INFLATION AND DEFLATION :INFLATION AND DEFLATION DR.

CHANDAN BORA (BORA’s INSTITUTE OF

COMMERCE AND MANAGEMENT)

INFLATION :INFLATION

Introduction :Introduction Situation of Substantial and Rapid general increase in price level Decline in the value of
money Wholesale Price Index (WPI) or Cost of Living Index or Consumer Price Index (CPI) used for the

Definitions :Definitions According to the Crowthers “Inflation means a state in which the value of money is falling i.e.,
prices are rising” According to Pigou,“ Inflation arises when money income is expanding more than in proportionate to
income earning activity” According to Prof. Samuelson “ Inflation occurs when the general level of prices and cost are
rising”

Types of Inflation :Types of Inflation According to the Rate of Inflation 1. Creeping Inflation 2. Walking Inflation 3.
Running Inflation 4. Galloping Inflation 5. Hyper Inflation

Types of Inflation :Types of Inflation According to the Government Reaction 1. Open Inflation 2. Suppressed
inflation According to the Nature of Time Period of Occurrence 1. War Time Inflation 2. Post War Inflation 3. Peace
Time Inflation

Types of Inflation :Types of Inflation According to the Scope or Coverage 1. Comprehensive Inflation 2. Sporadic
Inflation According to the Nature 1. Full Inflation 2. Partial Inflation

Types of Inflation :Types of Inflation According to the Causes 1. Credit Inflation 2. Currency Inflation 3. Scarcity
Inflation 4. Deficit Inflation 5. Profit Inflation 6. Tax Inflation 7. Cost Inflation 8. Demand Inflation

Causes of Inflation :Causes of Inflation Increase in money supply Expansion of bank credit Deficit Financing Black
Money Scarcity Taxes Increase in the supply of Gold Population Growth Entrepreneurial Bottle-neck

Effect of Inflation :Effect of Inflation Debtors and Creditors People with fixed income Consumers Producers and
Businessmen Agriculturists (Farmers) Tax Payers and Government

Inflation Vs. Deflation :Inflation Vs. Deflation

Inflation Vs. Deflation :Inflation Vs. Deflation

introduction :introduction Inflation

Inflation :Inflation This is the process by which the price level rises and money loses value. There are two kinds of
inflation: a) Demand pull b) Cost push

Demand pull inflation :Demand pull inflation Demand pull inflation may be due to : Increase in money supply
Increase in government purchases Increase in exports

Cost push Inflation :Cost push Inflation Cost push inflation may arise because of : Increase in money wage rates
Increase in money prices of raw materials.

Hyper inflation :Hyper inflation Extremely rapid or out of control inflation. There is no precise numerical definition to
hyperinflation. Price increases are so out of control that the concept of inflation is meaningless. The most famous
example of hyperinflation occurred in Germany between January 1922 and November 1923. By some estimates, the
average price level increased by a factor of 20 billion!

Money and Prices During Hyperinflations :Money and Prices During Hyperinflations Copyright © 2004 South-
Western (a) Austria (b) Hungary Money supply Price level Index (Jan. 1921 = 100) Index (July 1921 = 100) Price
level 100,000 10,000 1,000 100 1925 1924 1923 1922 1921 Money supply 100,000 10,000 1,000 100 1925 1924
1923 1922 1921

Stagflation :Stagflation A condition of slow economic growth and relatively high unemployment accompanied by
inflation. This happened to a great extent during the 1970s, when world oil prices rose dramatically, fueling sharp
inflation in developed countries. At least some central banks have expressed concern over inflation even as the
global economy seems to be slowing down.

Money Supply, Money Demand, and the Equilibrium Price Level :Money Supply, Money Demand, and the
Equilibrium Price Level Copyright © 2004 South-Western Quantity of Money Value of Money, 1 / P Price Level, P 0 1
(Low) (High) (High) (Low) 1 / 2 1 / 4 3 / 4 1 1.33 2 4

The Effects of Excess Money Supply :The Effects of Excess Money Supply Copyright © 2004 South-Western
Quantity of Money Value of Money, 1 / P Price Level, P 0 1 (Low) (High) (High) (Low) 1 / 2 1 / 4 3 / 4 1 1.33 2 4

How is inflation measured? :How is inflation measured? WPI (Wholesale Price Index) India- the only major country
that uses WPI (1st published in 1902) What is WPI? The WPI number is a weekly measure of wholesale price
movement for the economy

WPI- The Indian Example :WPI- The Indian Example Indian government constructed its present WPI way back in
1993-94 (1993-94 series replacing 1981-82 bases) by making a basket of 435 commodities Laspeyres formula
employed The 100-point index is subdivided into three groups

Slide 12:Major Groups: I. Primary Articles (98 items)- 22.02 % Food Articles, Non-Food Articles, Minerals II. Fuel,
Power, Light & Lubricants (19 items) - 14.23 % III. Manufactured Products (318 items) - 63.75 % Food Products
Beverages, Tobacco & Tobacco Products Textiles… etc

Slide 13:The Office of the Economic Advisor (OEA) compile the WPI numbers on weekly basis On Friday inflation
figures are announced The working group on WPI, headed by Planning Commission member Abhijit Sen, has worked
out a new index The base year of the new index :2000-01 The basket of commodities- around 1200 To Reflect the
post-liberalisation consumption pattern

Consumer Price Index (CPI) :Consumer Price Index (CPI) A measure of the average price of consumer goods and
services purchased by households (1st published in 1970) CPI indicates the change in the purchasing power of the
consumer CPI for Industrial Workers (CPI-IW), CPI for Agricultural Labourers / Rural Labourers (CPI -AL/RL), CPI for
Urban Non-Manual Employees (CPI-UNME) Published on a monthly basis

Slide 15:Producer Price Index (PPI) Measures average changes in prices received by domestic producers for their
output Service Price Index (SPI) The share of the service sector in the (GDP) gone up from 28% (1950) to over 50%
Necessitates representation of Services in the price index

Discussion question :Discussion question Why is inflation bad?

Slide 17:Unanticipated inflation is bad because it makes the economy behave like a giant casino. Gains and losses
occur because of unpredictable changes in the value of money. If the value of money varies unpredictably over time,
the quantity of goods and services that money will buy will also fluctuate unpredictably. Resources are also diverted
from productive activities to forecasting inflation. Unanticipated inflation leads to : Redistribution of income, borrowers
and lenders Too much or too little lending or borrowing

The Economic Impacts of Inflation :The Economic Impacts of Inflation Redistribution of Income and wealth among
different groups Distortion in relative prices and outputs of different goods, or sometimes in output and employment
for the economy as a whole.

THE COSTS OF INFLATION :THE COSTS OF INFLATION Shoe leather costs Menu costs Tax distortions Confusion
and inconvenience Arbitrary redistribution of wealth

Shoe leather costs :Shoe leather costs Shoe leather costs are the resources wasted when inflation encourages
people to reduce their money holdings. Inflation reduces the real value of money, so people have an incentive to
minimize their cash holdings. Less cash requires more frequent trips to the bank to withdraw money from interest-
bearing accounts.
Menu costs :Menu costs Menu costs are the costs of adjusting prices. During inflationary times, it is necessary to
update price lists and other posted prices. This is a resource-consuming process that takes away from other
productive activities.

Inflation-Induced Tax Distortion :Inflation-Induced Tax Distortion The income tax treats the nominal interest earned
on savings as income, even though part of the nominal interest rate merely compensates for inflation. The after-tax
real interest rate falls, making saving less attractive.

Taming Inflation :Taming Inflation Monetary policy- Bank rate policies, Open Market operations, Reserve
requirement ratios Fiscal policy-taxation, public borrowing, public expenditure Direct Control-Fixing ceiling prices of
the products, Rationing. Miscellaneous methods-Controlling Wages, Controlling population growth

The Effects of Monetary Injection :The Effects of Monetary Injection Copyright © 2004 South-Western Quantity of
Money Value of Money, 1 / P Price Level, P 0 1 (Low) (High) (High) (Low) 1 / 2 1 / 4 3 / 4 1 1.33 2 4

After nearly three decades, India is experiencing deflation once again. While inflation is a measure
signifying an increase in prices, deflation is just the opposite and indicates a contraction in demand or
goods and services and hence a fall in prices. In inflation, the value of your money goes down. It thus
follows that in deflationary mode the value of any currency

increases.

So while people should, in general, be happy about the value of each Rupee going up, the situation is
fraught with problems. For one, deflation is historically associated with periods of economic slowdown or
depression. Second, when the economy is experiencing negative inflation there is always the expectation
that prices will fall further and so consumers prefer to postpone purchases leading to a further fall in
aggregate demand of goods and services, which hits industry in a way that creates idle capacity and in
turn leads to losses and job cuts, which further enhances the negative sentiment and we find ourselves in
a situation called deflationary spiral.

In addition there is a fear that the economy may fall into a liquidity trap. What happens in this case is that
the government tries to stimulate the economy by initiating interest
rate cuts. However if this fails to spur the economy to a full employment point, the Central government
keeps pushing down rates till it reaches point zero. After this the government can’t do anything and so
you have a situation where your saving or securities are not earning any interest on them but the
increased money supply fails to create additional demand. The successive rate cuts also work inversely in
a way that it prevents the government from stabilizing its monetary policy.

The reduction of interest rates has different effects in closed and open economies. In a country that is
heavily controlled by the government, the interest rate cuts don’t necessarily have a huge stimulating
impact. Reason being that on zero interest rates, returns on government securities are also nil and can
even be in the negative on short term investments. On the other hand, in economies that face less
interference from the government, the effect could be of carry trade(where investors borrow cheaper
currencies and lend more valuable ones) and devalues currency which makes imports more expensive
without necessarily increasing the volume of exports.

There is also a perceived positive side to deflation. It improves the value of money in a way that benefits
common man and especially the poor by brining essential commodities like food, clothing etc within their
reach more easily. This improves their standarIndia’s 2008 Economic Survey Report targeted a drop
in India’s Inflation Rate – but with food, oil and commodity price rises worldwide, the opposite is
happening.

According to the 2008 Economic Survey Report, India’s inflation rate was targeted by the Reserve Bank of
India (RBI) to be 4.1%, down from a rate of 5.77% in 2007. Inflation rates for many investment goods have
decreased dramatically in recent years. The price of basic goods such as lentils, vegetables, fruits and
poultry were expected to slow their rise. The price of various manufactured goods also fell in 2007, and this
contributed to a reduced inflation rate

However, the beginning of 2008 has seen a dramatic rise in the price of rice and other basic food stuffs.
There has also been a no-less alarming rise in the price of oil and gas. When coupled with rises in the price
of the majority of commodities, higher inflation was the only likely outcome.

Indeed, by July 2008, the key Indian Inflation Rate, the Wholesale Price Index, has risen above
11%, its highest rate in 13 years. This is more than 6% higher than a year earlier and almost
three times the RBI’s target of 4.1%.

Inflation has climbed steadily during the year, reaching 8.75% at the end of May. There was an alarming
increase in June, when the figure jumped to 11%. This was driven in part by a reduction in government fuel
subsidies, which have lifted gasoline prices by an average 10%.

The Indian method for calculating inflation, the Wholesale Price Index, is different to the rest of world. Each
week, the wholesale price of a set of 435 goods is calculated by the Indian Government. Since these are
wholesale prices, the actual prices paid by consumers are far higher.

In times of rising inflation this also means that cost of living increases are much higher for the populace.
Cooking gas prices, for example, have increased by around 20% in 2008.

With most of India’s vast population living close to – or below – the poverty line, inflation acts as a ‘Poor
Man’s Tax’. This effect is amplified when food prices rise, since food represents more than half of the
expenditure of this group.

The dramatic increase in inflation will have both economic and political implications for the government, with
an election due within the year.

Economic growth in emerging markets has slowed but is far from over. With the BRIC countries (Brazil,
Russia, India and China) alone accounting for more than 3 billion people, and with these people consuming
more resources every year, it is likely that higher inflation rates will be with us for a good while yet – and
that is worrying news for the government of India. d of living despite the economy being in recession