Price Stability

Types of price rise-

1. Creeping-2 percent annually
2. Walking-5 percent annually
3. Running-10 percent annually
4. Galloping or Hyper Inflation-more than 10 percent annually
On the basis of time-
1. Peace time
2. War time
3. Post war time
Main causes
1. Demand Pull
2. Cost-push-wage push, profit push, material push
Causes
Factors causing increase in demand
1. Increase in money supply
2. Increase in government expenditure
3. Increase in private expenditure
4. Increase in exports
5. Increase in population
6. Paying off debts
7. Black money
Factors causing decease in supply
1. Scarcity of factors of production
2. Hoarding
3. Trade union activities
4 .Natural calamities
5. Increase in exports
6. Law of diminishing returns
7.War
8.International Causes
Effects of Price Rise
1. Effects on Production
2. Effects on Distribution
3. Non-Economic Consequences
d. Social effects
e. Moral effects
f. Political effects
 Control of Price Instability

Monetary

Fiscal

Direct Controls
 Demand Pull Inflation

The Monetarist Theory Keynesian Theory

S s
P3

P2 P2
Price Level

d4
P1 P1
D2
s d3
D1
P d d2
D d1
M m m1 m3 m4 Output
Output
 Cost Push Inflation
S

E1
P1
E
Price Level

S1
D
S

M1 M Output
 INFLATIONARY GAP

According to Keynes, inflationary gap exists when, at full

employment income level, aggregate demand exceeds
supply. This means that due to increase in investment and
government expenditure, the money income increases,
but production does not increase because of the
limitations of productive capacity. As a result, an
inflationary gap comes to exist, causing the prices to rise.
The prices continue to rise so long as the inflationary gap
exists.
Y=C+I+G is the equilibrium line which shows the equality of total income and total expenditure. The
initial equilibrium of the economy is at point Eo which represents full employment income OYo.
When expenditure increases from C+I+G to C’+I’+G’, the new equilibrium will be at E1,
representing higher money income OY1. The available output is EoYo or OYo which is less than
the money income E1Y1 or OY1 by the vertical distance E1G. This is Inflationary Gap.

Y=C+I+G

C’+I’+G’

EXPENDITURE
E1
C+I+G

E0 G

O Yo Y1
INCOME
 Inflationary and Deflationary Gaps AS or
Inflationary Y=C+I+G
Inflationary gap occurs when AD gap

EXPENDITURE
exceeds AS at full employment
level of output. In this case, money AD or

(C+I+G)
rises to a higher equilibrium, but E C+I+G
real income being at full employment A
output level remains unchanged. As a
result there is an upward rise in prices
because the consumers compete for B
limited supply of output and bid prices Income (Y)
up. O Yf YO
AS or
Deflationary Y=C+I+G
EXPENDITURE gap B
Deflationary gap prevails when AD is
(C+I+G)

less than AS at full employment level

E AD or
of output. Income equilibrium occurs A C+I+G
while resources are unemployed.

Income (Y)
O
YO Yf
 Causes of Deflation

Less Aggregate Demand

Less Investment Expenditure Less Consumption Expenditure

Low MEC High Rate of Interest

High Liquidity Preference Less Supply of Money

 Phillips Curve
In 1958, A.W.Phillips presented an empirical theory of inflation commonly known as Phillips curve hypothesis.
The Phillips curve expresses empirical wage-price-employment relationship. On the basis of the data of the
UK for the period between 1861-1957, Phillips found that there existed a stable, inverse and non-linear
relationship between the rate of change in money wage (W) and unemployment rate (U). When
unemployment is low, wages will rise; when unemployment is high, wages will tend to fall but slowly
because of the downward rigidity of wage rates.

W3

Wage Inflation W2

W1
U

U3 U2 U1 U0 w
Wage Inflation
Rate
 OUTPUT INSTABILITY
(BUSINESS CYCLES)
• J.M.Keynes says, “ A trade cycle is composed of periods of
good trade characterized by rising prices and low
unemployment percentages with periods of bad trade
characterized by falling prices and high unemployment
percentages.”
• Thus the period of high income, output and employment has
been called the period of expansion, recession, downswing or
depression. These alternating periods of expansion and
contraction in economic activity has been called as business
cycles.
 Level of GNP
Ex
p an s
io n
Contr
ction a

Peak
Exp
an s io n

Depression
Contract
n io
Peak
Expa
n sion
C ont r
action
Peak

Ex

TIME
pan
sio
n
Contr
ction a
Peak

Exp
a
(BUSINESS CYCLES)

n si o
C on t r n
action
Peak

Depression

Exp
a ns io n
Contr
ction a
Peak
 Phases of Business Cycles
Business Cycles has different phases.

1. Expansion (Boom, Upswing or Prosperity)

2. Peak ( upper turning point)

3. Contraction (Downswing, Recession or Depression)

4. Trough (lower turning point)

 Phases of Business Cycles
Business Cycle (Trade Cycle) has different phases.
1. Prosperity

2. Recession

3. Depression

4. Recovery Phase
 Prosperity
According to Haberler the characteristic features of Prosperity are-
(i) A high level of output and trade
(ii) A high level of effective demand
(iii) A high level of employment and income
(iv) A high marginal efficiency of capital
(v) A price inflation
(vi) A rising structure of interest rate
(vii) A large expansion of bank credit
(viii) Overall business optimism
(ix) Tendency of the economy to operate at almost full capacity
along its production possibility frontier
 Recession
• When prosperity ends, recession begins
• Recession relates to a turning point rather than a phase
• It lasts relatively for a shorter period of time
• Forces of contraction wins over the forces of expansion
• Liquidation in the stock market, repayment of bank loans
• Businessmen lose confidence
• Pessimistic wave prevails and industrial growth rate falls
• Banking run for liquidity
• Business orders are cancelled and workers are laid off
• There is decline in aggregate demand, in turn prices, profit and
business decline
 Depression
According to Haberler the characteristic of Depression are-
1. Shrinkage in the volume of output, trade and transactions
2. Rise in the level of unemployment
3. Rise deflation
4. Fall in the aggregate income of the community
5. Fall in the structure of interest rates
6. Curtailment in consumption expenditure and reduction in the
level of effective demand
7. Collapse of the MEC and decline in the investment demand
function
8. Contraction of bank credit
 Important Business Cycle Theories
1. Purely Monetary Theory-R.G.Hawtrey
2. Monetary Over-investment Theory-F.A.Hayek
3. Non-monetary Over-investment Theory (real capital/investment goods
rather than money)
4. Under-consumption theory ( or Over-Saving Theory)
5. Psychological theory-J.S.Mill & Pigou (Over optimism and Over
pessimism in the business community)
6. Innovation theory-J.A.Schumpeter (Introduction of new type of goods, new
methods of production, opening of new markets, new raw material source)
7. Keynes’s MEC theory
8. Hicks’s theory-Multiplier and Accleration Principle ( The acceleration
theory shows how the demand for capital goods changes as a result of
changes in the demand for consumption goods.
 Anti Cyclical Policies
MONETARY

FISCAL

EXIM POLICY-DEVALUATION/APPRECIATION