Inflation Dynamics

Dr.Mrutyunjay Dash

Few words about inflation… It is a process in which the general price level in a country records a sustained and appreciable increase over a period of time. The increase is significant or appreciable. Slow rate of increase [less than 2 % per annum] is considered with price stability. It has a time dimension/over a period of time generally taken as one year. It is a key indicator of the state of business environment and economic performance.

Consumer Price Index (CPI): It measures the cost of buying a standard basket of goods and services at different points of time. The standard basket is constituted to represent as closely as possible the consumption pattern of the population. It may include food and clothing, housing, entertainment, electricity, fuel, and other common items of consumption in day-to-day life. Weights are to be given to each item for calculating weighted average. How the weight is decided? Based on the proportion of the item in the total consumer expenditure on the basket. How to find out the proportion? Extensive household surveys are conducted.

Calculation of Inflation Rate based on CPI
Pdt.Group Share in Basket Expenditure Price Index 2002 2003 100 100 100 100 100 100 110 100 120 110 115 125 Weighted Index

Food 0.10 Clothing 0.05 Housing 0.25 Fuel 0.10 Transportation 0.20 Education 0.30 Total 100

11 05 30 11 23 38 118

GDP Deflator: It is the numerical factor by which GDP value at current prices discounted so that the impact of increased prices in the valuation of GDP is removed and the real GDP figure is arrived at. GDP Rs 300bn -2002 ---Rs 390bn---2003 The general price level rises -20% 2002-Base year Price index in 2002-100 ----120---2003 GDP Deflator 120/100=1.2 Real or inflation –adjusted GDP value for 2003 390/1.2=325bn In nominal terms GDP rises by 30%[300-390] But in real terms it is 8.3% [300-325] Real GDP=Nominal GDP/GDP Deflator Or GDP Deflator =Nominal GDP/Real GDP

Demand-Pull Inflation: Inflation is caused by an excess of demand or spending relative to the available supply of goods and services at existing prices. Inflationary Gap: As an excess of anticipated expenditures over available output at base prices. This inflationary gap measures the extent of excess demand. Total output: Rs 3000 crores/ available for consumption in exchange of money income. If the economy injects Rs 5000 crores. Tax paid Rs 800 crores Net disposable income:Rs 4200 crores Then the inflationary gap would be Rs 1200 crores. How the inflationary gap can be bridged?

Increased Tax: If 20%, then Net disposable income would be 4000. [5000-20 % 5000] Inflationary gap would be reduced by Rs 200 crores. Increased Saving: If 15% is saved then Net disposable income would be 4000-15% of 4000=Rs 3400 Inflationary gap would be further reduced to 34003000=400 Increased Supply: Existing supply can be increased to bridge the gap.

Inflation is a continual increase in the overall level of prices. It is an increase in average prices that lasts at least a few months. The most widely reported measurement of inflation is the consumer price index (CPI). The CPI compares the prices of a set of goods and services relative to the prices of those same goods and services in a previous month or year. Changes in the prices of those goods and services approximate changes in the overall level of prices paid by consumers. The core consumer price index is the average price of the same set of goods and services, without including food and energy prices, relative to the price of the set without food and energy prices in a previous month or year.

How the CPI is Calculated

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Assume that there are only three goods (instead of goods and services in over 200 categories in the actual calculation) included in the typical consumer's purchases and, in the base or the original year, the goods had prices of $10.00, $20.00, and $30.00. The typical consumer purchased ten of each good. In the current year, the goods' prices are $11, $24, and $33. Consumers now purchase 12, 8, and 11 of each good. The CPI for the current year would be the quantities purchased in the market basket in the base year (ten of each good) times their prices in the current year divided by the quantities purchased in the market basket in the base year times their prices in the base year. Thus [(10 x $11) + (10 x $24) + (10 x $33)] / [( 10 x $10) + (10 x $20) + (10 x $30)] = $680 / $600 = 1.133. That is, prices in the current year are 1.133 times the prices in the original year. Prices have increased on average by 13.3 percent. The quantities are the base year quantities in both the numerator and the denominator. By convention, the indexes are multiplied by 100 and reported as 113.3 instead of 1.133. The base year index simply divides the prices in the base year (times the quantities in the base year) by the prices in base year (times the quantities in the base year). The base-year index then is 1.00; or multiplied by 100 equals 100.

Causes of Inflation  Over short periods of time, inflation can be caused by increases in costs or increases in spending. Inflation resulting from an increase in aggregate demand or total spending is called demand-pull inflation . Increases in demand , particularly if production in the economy is near the full-employment level of real GDP, pull up prices. It is not just rising spending. If spending is increasing more rapidly than the capacity to produce, there will be upward pressure on prices.  Inflation can also be caused by increases in costs of major inputs used throughout the economy. This type of inflation is often described as cost-push inflation . Increases in costs push prices up. The most common recent examples are inflationary periods caused largely by increases in the price of oil. Or if employers and employees begin to expect inflation, costs and prices will begin to rise as a result.

Over longer periods of time, that is, over periods of many months or years, inflation is caused by growth in the supply of money that is above and beyond the growth in the demand for money. Inflation, in the short run and when caused by changes in demand, has an inverse relationship with unemployment. If spending is rising faster than capacity to produce, unemployment is likely to be falling and demand-pull inflation increasing. If spending is rising more slowly than capacity to produce, unemployment will be rising and there will be little demand-pull inflation. That relationship disappears when inflation is primarily caused by increases in costs. Unemployment and inflation can then rise simultaneously.

Costs of Inflation  Understanding the costs of inflation is not an easy task. There are a variety of myths about inflation. There are debates among economists about some of the more serious problems caused by inflation.  High rates of inflation mean that people and business have to take steps to protect their financial assets from inflation. The resources and time used to do so could be used to produce goods and services of value. Those goods and services given up are a true cost of inflation.  High rates of inflation discourage businesses planning and investment as inflation increases the difficulty of forecasting of prices and costs. As prices rise, people need more dollars to carry out their transactions. When more money is demanded, interest rates increase. Higher interest rates can cause investment spending to fall, as the cost of investing increases. The unpredictability associated with fluctuating interest rates makes customers less likely to sign long-term contracts as well.

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The adage "inflation hurts lenders and helps borrowers" only applies if inflation is not expected. For example, interest rates normally increase in response to anticipated inflation. As a result, the lenders receive higher interest payments, part of which is compensation for the decrease in the value of the money lent. Borrowers have to pay higher interest rates and lose any advantage they may have from repaying loans with money that is not worth as much as it was prior to the inflation. Inflation does reduce the purchasing power of money. Inflation does redistribute income. On average, individuals' incomes do increase as inflation increases. However, some peoples' wages go up faster than inflation. Other wages are slower to adjust. People on fixed incomes such as pensions or whose salaries are slow to adjust are negatively affected by unexpected inflation.

Economists define the approximate unemployment rate, at which there are not upward or downward pressures on wages and price, as full employment rate of unemployment.  If unemployment falls to level below the full employment rate, there will be upward pressure on wages and prices. If unemployment rises to a very high rate, there will downward pressure on wages and prices or wages and prices will remain steady. In the middle is a level, or more likely a range, where there is not pressure on wages and prices to rise or fall.

Economists do not know for certain what that unemployment rate is, and even if they did, it does change over time. A current consensus estimate is that the full employment rate of unemployment is currently between 4.0 and 4.7 or 4.8 percent of the labor force being unemployed. That is if unemployment were to fall to 4.0 percent of the labor force or below, there will increased upward pressure on wages and that may cause prices to begin to increase. If unemployment were 6.0 percent, workers competing for jobs may cause wages to fall. Costs of producing fall and prices may fall. Or at least not increase as rapidly.

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