Principles of Economics

EGMC001
Inflation: Unit 14

Learning Objectives:
Understand the concept of Inflation.
Outline the reasons for occurrence of inflation.
Comprehend the impact of inflation on different sections of society.
Enumerate measures to control inflation?
Causes of Inflation: Demand Pull
Inflation
•Monetarist View: Too much money chasing too few goods.
•JM Keynes Theory of Demand Pull Inflation:

•Causes: Real factors:

1.Excessive Fiscal Deficit

2.Decrease in tax rate
3.Increase in investment
4.Increase in foreign demand
Causes of Inflation: Cost Push
Inflation
1. Wage Push Inflation - Rapidly rising money wage
•Main reason of induced wage increase:
i) Excess demand for labor
ii)Increase in the cost of living
iii)Increase in productivity per worker

2. Profit Push Inflation

Increase in profit margin called sellers or mark – up inflation/ Profit –

Push Inflation
Causes of Inflation: Other Factors

3.Other factors

International Factor: e.g. rise in price of imported raw materials, tariffs ,

restriction imposed by the foreign country High Indirect tax like excise
duties
Fall in the availability of basic inputs.
Higher administered price of inputs.
Anticipated vs. Unanticipated Inflation
 Anticipated inflation is the Expected inflation
 Suppose expected inflation rate is 5% per annum in Q3 of FY21
 Actual is 8%. It is more than 5% Expected
 If inflation > expected/ anticipated
 Sellers lose (Wage and salary earners, lenders)
 Buyers gain (Employers, borrowers)
 If inflation < expected/ anticipated
 Actual is 4%. It is less than 5% Expected
 Sellers gain (Wage and salary earners)
 Buyers lose (Employers, borrowers)
Anticipated Inflation

Perfectly anticipated inflation.

Imperfectly anticipated inflation/Unanticipated inflation.

•Perfectly Anticipated Inflation

•Inflation can be predicted.

•Cost of anticipated Inflation:

 Shoe leather cost
 Menu cost
Unanticipated Inflation
•Inflation rate is higher or lower than that has been expected.

•Cost of unanticipated Inflation

During decision making:
•During inflation, contracts are made in nominal terms
• Debtor loses , Creditor gains

Wealth Redistribution
•During inflation, real value of assets fixed. in nominal terms falls,
•Purchasing power of all claims or assets fixed in money terms
decreases.
Effect of Inflation
Pensioner loses: Reason: gets a fixed pension.
If inflation is more the expected: Debtors (borrowers) gain, Creditors (holders or bond,
lenders) lose .
•Example
•Land mortgaged for 30 years
•At rate of interest - 6% per year
•Expected inflation rate of 4%.
•Expected Real Return : 2% (6 - 4%)
•Over 30 years inflation rate averaged 5%
•Real Return = 1% (6 – 5%).
•The debtor benefited and the creditor lost.

Wages are fixed in nominal terms. Wage earners lose

Increase in Tax liabilities
Old people are more vulnerable to inflation than the young one.
 Index to measure Inflation

• Price index shows the average price of products.

• An Index number compares the value of some variable in a particular year to its value
in base year or reference year

• Wholesale Price Index (WPI) measures the average change in prices of goods traded in
wholesale market. It is available on a weekly basis with a time lag of only two weeks
(i.e. it reflects two weeks back inflation rate). Used in India as an index since 1902.
• Consumer Price Index (CPI) measures the retail price of selected goods & services
purchased by households. It is a weighted index (i.e. some commodities are more
important than others in determining price changes). Used in developed countries
since 1970s. The CPI is published on a monthly basis.
• Producer Price Index (PPI) measures the change in the average of sale prices for all
goods and services at the prices prior to the retail level.  In general terms, it means
prices of goods as they are sold by the producers to the wholesalers.

• WPI CPI(IW) CPI(AL) CPI(RL) CPI(UNME) (Jan. 1980 to Dec.2010)

 CPI & WPI in India
• The CPI-IW series on was introduced with base 1960,
then revised in 1982, 1999-2000, 2001, 2004-05,
2012. Has 448 items in rural basket and 460 in urban
basket. Data is released by Central Statistics Office
(Ministry of Statistics and Programme
Implementation) on monthly basis.
• Since the introduction WPI, revisions have taken place
introducing the new base years, viz., 1952-53, 1961-
62, 1970-71, 1981-82, 1993-94, 2004-05, 2011-12.
Has 697 items in the commodity basket. Data is
released by Office of Economic Advisor (Ministry of
Commerce and Industry).
MEASURES TO CONTROL INFLATION
1. Monetary Policy - Central bank control the money supply with both
quantitative and qualitative techniques.
•Chief quantitative instruments : Rise in Bank Rate, Sale of government
bonds in open market or a Rise reserve ratio.
• Main qualitative technique : Moral Suasion, Direct Action, Rationing of
Credit, Fixation of Margin Requirements and Differential Rate of Interests.
2.Fiscal Policy - Controlling public expenditure and government borrowings.
• High tax on luxury goods.
• Encourage savings
• Ensure no tax evasion.
• Reduce Indirect tax.
MEASURES TO CONTROL INFLATION
3. Direct Price Controls - Fixing price ceiling
 Rationing of goods in short supply
 Wage freeze

4. Indexation
•A bond is indexed when either interest or principal or both are adjusted for
inflation. The holder of the bond will receive interest equal to real interest rate
•Example
• Inflation rate is 18%
• Bond holder will receive  21%
• In this way, the bond holders are compensated for inflation.
INDEXATION
•Effect of Wage Indexation :
• Prevents real wages from falling.
•Indexation reduces cost of unanticipated inflation but Government is
reluctant to index
•Reasons
1.Indexation of wages: many labor contracts include automatic Cost-Of-
Living Adjustment (COLA) provisions. COLA provisions link increase in
the money wage to the increase in the price level which allows workers to
recover purchasing power lost through price rise.
2.Indexation maintain the real wages by maintaining a balance between
advantages of tong-term Wage contracts and interest of workers and firms.
THANKS!
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