You are on page 1of 61

INFLATION AND DEFLATION

1

INTRODUCTION
Inflation

and deflation are both far-reaching titanic forces that spread out and greatly influence returns across all major financial markets.
The

usefulness of money to an economy depends on its stability.
Inflation

and deflation hurt an economy because people can’t count on the value of their money. 2

CONCEPT OF INFLATION AND DEFLATION
Inflation

A consistent increase in the prices of goods and services over time is known as inflation.

During inflationary times, money loses its "buying" or "purchasing" power, and it takes more units of currency to purchase the same units of goods or services.

3

Inflation's effects on an economy are various and can be simultaneously positive and negative. This situation occurs when there is a more rapid increase in the quantity of money than in the output of goods and services. • • 4 .• The basic cause of inflation is the creation of too much money by the government.

During deflationary times. money increases in its "buying" or "purchasing" power. and it takes less units of currency to purchase the same units of goods or services. 5 .Deflation • • • A consistent decrease in the prices of goods and services over time is known as deflation. resulting in an increase in the real value of money. It occurs when the annual inflation rate falls below zero percent (a negative inflation rate).

. prices are rising” According to Pigou: “ Inflation arises when money income is expanding more than in proportionate to income earning activity” According to Prof.BASIC AND RELATED DEFINITIONS • Various Definitions for Inflation:  According to the Crowthers : “Inflation means a state in which the value of money is falling i.e. Samuelson : “ Inflation occurs when the general level of prices and cost are rising”   6 .

• 7 .• Disinflation– a decrease in the rate of inflation. Reflation– an attempt to raise the general level of prices to counteract deflationary pressure. • • Stagflation – a combination of inflation. slow economic growth and high unemployment. Hyperinflation – an out-of-control inflationary spiral.

steady rate of inflation. Both inflation and deflation can negatively impact the economy. most economists consider the effects of moderate long-term inflation to be less damaging than deflation.INFLATION VS DEFLATION • • • • Today. 8 . inflation favors short-term consumption and borrowers and is a burden on currency holders and savers. Deflation causes a burden on borrowers and holders of various illiquid assets and is favorable for savers and holders of liquid assets and currency. However. On the other hand. most economists favor a low.

CAUSES OF INFLATION 9 .

Constructive to a faster rate of economic growth EXCESS DEMAND FAVORABLE MARKET CONDITIONS 10  INVESTMENT & EXPANSION .CAUSE 1: DEMAND RELATED  Rate of inflation accelerates:  aggregate demand > goods and services available  This shortage of supply enables sellers to raise prices till equilibrium between supply and demand.

  11 .CAUSE 2: COST RELATED   “SUPPLY SHOCK INFLATION” Causes:  Natural disasters  Increased prices of inputs  Hoarding (recession) Shortage of products causes ripple effect through economy by raising prices through supply chain Example: Decrease in oil supply increased oil prices Producers (who use oil) passes this to consumers as increased prices.

CAUSE 3: BUILT-IN INFLATION  A GDP level where economy is at optimal level of production GDP > potential level   Inflation accelerates suppliers increase prices  GDP < potential level  inflation decelerates suppliers cut prices Workers demand higher wages to stay above the rate of inflation Firms pass higher labor costs onto customers as higher prices 12 .

This will drive up prices and hence. inflation. Low interest rates High level of money supply Allows more investment in big business Unsustainable levels of inflation as cheap money is available 13  . it may grow at rate faster than GDP.CAUSE 4: MONEY SUPPLY  Central banks influence money supply: makes money cheaper / expensive by varying interest rates If money supply not controlled.

CAUSES OF DEFLATION 14 .

CAUSE 1: DEMAND-SIDE CAUSES  Consumption supply and demand curve is in a downswing  Meaning people in the country are not buying products and services (most notably durable goods). 15 .

GROWTH DEFLATION: People do not have money due to unemployment. Scenario: Money supply not increased at rate of positive population ` growth and economic growth Available amt of hard currency per person falls Money scarce 16 Purchasing power of unit of currency increases . Two primary reasons for non-consumption: 1.

CASH BUILDING (HOARDING) DEFLATION: Low consumer spending index. Two primary reasons for non-consumption: 2. even in the most solid of securities Produces a liquidity trap 17 . people pessimistic about financial future Deflation is related to risk (scenario): Risk-adjusted return on assets drops to negative Investors and buyers hoard currency than invest it.

CAUSE 2: SUPPLY-SIDE CAUSES BANK CREDIT DEFLATION: Central bank initiates higher interest rates (to 'control' inflation). thereby popping an asset bubble 18 .

TYPES OF INFLATION There are basically 4 different classifications for inflation. Based on Rate of Inflation Based on Cause Based on the Government Reaction Based on the Nature of Time Period of 19 Occurrence .

BASED ON THE RATE OF INFLATION Sneaking •Small Inflation or sneaky rise less than 3 percent per annum •Annual •Safe 20 and essential .

Walking •Moderately •Annual or jogging Inflation rise between 3-7% •Warning signal for the government Consecutive •Fast •Annual Inflation rise of 10-20% per annum •Affects deprived and middle class 21 •Requires strong monetary measures .

increase many times every day.Twitchy •Also Inflation called hyper inflation •Immeasurable •Prices and completely uncontrollable. . Hurtling •Very inflation rapid •Annual •Also 22 rise of more than 20-100% called runaway inflation.

GRAPHICAL REPRESENTATION 23 .

caused by a drop in aggregate supply (potential output) Built-in 24 inflation (Hangover inflation) -caused by adaptive expectations .caused by increase in aggregate demand Cost-push inflation (supply shock inflation) .BASED ON THE CAUSE OF INFLATION Demand-pull inflation .

does not attempt to prevent price rise Free market mechanism  Repressed Inflation   Govt.BASED ON GOVERNMENT REACTION  Open Inflation   Govt. interrupts Price rise Price control and rationing 25 .

BASED ON TIME PERIOD OF OCCURENCE  War Time Inflation Post War Inflation Peace Time Inflation   26 .

TYPES OF DEFLATION  Cash Building Deflation Growth Deflation Bank Credit Deflation Confiscatory Deflation    27 .

POSITIVE EFFECTS OF INFLATION Decreasing unemployment rates  Drop in real interest rates  Increasing value of assets  Room to manoeuvre  28 .

NEGATIVE EFFECTS OF INFLATION Loss of purchasing power  Effect on saving  Effect on interest rates  Effect on international competition  Uncertainty  Hoarding  Labour unrest  29 .

COSTS OF DEFLATION Effect on investment  Cost to debtors  Unemployment  30 .

MEASUREMENT METHODS Consumer price index  List of the typical goods and services consumed by the average household. grouped into a number of different Categories. The prices of these items are measured each month to calculate the change in the price of the “basket”. The change in the price of the basket is reflected in the measure called the consumer price index.   31 .

usually a year.Gross Domestic Product  measures the value of a nation's output of goods and services for some period of time. for example. publishes an index of industrial production but the GDP has become a favorite among economists because it is the most comprehensive of output measures. not the only measure of output--the Federal Reserve.   32 .

Other widely used price indices for calculating price inflation include the following:  Producer price index price index  Commodity  Core price index 33 .

there are a number of methods to measure inflation .PROBLEMS IN MEASUREMENT As we have seen. Some of them are •Consumer Price Index (CPI) •Producer Price Index (PPI) •Employment Cost Index (ECI) •Gross Domestic Product Deflator (GDP Deflator) •BIS International price program All these measuredifferent aspects of inflation 34 .

Since CPI is a convenient way to compute the cost of living and the relative price level across time . it does not provide a completely accurate estimate of the cost of living. The limitations with the CPI are either   limitations in applications limitations in measurement or 35 . and as it is based on a fixed basket of goods.

Since the CPI uses only a fixed basket of goods. new items enter into the basket of goods and services purchased by the typical consumer. Moreover. the introduction of a new product cannot be reflected. this takes a good deal of time. Items are removed or added to be more representative of the typical household’s demand. . However. then this 36 limits the ability of analysts to make comparisons from one time period to another. if the items in the basket are changed.LIMITATIONS IN APPLICATION 1) Introduction of New Items -  As time goes on.

they all do not change by the same amount.2) Substitution Bias –  As the prices of goods and services change from one year to the next.  The number of specific items that consumers purchase changes depending upon the relative prices of items in the fixed basket. 37 .  The intuitive phenomenon of consumers substituting purchase of low priced items for higher priced items is not accounted for by the CPI.

For example. the “basket” of a family with children will be very different from that of an elderly couple. the “basket” of a rich family will be different from that of a poor family. but this will not be applicable to all people. The purchasing habits of different people will vary greatly. The basket used in any country represents the purchasing habits of a “typical” household.3) Differences in purchasing habits. Similarly. 38 .

4) Change in quality When an item in the fixed basket of goods used to compute the CPI increases or decreases in quality, the value and desirability of the item changes. For example, if some good X becomes much more satisfying than in earlier time , but the price of X does not change, then the cost of living would remain the same

5) Seasonal changes of pricesPrices may change for a variety of reasons that are not sustained.
39

LIMITATIONS IN MEASUREMENT
1. There may be errors in the collection of data that limit the accuracy of the final results. The larger the sample, the more accurate will be the results, but this is timeconsuming and very costly. 2. Countries measure their rate of inflation in different ways, and include different components. This can make it problematic to make international comparisons.

40

LIMITATIONS IN MEASUREMENT (Contd....)
3) There may be variations in regional rates of inflation within a country. This will be harmful if the group has a higher cost of living and beneficial for those whose spending costs are less than the average.

4) The CPI only measures changes in consumer prices. The changes in producer prices and commodity prices are not given due importance in the measurement of inflation.

41

42 .CONTROL MEASURES FOR DEFLATION  Reduction in Taxation Reduce the number and burden of taxes levied on commodities This will increase the purchasing power of the people Redistribution of Income Redistribution of income and wealth from the rich to the poor   Repayment of Public Debt The government can repay the old public debts This will increase the purchasing power of the people and push up effective demand.

 Subsidies The government should give subsidies to induce the businessmen to increase investment Reduction in Interest Rate The monetary authority of a country reduced the interest rate This stimulates investment and thereby expands economic activity in the economy Credit Expansion The central bank and the commercial banks adopt a credit expansion to promote business and industry in the country 43 Bank credit should be made easily available to the entrepreneurs for productive purposes   .

reduce imports This will solve the problem of overproduction. and help overcoming deflation Regulation of Production Production in the economy should be regulated in so that the problem of over-production does not arise Attempts should be made to adjust production with the existing demand to avoid over-production. on the other hand. and. 44  . Foreign Trade Policy The government should adopt such a foreign trade policy to increase exports.

CONTROL MEASURES FOR INFLATION 1.  Monetary measures bank rate policy Increased cost of borrowing which reduces commercial banks borrowing from the central bank.   45 . sells securities in the open market. raises the reserve ratio etc. The flow of money from the commercial banks to the public gets reduced Open Market Operations Central bank sells the government securities to the public through the banks Credit Control Central bank raises the bank rates.

one new note is exchanged for a number of notes of the old currency 46 . Issue of New Currency The most extreme monetary measure is the issue of new currency in place of the old currency Under this system.

and hence personal consumption expenditure The government should float public loans carrying high 47 rates of interest. corporate and commodity taxes should be raised and even new taxes should be levied The government should reduce import duties and increase export duties Increase in Savings This will tend to reduce disposable income with the people. start saving schemes with prize money. Fiscal Measures  Reduction in Unnecessary Expenditure Government should reduce unnecessary expenditure on non-development activities in order to curb inflation  Increase in Taxes The rates of personal.2. or lottery for long periods etc  .

 Surplus Budgets Government should give up deficit financing and instead have surplus budgets It means collecting more in revenues and spending less Public Debt Stop repayment of public debt and postpone it to some future date till inflationary pressures are controlled within the economy Instead. the government should borrow more to reduce money supply with the public  48 .

kerosene oil. etc If there is need. vegetable oils. sugar. etc. financial help . raw materials.3. should be provided to different consumer goods sectors to increase production 49 .subsidies. Other Measures  To Increase Production Increase the production of essential consumer goods like food. clothing. raw materials for such products may be imported on preferential basis to increase the production of essential commodities All possible help in the form of latest technology.

Rational Wage Policy Increase in wages to increase in productivity This will control wage and at the same time increase productivity. and hence production of goods in the economy  Price Control Price control means fixing an upper limit for the prices of essential consumer goods They are the maximum prices fixed by law and anybody charging more than these prices is punished by law  50 .

kerosene oil.Rationing It aims at distributing consumption of scarce goods to make them available to a large number of consumers Applied to essential consumer goods like wheat. etc. rice. meant to stabilise the prices of necessaries and assure distributive justice  51 . sugar.

on average. during 2008/10 .000 suffered an inflation rate.17% during 2008/10 • 13.000.CASE STUDY:INFLATION PAKISTAN •concentrated on the food and energy •40% increase in wheat price in Pakistan would cause 2 percentage point increase in national poverty. •lower income groups in Pakistan tended to experience higher inflation rates than higher income groups •the low 52 income group having income up to Rs5.95% for income group earning above Rs12. of 15.

CAUSES •floods and sporadic rains • • • weak currency flattening yield growth of major crops low productivity gains costs of agriculture inputs •increasing • • population syndrome 53 energy shortage of essential items •stocking .

REMEDIES making Pakistan Agriculture Research Council more vibrant and •strong checks on food cartels and hoardings result oriented •building water reservoirs • • broad-based productivity gains • improving farm-to-market road networks •timely • scientifically import ofmaintaining essential food storage items capacity to soften of • agri-produce prices corporate- • regional trade liberalisation effective support price mechanism and encouraging • broadening of the safety nets for the poor framing concept 54 .

JAPAN •Deflation started in the early 1990’s. •but did not create a sustained increase in broad money and deflation persisted.. •The Bank of Japan and the government have tried to eliminate it by reducing interest rates. 55 . • In July 2006. the zero-rate policy was ended.

the money supply shrinks. •Insolvent Companies •Insolvent banks •Fear of insolvent banks: Japanese people are afraid that banks will collapse so they prefer to buy gold or Treasury bonds instead of saving their money in a bank account. raw materials. When assets decrease in value.CAUSES •Fallen asset prices. •Imported deflation: Japan imports Chinese and other countries' 56 inexpensive consumable goods. . which is deflationary.

•To measure change in average price level • WPI index released weekly on every Thursday •Focus on price of goods traded between corporations •Helps in analyzing microeconomic and macroeconomic conditions 57 .MEASUREMENT OF INFLATION IN INDIA WPI (Wholesale Price Index) •Gives the price of a representative basket of wholesale goods.

0253) – 22% Index •Fuel. Light.7485) – 64% Index 58 . and Lubricants (weight of 14.2262) .14% Index •Manufactured Products (weight of 63.CALCULATION OF WPI IN INDIA •No of items used 435 items (Base year -1993-94) 676items (Base year 2004-05) This consists of •Primary Articles (weight of 22. Power.

REASONS FOR HIGHER INFLATION RATE IN INDIA Uncertainty of the monsoons • Agricultural product supply decreases • Increase in price Hike in fuel prices  Increases manufacturing cost 59 .

MEASURES TAKEN TO CURB INFLATION During 2006-07 RBI announced the following measures  Increasing repo rates Increasing Cash Reserve Ratio Reducing rate of interest on cash deposited by banks 60 .

PERSPECTIVES Traditional anti-inflationary measures Changing interest rates slows down economic growth Showed economic mismanagement 61 .