ECONOMY

LECTURE: 4 INFLATION
Inflation
• A rise in the general level of prices; a sustained rise in the general level of prices; persistent increases
in the general level of prices; an increase in the general level of prices in an economy that is sustained
over time; rising prices across the board—is inflation.
• When the general level of prices is falling over a period of time this is deflation.
• Disinflation is a decrease in the rate of inflation – a slowdown in the rate of increase of the general
price level of goods and services in a nation's gross domestic product over time.
• Core Inflation – It refers to the price increase excluding volatile fluctuation of prices of food and energy.
Also known as Structural Inflation.
Other variants of Inflation
• Low inflation - Such inflation is slow and on predictable lines, which might be called small or gradual.
This is a comparative term which puts it opposite to the faster, bigger and unpredictable inflations.
Low inflation takes place in a longer period and the range of increase is usually in ‘single digit’. Such
inflation has also been called as ‘creeping inflation’.
• Galloping Inflation - This is a ‘very high inflation’ running in the range of double- digit or triple digit
• Hyperinflation - This form of inflation is ‘large and accelerating’ which might have the annual rates in
million or even trillion. In such inflation not only the range of increase is very large, but the increase
takes place in a very short span of time, prices shoot up overnight.
• Bottleneck Inflation - This inflation takes place when the supply falls drastically and the demand
remains at the same level.
• Inflation Spiral - An inflationary situation in an economy which results out of a process of wage and
price interaction ‘when wages press prices up and prices pull wages up’ is known as the inflationary
spiral. It is also known as the wage-price spiral.
• Inflation Premium - The bonus brought by inflation to the borrowers is known as the inflation premium.
The interest banks charge on their lending is known as the nominal interest rate, which might not be
the real cost of borrowing paid by the borrower to the banks. To calculate the real cost a borrower is
paying on its loan, the nominal rate of interest is adjusted with the effect of inflation and thus the
interest rate we get is known as the real interest rate.
• Reflation - Reflation is a situation often deliberately brought by the government to reduce
unemployment and increase demand by going for higher levels of economic growth. Governments go
for higher public expenditures, tax cuts, interest rate cuts, etc.
• Stagflation - Stagflation is a situation in an economy when inflation and unemployment both are at
higher levels, contrary to conventional belief. When the economy is passing through the cycle of
stagnation (i.e., long period of low aggregate demand in relation to its productive capacity) and the
government shuffles with the economic policy, a sudden and temporary price rise is seen in some of
the goods—such inflation is also known as stagflation. Stagflation is basically a combination of high
inflation and low growth.
• Skewflation - A price rise of one or a small group of commodities over a sustained period of time is
called skewflation.
• Base Effect - It refers to the impact of the rise in price level (i.e., last year’s inflation) in the previous
year over the corresponding rise in price levels in the current year (i.e., current inflation.
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 • The index has increased by 20 points in all the three years, viz., 2008, 2009 and 2010. However, the
inflation rate (calculated on ‘year-on-year’ basis) tends to decline over the three years from 20 percent
in 2008 to 14.29 percent in 2010.
• Current Inflation Rate = [(Current Price Index – Last year’s Price Index)] ÷ Last year’s Price Index] x 100
• Inflationary Gap - The excess of total government spending above the national income (i.e., fiscal
deficit) is known as inflationary gap. This is intended to increase the production level, which
ultimately pushes the prices up due to extra-creation of money during the process.
• Deflationary Gap - The shortfall in total spending of the government (i.e., fiscal surplus) over the
national income creates deflationary gaps in the economy. This is a situation of producing more than
the demand and the economy usually heads for a general slowdown in the level of demand. This is also
known as the output gap.
• Inflation Tax - Inflation erodes the value of money and the people who hold currency suffer in this
process. As the governments have authority of printing currency and circulating it into the economy
(as they do in the case of deficit financing), this act functions as an income to the governments. This is
a situation of sustaining government expenditure at the cost of people’s income. This looks as if
inflation is working as a tax. That is how the term inflation tax is also known as seigniorage.
Causes of inflation
Demand Pull
• Demand-pull inflation exists when aggregate demand for a good or service outstrips aggregate supply.
It starts with an increase in consumer demand. Sellers meet such an increase with more supply. But
when additional supply is unavailable, sellers raise their prices.
• The first cause is growing economy
• The second cause is higher inflationary expectation. Once people expect inflation, they will buy things
now to avoid higher future prices. That increases demand, which then creates demand-pull inflation.
Once expectation of inflation sets in, it's hard to eradicate.
• The third cause is over-expansion of money supply either due to expansionary monetary policy or
expansionary fiscal policy.
• The fourth is a strong brand, itself created by marketing. Marketing can create high demand for certain
products.
Cost Push or Supply shock –
• Cost push inflation is inflation caused by an increase in prices of inputs like labour, raw material, etc or
the level of supply falls. The increased price of the factors of production leads to a decreased supply of
these goods. While the demand remains constant, the prices of commodities increase causing a rise in
the overall price level.
• Cost-push inflation occurs when demand is inelastic. For example demand for petroleum.
• The first cause is monopoly over an industry, which sometimes reduces supply to increase profit
margins. For example the organisation of petroleum exporting countries(OPEC) restricted supply in
1973 and the prices quadrupled
• The second cause is wage increases when workers have enough leverage to force it. This eventually
increases input costs of the producers.
• The third cause is Natural disasters that disrupt supply. A good example is right after Japan's
earthquake in 2011. It disrupted the supply of auto parts. It also occurred after Hurricane Katrina.
When the storm destroyed oil refineries, gas prices soared.
• A fourth driver is government regulation and taxation. These rules can reduce supplies of many other
products. Taxes on cigarettes and alcohol were meant to lower demand for these unhealthy products.
U.S government subsidies of ethanol production led to soaring food prices in 2008.
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• The fifth reason is a shift in exchange rates. Any country that allows the value of its currency to fall will
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experience higher import prices. The foreign supplier does not want the value of its product to drop

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 along with that of the currency. If demand is inelastic, it can raise the price and keep its profit margin
intact.
Real Interest rate
• Nominal interest rate = real interest rate + rate of inflation
• This is also called Fisher Equation.
• The concept is widely used in the fields of finance and economics. It is frequently used in calculating
returns on investments or in predicting the behaviour of nominal and real interest rates. One example
is when an investor wants to determine the actual (real) interest rate earned on an investment after
accounting for the effect of inflation.
• Real Wages - Real wages are wages adjusted for inflation, or, equivalently, wages in terms of the
amount of goods and services that can be bought. This term is used in contrast to nominal wages or
unadjusted wages.
Measures of Inflation
Consumer Price Index –
• The Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket
of consumer goods and services, such as transportation, food and medical care. It is calculated by
taking price changes for each item in the predetermined basket of goods and averaging them. Changes
in the CPI are used to assess price changes associated with the cost of living.
• India officially targets CPI- combined which is also called headline inflation.
• CPI-combined, CPI(urban) and CPI(rural) are calculated by NSO(National Statistical Office)
• CPI AL(agricultural labourer), CPI RL(rural labourer) and CPI IW(industrial worker) are calculated by
Department of Labour.
• Consumer Price Index is used in calculation of Dearness Allowance.
Wholesale price index-
• Wholesale price, the price at which goods are traded in bulk. This may differ from consumer price in
value because of the margin kept by traders. Goods which are traded in bulk (such as raw materials or
semi-finished goods) are not purchased by ordinary consumers.
• Some countries (like the Philippines) use WPI changes as a central measure of inflation.But now India
has adopted new CPI to measure inflation.
• It is published by the Office of the Economic Advisor to the Government of India (Ministry of Commerce
& Industry). WPI continues to constitute three major groups— Primary Articles, Fuel and Power, and
Manufactured Products. The new series of the WPI was released by the Government with the revised
base year as 2011-12. The prices used for compilation do not include indirect taxes in order to remove
impact of fiscal policy and allow for a smooth transition of WPI to Producer Price Index(PPI)
• A new Wholesale Food Price Index (WPFI) has been introduced—combining the Food Articles
(belonging to the group Primary Articles) and Food Products (belonging to the group Manufactured
Products). Together with the Consumer Food Price Index (CPFI) released by National Statistical Office.
Producer price index –
• A working group was set up in 2003-04 under the chairmanship of Prof. Abhijit Sen to recommend a
producer price index (PPI) for India to replace WPI.
• The PPI measures price changes from the perspective of the producer while the consumer price index
(CPI) measures it from the consumers’ perspective.
• Wholesalers charge higher prices to retailers, in turn retailers charge higher prices to consumers and
the price increase is translated into the higher consumer prices—thus the PPI is useful in having an
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idea of the consumer prices in the future.

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• In PPI, only basic prices are used while taxes, trade margins and transport costs are excluded.

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 • The Working Group set up (in August 2014 under the Chairmanship of B. N. Goldar) by the Government
to advise methodology for introducing PPI in the country submitted its recommendations in August
2017. The advises of the expert committee are under consideration of the Government.
• Once India shifts from the WPI to the upcoming PPI, the economy is supposed to have a better idea
about the trends of inflation.
Advantages of PPI
• How is PPI better than WPI only measures price changes in goods, not services. WPI based prices
included indirect taxes as well.
• PPI will also help in predicting the expected CPI movement and thus allow the government to take
decisions proactively.
• In 2017, tax component while measuring wholesale prices for WPI was removed. This was a step
towards transitioning from WPI to PPI.
• Once PPI and CPI are properly tracking the price changes, the estimation of inflation in the country will
improve.
GDP deflator = (Nominal GDP) / (Real GDP)
Housing price index –
• The Housing Price Indices (HPIs) are a broad measure of movement of residential property prices
observed within a geographic boundary.
• NHB RESIDEX: It is the first official housing price index launched in 2007 by the National Housing Bank
(NHB). The base year has been revised to FY 2012-13 to ensure capturing the latest information and
accurately reflect the current economic situation in the country.
• Currently, National Housing Bank is publishing NHB RESIDEX for 50 cities on quarterly basis.
• NHB is not computing the composite all India housing price index as of now.
• However using population proportion as weights, an all India index as weighted average of city indices
has been computed. The rate of growth in housing prices at All India level has started to decline from
the quarter ending December, 2016.
What is the difference between GDP deflator and price indices like CPI and WPI ?
• The goods purchased by consumers do not represent all the goods which are produced in a country.
GDP deflator takes into account all such goods and services.
• CPI includes prices of goods consumed by the representative consumer, hence it includes prices of
imported goods. GDP deflator does not include prices of imported goods.
• The weights are constant in CPI – but they differ according to production level of each good in GDP
deflator.
Phillip’s curve
• Describing a historical inverse relationship between rates of unemployment and corresponding rates
of inflation that result within an economy.
• Stated simply, decreased unemployment, (i.e., increased levels of employment) in an economy will
correlate with higher rates of inflation.
Impacts of Inflation
• Creditors and Debtors - lenders suffer and borrowers benefit out of inflation. The opposite effect takes
place when inflation falls.
• Upward pressure on nominal interest rates.
• Investment in the economy is boosted by inflation because firstly, higher inflation would lower real
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interest rates thus more credit offtake and secondly, higher inflation indicates higher demand and
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suggests entrepreneurs to expand their production level.

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 • Inflation decreases the real value of wages. That is why there is a negative impact of inflation on the
purchasing power and living standard of wage employees. Dearness Allowance is given by Government
to neutralise this impact.
• Regressive impact on redistribution of income. Higher inflation negatively impacts low income groups.
• Holding money does not remain an intelligent economic decision (because money loses value with
every increase in inflation) that is why people visit banks more frequently and try to hold least money
with themselves and put maximum with the banks in their saving accounts. This is also known as the
shoe leather cost of inflation.
• But this happens only when the banks provide higher interest rates on deposits. If banks are unable to
provide deposit rates high enough to cover inflation, then people are disincentivized to deposit money
in bank.
• Shoe-Leather Cost - Metaphorically, shoe leather cost is the cost of time and effort that people expend
by holding less cash in order to reduce the inflation tax that they pay on cash holdings when there is
high inflation.
• Extremely high levels of inflation reduces public morale.
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