Khushboo P Shah Farheen Mehdi Senthilvel

• This is the process by which the price level rises and money loses value. • There are two kinds of inflation: • a) Demand pull • b) Cost push

• Deflation is a decrease in the general price level of goods and services. • It occurs when the annual inflation rate falls below 0% (a negative inflation rate). This should not be confused with disinflation, a slow-down in the inflation rate (i.e. when inflation declines to lower levels). • Inflation reduces the real value of money over time; conversely, deflation increases the real value of money – the currency of a national or regional economy. This allows one to buy more goods with the same amount of money over time.

Purchasing Power
• Purchasing power is the number of goods/services that can be purchased with a unit of currency. • If one's money income stays the same, but the price level increases, the purchasing power of that income falls. • Inflation does not always imply falling purchasing power of one's money income since it may rise faster than the price level. A higher real income means a higher purchasing power since real income refers to the income adjusted for inflation.

Demand pull inflation • Demand pull inflation may be due to : a)Increase in money supply b)Increase in government purchases c)Increase in exports • .

c) .Cost push Inflation • Cost push inflation may arise because of : a)Increase in money wage rates b)Increase in money prices of raw materials.

M to compensate for the 10% rise in . • Eg: if a worker correctly anticipates the rate of inflation in a particular year to be equal to 10% and if his present wage rate is Rs.P. he can enter into a contract with the employer for his money wage rate per month next year be raised by 10% so that next year he gets Rs.5000/.P.M. then people take steps to make suitable adjustments in their contracts to avoid the adverse effects which inflation could bring to them.Anticipated Versus Unanticipated Inflation • If the rate of inflation is anticipated.5500/.

The significant effect of unanticipated inflation is that it arbitrarily redistributes wealth among individuals.1000 bearing 8% nominal interest rate in 1996 will find that Rs. A person who bought government bond of 10 years maturely with a face value of Rs. . • It effects individuals who retire on pensions fixed in rupee terms.Anticipated Versus Unanticipated Inflation • Unanticipated inflation has a more substantial and harmful effect as compared to the cost of anticipated inflation rate. • Eg: Between 1995 and 2006 price level in India rose by about 100%.1000 he gets back in 2006 has far less value than when he purchased the bond in 1996.

Effects of unanticipated inflation • Effect on • Effect on wealth • Effect on • Effect on real income distribution of income and output long-run economic growth .

• Price increases are so out of control that the concept of inflation is meaningless. • By some estimates. the average price level increased by a factor of 20 . • There is no precise numerical definition to hyperinflation. • The most famous example of hyperinflation occurred in Germany between January 1922 and November 1923.Hyper inflation • Extremely rapid or out of control inflation.

000 (b) Hungary Price level 10.000 1.000 100 Money supply 1921 1922 1923 1924 1925 1921 1922 1923 1924 1925 Copyright © 2004 South-Western . 1921 = 100) 100.Money and Prices During Hyperinflations (a) Austria Index (Jan.000 10.000 1.000 100 Price level Money supply Index (July 1921 = 100) 100.

when world oil prices rose dramatically. •    . • At least some central banks have expressed concern over inflation even as the global economy seems to be slowing down. fueling sharp inflation in developed countries.Stagflation • A condition of slow economic growth and relatively high unemployment accompanied by inflation. • This happened to a great extent during the 1970s.

and the Equilibrium Price Level Value of Money. Money Demand.33 12 / A 2 Equilibrium price level Equilibrium value of money 14 / 4 Money demand (Low) 0 Quantity fixed by the Fed Quantity of Money (High) Copyright © 2004 South-Western .Money Supply. P 1 (Low) 3 4 / 1. 1/P (High) 1 Money supply Price Level.

12 / 2 B Money demand 14 / 4 (Low) 0 M1 M2 Quantity of Money (High) Copyright © 2004 South-Western . decreases the value of money . .33 3. /4 A 1. 1/P (High) 1 MS1 MS2 Price Level. and increases the price level. . . .The Effects of Excess Money Supply Value of Money. . An increase in the money supply . . . . . . (Low) 3 2. P 1 1.

financing the deficit of money by printing • Sudden increase in production costs • Significant increase in the level of energy resources • Faulty structure of the economy • Exported goods far exceeding imported ones • Too many monopolies in the economy • Imported inflation • .REASONS OF INFLATION • Lack of balance in the country’s budget • Financial problems.

CONSEQUENCES OF INFLATION • Decrease in value of money which are not deposited in the bank • Shoe-leather costs of inflation • Menu costs of inflation • Difficulties in comparing the prices when the level of inflation high and changes over certain time • Problems with financial planning • Fiscal drag • .

Inflation Rate and Interest – Fisher Effect • Nominal Interest Rate: The stated interest rate which a bank provides to its depositers on the saving account and the fixed deposits of different maturity periods.: If your bank gives you 8% interest rate on the FD of one year then 8% is the nominal interest rate. • . • Eg.

Inflation Rate and Interest – Fisher Effect • Real Interest Rate: How fast the purchasing power of your deposits in the bank increases over a year. • The rate of increase in purchasing power of your money deposits over time depends not only on the nominal interest rate but also on the inflation rate that takes place over time. • Therefore in this case 8% .A and the inflation rate is 5% then 5% of purchasing power of nominal interest rate has been wiped out by inflation. • Eg: if the nominal interest rate on an FD is 8% P.5% = 3% is the increase in purchasing power of your .

∏ Where: r= real interest rate i= nominal interest rate ∏= inflation rate   i= r + ∏  . • Thus relationship among the real rate of interest.Inflation Rate and Interest – Fisher Effect • Thus real interest rate can be obtained from nominal interest rate by adjusting for inflation rate that takes place in a year. nominal rate of interest and inflation rate can be stated as under:  r= i .

This equation is called the fisher equation.   .Fisher Equation i= r + ∏ • The above equation shows that change in i can occur due to the reasons: a)changes in real interest rate b)Changes in rate of inflation.

• There is a higher growth of money supply hence inflation rate rises to 6. therefore following the equation i becomes 9. the higher will be the nominal interest rate.Fisher Effect • If central bank increases the money supply. • Adjustments to nominal rate to changes in inflation rate is called fisher effect. • The higher the rate of inflation. it will cause the inflation rate to rise which will cause the nominal interest rate to rise • Rise in inflation causes rise in nominal interest rate . • Eg: bank’s rate of interest = 8. inflation rate = 5 then real interest rate = 3. . real interest rate remaining unchanged.

the only major country that uses WPI (1st published in 1902) • What is WPI? • The WPI number is a weekly measure of wholesale price movement for the economy   .How is inflation measured? • WPI (Wholesale Price Index) • India.

WPI.The Indian Example • Indian government constructed its present WPI way back in 1993-94 (1993-94 series replacing 1981-82 bases) by making a basket of 435 commodities • Laspeyres formula employed • The 100-point index is subdivided into three groups  .

02 % • Food Articles. Light & Lubricants (19 items)  . Minerals • II.14. Fuel.22.23 % • III. Primary Articles (98 items). Non-Food Articles.75 % • Food Products • Beverages.• Major Groups: • I.63. Manufactured Products (318 items)  . Tobacco & Tobacco Products • Textiles… etc . Power.

• The Office of the Economic Advisor (OEA) compile the WPI numbers on weekly basis • On Friday inflation figures are announced • The working group on WPI. has worked out a new index • The base year of the new index : 2000-01 • The basket of commodities.around . headed by Planning Commission member Abhijit Sen.

  GDP Deflator = (Nominal GDP/Real GDP)*100 .GDP Deflator • Refers to the Index of the average price of goods and services produced in the economy.

• CPI for Agricultural Labourers / Rural Labourers (CPI -AL/RL). • CPI for Urban Non-Manual Employees (CPIUNME) • Published on a monthly basis .Consumer Price Index (CPI) • A measure of the average price of consumer goods and services purchased by households (1st published in 1970) • CPI indicates the change in the purchasing power of the consumer • CPI for Industrial Workers (CPI-IW).

• Producer Price Index (PPI) • Measures average changes in prices received by domestic producers for their output • Service Price Index (SPI) • The share of the service sector in the (GDP) gone up from 28% (1950) to over 50% • Necessitates representation of Services in the price index • .

Discussion question • Why is inflation bad? .

• If the value of money varies unpredictably over time. the quantity of goods and services that money will buy will also fluctuate unpredictably. • Unanticipated inflation leads to : a)Redistribution of income. borrowers .• Unanticipated inflation is bad because it makes the economy behave like a giant casino. • Resources are also diverted from productive activities to forecasting inflation. • Gains and losses occur because of unpredictable changes in the value of money.

The Economic Impacts of Inflation • Redistribution of Income and wealth among different groups • Distortion in relative prices and outputs of different goods. . or sometimes in output and employment for the economy as a whole.

THE COSTS OF INFLATION • • • • •  Shoe leather costs Menu costs Tax distortions Confusion and inconvenience Arbitrary redistribution of wealth .

• Less cash requires more frequent trips to the bank to withdraw money from interest-bearing accounts. • . • Inflation reduces the real value of money. so people have an incentive to minimize their cash holdings.Shoe leather costs • Shoe leather costs are the resources wasted when inflation encourages people to reduce their money holdings.

it is necessary to update price lists and other posted prices. • During inflationary times.Menu costs • Menu costs are the costs of adjusting prices. • This is a resource-consuming process that takes away from other productive activities. .

making saving less attractive. .Inflation .Induced Tax Distortion • The income tax treats the nominal interest earned on savings as income. • The after-tax real interest rate falls. even though part of the nominal interest rate merely compensates for inflation.

public expenditure Direct Control-Fixing ceiling prices of the products. Open Market operations. Rationing. Miscellaneous methods-Controlling Wages.Bank rate policies. Reserve requirement ratios Fiscal policy-taxation. public borrowing. Controlling population growth .Taming Inflation Monetary policy.

(Low) 3 2. P 1 1. . . decreases the value of money . . and increases the price level. . . . .33 3. .The Effects of Monetary Injection Value of Money. An increase in the money supply . . 12 / 2 B Money demand 14 / 4 (Low) 0 M1 M2 Quantity of Money (High) Copyright © 2004 South-Western . 1/P (High) 1 MS1 MS2 Price Level. . /4 A 1.

Problem   Calculate the rate of interest.7 136.3 144.2 152. Year 1985 1986 Price 107.6 113.3 124 130.4 1995 .6 109.6 118.5 148.2 140.

6-107.   Rate of inflation= (P1-P0)/P0 X 100 ROI = (109.858  .6 X 100  = 1.6)/107.

25 151.28 59.25 301.041 Price in ‘08 P0 270 300 180 280 300 230 250 Price in ‘09 P1 270 330 180 308 330 241 250 P0W 47.67 10.28 10.193 Medicine 0.86 .046 Transport 0.036 ent Others 0.049 Entertainm 0.04 14.44 16.8 8.25 280.460 Apparel 0.17 8.25 138 8.28 54.7 8.Calculate ROI Goods & Weight Services W Food 0.8 P1W 47.175 Housing 0.

5 %  . Rate of Inflation= (-P0W + P1W)/ P0W X 100  = (301.8)/280.8  = 7.86280.

We are open for Queries??? .

Sign up to vote on this title
UsefulNot useful