Price Stability

- Dr Vighneswara Swamy

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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,
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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.

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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

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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.

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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

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Illustration
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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Consumer Price Index (CPI)
The CPI measures the price increases of a particular basket of goods and services.
(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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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 looses 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 (no rapid rise)
occurs when inflation contributes towards economic
steadily increases for stability – which encourages saving,
a long time investment, 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.
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Core Inflation Vs. Headline Inflation
Core Inflation
1. An inflation measure which excludes transitory or
temporary price volatility as in the case of some
commodities such as food items, energy products etc. It
reflects the inflation trend in an economy.
2. Core means, we should ignore food and fuel part.
3. Core inflation = Only WPI of Non-food manufacturing
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.
Headline Inflation
1. Point-to-point changes in the wholesale price index
(WPI) were considered the headline inflation rate.
2. The WPI is a weighted average of the prices of most
goods produced in the economy, with the weights being
their shares in domestic output and their prices those
prevailing in wholesale markets.
3. Headline inflation is your general index like WPI (for
India), CPI etc. that includes all the items used for
measuring inflation.
4. Headline inflation tends to revert strongly towards core
inflation over a time period making the case for core
stronger.
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 Inflation vs. Disinflation
Assume the following Inflation Disinflation
annual price levels as
compared to the prices in As the economy Between 2013 and 2015, the rise in price
2012: moves through levels slows down. Between 2013 and
2012 to 2015, 2014, the price level only increases by two
2012: 100% of 2012 prices there is a percentage points, which is lower than the
2013: 104% of 2012 prices continued growth four percentage point increase between
in the price level. 2012 and 2013. The trend continues
2014: 106% of 2012 prices
This is an between 2014 and 2015, where there is
2015: 107% of 2012 prices example of only a one percentage point increase. This
2016: 105% of 2012 prices inflation; the is an example of disinflation; the overall
price level is price level is rising, but it is doing so at a
continually rising. slower rate.
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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.
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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.

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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.
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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.
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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.
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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 21
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.
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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.

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 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.
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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.

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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
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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
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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.
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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.

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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.

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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

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