Inflation

Some definitions

The state in which value of money is falling, i.e. price is rising

Prof Crowther

Criticisms

• Every increase in price level is inflationary and has harmful consequences

• Emphasized the symptom rather than the cause of the disease – fails to explain why price level increases

Definitions (cont….)

• Issue of too much money

Prof Hawtrey• Too much currency in relation to physical

volume of business being done.

Prof Kermmerer• Inflation is too much money chasing too few

goods.

Prof Coulbourn

Inflation is that state of disequilibrium in which an expansion of purchasing power tends to cause or is the effect of an increase of price level.

Prof Paul Einzig

Inflation means a continuous increase in general (macro) prices.

Meaning of Inflation

• Goods & services – tangible and intangible commodities that is produced to sell to one another, e.g. food, haircut, houses, health care, etc.

• Money price – amount of money per unit of a commodity e.g. per kg of butter.

• Relative price – barter price at which one commodity trades for another e.g. 3 litres of petrol for 1 hr of labour, etc. Inflation does not refer to movement of relative prices, but to movements of absolute prices, i.e. money price.

• Rising – does not mean ‘high’. If prices are high but do not rise for 1 yr, it is zero rate of inflation. Conversely, if prices are low and continue to rise month after month, or year after year, it is indicative of inflation.

Inflation refers to pervasive, widespread increase in money prices.

General Price

• The exchange value of a unit of good or service expressed in terms of money.

• There are as many prices as there are goods and services.

• All individual (micro) prices are combined into one, called the general (macro) price.

General Price Level

Weighted average of individual goods’ prices.

n

Pt = wi Pit

i=1

wi >= 0

wi = 1

Example

Suppose there are only 3 goods in the economy, with their prices in 2009 and weights as follows:

Goods Price Weight

Rice Rs. 65 / kg 0.6

Shirt Rs. 1200 / piece 0.3

House (room) Rs.3000 / mon 0.1

General price in 1999

P99 = 0.6 (65) + 0.3 (1200) + 0.1 (3000) = Rs. 699

Note: the general price is merely a concept. There is nothing particular that you can buy for Rs. 699.

Weights

The weights for the various component items are determined by the relative significance of that item in all the items during the base period.

Qi0 Pi0

Wi = ------------------ Qi0 Pi0

iwhere Qi0 and Pi0 are the quantity and price

of the good ‘i’ in the base period.

Price Index

• A Price Index is expressed as the current price in relation to its value in the base period.

• Thus, price index for period t is defined as:

PIt = Pt / P0

Example

Price of shirt in base year, say 1999 was Rs. 900 and in 2009 it was Rs.1200, the price index

PI 09 = Rs. 1200 / Rs. 900 = 1.33

• An index helps to compare the data without worrying about the unit of measurement.

• Price Index of 1.33 indicates that between 1999 and 2009, price of shirt has increased by 33 %.

• Index numbers are usually written with a base value = 100 (above number has to be multiplied by 100).

Price index of general price

weighted average of various prices

Pit

PIt = Wi ------

Pi0

Substituting for Wi

Qi0 Pi0 Pit Qi0 Pit

PI = ------------ x -------- = -----------------

Qi0 Pi0 Pi0 Qi0 Pi0

Laspeyre’s Index

Qio Pit

PIt = ------------------

Qio Pio

Paasche’s Index

Qit Pit

PIt = ------------------

Qit Pio

Laspeyre vs Paasche• The only difference between the two is the

Laspeyre’s index takes the base year quantities, while the Paasche’s index works with the current year quantities.

• Laspeyre’s index measures the changes in the cost of a fixed basket of goods from a base period, and thus assumes no substitution due to relative price changes. Thereby, it over-estimates the true index.

• The Paasche’s index is at the other extreme as it assigns weights by current composition pattern, and as such tends to overstate the substitution and understate the price index relative to an earlier base period.

Inflation rate

• It means the rate of change in general price (P or PI) per year, expressed in percentages.

• Thus the simple inflation rate in period t (Pt) over the last one year is given by:

Pt – P t-1

Pt = ------------------ x 100

Pt-1

If it is compounded once in a year only.

If compounding is done on a continuous basis:

Pt

Pt = ln ------ x 100

Pt-1

Where ln stands for natural logarithm.

Example

If the general price index rises from, say, 150 in 2008 to 160 in 2009, the simple inflation rate during 2008-09 = 6.67% {(160-150)/150 x 100} and the continuous compounded inflation rate = 6.45 % {ln (160/150) x 100}.

In practice, the annual compounding rate is often used.

GDP Deflator

• GDP deflator refers to the index of average price of the goods and services produced in the economy.

• Includes the prices of all (only) final goods and services – excludes all intermediate goods and raw materials.

• Producers and buyers of these goods is immaterial.

• Computed as the ratio of the nominal (current price) GDP in a given year to the real (constant price) GDP of that year.

• Nominal GDP is the value of current production valued at current price

• Real GDP is the value of current production valued at base price.

• To illustrate, consider the following three product economy:

Period Rice Shirt House (room)

  Price Quantity Price Quantity Price Quantity

2001 30 10,000 900 400 1,500 50

2009 65 12,000 1,200 500 3,000 75

Year Nominal GDP Real GDP

GDP Deflator

Base: 1991=1

2001

(30 x 10000) + (900 x 400) + (1500 x 50) =

735,000

(30 x 10000) + (900 x 400) + (1500 x 50) =

735,000

1

2009

(65 x 12000) + (1200 x 500) + (3000 x 75) =

1605,000

(30 x 12000) + (900 x 500) + (1500 x 75) =

922,500

1.739

Inflation Tax• Inflation is a hidden (concealed) form of taxation.

James Tobin• In times of war or emergency, the government needs

more goods and a larger workforce. If the economy is already working close to normal capacity, private citizens will have to buy less.

• Higher taxes should be imposed to achieve the shift but may be undesirable from political point of view.

• Govt. simply prints more money – price rise squeezes out private citizens, specially those depending on fixed income and assets.

Unemployment

Some concepts

Unemployment

• In physical termsUp = Population – employed people

• In economic termsU = workforce – employed peoplewhere workforce = population – people not employed = population employable (15-58 yrs)

Kinds of Unemployment

Voluntary and Hidden• Voluntary: willful unemployment – may

arise due to laziness, obsession with wealth and/or leisure – not considered an economic threat

• Involuntary: forced unemployment – caused by paucity of employment opportunities – an economic issue

Open and Hidden

Open Unemployment

• Frictional: unemployment when in between two jobs (for better prospects) – prevalent in developed countries where jobs are very demanding and they are available in plenty for capable persons – healthy, not an economic problem.

Kinds (cont….)

• Structural: mismatch between vacancies and skills of unemployed people; mismatch between location of unemployed and vacancies – requires retraining and additional skill sets; mobility; changes in demand of some goods creates unemployment

Structural + frictional = natural rate of

unemployment

• Cyclical: due to deficiency of effective demand – also called Keynesian unemployment

• caused by business cycles and economic fluctuations – serious problem

Hidden

• Disguised: when several people share a particular work at a given time and/or when such work is spread over time. Marginal product of withdrawn workers is zero.

Seasonal: some occupations are seasonal, e.g. farming

Underemployment: number of hours worked is less than the full employment hours’ norms. Part-time workers in industries and services and full time workers in agriculture suffer from such a malady.

Full Employment

• Literally, it means zero unemployment. • Economists regard voluntary unemployment

as no unemployment and the frictional unemployment as “not bad.”

• Voluntary unemployment is hard to quantify and the full frictional unemployment is estimated to be around 3-4 %, particularly in the developed countries.

• Thus, when the unemployment rate is close to say 3-4%, economists call it a “full employment” situation.

• When unemployment is equal to natural rate of unemployment.

• Full employment is a situation where the number of people unemployed equals the number of vacancies that is untenable.

Types of Inflation

Some classifications

Based on speed

Creeping inflation: mildest form of inflation – makes the economy dynamic.

• Prices rise slowly• Industry and trade receive stimulus and the

country develops economically. • According to some economists, price level

should rise by approx. 2% annually under creeping inflation.

• Walking: rate of increase of price-level gets further accelerated – rises by approx 5% annually. If proper control is not exercised, it can easily assume the form of running inflation.

• Running: price-level rises by approx 10% annually.

Galloping or Hyperinflation: Prices rise every minute and there is no upward limit to which it may rise in course of time.

• Lord Keynes has called it true inflation.• This type invariably occurs after the point of

full employment. • Price rises by 16% and more. • Examples are the Great Inflation of Germany

after First World War, and Great Chinese Inflation after the Second World War.

Extent of inflation • Comprehensive inflation occurs

when the prices of all commodities register a rise in the economy.

• Sporadic Inflation refers to sectoral inflation. Prices of only a few commodities register an increase – arises due to physical bottlenecks that may impede production.

Government’s response

Open Inflation: when the government takes no steps to check the rise in price level.

• The market mechanism is allowed to work itself out fully without restrictions being imposed by the government.

• It is left free to distribute resources amongst the various industries => if there is any shortage of resources, prices would rise and the market allocates that resource to that industry which can afford to pay a higher price.

Repressed Inflation: when government actively intervenes to check the rise in price level by resorting to price controls and rationing of scarce items in the economy.

• Gives rise to profiteering, black marketing, hoarding and corruption on a large scale.

Based on money supplyProf. Pigou’s classification• Partial: rise in price level consequent upon

increase in money supply in pre-full employment stage. There is only a slight increase in the price level under partial inflation. The increase in the supply of money goes to mobilize the idle resources of the economy.

• Full: increase in money supply after the point of full employment does not increase output and employment, but leads to a sharp uninterrupted rise in prices

Ratchet Inflation

• The prices in certain sectors are not allowed to fall (or are held in a fixed position/level) even though there are strong reasons for it to fall.

• Prices in excess-demand sectors rise, but prices in deficient-demand sectors are not allowed to fall. The net result is a rise in the general price level

Stagflation

• New type of inflation, which came into vogue in the post-war period particularly since the sixties.

• It is not inflation in the Keynesian sense – inflation is accompanied by over-full employment.

• Present-day inflation is accompanied, not by full employment but by increasing unemployment – inflation accompanied by stagnation on the development front.

• High prices and high unemployment go hand in hand.

• Most difficult to deal with • well known Keynesian remedies, such as

budget surpluses, higher taxes and spending cuts have not only not arrested inflation, but they have also aggravated the unemployment situation in various counties of the world.

• Any steps to ease the unemployment situation through increased capital investment add to inflationary fire.

• The world stands between the devil (inflation) and the deep sea (unemployment).

Theories of Inflation

Demand-Pull Inflation

• Inflation is caused by an excess of demand (spending) relative to the available supply of goods and services at existing prices.

• The classicals - the key factor is the money supply. The quantity theory of money => only an increase in money supply is capable of raising the general price level.

• In modern income theory, means an excess of aggregate demand relative to the economy’s full employment output level.

• Prices rise in response to an excess of aggregate demand over existing supply of goods and service => caused by an increase in quantity of money

• May also be caused when MEC or MPC goes up causing an increase in expenditures and hence prices.

Y0

SD2

D1

D0

S

P0

P1

P2

Real Income

Pric

e le

vel

Demand Pull Inflation

Cost Push Inflation

• This theory maintains that prices, instead of being pulled-up by excess demand, are pushed-up as a result of a rise in the cost of production.

• Prices rise on account of a rise in the cost of raw materials, especially wages.

• Some producers, group of workers, or both, succeed in raising the prices for either their product or services above the levels that would prevail under more competitive conditions

• Inflation of the cost-push type originates in industries, which are relatively concentrated, and in which, sellers can exercise considerable discretion in the formulation of both prices and wages.

• It may not be possible in an economy characterized by pure competition.

Y0Y1Y2

S0

S1

P0

P1

D0

D1

D2

S

Inflationary Gap

• The inflationary gap shows the situation in the economy when anticipated expenditures (demand) exceed the available output (supply) at base prices or at the pre-inflation prices.

• Keynes has developed the concept of inflationary gap in his pamphlet ‘How to Pay for War’ by functionally relating expected expenditures to disposable income in relation to the value of available output at base prices.

• Money income rises, on account of increased investment expenditure or government expenditure or both,

• Supply of goods and services does not increase in the same proportion due to the limitation of the capacity to produce,

• Inflationary gap comes to exist giving a fillip to rise in prices. Prices continue to rise as long as the gap exists.

How an inflationary gap will arise in a war economy

Money income of the community Rs. 1,000 cr

Taxes Rs. 100 cr

Disposable Income Rs. 900 cr

GNP at pre-inflationary prices Rs. 1,100 cr

War Expenditure Rs. 300 cr

NNP available for civilian consumption

Rs. 800 cr

The inflationary gap Rs. 100 cr

Inflationary Gap

Y0Y1

E0

E1

G

C+I

C’+I’

C = YC

onsu

mpt

ion,

IG

O

Limitations Inflationary gap is highly dynamic • There are always time lags between the receipt and expenditure

of income, and between the adjustment of wages and prices. The larger the spending lags, the lower is the impact of inflationary gap.

The gap analysis is related entirely to the flow-concepts, i.e. it deals with current flows of income, war spending, consumption and savings.

• The rise in prices will not be confined to the current output alone but also stock of output previously produced and still available in the market.

• Also, disposable income may include idle balances, which will further aggravate inflation.

Effects of Inflation

Effect on Production• Mild inflation is beneficial to the economy. • Hyperinflation disrupts the economy: discourages savings

=> capital accumulation falls. Drives out foreign capital already invested in the economy.

• Volume of production will fall not only on account of fall in capital accumulation, but also due to the uncertainty.

• Pattern of production may change. • Seller’s market (A market which has more buyers than sellers. High

prices result from this excess of demand over supply) => results in deterioration of the quality of goods produced. Give impetus to speculative activities.

• Most serious: disrupts the smooth functioning of the price mechanism.

Effect on DistributionResults in redistribution of income and wealth.• Debtors & Creditors: Debtors are gainers – they

borrowed when purchasing power of money was high and return the loans when pp of money is low due to rising prices. Creditors are losers – receive less in real terms.

• Wage & Salary Earners: wages do not rise proportionally with rise in cost of living. If they are well organized in trade unions, they may not suffer much.

• Farmers: gain – prices of farm products go up while costs incurred do not go up to the same extent – time lag between rise in prices and costs. Farmers are generally debtors and can repay their debts in terms of less purchasing power.

• Fixed income groups: hardest hit – persons who live on past savings, pensioners, interest and rent receivers suffer most during inflation.

• Entrepreneurs: Inflation is a boon – whether manufacturers, traders, merchants and businessmen – rising prices serve as a tonic for business enterprise – experience windfall gains as the prices of their inventories (stocks) suddenly go up. Also gain as their costs (on wages, raw materials, etc) do not go up as rapidly as prices.

• Investors: of two types (a) Invest in equities (shares) – Dividends on equities increase with increase in prices and corporate earnings.(b) Invest in fixed interest-yielding bonds and debentures – income from bonds remain fixed and as such they have much to lose during inflation. Frequently, the value of their savings is largely, if not completely, wiped out as a result of depreciation in the value of money.

Measures to Control Inflation

Monetary Policy

Measures adopted by the Central Bank such as • increase in re-discount rates: increases the cost

of borrowing for business and consumer spending and discourages excessive activity based on borrowed funds

• sale of government securities in the open market: mops up excessive purchasing power from the public

• increase in reserve ratios: cash reserve ratio and statutory liquidity ratio; and

• adjustments in selective controls: consumer credit control and higher margin requirements, etc.

Fiscal Policy• Government Expenditure: during inflation, effective

demand increases far too much due to unregulated private spending. To counteract this, the government should reduce its own expenditure to the minimum.

• Taxation: the problem is to reduce the size of the disposable income in the hands of the general public The rates of existing taxes should be increased while new taxes should be imposed.

• Public Borrowing: the objective is to take away from the public excess purchasing power. Public borrowing may be voluntary or compulsory.

• Debt Management: refers to public borrowing and repayment – the government borrowing may assume the form of borrowing from non-bank public through sale of bonds and securities, which will curtail consumption and private investment.

• Overvaluation: of domestic currency in terms of foreign currencies will serve as an anti-inflationary measure as (i) it will discourage exports and thereby result in an increased availability of good and services at home, (ii) encourage imports – add to domestic stock of goods and services, (iii) by lowering the price of foreign inputs, it will help in checking the upward cost-price spiral.

Physical Policy Expansion of output: increased production is the best

antidote to inflation – steps should be taken to increase output of those goods, which seem to be extremely sensitive to inflationary pressures by shifting resources.

Wage Policy: wage increase has to be controlled – wages should be allowed to rise only if there is an increase in the productivity, i.e. output per worker. In such a situation, higher wages will not give rise to higher costs and hence to higher prices.

Price Control and Rationing: the objective of price control is to lay down the upper limit beyond which, the price of a particular commodity will not be allowed to rise. Demand can also be controlled through rationing of essential commodities.