Inflation

Dr.Mrutyunjay Dash

“state in which the value of money is falling, i.e., the prices are rising.”: Crowther “Inflation is a persistent and appreciable rise in the general level or average of prices.” : Ackley However there is no generally accepted definition of inflation and different economist define it differently.

• Modern economists analyse inflation in a comprehensive and unified manner.
Inflation

is always accompanied by a rise in the price level. It is a process of uninterrupted increase in prices. Inflation is essentially a monetary phenomenon and is generally caused by excessive money supply.

Demand-Pull Inflation
• Demand-pull inflation or excess demand inflation occurs when aggregate demand for goods and services is greater than the available supply of these goods and services at the existing prices level.

• Thus, demand-pull inflation may be defined as a situation where the aggregate demand exceeds the economy’s ability to supply the goods and services at the current prices, so that the prices are pulled upward by the upward shift of demand function.

Cost-Push Inflation
• The true source of inflation is the increase in cost of production • The increase in cost of production is autonomous of the demand conditions • The push forces operate through important cost components, such as, wages, profits or material costs, so that cost-push inflation may take the form of wage-push, profitpush or material-push inflation.

Reasons for Wage-Push Inflation
• In the modern times, the trade unions have become very strong and they succeed in securing higher wages for their members. This raises the cost of production and, to maximise their profits, the businessmen raise the prices of their products. • Wage rise may be induced by an excess demand for labour, which may be the result of excess demand conditions in the commodity market. • For wage-push inflation to occur, it is necessary that trade unions have substantial control over the supply of labour. • In a country like India where the major portion of the labour force is not unionised, trade unions do not have much influence on wages.

Profit-Push Inflation
• Cost-push inflation also occurs when the monopoly power of the business enables them to raise prices to create their profits. Once started by a few powerful firms other small firms follow the suit and the over all consequence is inflation.

Material-Push Inflation
• Cost-push inflation is also caused by the increase in the prices of some key materials such as steel, basic chemicals, oil, etc. Since these materials are used directly or indirectly, in almost all the industries, the increase in their prices affect the whole of the economy and the prices everywhere tend to increase.

THE COSTS OF INFLATION
• • • • • • • Shoeleather costs Menu costs Relative price variability Tax distortions Inflation-Induced Tax Distortions Confusion and inconvenience Arbitrary redistribution of wealth

Is inflation a tax ?
How can a person avoid paying the inflation tax?
By holding less money More wealth in interest-bearing savings account & less in wallet. The cost of reducing money holdings : Shoeleather cost
MENU COSTS: When does annual price adjustment become impractical?  Cost of deciding on new prices  Cost of printing new price lists and catalogs  Cost of sending the new prices & catalogs to dealers and customers  Cost of advertising the new prices  Cost of dealing with customer annoyance over price changes

Relative price variability Why does this matter?
Market economies-relative prices –allocation of scarce resources Consumers decision I. Price II. Quality Inflation distorts relative prices, consumer decisions are distorted and markets are less able to allocate resources to their best use.

Inflation-Induced Tax Distortions Does Inflation exaggerate the size of capital gains and increase the tax burden on this type of income? Tax treatment of capital gains Example: Buy a stock in Microsoft for $10—1980 Sell it at $50—1985 What is the capital gain as per Tax law? $40--- must be included in your income If the price level is doubled by this time then what is the real gain in terms of dollar? $30 [$20—2005-($50-$20) Tax is imposed on a gain of $40 instead of $30

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.

Confusion and inconvenience
Express a yard in inches?
How do we measure economic transaction? Is there any possibility for accountants to measure firm’s earnings? Inflation causes dollars at different times to have different real values. Computation of a firm’s profit (R-C) gets more complicated in the presence of inflation

• Unexpected inflation redistributes wealth among the population in a way that has nothing to do with either merit or need. • These redistributions occur because many loans in the economy are specified in terms of the unit of account—money.
Arbitrary redistribution of wealth $20,000—7% interest rate. After 10 yrs X’s liability to the bank---$40,000 Hyper inflation—X is better off Deflation- Falling income & wages X is worse off.

UNEMPLOYMENT
– Categories of Unemployment
• The problem of unemployment is usually divided into two categories, the long-run problem and the short-run problem. • The natural rate of unemployment • The cyclical rate of unemployment

Natural Rate of Unemployment
– The natural rate of unemployment is unemployment that does not go away on its own even in the long run. – It is the amount of unemployment that the economy normally experiences.

Cyclical Unemployment
– Cyclical unemployment refers to the year-to-year fluctuations in unemployment around its natural rate. – It is associated with with short-term ups and downs of the business cycle.

Frictional unemployment It refers to the unemployment that results from the time that it takes to match workers with jobs.
– In other words, it takes time for workers to search for the jobs that are best suit their tastes and skills.

Structural unemployment It is the unemployment that results because the number of jobs available in some labor markets is insufficient to provide a job for everyone who wants one.

…………Structural unemployment It occurs when the quantity of labor supplied exceeds the quantity demanded. • Structural unemployment is often thought to explain longer spells of unemployment. • Why is there Structural Unemployment?
– Minimum-wage laws – Unions – Efficiency wages

Wage

Unemployment from a Wage Above the Equilibrium Level
Surplus of labor = Unemployment Labor supply

Minimum wage WE

Labor demand

0

LD

LE

LS

Quantity of Labor

• When the minimum wage is set above the level that balances supply and demand, it creates unemployment. • Efficiency wages are above-equilibrium wages paid by firms in order to increase worker productivity. • The theory of efficiency wages states that firms operate more efficiently if wages are above the equilibrium level.

A firm may prefer higher than equilibrium wages for the following reasons:
– Worker health: Better paid workers eat a better diet and thus are more productive. – Worker turnover: A higher paid worker is less likely to look for another job. – Worker quality: Higher wages attract a better pool of workers to apply for jobs. – Worker effort: Higher wages motivate workers to put forward their best effort.

 

Job search is the process by which workers find appropriate jobs given their tastes and skills. It results from the fact that it takes time for qualified individuals to be matched with appropriate jobs. This unemployment is different from the other types of unemployment. It is not caused by a wage rate higher than equilibrium. It is caused by the time spent searching for the “right” job.

Measurement of Unemployment ?
Describing Unemployment: Three Basic Questions
– How does government measure the economy’s rate of unemployment? – What problems arise in interpreting the unemployment data? – How long are the unemployed typically without work?

• Unemployment is measured by the Bureau of Labor Statistics (BLS). • It surveys 60,000 randomly selected households every month. • The survey is called the Current Population Survey. Each adult into one of three categories:
– Employed – Unemployed – Not in the labor force

Labor Force
– The labor force is the total number of workers, including both the employed and the unemployed

The unemployment rate is calculated as the percentage of the labor force that is unemployed.

The labor-force participation rate is the percentage of the adult population that is in the labor force.

Labor force participation rate e = Labor force X 100 Adult population

Employed (139.3 million) Adult Population (223.4 million) Unemployed (8.1 million)

Labor Force (147.4 million)

Not in labor force (76.0 million)

INFLATION & UNEMPLOYMENT
Inverse relationship between Inflation & Unemployment

INFLATION & UNEMPLOYMENT
Demand-Pull Factor:  AD > AS [Less unemployment]  Increase in price  Increased demand for labour  More demand for labour---Less unemployed  Bid wage rates up  Offer a bit more wage than the prevailing rates Interpretation:  Inverse relationship between unemployment & wage rate  Upward movement in wage rates is rapid & high  Conversion of unemployed labour to employed labour

Wage-Push Factor
 

Active role of trade unions Unemployment rate [lower is the u. rate higher is the
wage rate] Buoyant product market Willingness of employers to pay more wages Upward movement in wage rates----decrease inU. Rate High U. rate & low profits Less willingness for high wage rates Result--- Inverse relationship bt, U.rate & inflation

     

Inflation- Unemployment Trade-off
A certain rate of inflation can be traded for some rate of unemployment  There can be number of trade off points bt. Inflation & unemployment Policy Dilemma Loss of output:  Unemployment means loss of output expected from the employment of unemployed labour force  Loss of output= expected average productivity times number of unemployed persons

Human cost of Unemployment: M. Harvey Brenner Research Findings

One % increase in unemployment rate Deaths-38,886 Cardiovascular failures-22,240 Cirrhosis-494 Suicides-920 Homicides-648 Entry to state prisons-3,340 Admission to mental hospitals-4,227

AD, AS & PHILLIPS CURVE

Adverse shock to AS

Long-Run Phillips Curve

Expected Inflation Short-run Phillips Curve

Monetary Policy
• Monetary policy is essentially a programme of action undertaken by the monetary authorities generally the central bank, to control and regulate the supply of money with the public and the flow of credit with a view to achieving predetermined macroeconomic goals. Shaw defines monetary policy as “any conscious action undertaken by the monetary authorities to change the quantity, availability or cost…. Of money”.

Instruments of Monetary Policy
Quantitative Measures of Monetary Control
Bank Rate Open Market Operations Cash Reserve Ratio

BANK RATE • It is the rate of interest charged to a commercial bank which wants to borrow from the central bank. • How a rise in bank rate is anti-inflationary?

Open Market Operation
• It refers to purchase and sale of govt. securities in the open market by the central bank on its own initiative. A central bank can also buy and sell not merely govt. securities but also other kinds of assets ,viz., bills,bonds,gold and foreign exchange.

Variable Reserve Ratio
• It is a method by which the central bank can alter the reserve requirements of commercial banks. The commercial banks are required by law to keep a minimum proportion of their deposits as cash with the central bank. This is called the statutory minimum reserve and any amount of cash kept by the banks in excess of this is known as excess reserves. The credit creating power of the banks rests on the excess reserves.

Qualitative or Selective Credit Controls
• Fixation of Margin Requirements • Consumer credit regulation
• • •

By raising the minimum down payments By lowering the maximum maturities or repayment periods By extending the coverage of durable goods for the purpose of application of this regulation.

• Control Through Directives • Moral Suasion • Direct Controls

• Moral Suasion: Moral suasion as a form of selective credit control takes the shape of advice and direction by the central bank not to adopt unsound lending policies. The central bank can encourage banks to follow policies which are in the interest of the country. Moral suasion implies persuading the commercial banks to co-operate with the central bank in pursuing an appropriate credit policy.

Direct Action
• It refers to coercive actions taken by the central bank against commercial banks for follwing unsound credit policies.
– It may charge penal rates of discount over and above the normal bank rate.

Publicity
• It implies weekly statements of its assets and liabilities ,monthly reviews of credit and business conditions and comprehensive annual reports on its own operations, banking conditions published by the central bank. The central bank may employ this instrument of publicity in order to enable others to know its views so that it helps others to shape their policies in a proper way.

Fiscal Policy
Fiscal policy is defined as the government’s programme of taxation, expenditure and other financial operations to achieve certain national ends. Taxation: Revenue function Regulatory function

Revenue function
• In pursuance of its revenue objective, the central government and also the state governments, used their taxing powers extensively and intensively. The govt. may stretch its tax net far wide like the Govt. of India imposed five new taxes such as estate duty, wealth tax, gift tax, expenditure tax, Professional tax, etc.

…………Continued
• Regulatory Function: • Reduction of disparities in income and wealth • Restriction of consumer demand with a view to containing inflation • Shift of investment from non-essential to essential or priority sectors.

Long-run Phillips Curve

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