You are on page 1of 6

# All About Inflation By Ravishankar Panda New method to calculate inflation now September 02, 2004, Amid spiralling

prices of essential commodities in the country, the government is planning to revamp the method for measuring inflation with the help of World Bank's technical assistance. Moves are afoot in the government to come up with a more realistic way of measuring inflation through a Producers Price Index (PPI) that would replace Whole Price Index (WPI). committee has been set up under eminent economist and Planning Commission member, Abhijit Sen to come up with a PPI with a base year of 200001. (Press Trust of India)

Inflation is a fall in the market value (the value of something as expressed by transactions in a market place). Market value is typically measured and expressed using a unit of account. To understand the inflation we must know about the purchasing power. The purchasing power refers to the amount of goods and services a given amount of money or in other terms the liquid asset which can buy goods and services. If money income stays the same and the prices of the most of the goods and services go up in the market, then the effective purchasing power of the income falls. Thus the fall in purchasing power could be said a part of inflation. However inflation does not imply the purchasing power always as the money income might rise faster than the rate of inflation. Inflation is the opposite of deflation. Deflation is a rise in the market value or purchasing power of money. This is same as a decrease in the general price level. In general, this means cost of goods and services is less. Deflation can be contrasted with disinflation which is reduction a reduction in the rate of inflation, i.e. the general level of prices are increasing at a decreasing rate. Zero or very low positive inflation is called price stability. In some contexts the word "inflation" is used to mean an increase in the money supply, which is sometimes seen as the cause of price increases. For example, some observers of the 1920s in the United States refer to "inflation" even though prices were not increasing at the time. Below, the word "inflation" will be used to refer to a general increase in prices unless otherwise specified. Inflation can be contrasted with "reflation," which is either a rise of prices from a deflated state, or alternately a reduction in the rate of deflation, i.e. the general level of prices are falling at a decreasing rate. A related term is "disinflation", which is a reduction in the rate of inflation but not enough to cause deflation. Measuring inflation Inflation is measured by observing the change in the price of a large number of goods and services in an economy (usually based on data collected by government agencies, through labour unions and business magazines have also done this job). The prices of goods and services are combined to give a price index measuring an average price level, the average price of a set of products. The inflation rate is rate of increase of the average price level. If PL1 is the current average price level and PL0 is the price level a year ago the rate of inflation during the year can be expressed as:

Inflation rate = Inflation rate is the percentage rate of increase in this index; while the price level might be seen as measuring the size of a balloon, inflation refers to the increase in its size. There is no single true measure of inflation, because the value of inflation will depend on the weight given to each good in the index.

Examples of common measures of inflation include: Consumer Price Index (CPI): It is a statistical measure of a weighted average of prices of a specified set of goods and services purchased by wage earners (consumers) in urban areas. It is also known as retail price index (RPI). This index tracks the price of a specified set of goods and services purchased. The CPI is a fixed quantity price index and generally does not reflect the improvement or deterioration of quality. The CPI also does not account for newly introduced products. In many industrial nations, annualised percentage changes in these indexes are the most commonly reported inflation figure. These measures are often used in wage and salary negotiations, since employees wish to have (nominal) pay raises that equal or exceed the rate of increase of the CPI. Sometimes, labour contracts include cost of living escalators (or adjustments) that imply nominal pay raises automatically occur with due to CPI increases, usually at a slower rate than actual inflation (and after inflation has occurred). Producer Price Index (PPI): It is group of indices used in economics to measure the price of goods and services received by the producers. Though CPI is a related index but differs as it measures the price paid by the end users. PPI is a measure of the price received by a producer. This differs from the CPI in the price subsidies, profits, and taxes may cause the amount received by the producer to differ from what the consumer paid. There is also typically a delay between an increase in the PPI and any resulting increase in the CPI. This allows a rough-and-ready prediction of CPI inflation tomorrow based on PPI inflation today. Wholesale Price Index (WPI): In the most part of the last century WPI had been one of the key economic indicators for the policy makers but was replaced by PPI. WPI measures the change in price of a selection of goods at wholesale (i.e., typically prior to sales taxes). These are very similar to the PPI. Commodity Price Index: It is a fixed weight index of the spot or transaction prices of multiple commodities. This measures the change in price of a selection of commodities. For example, the gold standard is a monetary system in which the standard economic unit of account is a fixed weight of gold. This is widely accepted by the several nations and it makes the rate of exchange between national currencies fixed. Thus, the gold standard is also seen as a monetary system in which changes in the gold prices are accepted as the sole measure of inflation or deflation. the sole commodity used was gold. While under the USA bimetallic standard the index included both gold and silver. GDP Deflator: GDP stands for Gross Domestic Products. GDP is defined as the total value of all the goods and services produced within a territory during a specified period. GDP deflator is a price index measuring changes in prices of all new domestically produced, final goods and services in an economy. It is not based on a fixed market basket of goods and services. It shows the expenditure pattern in the deflator as peoples response to changing prices. The role of inflation in the economy A great deal of economic literature concerns the question of what causes inflation and what effects it has. A small amount of inflation is often viewed as having a positive effect on the economy. One reason for this is that it is difficult to renegotiate some prices, and particularly wages, downwards, so that with generally increasing prices it is easier for relative prices to adjust. Many prices are "sticky downward" and tend to creep upward, so that efforts to attain a zero inflation rate (a constant price level) punish other sectors with falling prices, profits, and employment. Thus, some business executives see mild inflation as "greasing the wheels of commerce." Efforts to attain complete price stability can also lead to deflation (steadily falling prices), which can be very destructive, encouraging bankruptcy and recession (It is a fall of a countrys gross national product in two successive quarters. A sustained recession is known as economic depression.) Many in the financial community regard the "hidden risk" of inflation as an essential incentive to

invest, rather than simply save, accumulated wealth. Inflation, from this perspective is seen as the market expression of what the time value of money is. If value of Rupee today is worth more to someone than a Rupee a year from now, then there should be a discount in the economy as a whole for Rupees in the future. From this perspective, inflation represents the uncertainty about the value of future Rupees. Inflation, however, above these relatively low amounts is recognized as having increasingly negative effects on the economy. These negative effects are the result of "discounting" previous economic activity. Since inflation is often the result of government policies to increase the money supply (money supply, a macroeconomic concept, is the quantity of money available within the economy of a country to purchase goods and services. The government contribution to an inflationary environment is a tax on holding currency. As inflation increases, it increases the tax on holding currency, and therefore encourages spending and borrowing, which increase the velocity of money, and therefore reinforce the inflationary environment, a "vicious circle". To extremes this can become hyper-inflation. Increasing uncertainty may discourage investment and saving. Redistribution: (i) It will redistribute income from those on fixed incomes, such as pensioners, and shift it to those who draw a more flexible income, for example from profits and most wages which may keep pace with inflation. (ii) Similarly it will redistribute wealth from those who lend a fixed amount of money to those who borrow (if the lenders are caught by surprise or cannot adjust to inflation). For example, where the government is a net debtor, as is usually the case, it will reduce this debt redistributing money towards the government. Thus inflation is sometimes viewed as similar to a hidden tax. International trade: If the rate of inflation is higher than that abroad, a fixed exchange rate will be undermined through a weakening balance of trade. Shoe leather costs: Because the value of cash is eroded by inflation, people will tend to hold less cash during times of inflation. This imposes real costs, for example in more frequent trips to the bank. (The term is a humorous reference to the cost of replacing shoe leather worn out when walking to the bank.) Menu costs: Firms must change their prices more frequently, which imposes costs, for example with restaurants having to reprint menus.

Hyperinflation: if inflation gets totally out of control (in the upward direction), it can grossly interfere with the normal workings of the economy, hurting its ability to supply. In an economy where some sectors are "indexed" to inflation, while others are not, inflation acts as a redistribution towards the indexed sectors away from the unindexed sectors. Again, in small amounts this is a policy choice, acting as a tax on "liquidity preference" and hoarding, rather than saving. However, beyond this amount, the effect becomes distorting, as individuals begin "investing in inflation", which, again, encourages inflationary expectations. Because of the above reasons for discouraging inflation above the small amounts needed to discount previous actins and discourage hoarding of currency, most Central Banks define price stability as a central goal, with a perceptible, but low, rate of inflation as the target. Causes of inflation There are different schools of thought as to what causes inflation. Monetary Theory One of the most widespread theories of inflation is also the most straightforward: inflation is an increase in the supply or velocity of money at a rate greater than the expansion in the size of the economy. This is practically measured by comparing the GDP deflator to the rate of increase of the money supply, and setting the interest rate through the central bank to maintain a constant

quantity of money. This view differs from the Austrian school below in that it focuses on a "quantity of money" theory, rather than the "quality of money" theory. In the monetarist framework, it is the aggregate money supply which is important. The Quantity Theory of Money, simply stated is that the total amount of spending in an economy is primarily determined by the total amount of money in existence. From this theory the following formula is created:

P is the general price level of consumers' goods, Dc is the aggregate demand for consumers' goods and Sc is the aggregate supply of consumers' goods. The idea behind this formula is that the general price level of consumers' goods will rise only if the aggregate supply of consumers' goods goes down relative to the aggregate demand for consumers' goods, or if the aggregate demand increases relative to the aggregate supply of consumers' goods. Neo-Keynesian Theory According to Neo-Keynesian economic theory there are three major types of inflation, as part of what Robert J. Gordon calls the "triangle model": Demand pull inflation inflation due to high demand for GDP and low unemployment, also known as Phillips Curve inflation. Cost push inflation nowadays termed "supply shock inflation," due to an event such as a sudden increase in the price of oil. Built-in inflation induced by adaptive expectations, often linked to the "price/wage spiral" because 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. It is also known as "inertial" inflation, "inflationary momentum," and even "structural inflation." These three types of inflation can be added up at any time to get an explanation of the current inflation rate. However, over time, the first two (and the actual inflation rate) affect the amount of built-in inflation: persistently high (or low) actual inflation leads to higher (lower) built-in inflation. Within the context of the triangle model, there are two main elements: movements along the Phillips Curve, for example as unemployment rates fall, encouraging greater inflation, and shifts of that curve, as when inflation rises or falls at a given unemployment rate. 1. Phillips Curve or Demand inflation: A major demand-pull theory centres on the supply of money: inflation may be caused by an increase in the quantity of money in circulation relative to the ability of the economy to supply (its potential output). This has been seen most graphically when governments have financed spending in a crisis by printing money excessively (say, due to war or civil war conditions), often leading to hyperinflation where prices rise at extremely high rates (say, doubling every month). The money supply is also thought to play a major role in determining levels of more moderate levels of inflation, although there are differences of opinion on how important it is. For example, Monetarist economists believe that the link is very strong; Keynesian economics by contrast typically emphasise the role of aggregate demand in the economy rather than the money supply in determining inflation. That is, for Keynesians, the money supply is only one determinant of aggregate demand. A fundamental concept in such Keynesian analysis is the relationship between inflation and unemployment, called the Phillips curve. This model suggested that price stability was a trade off against employment. Therefore some level of inflation could be considered desirable in order to minimize unemployment. 2. Shifts of the Phillips Curve: Thus, modern macroeconomics describes inflation using a Phillips curve that shifts (so the trade-off between inflation and unemployment changes) due to such matters as supply shocks and inflation becoming built into the normal workings of the economy. The former refers to such events as the oil shocks of the 1970s, while the latter refers to the price/wage spiral and inflationary expectations implying that the economy "normally" suffers

from inflation. Thus, the Phillips curve represents only the demand-pull component of the triangle model. Supply-side Theory Supply-side economics asserts that inflation is always caused by either an increase in the supply of money or a decrease in the demand for money. The value of money is seen as being purely subject to these two factors. Thus the inflation experienced during the Black Plague in medieval Europe is seen as being caused by a decrease in the demand for money, whilst the inflation of the 1970s is regarded as been initially caused by an increased supply of money that occurred following the US exit from the Bretton Woods gold standard. Supply-side economics asserts that the money supply can grow without causing inflation as long as the demand for money also grows. One of the factors that supply side economists say was instrumental in ending the US experience of high inflation was the economic expansion of the 1980s ushered in by lower taxes. The argument is that an expanding economy creates an increased demand for base money and in so doing it counteracts inflation forces. An expanding economy can be seen as frequently leading to an increased demand for money and all else being equal an improvement in the value of money. In international currency markets such a principle is reasonably undisputed however supply side economists argue that economic expansion increases the domestic valuation of money and not just the international valuation. "Growth oriented" theories According to the adherents of "growth oriented" theories of the economy - which include both conservative supply-side economists and many neo-Keynesians - inflation is caused by misallocated demand. For the supply-side theorist, this means too much government demand, and the solution to inflation is to lower marginal tax rates on investment. To the neo-Keynesian, this means that goods are mispriced, and supply shocks result when externalities which have accumulated over time are suddenly priced into a good, for example, when pollution in an area starts to cause noticeable illnesses that must be treated, and the pollution cleaned up. To them the solution is to correctly price goods, which will reshape demand away from the over-consumption of seemingly cheap, but in reality expensive, resources. Stopping inflation There are a number of methods which have been suggested to stop inflation. Central Banks such as the Reserve Bank of India can affect inflation to a significant extent through setting interest rates and through other operations (i.e., using monetary policy). High interest rates (and slow growth of the money supply) are the traditional way that Central Banks fight inflation, using unemployment and the decline of production to prevent price increases. However, Central Banks view the means of controlling the inflation differently. For instance, some follow a symmetrical inflation target while others only control inflation when it gets too high. Monetarists emphasize increasing interest rates by reducing the money supply through monetary policy to fight inflation. Keynesians emphasize reducing demand in general, often through fiscal policy, using increased taxation or reduced government spending to reduce demand. They also note the role of monetary policy, particularly for inflation in basic commodities from the work of Robert Solow. Supply-side economists advocate fighting inflation by fixing the exchange rate between the currency and some stable reference currency such as gold, or by reducing marginal tax rates in a floating currency regime to encourage capital formation All of these policies are achieved in practice through a process of open market operations. Another method attempted is simply instituting wage and price controls. One of the main problems with these controls was that they were used at the same time as demand-side stimulus was applied, so that supply-side limits (the controls, potential output) were in conflict with demand growth. In general, most economists regard price controls as counterproductive in that they tend to distort the functioning of the economy because they encouraging shortages, decreases in the quality of products, etc. However, this cost may be "worth it" if it avoids a serious recession, which can have even greater costs, or in the case of fighting war time inflation. In fact, controls may complement a recession as a way to fight inflation: the controls make the recession more efficient as a way to fight inflation (reducing the need to increase unemployment),

while the recession prevents the kinds of distortions that controls cause when demand is high. (To be continued: In the next section the inflation situation in India will be discussed. In case students find difficulty in understanding any term do write to me at ravishankar.panda@careerlauncher.com)