introduction

Inflation
SUBMITTED BY
Khushboo P Shah Farheen Mehdi Senthilvel

Inflation
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
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

Cost push Inflation

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

Anticipated Versus Unanticipated Inflation

If the rate of inflation is anticipated, then people take steps to make suitable adjustments in their contracts to avoid the adverse effects which inflation could bring to them. 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.5000/- P.M, 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.5500/- P.M to compensate for the 10% rise in

Anticipated Versus Unanticipated Inflation

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

Effects of unanticipated inflation

Effect on Effect on wealth Effect on Effect on real income distribution of income and output long-run economic growth

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

Money and Prices During Hyperinflations

(a) Austria Index (Jan. 1921 = 100) 100,000 10,000 1,000 100 Price level Money supply Index (July 1921 = 100) 100,000

(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

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

Money Supply, Money Demand, and the Equilibrium Price Level

Value of Money, 1/P (High) 1 Money supply Price Level, P 1 (Low)

4 /

1.33

12

2 Equilibrium price level

Equilibrium value of money

14

4 Money demand

(Low)

Quantity fixed by the Fed

Quantity of Money

(High)

Copyright 2004 South-Western

The Effects of Excess Money Supply

Value of Money, 1/P (High) 1

MS1

MS2

Price Level, P 1 1. An increase in the money supply . . . (Low)

2. . . . decreases the value of money . . .

/4 A

1.33 3. . . . and increases the price level.

12

2 B Money demand

14

(Low) 0 M1 M2 Quantity of Money

(High)

Copyright 2004 South-Western

REASONS OF INFLATION
Lack of balance in the countrys budget Financial problems, 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

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. Eg.: If your bank gives you 8% interest rate on the FD of one year then 8% is the nominal interest rate.

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. Eg: if the nominal interest rate on an FD is 8% P.A and the inflation rate is 5% then 5% of purchasing power of nominal interest rate has been wiped out by inflation. Therefore in this case 8% - 5% = 3% is the increase in purchasing power of your

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. Thus relationship among the real rate of interest, nominal rate of interest and inflation rate can be stated as under: r= i - Where: r= real interest rate i= nominal interest rate = inflation rate

i= r +

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. This equation is called the fisher equation.

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

How is inflation measured?

WPI (Wholesale Price Index) India- 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

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

 Major Groups: I. Primary Articles (98 items)- 22.02 % Food Articles, Non-Food Articles, Minerals II. Fuel, Power, Light & Lubricants (19 items) - 14.23 % III. Manufactured Products (318 items) - 63.75 % Food Products Beverages, Tobacco & Tobacco Products Textiles etc

 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, headed by Planning Commission member Abhijit Sen, has worked out a new index The base year of the new index : 2000-01 The basket of commodities- around

GDP Deflator
Refers to the Index of the average price of goods and services produced in the economy.

GDP Deflator = (Nominal GDP/Real GDP)*100

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), CPI for Agricultural Labourers / Rural Labourers (CPI -AL/RL), CPI for Urban Non-Manual Employees (CPIUNME) Published on a monthly basis

 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?

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

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

Shoe leather costs

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

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

Inflation - Induced Tax Distortion

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

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

The Effects of Monetary Injection

Value of Money, 1/P (High) 1

MS1

MS2

Price Level, P 1 1. An increase in the money supply . . . (Low)

2. . . . decreases the value of money . . .

/4 A

1.33 3. . . . and increases the price level.

12

2 B Money demand

14

(Low) 0 M1 M2 Quantity of Money

(High)

Copyright 2004 South-Western

Problem

Calculate the rate of interest.

Year 1985 1986 Price 107.6 109.6 113.6 118.3 124 130.7 136.2 140.3 144.5 148.2 152.4

1995

Rate of inflation= (P1-P0)/P0 X 100

ROI = (109.6-107.6)/107.6 X 100 = 1.858

Calculate ROI
Goods & Weight Services W Food 0.175 Housing 0.460 Apparel 0.046 Transport 0.193 Medicine 0.049 Entertainm 0.036 ent Others 0.041 Price in 08 P0 270 300 180 280 300 230 250 Price in 09 P1 270 330 180 308 330 241 250 P0W 47.25 138 8.28 54.04 14.7 8.28 10.25
280.8

P1W 47.25 151.8 8.28 59.44 16.17 8.67 10.25

301.86

Rate of Inflation= (-P0W + P1W)/ P0W X 100 = (301.86280.8)/280.8 = 7.5 %

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