Engineering Economics and Finance

Unit 6
Inflation
Definition
• Inflation
• A sustained increase in average price level of all goods and services produced
in an economy

• Deflation
• A sustained decrease in average price level of all goods and services produced
in an economy
CPI index values (India vs China) CPI inflation
Measure of Inflation: Consumer Price Index

CPI is designed to measure the changes over time in general level of

retail prices of selected goods and services that households purchase for
the purpose of consumption. Such changes affect the real purchasing
power of consumers’ income and their welfare. The CPI measures price
changes by comparing, through time, the cost of a fixed basket of
commodities.
Calculating CPI
1) Fix the basket
• Basket of goods and services bought be typical consumer
• Weight given to goods and services depending upon importance of the same to consumers
2) Find the prices
• Prices of each of the goods and services in basket at each point in time
3) Compute the basket’s cost
• Current year’s prices x Quantity of goods in basket
4) Choose a base year and compute the index
CPI = (Price of basket of G&S in current year / Price of basket of G&S in base year) x 100
5) Compute inflation rate
CPI in year 2 −CPI in year 1
Inflation rate in year 2 = 𝑥 100
CPI in year 1
Example
 CPI Basket in India
Item Weight (Rural) Weight (Urban)
• Goods and services from 6 major groups
Food and beverages
considered for CPI
• Cereals and products
• Total 299 commodities
• Meat and fish
54.18 36.29
• Egg
• Weights given according to economic
• Milk and products
importance of each commodity
• …….
• Proportion of total spending on that
Pan, Tobacco and Intoxicants 3.26 1.36 item

Clothing and Footwear 7.36 5.57 • Prices collected from markets:

• 1181 village markets covering all
Housing - 21.67 districts
• 1114 urban markets distributed over
Fuel and light 7.94 5.58 310 towns
Miscellaneous
• Health
• Education 27.26 29.53
• Recreation and amusement
• …….
Problems in Measuring Cost of Living
• Substitution bias
• Fixed basket ignores possibility of consumer substitution
• May overstate increase in cost of living

• Introduction of new goods

• Greater variety due to new goods may reduce cost of maintaining level of economic well-
being
• Basket may not be revised quickly enough to introduce new goods

• Unmeasured quality change

• Change in quality of goods may change value of money
• Difficult to incorporate as quality is hard to measure
GDP Deflator vs CPI
• GDP deflator: ratio of nominal GDP to real GDP
• Reflects current level of prices relative to prices in base year

• Key differences b/w GDP deflator and CPI:

• GDP deflator reflects prices of G&S produced domestically while CPI reflects
prices of G&S bought by consumers
• CPI compares prices of fixed basket of goods, GDP deflator compares prices
of currently produced goods
 P
SS0
P1

Causes of Inflation P0
DD1
DD0
• Demand Pull Inflation: Q
• Rate of increase in money supply higher than rate of increase in supply of goods and services
• “Too much money chasing too few goods”
• Money supply increase leads to demand curve shift outwards

• Cost Push Inflation: P SS1 SS0

• Sharp increase in cost of production
o Example: natural disasters, high oil prices P1
• Higher costs passed on to consumers as higher prices P0

DD0
Q
Impact of Price Fluctuations
Decline in value of money
Same amount of money will get lesser goods and services
On Purchasing Power of Money
In 2019, you have 1 crore rupees. Following are prices of some products in economy: house: 10 lakh, laptop: 1 lakh,
table: 10000, school bag: 1000, haircut: 100. How many of these products can you purchase in the current time period?
Now imagine a hyperinflation where prices double every month. How many products will you be able to purchase then?

Time period 0 1 2 3 4 5 6
Rate of inflation 0 100 200 400 800 1600 3200
Houses 10 0.1 0.0 0.0 0.0 0.0 0.0
Laptop 100 1.0 0.5 0.2 0.1 0.1 0.0
Table 1000 9.9 5.0 2.5 1.2 0.6 0.3
School bag 10000 99.0 49.8 24.9 12.5 6.2 3.1
Haircut 100000 990.1 497.5 249.4 124.8 62.5 31.2
On Recipients and Payers of Fixed Interest Rates
In 2019 you have Rs. 10,000; you want to use that to buy shirts which cost Rs. 100 and banks are offering
you interest rate of 5%. How many shirts can you purchase in current time period? How many can you
purchase after one year if all the money is put in savings bank account?
Ans: 100; 105
Now assume an inflation of 2%, 5%, 7% and 10%. How many shirts can you buy after one year now?

2% 5% 7% 10%
Number of shirts after one year 103 100 98 95

• Inflation can have significant impact on real interest rate (nominal interest rate – inflation rate)

• Reduction in real interest rate may:

• Erode values of savings
• Adversely impact on pensioners
• Make servicing debt easier
Adverse Impact of Falling Prices
• Falling prices encourage consumers to delay making purchases. May lead to:
• Less economic activity
• Less income generated by producers
• Lower economic growth

• Ideal case for inflation: low, stable, predictable

Dealing with Inflation
• Contractionary policies
• Used when economy is overheated
• May involve raising interest rates, fixing exchange rate or setting prices

• Influencing inflation expectations

• Done through policy announcements
• Leads to built-in inflation components in contracts
• Success depends on credibility of central banks