Inflation

Definition
 Inflation is a state of persistent rise in prices
 Note:
 this does not mean that all prices must be
rising during a period of inflation –some
prices may even be falling; but the general
trend must be upward
 It is a process of rising prices & not a state
of high prices
Measuring Inflation

 Inflation is the rate of change in the

price level
 If the price level in the current year is
‘P1’ & in the previous year is ‘Po’,
then inflation for the current year is

(P1 – Po)/ Po x 100

Suppressed & Open Inflation
 Inflation is a state of disequilibrium at which
aggregate demand exceeds aggregate
supply at the existing prices, causing a rise
in general price level.
 But sometimes an inflationary situation does
not exhibit increases in the price level, if
price controls & rationing are introduced by
the government. Such a situation is called
suppressed inflation
 As soon as these controls are
withdrawn, prices start rising & inflation
becomes an open inflation
Causes (and theories) of
inflation
 Some economists (both Keynes & Classical
economists) assert that inflation is caused
by increase in demand in a situation of
given aggregate supply →demand
inflation
 According to classical economists, the
increase in demand is caused by an
increase in money supply
 According to Keynes it is increase in total
spending & not in money supply which is
responsible
Causes (and theories) of
inflation contd..
 A group of economists contend that
inflation is caused by an increase in
cost of production that results in a fall
in aggregate supply →cost-push
inflation
 Others believe that inflation results
from an amalgamation of demand &
cost elements → mixed inflation
Causes (and theories) of
inflation contd..
 It is also argued that inflation may be
the result of downward inflexibility of
prices, rigidity in the intersectoral
relations & emergence of excess
demand in some sectors, even if
aggregate demand equals aggregate
supply in the economy as a whole→
structural/ sectoral demand shift
inflation
Causes (and theories) of
inflation contd..
 Ackley shows that inconsistent price &
wage mark-ups can generate an endless
wage-price spiral in the absence of increase
in productivity of labour. Prices are fixed by
applying some standard mark-ups over the
costs of direct materials & labour & wages
are also administered on the basis of a fixed
mark-up over the cost of living of the
working class. The inflation generated by
the mark-ups applied by business & by
labour is called mark-up inflation
Causes (and theories) of
inflation contd..
 Ackley’s theory of mark-up inflation is based
on the concept of income inflation
developed by Duesenberry & others.
 This inflation arises from efforts of different
economic groups to increase or maintain
their real incomes by raising their monetary
incomes during the periods of full
employment. With output not being raised if
one group tries to raise its share while the
other groups attempt to maintain their real
income, then prices tend to rise
The two main theories of
inflation
 The Demand-Pull inflation → originates
from demand side of the economy
If aggregate monetary demand for domestic
output exceeds the value of the full employment
output at current prices, then the price level will
rise (fig text book)
 The Cost-Push inflation → originates
from supply side of the economy
It is caused by rising cost of production
independently of the excess demand in the
market (fig text book)
 The Demand-Pull inflation
-view of Classical Economists
 The analysis of this begins with the
Classical quantity theory of money
which states that price level
depends directly & proportionately
on the supply of money –
Ms ↑→excess demand for output at existing prices
→price level of the economy ↑ (given full employment)
 The Demand-Pull inflation
-Keynesian view
 An economy might experience demand inflation even when quantity
of money remains constant
Argument

With Ms constant if AD ↑ → prices ↑ (given full employment)

→ r ↑ (given Ms) → L2(r) ↓→ L1(Y) ↑
As r ↑ → I (r) ↓. But it cannot remove the excess demand unless L2(r) = 0
Thus, price level might rise even without rise in Ms

 Moreover, if Ms ↑ then P remains unaffected if the additional Ms

is absorbed in L2 (r) or if there is underemployment equilibrium
to start with → tie between quantity of money & level of
aggregate demand is broken
Keynes’ inflationary gap

 If total expenditure in the economy

exceeds the value of full-employment
level of output at current prices, then
the gap between the two is the
inflationary gap
 It is so called because this gap
causes price to rise
Figure to explain inflationary
gap
AS (C+I+G)’
A
Real Expenditure

C+I+G

(C+I + G)’’
C

Yf Ym Y
Explanation of the figure
 Let Yf be the full employment level of output at current
prices
 If AD curve in the economy is given by (C+ I + G) then
equilibrium occurs at full employment level
 If AD curve shifts to (C+ I + G)’ for some reason AD >
AS & there is an inflationary gap in the product market.
The size of this gap is AB (in fig) which is equal to AD
– AS at full employment
 If AD curve shifts to (C+ I + G)’’ for some reason AD <
AS & there is an deflationary gap of the magnitude BC
in the product market.
Explanation of inflationary
gap
 In the figure AD = C + I + G = total
expenditure on the aggregate output of the
nation. An upward shift in any one of these
components or a combination of these three
in a situation of full employment can
produce inflationary gap
 If foreign trade is added to (C + I + G) then
an increase in net exports (X – M) can also
produce such a gap
Facts about inflationary gap
 Any increase in autonomous expenditure in a situation
of full employment can produce inflationary gap at
current prices → P ↑

 Inflation continues as long as the gap between the real

planned expenditure & the full employment level of
real output exists

 The price rise cannot eliminate this gap because real

expenditure is independent of the price level

 So inflation continues without limit, till the indirect

effects of rising prices are sufficient to eliminate the
gap
Some of the Indirect Effects of
price rise on inflationary gap
 Ms remaining constant as P↑ M/P↓ → r↑→ I ↓ →
inflationary gap ↓

 Inflationary process leads to a redistribution of

income against fixed income groups & in favour of
the profit earners. If MPC of former > MPC of latter,
then aggregate consumption ↓ → inflationary gap ↓

 If foreign trade is considered then higher domestic

prices → M ↑ & X ↓ → (X – M) ↓ → inflationary gap ↓

 As P ↑→ real value of cash balances ↓ → C ↓. This is

called the real balance effect or Pigou effect
Limitations of Keynesian
inflationary gap
 Inflationary gap analysis is essentially static but
inflation is a dynamic process.

 Inflationary gap analysis contributes nothing

directly to the analysis of the time rate of inflation

 Inflationary gap analysis cannot explain the

inflationary price rise that occurs when there
considerable unemployment in the economy

 Yf is assumed to be fixed at a certain level. This is

not always true. As P↑→ W/P ↓→ N & real output Y
↑. If however, P↑ → equi proportionate W ↑ → W/P
comes back to original level & N & Y remains fixed
 The Cost-Push inflation
 In modern economy wages are not strictly market-determined
prices, but are administered prices → wages can rise even if
there is no excess demand for labour or even there is
unemployment

 If rate of increase in wage rate > rate of increase in productivity,

the wage cost per unit of output increases

 The employers now are less willing to supply goods at the

existing price level → supply of goods ↓

 Fall in supply is not accompanied by a fall in demand → product

prices rise & this rise continues till the original W/P restored

 Note: when W ↑→ employers actually raise price instead of

lowering supply & raising prices as a consequence. This is
spontaneous inflation
Wage-Price Spiral
 When W ↑ → P ↑ → cost of living of the
workers ↑
 Again when W ↑ → P ↑ → real wage rate ↓
 Both the consequences lead the trade
unions to claim a higher money wage
 If this claim is granted by employers, there
is a second round price inflation caused by
the cost factor
 Thus, there is a wage-price spiral

W↑→P↑→W↑→P↑
Types of Cost Push Inflation
 Wage -push inflation→ cost inflation stemming from
trade union pressure on wage rate
 Profit - push inflation→ inflation caused by
monopolistic practices of the managers of firms who
increase prices even in the absence of increase in
demand or rising costs
 Inflation if there is excess demand in some sectors
without no excess demand in other sectors →
excess demand in some sectors→ P↑→ excess
demand for labour → W ↑ here → trade union in other
sectors will demand W ↑. If this claim is granted W ↑ in
these sectors with no excess demand → cost inflation
Objections to cost inflation
 A continuing cost inflation is virtually impossible unless
the monetary authorities pursue an expansionary
monetary policy

 Explanation: if a rise in general level of wages &

prices is not accompanied by a proportionate increase
in Ms → real aggregate demand ↓ → unemployment
→ end to inflationary wage rise

 Note: the level of unemployment sufficient to eliminate

the inflationary wage increase should be fairly high
The Philips Curve

 Done in separate ppt

Concepts of Deflation,
Disinflation,Reflation &
Stagflation
 Deflation – is a condition of falling prices on
account of insufficient effective demand.
Results in a continuous fall in level of
economic activity & growing unemployment
 Disinflation – it is a process of lowering
costs & prices when they are excessively
high. Brings down inflationary trend in
prices without causing unemployment
Concepts of Deflation,
Disinflation, Reflation &
Stagflation
 Reflation – is a moderate degree of inflation
that is deliberately undertaken to relieve
depression

 Stagflation – a situation in which a high rate

of inflation prevails simultaneously with a
high rate of unemployment or stagnant
economic condition. It is a combination of
inflation & stagnation
Effects of inflation

 Effects on Production
 Effects on Income distribution

 Other Effects

 Refer handout
Control of Inflation

 Monetary Measures
 Fiscal Measures

 Other Measures

 Refer handout
Inflation & Economic
Development
 Refer handout
Inflation in India

 Assignment – refer text