Inflation

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 Inflation
• General rise in the level of prices.
• Inflation reduces the “purchasing power” of money. Each unit of money buys
fewer goods and services.
• Why does it occur? : demand supply imbalances.

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26-2
Hue and cry over onion prices

•During the period of December 2010 to January 2011, it seemed as if

all of India was shedding tears over onion prices, which had suddenly
registered a sharp rise.
•The average price, which was running around ₹ 30/- in the first week
of December 2010, had shot to above ₹ 50/- by the fourth week of
December. Some centres even recorded a much higher price, with a
peak of around ₹ 85/- in Gurgaon, a city in Haryana state in India.
•Consumers across all income strata reduced their onion consumption.
For some, in spite of a reduction in their consumption, the expenditure
on onions almost doubled. Even restaurant owners substituted onions
with shredded cabbage, carrots and pumpkin in their dishes.
•There was a hue and cry over the onion prices across the country,
with consumer forums blaming the government for not taking action to
curb onion prices.

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• The government suspected hoarding by the traders to be the main
culprit behind the soaring prices and warned them to release onions
from their stocks. It imposed a ceiling on stock holding and issued a
search order. The traders argued, on the contrary, that a natural
supply-demand gap was the main reason for the soaring prices.
• There was total chaos, with all the stakeholders blaming each other
for the situation and with no clear explanation of what was wrong.
Was the shortage due to a natural supply shock? Was it a result of
an artificially created shortage? Was it an outcome of wrong
government policies? Or was it simply the result of changes in
demand conditions?

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Onion prices : Supply side of the market

•India is the second largest producer of onions in the world. Maharashtra state
is the largest producer of onions in the country, accounting for 41% of the area
harvested and 38% of production. Within Maharashtra, Nashik district
contributes 35 to 40% of the state’s production. Lasalgoan in Nashik is the
biggest onion market in the country; hence, this market largely determines the
prices in the country. The other major onion – producing states are Karnataka,
Gujarat, Bihar, Madhya Pradesh and Rajasthan.
•There are three main seasons for onion production: Kharif (monsoon), late
Kharif and Rabi (winter). The rabi crop is the major crop, contributing 70% of
the total onion production. Some of the rabi varieties have excellent storage
quality of about four to six months.
•Onions are a commercial crop. The estimated cost of onion cultivation varies
from ₹ 79,590 per ha to ₹ 87,900 per ha which is comparatively smaller than
the cost of cultivating other crops. Apart from suitability of soil for onion
production, the lower cost of cultivation also attracts many small and medium
famers to this crop.

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• In spite of India being a major producer of onions, its productivity is one of
the lowest amongst the major growing countries. Apart from lower yield, the
crop is also subject to excessive post – harvest storage losses in the event
of adverse weather conditions, and pest and disease infestation, which
affect the economic viability of the crop.
• Unlike wheat, rice and other food grains, onions are a highly perishable
commodity; hence they cannot be stored for long periods. Also the
storability of onions depends on their variety and the harvesting period.
Kharif crops cannot be stored for more than a month, whereas Rabi crops
can be stored for four to six months. However, conventional methods of
onion storage can result in large losses, even in rabi crops, due to weight
loss, sprouting and rotting of bulbs.
• To overcome these losses, the country requires scientifically constructed
cold storage facilities, which, as per the Maharashtra State Agricultural
Marketing Board (online), can cost around Rs. 6,000/- per mt storage
capacity (excluding the cost of land). The country requires an additional
storage capacity of around 12 lakh tonnes and modernization of 8 lakh
tonnes capacity of existing units (National Bank of Agriculture and Rural
Development, 2000).

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• Because of the lack of proper storage facilities, most farmers bring
onions directly to the market and unload their entire stock within a
month of harvest. As a consequence of the glut in the market, the
prices are very low in the months of April and May, which adversely
affects the earnings of farmers. Wholesale traders store onions, but
in a traditional and unscientific manner; hence, the supply becomes
limited in the subsequent months and prices rise rapidly and
steeply, leading to dissatisfaction among consumers as well as
farmers. Consumers feel the pinch of the high prices because they
are accustomed to using the onions on a daily basis, whereas the
farmers’ agony is due to poor yield, lack of storage facilities and low
prices. Sometimes, they are not able to recover even the cost of
cultivation. In the absence of proper storage facilities, prices
fluctuate widely, which creates uncertainty in the environment and
hampers cultivation decisions in the ensuing onion –growing
season.

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 Demand side of the market

• Except for a few communities, onions are used in the day-to-day

cooking of both the poor and the rich across the country. Apart from
the households, restaurants are also major users . It is used not
only raw, but also in processed form-fried, boiled baked, dried and
powdered as well as in curries, soups and pickles.

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 Types of Inflation
Demand-Pull inflation
• Excess spending relative to economy’s capacity to produce output.
• ‘Too much spending on too few goods’.
• ‘Too much money chasing too few goods’.
• MV=PT
•Triggered by demand factors e.g. increase in incomes, increase in nominal money
supply.
•AD = total level of spending in the economy = C+I+G+NX= shifts to the right of the
original.
•Typically associated with a booming economy.
•Unique identification of demand pull inflation is: both Y and P will rise

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LO3 26-9
Cost-Push inflation
CC
•Associated with continuing rises in costs. Per-unit input costs rise.
•Per unit production cost is the average cost of producing a particular level of output. Per
unit production cost = total input cost
--------------------
units of output
•Costs of production rise independently of aggregate demand.

•Rising per unit production costs squeeze profits and reduce the amount of output firms are
willing to supply at the existing price level. They will also pass on part of the rising cost to
consumers in the form of increased prices. Result is that economy’s supply of goods and
services declines and price level rises. AS curve shifts to the left of the original.
•Such shifts occur when costs of production rise independently of aggregate demand .
•Effect on output and employment is the opposite of demand-pull inflation. With demand pull
inflation, output and employment rise. With cost-push inflation, output and employment fall.
•Unique feature of cost-push inflation: P rises but Y falls

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 Cost push inflation

Rises in costs originate from a number of sources:

•Wage push inflation : when trade unions push up wages independently of the demand for
labor.
•Profit push inflation : firms use monopoly power to make bigger profits by pushing up prices
independently of consumer demand.
•Import price push inflation : when import prices rise independently of the level of AD. Eg when
OPEC quadrupled the price of oil in 1973-74.
•Tax push inflation : increased taxation adds to the cost of living.
•Exhaustion of natural resources eg gradual running down of oil supply, pollution of seas
leading to decline in income for nations with large fishing industries. Bad harvest is also an
example.

 However, demand or, supply factors are convenient starting points. Beyond that
distinction gets blurred

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 Complexities

• The real world is more complex than the distinction between

demand pull and cost push.
• Suppose in a fully employed economy, a significant amount of
spending occurs. This will cause demand pull inflation.
• As the demand pull stimulus works its way through various product
and resource markets, individual firms find their wage costs,
material costs, fuel prices rising.
• As production costs rise, prices rise.
• The origin of inflation is demand pull. It may appear as cost push.

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 Inflation in India

• Structural in nature: certain industries face rising demand and

others experience falling demand. If prices and wages are
rising in the rising industries and prices and wages are
inflexible downward in the declining (contracting) industries,
then overall prices and wages will increase.
Rapid structural change in the economy can lead to structural
unemployment and increased structural inflation.
• Expectations : workers and firms take into account the
expected rate of inflation when taking decisions.
Higher the expected rate of inflation- higher level of pay
settlement – higher price rise – resulting actual rate of inflation
higher.
• Bottlenecks : infrastructure bottlenecks
• Policies such as APMC which create middlemen

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 Too many layers

Farmer Trader Agent

Rs. 12-15 Rs. 25 Rs. 40

Consumer Large wholesaler

Retailer
Rs. 70-80 retailer Rs. 50
Rs. 60
Rs. 55

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 Policies to tackle inflation
• Demand side policies: designed to affect AD.
1. Fiscal policy : increase taxes and reduce government expenditure
(contractionary or deflationary fiscal policy) reduce AD. Increase
government expenditure and reduce taxes to boost AD is known as
expansionary or reflationary fiscal policy.
2. Monetary policy : altering supply of money or manipulating the rate of
interest. Eg contractionary monetary policy involves reducing the
money supply or increasing interest rate. Reduced money supply will
make less money available for spending. Increased interest rate will
make borrowing more expensive. AD will decrease.
• Supply side polices : designed to reduce the rate of increase in costs.
Restrain monopoly influence on prices and incomes through restricting trade
union activities, policies to restrict mergers and takeovers. Design policies to
increase productivity such as tax incentives, encourage R&D, training of
labor, grants to firms to upgrade equipment .

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 Core Inflation
• Core inflation
• Without food and energy goods in CPI basket
• Focuses on more stable prices
• Core inflation is inflation minus prices of agricultural products and
energy prices

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 Redistribution Effects of Inflation
• Nominal income
• Unadjusted for inflation
• Real income
• Nominal income adjusted for inflation
• Anticipated vs. unanticipated income

Percentage Percentage Percentage

change in  change in change in
price level
real income
= nominal income

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 Costs of inflation
Who is hurt by inflation? : purchasing power is reduced
•Fixed-income receivers as real incomes fall
•Savers - Value of accumulated savings deteriorates
•Creditors - Lenders get paid back in “cheaper dollars”
Who gains from inflation?
•Business class – profit earning
•Debtor – pays back less
There is redistribution of income. : away from fixed income groups and those in
weak bargaining position in favor of those who own asset (property) that rise in
value during periods of inflation.
Uncertainty and lack of investment
Imports rise and exports fall and CAD will deteriorate.

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 Costs of Inflation (Roy)
Distribution Costs
--penalizes people with fixed income
--brings down the value of monetary assets
--lender looses, debtor gains
-- Redistributes income in favor of upper classes away from
middle and lower classes – growing inequality in distribution
of income
Output Effects
-- brings down the yields on financial assets
-- distorts saving-investment behavior
-- results in hoarding and capital flight
-- reduces the real value of tax collections
-- builds ‘inflationary expectations’
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 PRICE INDICES
Price indices measure the changes in the overall price level
which affect the purchasing power of goods and services in
general. There are three types of Price indices:

 Consumer Price Index (CPI)

 Wholesale Price Index (WPI)
 GDP Deflator

Let us begin with Consumer Price index (CPI)

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 Measurement: Consumer Price Index

Price of the Most Recent Market

CPI = Basket in the Particular Year x
100
Price estimate of the Market
Basket in base year

The CPI is arbitrarily set at 100 in base year .

207.3 - 201.6
Rate of = x 100 = 2.8%
increase
in CPI 201.6

The rate of inflation is equal to the percentage growth of CPI from

one year to the next. Eg CPI was 207.3 in 2007, up from 201.6 in
2006. So the rate of inflation is calculated as above.

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LO2 26-21
 HOW TO MEASURE PRICES(CPI)

Item Quantity Prices Weights Prices 5/3x100

(1) 1980/81 1980/81 1980/81 2000/01
(2) (3) (4) (5) (6)

Rice 15 kg Rs 10/kg 0.16 Rs 15/kg 150

Wheat 10 kg Rs 8/kg 0.09 Rs 10/kg 125

Milk 40 ltrs Rs5/ltr 0.22 Rs 7/ltr 140

Cloth 10 mtrs Rs 8/mtr 0.09 Rs.10/mt 125

House Two room Rs 200 0.44 Rs 400 200

Rice of rice has gone up by 50%, wheat 25%, milk 40% and so on

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 Preparing the index (CPI)

• Weights of each item in the basket in the base year is determined

by finding out the share of expenditure on that item in total
expenditure.
• Total expenditure in this basket is Rs. 910.
• Weight of rice is rs. 150/910 = 0.16
• The sum of weights must add to 1.
• A weighted average is used to construct an index.
• So, each item’s index in the current period (column 6) is multiplied
by its weight. Add all to obtain a weighted average for the entire
basket of goods.
• This gives an index of 165.3.
• This means that between the base year and current year, cost of the
basket of goods has gone up by 65.3%.
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 CPI Vs WPI
CPI (IW) WPI

Commodity Groups Weights Commodity Groups Weights

Food Group 46.2 Primary Food 15.40

Pan Supari, tobacco etc 2.3 Manufactured Food 11.54

Fuel & Light 6.4 Other Primary Goods 6.63

Housing 15.3 Other Manufactured 52.20

Goods
Clothing 6.6 Fuel & Power 14.23

Miscellaneous Group 23.3 All 100.00

Total 100.00

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Price Indices: A Comparison
CPI WPI GDP Deflator
Basis: Basis: Basis:
∑PtxQo ∑PtxQo ∑PtxQt
∑PoxQo ∑PoxQo ∑PoxQt

Prices: Prices: Prices:

Retail Wholesale Market

Basket: Basket: Basket:

Consumption goods & services Only goods; no services Domestically produced final
goods & services

Weights: Weights: Weights:

Fixed Fixed Not Fixed

Lag: Lag: Lag:

1 month 2 weeks 1 year

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 Deflation
• Deflation – when the rate of inflation is negative.
• CPI falls from 215.3 in 2008 to 214.5 in 2009. the rate of
inflation for 2009 was -0.4. Such price declines are
known as deflation.
• Mixed effects
• Incomes may rise
• Fixed assets values may fall
• For fixed-rate mortgages, real debt declines

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LO3 26-26
 Does Inflation Affect Output?
• Cost-Push inflation
• Reduces real output
• Redistributes a decreased level of real income
• Demand-Pull inflation
• One view is that zero inflation is best
• Another view is that mild inflation is best

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LO3 26-27
 Hyperinflation
• Extraordinarily rapid inflation
• Devastates an economy
• Businesses don’t know what to charge
• Consumers don’t know what to pay
• Money becomes worthless
• Zimbabwe’s 14.9 billion percent inflation in 2008

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LO3 26-28
 Nominal and Real Interest Rates

• Real interest rate

• Rates adjusted for inflation
• Nominal interest rates minus inflation rate
• Nominal interest rate
• Rates not adjusted for inflation

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LO3 26-29
 Anticipated Inflation

6%
11% = + Inflation
Premium
5%
Nominal Real
Interest Interest
Rate Rate

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LO3 26-30