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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.

Inflationis 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, profit-
push 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
Unemployment from a Wage Above the
Equilibrium Level
Wage

Labor
Surplus of labor =
supply
Unemployment
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 forcee participation rate

= Labor force X 100
Adult population
Employed
Labor Force
(139.3 million) (147.4 million)

Adult
Population
(223.4 million)
Unemployed (8.1 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