribution costs.
While we often expect the CPI and PPI to show similar rates of
inflation, they measure two different sets of price changes.

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Laspeyres Index
Laspeyres index, index proposed by German economist Étienne
Laspeyres (1834–1913) for measuring current prices or quantities in
relation to those of a selected base period.
A Laspeyres price index is computed by taking the ratio of the total
cost of purchasing a specified group of commodities at current prices
to the cost of that same group at base-period prices and multiplying
by 100.
The base-period index number is thus 100, and periods with higher
price levels have index numbers greater than 100.

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Laspeyres Index..
The distinctive feature of the Laspeyres index is that it uses a group of commodities
purchased in the base period as the basis for comparison. In other words, in
computing the index, a commodity’s relative price (the ratio of the current price to
the base-period price) is weighted by the commodity’s relative importance to all
purchases during the base period.
The Laspeyres price index tends to overstate price increases because, as prices
change, consumers typically alter their purchasing decisions by selecting fewer
products with large price increases while buying more products that show low or no
price increases. If consumers can do this without reducing their total satisfaction, the
use of base-period commodity selections tends to overstate declines in the standard
of living. Similar to the price index, the Laspeyres quantity index uses base-period
prices to compare aggregate production levels in two periods.

32
 Laspeyres Index..
Merit
1. The distinctive feature of the
Laspeyres index is that it uses
a group of commodities
purchased in the base period
as the basis for comparison.
2. In computing the index, a
commodity’s relative price
(the ratio of the current price
to the base-period price) is
weighted by the commodity’s
relative importance to all
purchases during the base
period.
Demerit
1. The Laspeyres price index tends to overstate price
increases because, as prices change, consumers
typically alter their purchasing decisions by
selecting fewer products with large price increases
while buying more products that show low or no
price increases.
2. If consumers can do this without reducing their
total satisfaction, the use of base-period
commodity selections tends to overstate declines
in the standard of living.
3. Similar to the price index, the Laspeyres quantity
index uses base-period prices to compare
aggregate production levels in two periods. 33
Paasche Index
Paasche index, index developed by German economist Hermann Paasche for
measuring current price or quantity levels relative to those of a selected base
period.
It differs from the Laspeyres index in that it uses current-period weighting.
The index is a ratio that compares the total purchase cost of a specified bundle of
current-period commodities (commodities valued at current prices) with the value
of those same commodities at base-period prices; this ratio is multiplied by 100.
The Paasche price index tends to understate price increases, since it already
reflects some of the changes in consumption patterns that occur when consumers
respond to price increases—i.e., increased consumption of goods will indicate
reduced relative prices.
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GDP Deflator
GDP Deflator is an adjustment for the impact of changes in prices on changes in nominal GDP.
GDP Deflator can be considered the most comprehensive measure of inflation since a wide array of goods
and services are included in its construction. But it may not reflect the full impact of inflation on consumer
welfare because it does not include imported goods and services that constitute a significant portion of what
people buy.
GDP Deflator is the ratio of the value of aggregate final output at current market prices (Nominal GDP) to its
value at the base year prices (Real GDP). In effect the basket of goods for the construction of this price index
includes all the final output produced within the geographic boundaries of the country.
GDP Deflator = Nominal GDP/ Real GDP
CPI and GDP Deflator measure the same thing, but there are a few key differences:
 (1) GDP Deflator includes only domestic goods and not anything that is imported. Whereas, CPI includes
anything bought by consumers including foreign goods.
 (2) GDP Deflator is a measure of the prices of all goods and services, while the CPI is a measure of only
goods bought by consumers.

35
Who Measures Inflation?
In the U.S. inflation is published monthly by the Bureau of Labor Statistics
In India, two Ministries – Ministry of Statistics and Programme
Implementation (MOSPI) and Ministry of Labour and Employment (MOLE)
are engaged in the construction of different CPIs for different
groups/sectors.
 In India, there is no single measure of inflation which captures economy-
wide inflationary pressures in the economy. It is the year on year
percentage change in wholesale price index (WPI), which is used as an
indicator of headline inflation.
Although there are four consumer price indices (CPIs), they are targeted
at different population groups and none of them captures economy-wide
inflationary pressures. CPI (Rural), CPI (Urban) and CPI (All India)
36
Types of Inflation
From the quantitative point of view
Creeping
Galloping inflation Hyperinflation
inflation
The slow but The rate of inflation It is inflation that is "out of control", a
steady increase in exceeds the rate of condition in which prices increase rapidly as a
prices. production growth, currency loses its value. Hyperinflation is over
The rate of inflation Galloping inflation is 100% per year. Prices as well as wages are
doesn’t exceed the from 10% to 100%. extremely erratic. Money have no value and
rate of production Money loose barter trade emerges (barter means the
growth. Creeping purchase power, exchange of good for good). Example:
inflation is < 10% people hold as little Germany after I.WW, Hungary after II.WW.,
money as possible. Zimbabwe, Venezuela
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Types of Inflation..
Open
Suppressed inflation
inflation
If economic If state authorities damp or even
imbalance is stop the rise of price level by
accompanied with administrative means. Such
rising price level. situation is followed by existence
of scarce commodities, shadow
economy etc.
In such cases the provision of
basic necessities such as
agricultural products is set by the
government by introducing price
controls on commodities
Hidden inflation
Government imposes strict controls
to curb price inflation, producers
are forced to sell the products at
the prices required.
Producers can not sell the
commodity at higher prices to get
the profit, therefore, lower on the
quality of products. This means
that employers are selling lower
quality products at higher prices ->
inflation is hidden.
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Types of Inflation..
Chronic Low Inflation
Inflation
Chronic inflation Low inflation contributes towards
occurs when inflation economic stability – which
steadily increases for encourages saving, investment,
a long time economic growth, and helps
maintain international
competitiveness.
Generally the governments target an
inflation rate of around 2-4%. This
moderate but low rate of inflation is
considered the best compromise
between avoiding the costs of
inflation but also avoiding the costs
of deflation
Walking Inflation
Walking inflation is a type of strong, or
pernicious, inflation is between 3-10 percent
a year.
It heats up economic growth too fast. People
start to buy more than they need, just to
avoid tomorrow's much higher prices.
This drives demand even further so that
suppliers can't keep up. More important,
neither can wages.
As a result, common goods and services are
priced out of the reach of most people.
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Types of Inflation…
Wage Inflation Asset Inflation
Wage inflation is when workers' pay rises fasterAsset inflation occurs in any asset class
than the cost of living. This occurs in three when the asset prices experience high
situations. First, is when there is a shortage of
levels of price rise.
workers. Second, is when labor unions negotiate Good examples are housing, oil and
ever-higher wages. Third is when workers gold.
effectively control their own pay. It is generally overlooked by the central
banks and other inflation-watchers
Of course, everyone thinks their wage increases when the overall rate of inflation is low.
are justified. But higher wages are one element But the subprime mortgage crisis and
of cost-push inflation. That can drive up ​the subsequent global financial crisis
prices of a company's goods and services. demonstrated how damaging unchecked
asset inflation can be.
40
Demand-pull Inflation
 Demand-pull inflation occurs when aggregate
demand for goods and services in an
economy rises more rapidly than an
economy's productive capacity.
 One potential shock to aggregate demand
might come from a central bank that rapidly
increases the supply of money.
 The increase in money in the economy will
increase demand for goods and services from
D0 to D1.
 The economy's equilibrium moves from point
A to point B and prices will tend to rise,
resulting in inflation.
41
42
Cost-push Inflation
• Cost-push inflation, on the other hand, occurs
when prices of production process inputs
increase.
• Rapid wage increases or rising raw material
prices are common causes of this type of
inflation.
• The sharp rise in the price of imported oil during
the 1970s provides a typical example of cost-
push inflation (illustrated in Figure).
• Rising energy prices caused the cost of producing
and transporting goods to rise.
• Higher production costs led to a decrease in
aggregate supply (from S0 to S1) and an increase
in the overall price level because the equilibrium
point moved from point Z to point Y. 43
44
Causes of
Demand-pull Inflation
1. Depreciating exchange rate
2. Higher demand from a fiscal
stimulus
3. Monetary stimulus to the economy
4. Fast growth in other countries
5. Rising property prices
6. Increasing consumer wealth
Cost-push Inflation
1. Component costs
2. Increasing oil prices
3. Rising labour cost
4. Expectations of inflation
5. Higher indirect taxes
6. A fall in the exchange rate
7. Monopoly employers/profit-
push inflation
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Low inflation
Low Inflation is a phenomenon when the prices of goods and
services do not increase rapidly.
A low inflation is the rate of inflation that has been consistently
below the targeted rate of inflation by the central bank of the
country.

46
 Core Inflation Vs. Headline Inflation
Core Inflation Headline Inflation
1. An inflation measure which excludes transitory or 1. Headline inflation is your general index like WPI (for
temporary price volatility as in the case of some India), CPI etc. that includes all the items used for
commodities such as food items, energy products etc. It measuring inflation.
reflects the inflation trend in an economy. 2. Headline inflation tends to revert strongly towards core
2. Core means, we should ignore food and fuel part. inflation over a time period making the case for core
3. Core inflation = Only WPI of Non-food manufacturing stronger.
industries= Headline WPI – (primary + fuel + food mfg.
industries)
4. A dynamic consumption basket is considered the basis
to obtain core inflation. Some goods and commodities
have extremely volatile price movements. Core inflation
is calculated using the Consumer Price Index (CPI) by
excluding such commodities.
5. Core inflation index excludes a certain items whose
prices are more volatile and hence may not represent a
true picture of the inflation.

47
 Deflation Vs. Disinflation
Deflation Disinflation
1. Deflation is a sustained decrease in 1. Disinflation is a reduction in the rate of inflation
the price level 2. Disinflation is not the same as deflation, when
2. It is a decrease in the general price inflation drops below zero.
level, that is, in the nominal cost of 3. During periods of disinflation, the general price
goods and services. level is still increasing, but it is occurring slower
than before.
4. Disinflation can be illustrated as movements
along the short-run and long-run Phillips curves.
5. Disinflation can be caused by decreases in the
supply of money available in an economy. It can
also be caused by contractions in the business
cycle, otherwise known as recessions.
48
 Inflation vs. Deflation vs. Disinflation
Assume the following annual
price levels as compared to Inflation Disinflation Deflation
the prices in 2012: As the economy Between 2013 and 2015, the rise in Between 2015
2012: 100% of 2012 prices moves through price levels slows down. Between and 2016, the
2012 to 2015, 2013 and 2014, the price level only price level does
2013: 104% of 2012 prices there is a increases by two percentage points, not increase, but
2014: 106% of 2012 prices continued which is lower than the four decreases by two
growth in the percentage point increase between percentage
2015: 107% of 2012 prices price level. This 2012 and 2013. The trend continues points. This is an
2016: 105% of 2012 prices is an example between 2014 and 2015, where there example of
of inflation; the is only a one percentage point deflation; the
price level is increase. This is an example of price rise of
continually disinflation; the overall price level is previous years has
rising. rising, but it is doing so at a slower reversed itself.
rate.
49
Stagflation
Stagflation occurs when economic growth is stagnant but there still is price inflation.
This seems contradictory, if not impossible.
Why would prices go up when there isn't enough demand to stoke economic
growth?
Stagflation occurs when the prices of goods rise while unemployment increases and
spending declines.
It happened in the 1970s when the United States abandoned the gold standard.
Once the dollar's value was no longer tied to gold, it plummeted. At the same time,
the price of gold skyrocketed.
Stagflation is also considered an unnatural phenomenon since inflation shouldn't
happen when an economy is weak.
50
Threshold Inflation
Threshold level of inflation can be described as that inflexion point
beyond which the output growth is not optimal.
Empirical studies have shown that at inflation rates higher than
threshold level, the output growth has retarded.
The threshold inflation rate is within 4 to 4.5 per cent for India.
Beyond this level, inflation is growth retarding.

51
Drivers of Inflation
1. Large and sequential supply side shocks
2. Oil price shocks
3. Wage growth
4. According to Quantity Theory too much money in the economy
causes inflation.

52
Causes of Inflation
Demand-pull inflation
Arises when aggregate demand in an
economy outpaces aggregate supply.
It involves inflation rising as real gross
domestic product rises and
unemployment falls. This is commonly
described as "too much money chasing
too few goods".
Possible causes of demand-pull inflation:
(i) Excessive investment expenditures; (ii)
Excessive growth of consumption
expenditures; (iii) Low-cost loans; (iv) Tax
cutting; (v) Augmentation of government
expenditures
Cost-push inflation
(or supply-shock)
It is a type of inflation
caused by large increases
in the cost of important
goods or services where
no suitable alternative is
available.
Possible causes of cost-
push inflation: (i)
Imperfect competition; (ii)
Increased taxes; (iii) Rising
wages; (iv) Political
incidents (like oil crises)
Built-in inflation (or
Anticipated inflation)
It is induced by adaptive
expectations, often linked to
the "price/wage spiral“
It involves workers trying to
keep their wages up with
prices and then employers
passing higher costs on to
consumers as higher prices as
part of a "vicious circle.“
Built-in inflation reflects
events in the past, and so
might be seen as hangover
inflation.
53
Causes of Inflation
Short-run Long-run
1.Expectations 1.Too much money chasing too few
2.Excess demand goods
3.Supply shocks 2.“Inflation is always and everywhere
a monetary phenomenon…”
(Milton Friedman)

54
The Fisher Effect
Nominal Inflation Real interest
= +
interest rate rate rate

This relationship is called the Fisher effect

In the long run, money is neutral, so a change in the money growth
rate affects the inflation rate but not the real interest rate.
So, the nominal interest rate adjusts one-for-one with changes in the
inflation rate.

55
Money and Inflation in Ordinary Business Cycles
Annual M2 growth and the inflation rate of the GDP deflator for the U.S.
Inflation
is closely
linked to
M2
growth

56
Effects of Inflation
Redistribution Social Impact of
Impact on Economy Balance
Effect of Inflation Inflation
• Inflation affects recipients • Socially poor persons • Fall of real product bellow potential product
of fixed income firstly suffer from inflation • Changes in the structure of consumption
(nominal incomes remain more then rich (consumers are buying cheaper goods)
same but the real value of • In case of fixed currency exchange rate higher
income drop) exports are incited.
• Inflation affects the • Inflation deforms prices
purchasing power of • Inflation causes higher costs and makes economy
wages that don’t follow less efficient
the rise of prices • Creeping and anticipated inflation has positive
• Inflation causes effect on economy and stimulates economic
diminishing value of loans growth
and savings • High inflation and not anticipated inflation are
serious problems in economy.
57
How to Stop the inflation?
There are a number of methods which have been
suggested to stop inflation.
1. Managing the wages and prices – determined by state income
policy (authority can set wages ceiling)
2. Stimulating market competition – e.g. antimonopoly
regulations
3. Fiscal and monetary policy – e.g. central banks can affect
inflation to a significant extent through setting interest rates

58
Expected vs. Unexpected Inflation
1. Expected inflation
1. Expected inflation is the
inflation that economic
agents expect in the future.
2. Wage negotiations and
pricing adjustments in the
businesses can help solve
this problem of expected
inflation.
3. Expected inflation can give
rise to menus costs and
shoe-leather costs.
1. Unexpected inflation
1. Unexpected inflation is the inflation experienced that
is above or below that which we expected.
2. Unexpected inflation redistributes wealth from
creditors to debtors.
3. When unexpected inflation is higher than expected,
the borrowers tend to benefit.
4. When the unexpected inflation is lower than
expected, lenders tend to benefit.
5. Unexpected inflation can give rise to inequality,
information asymmetry, and risk premium.
59
Costs of Inflation
Costs of extremely high inflation are generally vivid:
If prices rise rapidly enough, money stops being a useful
medium of exchange
Costs of low, expected inflation are difficult to see
Regardless, public has a distaste for it → becomes a policy issue

60
 Costs of Inflation
The costs of inflation include:
1. Menu costs - a menu cost is the cost to a firm resulting from changing its prices.
2. Shoe leather costs - the cost of time and effort that people spend trying to counter-act
the effects of inflation, such as holding less cash and having to make additional trips to
the bank.
3. Loss of purchasing power - Money loses value with inflation, leading to a drop in the
purchasing power of an individual dollar. Unless wages increase with inflation, individuals’
purchasing power will also drop.
4. Redistribution of wealth.
5. Tax distortions: Inflation makes nominal income grow faster than real income. So,
inflation causes people to pay more taxes even when their real incomes don’t increase.
6. Other costs of high and/or unexpected inflation include the economic costs of hoarding
and social unrest.

61
 Cost of Expected Inflation
1. Inflation Tax
2. Menu Cost -Increased price changing- Inflation causes firms to change their posted prices more often, the
logistics of which can be costly. This is sometimes referred to as menu costs in reference to restaurants having to
print new menus.
3. Inefficiency due to inflation variability
4. Increase in tax liability - Distortions in the way taxes are levied- The tax code doesn’t take into account inflation
so the way tax liabilities are assessed is altered from the economically efficient level.
5. Consumer inconvenience - Undertaking economic transactions in a world with changing price levels in
inconvenient and inefficient.
6. When inflation is expected, it has few distribution effects between borrowers and lenders. This is because the
inflation rate is built in to the nominal interest rate, which is the sum of the real interest rate and expected
inflation.
7. Reluctance to hold money- Holding money as cash doesn’t earn an interest rate, and with the presence of
inflation actually decreases in value over time. With inflation, people are reluctant to hold money and thus make
more frequent trips to the bank (this is sometimes referred to as shoe-leather costs)
62
The Inflation Tax
When tax revenue is inadequate and ability to borrow is limited, Govt. may
print money to pay for its spending.
Almost all hyperinflations start this way.
The revenue from printing money is the
inflation tax: printing money causes inflation, which is like a tax on
everyone who holds money.
In the U.S., the inflation tax today accounts for less than 3% of total revenue
Inflation is also called an arbitrary tax, because it lessens people’s
disposable income while effecting them randomly
63
Costs of Unexpected Inflation
1. Redistributions of wealth -
Creditors / Debtors and Employees (on contract) / Employers

2. Interference with long-term planning

Future purchasing power is uncertain

3. “Noise” in the price system

Information conveyed by prices becomes difficult to interpret

4. Shoe leather costs

Time and effort spent to minimize the effect of inflation

5. Distortions of the tax system

“Bracket creep” and future value of depreciation allowances
6. Other costs of high and/or unexpected inflation include the economic costs of hoarding and social
unrest. 64
Inflation Tax..
1. Independent central banks issue fiat money
2. Monetizing the debt
3. Seignorage
4. Inflation Tax

65
The Fisher Effect & the Inflation Tax
Nominal = Inflation + Real interest
interest rate rate rate

The inflation tax applies to people’s holdings of money, not their

holdings of wealth.
The Fisher effect: an increase in inflation causes an equal increase
in the nominal interest rate,
so the real interest rate (on wealth) is unchanged.
66
Costs of Unexpected Inflation..
6. Loss of returns:
6. creditors lose if π* > π
7. borrowers lose if π* < π

7. Loss of real income when income is fixed

8. Arbitrarily redistributes wealth among individuals- For example loan agreements
have an interest rate that has taken inflation into consideration. If inflation is higher than
expected, the borrower is better off because he/she is repaying the fixed loan with less
valuable dollars. The opposite situation is true if inflation is lower than expected.
9. Hurts individuals on fixed pensions and those bound by fixed contracts-
Similar to the borrower/lender example, unexpectedly high or low inflation can hurt one
party in a fixed long term contract or payment system, thereby discouraging their use.

67
Benefits of Inflation
Unexpectedly high inflation tends to transfer wealth from creditors to debtors and from
the rich to the poor.
Inflation is good for borrowers and bad for lenders because it reduces the value of the
money paid back to the lenders.
The inflation rate is built in to the nominal interest rate, which is the sum of the real
interest rate and expected inflation. When the inflation rate rises or falls unexpectedly,
wealth is redistributed between creditors and debtors.
Those with savings in the form of currency or bonds lose money from inflation. Those
with negative savings (debt) or savings in the form of stocks, however, are better off with
higher inflation.
Unexpected inflation often manifests as a wealth transfer from older individuals to
younger individuals.
68
Hyperinflation
Definition: Hyperinflation is a rapid and often uncontrollable currency devaluation causing
the prices of goods and services to skyrocket in a short period of time.
Although there is no precise threshold for hyper-inflation, normally it describes an inflation
rate that exceeds 50 percent.
Hyperinflation is usually caused by an extremely rapid growth in the money supply of an
economy. When the monetary and fiscal policy allow the issuance of “new” money to
accommodate for government spending, the money supply grows faster than the real
output of the economy, thus causing inflation.
Hyperinflation refers to a period of massive price rise.
Prices grow so rapidly that the payment system is damaged to the point of shutdown
Too much money has been printed → outward push of AD dominates all else in our
macroeconomic models 69
Hyperinflation
Hyper inflation is a fast decrease in the value of a currency that drastically
reduces the purchasing power of the currency marked by extreme price
increases of normal goods and services.
When π > 50% per month
All unexpected costs get larger
Delay in tax collection
Inflation psychology
Caused by excessive printing press
Cure required fiscal reform

70
Episodes of Hyperinflation
Country Period CPI Inflation % per year
Angola 1995-96 4,145
Peru 1988-90 5,050
Zimbabwe 2005-07 5,316
Nicaragua 1988 33,000

71
Hyperinflation in Germany
Date Price in marks
Price of a newspaper in January 1921 0.30
Germany, 1921-1923: May 1922 1
October 1922 8
February 1923 100
September 1923 1,000
October 1, 1923 2,000
October 15 20,000
October 29 1,000,000
November 9 15,000,000
Source: Mankiw, Macroeconomics, 5th ed., November 17 70,000,000
pp. 105-106
72
Hyperinflation
: very high
rates of
inflation →
around 1,000
percent per
annum

73
Why governments create hyperinflation?
When a government cannot raise taxes or sell bonds, it must
finance spending increases by printing money.
In theory, the solution to hyperinflation is simple: stop printing
money.
In the real world, this requires drastic and painful fiscal restraint.

74
The role of government and RBI to control inflation
The main policy tools to control inflation include:
1. Monetary policy – Setting interest rates. Higher interest rates reduce
demand, leading to lower economic growth and lower inflation
2. Control of money supply – Monetarists argue there is a close link between
the money supply and inflation, therefore controlling money supply can
control inflation.
3. Supply-side policies – policies to increase competitiveness and efficiency of
the economy, putting downward pressure on long-term costs.
4. Fiscal policy – a higher rate of income tax could reduce spending and
inflationary pressures.
5. Wage controls - Trying to control wages could, in theory, help to reduce
inflationary pressures. However, apart from the 1970s, rarely used.
75
Economic impacts of inflation
1. Inflation can cause unemployment when the uncertainty of inflation leads to
lower investment and lower economic growth in the long term.
2. Inflationary growth is unsustainable leading to a boom and bust economic cycle.
3. Inflation leads to decline in competitiveness and lower export demand, causing
unemployment in the export sector (especially in a fixed exchange rate).
4. There is no direct link between unemployment but often we see a trade-off e.g. in
a period of strong economic growth and falling unemployment, we see a rise in
inflation.
5. A period of high and volatile inflation discourages firms from investing. Because
inflation is high, firms are less certain investment will be profitable.

76
The Sacrifice Ratio
To reduce inflation, policymakers can contract aggregate
demand, causing unemployment to rise above the natural
rate.
The Sacrifice Ratio measures the percentage of a year’s real
GDP that must be foregone to reduce inflation by 1
percentage point.
A typical estimate of the ratio is 5.

77
The Sacrifice Ratio-An Illustration
To reduce inflation from 6 to 2 percent, must sacrifice 20
percent of one year’s GDP:
GDP loss = (inflation reduction) x (sacrifice ratio)
20 = 4 x 5
This loss could be incurred in one year or spread over several,
e.g., 5% loss for each of four years.
The cost of disinflation is lost GDP.

One could use Okun’s law to translate this cost into

unemployment.

78
 Is a little inflation is good for the economy?
A little inflation (around 3-5%) is always considered as good for overall growth of economy. Some of
the reasons for the same are as following:
1. The consumer always expects the prices of goods to increase, so they spend more frequently,
which increases demand and provide profitability to the manufacturers.
2. A little inflation is a sign of growing and healthy economy.
3. Inflation always works as a lubricant for any shock to economy and help it to recover. For
example in a recession time cutting wages are considered more profitable than cutting jobs,
but the earlier is not accepted easier than the later, and as we know job cuts are always bad
for economy. But if there’s inflation in economy, employers just need to provide lesser raise
than inflation rate and no one would mind.
4. Inflation drives people to invest their money, instead of locking them up, because each day
reduces the purchasing power of money and it’s better to invest than loose purchasing
power.
5. Investment helps companies or government to raise money for growth easier.
79
Is a little inflation is good for the economy?
1. A small amount inflation reduces the natural rate of unemployment
2. It provides a necessary mechanism for lowering the real wages
without cutting the nominal wages.

80
The Phillips
Curve
In 1958 A.W. Phillips published a
study of wage behavior in the U.K.
between 1861 and 1957
The main findings are summarized
in Figure.
1. There is an inverse relationship
between the rate of
unemployment and the rate of
increase in money wages
2. From a policymaker’s
perspective, there is a trade-off
between wage inflation and
unemployment
81
The Phillips
Curve..
The curve sloped down from left to
right and seemed to offer policy
makers with a simple choice
- you have to accept inflation or
unemployment. You cannot lower
both.
The Phillips curve is a dynamic
representation of the economy; it
shows how quickly prices are rising
through time for a given rate of
unemployment.
The relationship between inflation
and unemployment depends upon
the time frame
82
The Phillips Curve..
The PC shows the rate of growth of wage inflation decreases with increases in
unemployment
◦ If Wt = wage this period
Wt+1 = wage next period Wt 1  Wt
gw = rate of wage inflation, then g w  (1)
Wt

If * represents the natural rate of unemployment, the simple PC is defined as:

gw   (    * ) (2)
where  measures the responsiveness of wages to unemployment
◦ Wages are falling when  > * and rising when  < *
◦ ( - *) is called the unemployment gap
83
Short-run Phillips curve
Short-run Phillips curve is a curve that shows
the relationship between the inflation rate
and the unemployment rate when the
natural unemployment rate and the
expected inflation rate remain constant.
In the Figure:
1. The natural unemployment rate is 6 percent.
2. The expected inflation rate is 3 percent a year.
3. This combination, at point B, provides the anchor
point for the short-run Phillips curve.
4. The short-run Phillips curve passes through points
A, B, and C and is the curve SRPC.
84
Aggregate Supply and the Short-Run Phillips Curve
The AS-AD model explains the negative relationship between unemployment and inflation
along the short-run Phillips curve.
The Short-run Phillips Curve is another way of looking at the upward-sloping aggregate
supply curve.
Both curves arise because the money wage rate is fixed in the short run.
So when the price level rises, the real wage rate falls.
And the quantity of labor employed increases.
Along the short-run Phillips curve, the rise in the price level means an increase in inflation.
The increase in quantity of labor employed means a decrease in the number unemployed
and a decrease in the unemployment rate.
So a movement along the AS curve is equivalent to a movement along the short-run
Phillips curve.
85
The Long-Run Phillips Curve
The long-run Phillips curve is a vertical line
that shows the relationship between
inflation and unemployment when the
economy is at full employment.
The long-run Phillips curve is a vertical line
at the natural unemployment rate.
In the long run, there is no unemployment-
inflation trade-off.
In the long run, the only unemployment rate
available is the natural unemployment rate,
but any inflation rate can occur.

86
Short-run and Long-
run Phillips Curve
In the Figure, If the natural
unemployment rate is 6
percent, the long-run Phillips
curve is LRPC.
1. If the expected inflation rate
is 3 percent a year, the short-
run Phillips curve is SRPC0.
2. If the expected inflation rate
is 7 percent a year, the short-
run Phillips curve is SRPC1.

87
Short-run and Long-run Phillips Curve
Long-run and Short-Run Phillips Curves
intersect when actual inflation is equal
to expected rate of inflation.

88
Long-run & Short-run Phillips Curves in terms of Output (Y)

89
The Natural Rate Hypothesis
The natural rate hypothesis is the proposition that
when the inflation rate changes, the unemployment
rate changes temporarily and eventually returns to
the natural unemployment rate.
The inflation rate is 3 percent a year and the
economy is at full employment, at point A. Then the
inflation rate increases.
In the short run, the increase in inflation brings a
decrease in the unemployment rate — a movement
along SRPC0 to point B.
Eventually, the higher inflation rate is expected and
the short-run Phillips curve shifts upward to SRPC1.
At the higher expected inflation rate,
unemployment returns to the natural
unemployment rate—the natural rate hypothesis.
90
Effect of Changes in the
Natural Unemployment Rate
The expected inflation rate is 3
percent a year.
The natural unemployment
rate is 6 percent.
The short-run Phillips curve is
SRPC0 and the long-run Phillips
curve is LRPC0.
A decrease in the natural
unemployment rate shifts the
two Phillips curves leftward to
LRPC1 and SRPC1.

91
 Influencing Inflation and
Unemployment
Effects of Central Bank policy:
The economy starts at point A, with the unemployment
rate higher than the natural unemployment rate on
SRPC0.
The Fed increases the growth rate of real GDP and the
economy slides up along SRPC0.
If the Fed continues to increase the growth rate of
aggregate demand, the inflation rate rises and
unemployment falls below the natural rate.
With the inflation rate rising, the expected inflation rate
gradually rises and both inflation and unemployment
increase.
 The economy gradually moves to point B.

 With an expected inflation rate of 10 percent a year, the

short-run Phillips curve has shifted up to SRPC1.
92
Non-Accelerating Inflation Rate of
Unemployment (NAIRU).
NAIRU, a Keynesian explanation
which exists at the Long Run
Phillips Curve, is the rate of
unemployment at which
inflation will stabilise - in other
words, at this rate of
unemployment, prices will rise
at the same rate each year.

93
Does the trade-off still exist?
The unemployment between 1993 and
2008 fell to record lows, but inflation did
not rise, as predicted by the Phillips curve.
Many economists explain this by pointing
to the successful supply-side policies that
have been pursued over the last 20 years.
Supply-side policies: The effectiveness of
supply side policies has meant that the
economy can continue to expand without
inflation.
Indeed, many argue that the long run
Phillips Curve still exists, but that for the
UK it has shifted to the left.

94
Supply Shocks
1. A supply shock is a disturbance in
the economy whose first impact is a
shift in the AS curve
2. An adverse supply shock is one that
shifts AS inwards (as in Figure )
◦ As AS shifts to AS’, equilibrium shifts
from E to E’ and prices increase while
output falls
◦ The u at E’ forces wages and prices
down until return to E, but process is
slow
95
Supply Shocks..
After the shock:
1. Economy returns to the full employment level of
employment
2. Price level is the same as it was before the shock
3. Nominal wages are LOWER due to the increased u at
the onset of the shock
4. Real wages must also fall
W
w
P
where w is the real wage and W is the
nominal wage
96
Supply Shocks…
1. Figure also shows the impact of AD policy
after an adverse supply shock
2. Suppose G increases (to AD’):
 Economy could move to E* if increase
enough
 Such shifts = “accommodating
policies” (accommodate the fall in the
real wage at the existing nominal
wage)
 Added inflation, although reduce u
from AS shock
97
Using AD/AS to demonstrate the Phillips Curve effect
When the economy is at a stable
equilibrium, at Y. An increase in
government spending will shift AD from AD
to AD1, leading to a rise in income to Y1,
and a fall in unemployment, in the short
term.
However, households will successfully
predict the higher price level, and build
these expectations into their wage
bargaining.
As a result, wage costs rise and the AS
shifts up to AS1 and the economy now
moves back to Y, but with a higher price
level of P2. 98
Why is Phillips Curve so Important?
1. The Phillips curve focuses directly on two policy targets: the
inflation rate and the unemployment rate.
2. The aggregate supply curve shifts whenever the money wage rate
or potential GDP changes, but the short-run Phillips curve does
not shift unless either the natural unemployment rate or the
expected inflation rate change.

99
Linkage Among Money, Prices, and Interest Rates
• Changes in money
demand and supply
determine the price
level
• Changes in the price
level determine the
inflation rate
• The inflation rate
affects the interest
rate
• The nominal interest
rate affects the money
demand
100
Keywords
Inflation
Deflation Demand-pull and Cost-push inflation
Disinflation Expected and Unexpected inflation
Hyperinflation Consumer price index
Threshold inflation Phillips Curve
Stagflation Unemployment
Core inflation Natural employment
Headline Inflation Supply shocks

101
MCQ 1
Which of the following is caused by unexpected
inflation (as opposed to expected inflation)?
1. Menu costs
2. Uneven distribution of wealth between lenders and
borrower
3. Shoe leather costs

102
MCQ 1
Which of the following is caused by unexpected
inflation (as opposed to expected inflation)?
1. Menu costs
2. Uneven distribution of wealth between lenders and
borrowers
3. Shoe leather costs

103
MCQ 2
Who would most likely benefit from an
unexpected 10% inflation rate?
1. Alok who has INR 5000 in a savings account
2. Madhura, who has INR 5000 life insurance policy
3. Jagat, who loaned Angad INR 5000 last year
4. Ananya who borrowed INR 5000 last year

104
MCQ 2
Who would most likely benefit from an
unexpected 10% inflation rate?
1. Alok who has INR 5000 in a savings account
2. Madhura, who has INR 5000 life insurance policy
3. Jagat, who loaned Angad INR 5000 last year
4. Ananya who borrowed INR 5000 last year

105
Short Question 1
What does the foreign sector have to do
with inflation?
Ans:
If more money enters the country than
leaves, the money supply increases

106
Short Question 2
What is the equation of exchange?
Ans:

MV = PQ
107
Short Question 2
What is the equation of exchange?
Ans:
MV = PQ

108
Short Question 3
What determines the price level?
Ans:
MV/Q = P

109
Short Question 4
What can reduce the Inflation rate?
Ans:
Decrease M,
decrease V, and/or
increase Q
110
Short Question 5
Who influence the money supply?
Ans:
RBI in India
Fed in the U.S.

111
Short Question 6
Do you think government
mandated price controls work?
Ans:
NO, they simply alter the economic system.

112
Short Question 7
D you think businesses or
consumers can cause inflation?
Ans:
Maybe for a short time, but very quickly
prices will come down due to a lack of
buying pow.
113
Short Question 8
Is it easy to fight
demand pull inflation?
Ans:
YES, When we lower demand prices will
soon drop.

114
Short Question 9
What do you mean by supply side
inflation?
Ans:
It is the Inflation caused by reductions in
aggregate supply .

115
Short Question 10
How are savers effected by
inflation?
Ans:
With an inflation rate of 7% and an interest
rate of 6%, Assuming that there is no
increase in taxes, a saver is worse off by 1%
116
Short Question 11
What fiscal policies would you use to
bring down inflation?
Ans:
1. Cut government spending
2. Raise taxes to pay debt
3. Relax trade restrictions
4. Increase productivity

117
Short Question 12
How one can protect oneself from
hyperinflation?
Ans:
1. real estate
2. art
3. gold
118
Short Question 13
Do you think Inflation causes a fall
in Purchasing Power?

Ans: Inflation does not in itself reduce people’s

real purchasing power.

119