DEFINING INFLATION

Inflation is best defined as a sustained increase in the general price level leading to a fall in the value of money.

Inflation is also an erosion in the purchasing power of money a loss of real value in the internal medium of exchange and unit of account in the economy.

CONTENTS

Introduction
Concept of inflation

Measurement
Consumer Price Index Wholesale Price Index Calculation of Inflation from Various Price Index Other measurement indices

Main Causes of Inflation Types Of Inflation

Demand Pull Inflation Causes of Demand Pull Inflation Cost Push Inflation

Consequences of inflation Anticipated and Unanticipated Inflation Aspects of Inflation

Negative Aspects Positive Aspects

References

INTRODUCTION

CONCEPT OF INFLATION
In economics, the inflation rate is a measure of inflation, the rate of increase of a price. It is the percentage rate of change in price level over time. A sustained fall in the general price level is called Deflation- in this situation, the rate of inflation becomes negative. Other related terms are:

disinflation a decrease in the rate of inflation. hyperinflation an out-of-control inflationary spiral. stagflation a combination of high inflation and high unemployment. reflation an attempt to raise the general level of prices to counteract deflationary pressures.

MEASUREMENT

THE CONSUMER PRICE INDEX

The CPI is a statistical estimate constructed using the prices of a sample of representative items whose prices are collected periodically. CPI2/CPI1 = PRICE2/PRICE1

This is a method to calculate CPI of a single item. Where 1 is usually the comparison year and CPI1 is usually an index of 100. CPI keeps tracks of the prices of a specific basket of goods and services that a typical consumer purchases.

WHOLE SALE PRICE INDEX

India is the only major country that uses WPI as a measure of headline inflation. The Wholesale Price Index focuses on the price of goods traded between corporations. The wholesale price index consists of over 2,400 commodities. The following methods are used to compute the WPI:

Laspeyres Formula (relative method):It is the weighted arithmetic mean based on the fixed value-based weights for the base period. Ten-Day Price Index: Under this method, sample prices with high intra-month fluctuations are selected and surveyed every ten days.

CPI is more relevant in measurement of inflation than WPI as it actually measures impact of price changes in a household.

Calculation Of Inflation from Price Index of Various Items

The price index (for multiple items) for a year is given by: PI = sum of (price x weight) / sum of the weights

Weight: The goods are weighted according to their importance. Now from the price index of different years we calculate inflation rate:

Inflation Rate= (PI2 PI1)/PI1 *100

OTHER MEASURING INDICES

Commodity Price Index Core price index GDP Regional inflation Historical inflation Asset Price

THE MAIN CAUSES OF INFLATION

CAUSES
Can be divided into two broad areas: Quality theories of inflation Quantity theories of inflation

The quality theory of inflation rests on the expectation of a seller accepting currency to be able to exchange that currency at a later time for goods that are desirable as a buyer.
The quantity theory of inflation rests on the quantity equation of money, that relates the money supply, its velocity and the nominal value

*Continued
Inflation may come direct from the domestic economy, for example the decisions of the major utility companies providing electricity or gas or water on their prices for the year ahead, or the pricing strategies of the leading food retailers based on the strength of demand and competitive pressure in their markets. Inflation can also come from external sources, for example an unexpected rise in the price of crude oil or other imported commodities, foodstuffs and beverages.

TYPES OF INFLATION

DEMAND PULL INFLATION

Demand-pull inflation is likely when there is full employment of resources and aggregate demand (AD) is increasing at a time when SRAS is inelastic. In these circumstances an increase in AD will lead to an increase in prices. AD might rise for a number of reasons some of which occur together at the same moment of the economic cycle

CAUSES OF DEMAND PULL INFLATION

Demand pull inflation is largely the result of the level of AD being allowed to grow too fast compared to what the supply-side capacity can meet. The result is excess demand for goods and services and pressure on businesses to raise prices in order to increase their profit margins. Possible causes of demand-pull inflation include: A depreciation of the exchange rate which increases the price of imports and reduces the foreign price of exports. If consumers buy fewer imports, while foreigners buy more exports, AD in will rise. Higher demand from a fiscal stimulus a reduction in direct or indirect taxation or higher government spending. Higher government spending and increased government borrowing feeds through directly into extra demand in the circular flow Monetary stimulus to the economy: A fall in interest rates may stimulate too much demand for example in raising demand for loans or in causing a sharp rise in house price inflation Faster economic growth in other countries providing a boost to exports overseas. Export sales provide an extra flow of income and spending. The rapid growth of the money supply perhaps as a consequence of increased bank and building society borrowing if interest rates are low. Rising consumer confidence and an increase in the rate of growth of house prices both of which would lead to an increase in total household demand for goods and services

COST PUSH INFLATION

Cost-push inflation occurs when firms respond to rising costs, by increasing prices to protect their profit margins. There are many reasons why costs might rise: Component costs: e.g. an increase in the prices of raw materials and other components used in the production processes of different industries. This might be because of a rise in world commodity prices such as oil, copper and agricultural products used in food processing Rising labour costs - caused by wage increases, which are greater than improvements in productivity. Wage costs often rise when unemployment is low (skilled workers become scarce and this can drive pay levels higher) Higher indirect taxes imposed by the government for example a rise in the specific duty on alcohol and cigarettes, an increase in fuel duties or a rise in the standard rate of Value Added Tax. Depending on the price elasticity of demand and supply for their products, suppliers may choose to pass on the burden of the tax onto consumers

CONSEQUENCES OF INFLATION

CONSEQUENCES OF INFLATION
It is very clear that hyperinflation can lead to breakdown of the economy. Inflation can disrupt business planning. Budgeting becomes difficult because of the uncertainty created by rising inflation of both prices and costs. Money loses its value and people lose confidence in money as the value of savings is reduced. Inflation can get out of control- price rise leads to higher wage demand as the people try to maintain their living standards. This is known as wage price spiral.

ANTICIPATED & UNANTICIPATED INFLATION

ANTICIPATED & UNANTICIPATED INFLATION

Anticipated inflation: When people are able to make accurate predictions of inflation, they can take steps to protect themselves from its effects. For example Households may also be able to switch savings into deposit accounts offering a higher nominal rate of interest or into other financial assets such as housing or equities where capital gains over a period of time might outstrip general price inflation. Unanticipated inflation: When inflation is volatile from year to year, it becomes difficult for individuals and businesses to correctly predict the rate of inflation in the near future.

ASPECTS OF INFLATION

NEGATIVE ASPECTS OF INFLATION

There can be negative impacts to trade from an increased instability in currency exchange prices caused by unpredictable inflation.
Wage Spiral High inflation can prompt employees to demand rapid wage increases, to keep up with consumer prices. Rising wages in turn can help fuel inflation. In the case of collective bargaining, wage growth will be set as a function of inflationary expectations, which will be higher when inflation is high. This can cause a WAGE SPIRAL. Hoarding People buy consumer durables as stores of wealth in the absence of viable alternatives as a means of getting rid of excess cash before it is devalued, creating shortages of the hoarded objects. Hyperinflation If inflation gets totally out of control (in the upward direction), it can grossly interfere with the normal workings of the economy, hurting its ability to supply goods. Allocative efficiency when prices are constantly changing due

POSITIVE ASPECTS OF INFLATION

Debt relief Debtors who have debts with a fixed nominal rate of interest will see a reduction in the "real" interest rate as the inflation rate rises. The real interest on a loan is the nominal rate minus the inflation rate. Tobin effect It states that a moderate level of inflation can increase investment in an economy leading to faster growth or at least a higher steady state level of income.

Government Policies to Control Inflation

Inflation can be reduced by policies that Slow down the growth of AD Boost the rate of growth of aggregate supply (AS) The main anti-inflation controls available to a government are: Fiscal Policy: If the government believes that AD is too high, it may reduce its own spending on public and merit goods or welfare payments or it can choose to raise direct taxes, leading to a reduction in disposable income. This helps to take money out of the circular flow of income and spending Monetary Policy: A tightening of monetary policy involves higher interest rates to reduce consumer and investment spending. Supply side economic policies: Supply side policies include those that seek to increase productivity,

References
http://vijnanacintamani.org http://en.wikipedia.org/wiki http://www.tutor2u.net http://www.oecd.org http://www.investopedia.com/terms/c/c onsumerpriceindex.asp