NALANDA SCHOOL OF MANAGEMENT

Macro Economics &

Business Environment
Report on “INFLATION”
In partial completion of P.G.D.M:2010-2012.
Submitted to: Prof. Meghna Dangi
Submitted by: Pratik K. Acharya

Approval
 Introduction
One of the most important economic concepts is inflation. At its most
basic level, inflation is simply a rise in prices. Over time, as the cost of goods
and services increase, the value of a rupee is going to go down because you
won't be able to purchase as much with that dollar as you could have last
month or last year. Of course, it seems like the cost of goods are always going
up, at least to an extent, even when inflation is thought to be in check. This
piece of work will help you to understand the concepts of inflation, causes and
consequences of inflation, measuring the inflation and types of inflation.

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 Index
What is inflation?..............................................................................4
Measuring the inflation…………………………………………….……5
Types of inflation…………………………………………...…………….6
Causes of inflation………………………………………….………….…7
Consequences of inflation…………………………………..……….…11
Inflation rate in India………………………………………….……….14
Inflation rate in other countries...............................................…...16
Conclusion……………………………………………………………….18
Bibliography…………………………………………………….……… 19

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 What is Inflation?

In general, inflation is a rise in the general level of prices of goods and

services in an economy over a period of time.
When the general price level rises, each unit of currency buys fewer
goods and services. Consequently, inflation also reflects 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. A chief measure of price
inflation is the inflation rate, the annualized percentage change in a general
price index (normally the Consumer Price Index but in India it is measured by
Wholesale price Index) over time.
Inflation's effects on an economy are various and can be simultaneously
positive and negative. Negative effects of inflation include a decrease in the
real value of money and other monetary items over time, uncertainty over
future inflation may discourage investment and savings, and high inflation may
lead to shortages of goods if consumers begin hoarding out of concern that
prices will increase in the future. Positive effects include ensuring central
banks can adjust nominal interest rates (intended to mitigate recessions), and
encouraging investment in non-monetary capital projects.

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 Measures the inflation
Inflation is usually estimated by calculating the inflation rate of a price
index, usually the Consumer Price Index. The Consumer Price Index measures
prices of a selection of goods and services purchased by a "typical consumer".
The inflation rate is the percentage rate of change of a price index over time.

For instance, in January 2007, the U.S. Consumer Price Index was 202.416,
and in January 2008 it was 211.080. The formula for calculating the annual
percentage rate inflation in the CPI over the course of 2007 is

The resulting inflation rate for the CPI in this one year period is 4.28%,
In India it is measured by Wholesale price Index.

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 Types of Inflation
By the degree of inflation & trend in the inflation rate, five kinds of inflation
are distinguish
Hyperinflation: Hyperinflation is also known as runaway inflation or
galloping inflation. This type of inflation occurs during or soon after a war.
This can usually lead to the complete breakdown of a country’s monetary
system. However, this type of inflation is short-lived. In 1923, in Germany,
inflation rate touched approximately 322 percent per month with October
being the month of highest inflation.
High inflation: refers to inflation at the high two digit rate to the top of the
three digit rate per year.
Galloping inflation: Where the inflation rate is in creasing over the time.
Inflation may record more than 100 per cent rise in prices over a decade.
Crawling inflation: is the one which is low and moves up and down slowly.
Low inflation: inflation rate falls within one digit to the low two digits per
year.
An increase in the money supply may be called ‘monetary inflation’, to
distinguish it from rising prices, which may also for clarity be called 'price
inflation'

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 Causes of Inflation
The basic causes of inflation were covered at AS level. This note considers the
demand and supply-side courses in more detail including the impact of changes
in the exchange rate and the prices of goods and services in the international
economy.

Cost Push Inflation

Cost-push inflation occurs when businesses respond to rising production costs,

by raising prices in order to maintain their profit margins. There are many
reasons why costs might rise:

Rising imported raw materials costs perhaps caused by inflation in countries

that are heavily dependent on exports of these commodities or alternatively by
a fall in the value of the pound in the foreign exchange markets which
increases the UK price of imported inputs. A good example of cost push
inflation was the decision by British Gas and other energy suppliers to raise
substantially the prices for gas and electricity that it charges to domestic and
industrial consumers at various points during 2005 and 2006.

Rising labor costs - caused by wage increases, which exceed any

improvement in productivity.  This cause is important in those industries,
which are ‘labor-intensive’. Firms may decide not to pass these higher costs
onto their customers (they may be able to achieve some cost savings in other
areas of the business) but in the long run, wage inflation tends to move closely
with price inflation because there are limits to the extent to which any business
can absorb higher wage expenses.

Higher indirect taxes imposed by the government – for example a rise in the
rate of excise duty on alcohol and cigarettes, an increase in fuel duties or
perhaps a rise in the standard rate of Value Added Tax or an extension to the
range of products to which VAT is applied. These taxes are levied on
producers (suppliers) who, depending on the price elasticity of demand and
supply for their products, can opt to pass on the burden of the tax onto
consumers. For example, if the government was to choose to levy a new tax on
aviation fuel, then this would contribute to a rise in cost-push inflation.

Cost-push inflation can be illustrated by an inward shift of the short run

aggregate supply curve. This is shown in the diagram below. Ceteris paribus, a

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fall in SRAS causes a contraction of real national output together with a rise in
the general level of prices.

Demand-pull inflation is asserted to arise when aggregate demand in an

economy outpaces aggregate supply. It involves inflation rising as real
gross domestic product rises and unemployment falls, as the economy
moves along the Phillips curve. This is commonly described as "too much
money chasing too few goods". More accurately, it should be described as
involving "too much money spent chasing too few goods", since only
money that is spent on goods and services can cause inflation. This would
not be expected to persist over time due to increases in supply, unless the
economy is already at a full employment level. The term demand-pull
inflation is mostly associated with Keynesian economics.
According to Keynesian theory, the more firms will employ people, the
more people are employed, and the higher aggregate demand will become.
This greater demand will make firms employ more people in order to
output more. Due to capacity constraints, this increase in output will
eventually become so small that the price of the good will rise. At first,
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unemployment will go down, shifting AD1 to AD2, which increases Y by
(Y2 - Y1). This increase in demand means more workers are needed, and
then AD will be shifted from AD2 to AD3, but this time much less is
produced than in the previous shift, but the price level has risen from P2 to
P3, a much higher increase in price than in the previous shift. This
increase in price is called inflation.

Money supply plays a large role in inflationary pressure as well.

Monetarist economists believe that if the Reserve Bank of India does not
control the money supply adequately, it may actually grow at a rate faster
than that of the potential output in the economy, or real GDP. The belief
is that this will drive up prices and hence, inflation. Low interest rates
correspond with a high level of money supply and allow for more
investment in big business and new ideas which eventually leads to
unsustainable levels of inflation as cheap money is available. The credit
crisis of 2007 is a very good example of this at work.
Inflation can artificially be created through a circular increase in
wage earners demands and then the subsequent increase in producer costs
which will drive up the prices of their goods and services. This will then
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translate back into higher prices for the wage earners or consumers. As
demands go higher from each side, inflation will continue to rise.

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 Consequences of Inflation
High and volatile inflation is widely seen by economists to have a range of
economic and social costs – hence the continued importance attached to
the control of inflationary pressure in an economy by both the government
and also the central bank (in the UK’s case, the Bank of England). This
chapter considers some of the effects of inflation on an economy.
Why does inflation matter?
The impact of inflation on individuals and businesses depends in part on
whether inflation is anticipated or unanticipated:
Anticipated inflation: When people are able to make accurate predictions
of inflation, they can take steps to protect themselves from its effects. For
example, trade unions may exercise their collective bargaining power to
negotiate with employers for increases in money wages so as to protect the
real wages of union members. 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. In this way,
people can help to protect the real value of their financial wealth.
Companies can adjust prices and lenders can adjust interest rates.
Businesses may also seek to hedge against future price movements by
transacting in “forward markets”. For example, most of the major airlines
buy their aviation fuel several months in advance in the forward market,
partly as a protection against fluctuations in world oil prices.
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. Unanticipated inflation occurs when
economic agents (i.e. people, businesses and governments) make errors
in their inflation forecasts. Actual inflation may end up well below, or
significantly above expectations causing losses in real incomes and a
redistribution of income and wealth from one group in society to another.

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Money Illusion
It is a fact of life that people often confuse nominal and real values in their
everyday lives because the effects of inflation mislead them. For example,
a worker might experience a 6 per cent rise in his money wages – giving
the impression that he or she is better off in real terms. However if
inflation is also rising at 6 per cent, in real terms there has been no growth
in income. Money illusion is most likely to occur when inflation is
unanticipated, so that people’s expectations of inflation turn out to be
some distance from the correct level. When inflation is fully anticipated
there is much less risk of money illusion affecting both individual
employees and businesses
The Main Costs of Inflation
The case for maintaining pricesability
‘It is clear that very high inflation – in extreme cases hyperinflation – can
lead to a breakdown of the economy. There is now a considerable body of
evidence that inflation and output growth are negatively correlated in
high-inflation countries.
In explaining and assessing the costs of inflation, we must be careful to
distinguish between different degrees of inflation, since low and stable
inflation is perceived to have less of a damaging effect than hyper-
inflation where prices are out of control. Another important part of your
evaluation is to be aware that inflation will have differing effects both on
individuals and also the performance of the economy as a whole.
Impact of Inflation on Savers:
Inflation leads to a rise in the general price level so that money loses its
value. When inflation is high, people may lose confidence in money as the
real value of savings is severely reduced. Savers will lose out if nominal
interest rates are lower than inflation – leading to negative real interest
rates. For example a saver might receive a 3% nominal rate of interest on
his/her deposit account, but if the annual rate of inflation is 5%, then the
real rate of interest on savings is -2%.
Inflation Expectations and Wage Demands
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Inflation can get out of control because price increases lead to higher wage
demands as people try to maintain their real living standards.  Businesses
then increase prices to maintain profits and higher prices then put further
pressure on wages. This process is known as a ‘wage-price spiral’. Rising
inflation leads to a build-up of inflation expectations that can worsen the
trade-off between unemployment and inflation.
Arbitrary Re-Distributions of Income
Inflation tends to hurt those employees in jobs with poor bargaining
positions in the labour market - for example people in low paid jobs with
little or no trade union protection may see the real value of their pay fall.
Inflation can also favour borrowers at the expense of savers as inflation
erodes the real value of existing debts. And, the rate of interest on loans
may not cover the rate of inflation. When the real rate of interest is
negative, savers lose out at the expense of borrowers.
Business Planning and Investment
More generally, inflation can disrupt business planning. Budgeting
becomes difficult because of the uncertainty created by rising inflation of
both prices and costs - and this may reduce planned capital investment
spending. Lower investment then has a detrimental effect on the
economy’s long run growth potential
Competitiveness and Unemployment
Inflation is a possible cause of higher unemployment in the medium term
if one country experiences a much higher rate of inflation than another,
leading to a loss of international competitiveness and a subsequent
worsening of their trade performance.

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Inflation rate in India and other countries

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Rank Country Inflation rate (CPI) (%)
1 Zimbabwe 563
2 Ethiopia 44.4 61 South Africa 11.3
3 Seychelles 37 62 Liberia 11.2
4 Venezuela 30.4 63 Lithuania 10.9
5 Mongolia 28 64 Papua New Guinea 10.8
6 Burma 26.8 Rank Country Inflation rate
7 Kenya 26.3 65 Burkina Faso 10.7
8 Iran 25.6 66 Lesotho 10.7
9 Ukraine 25.2 67 Kuwait 10.6
10 Kyrgyzstan 24.5 68 Dominican Republic 10.6
11 Vietnam 24.4 69 Libya 10.4
12 Burundi 24.1 70 Estonia 10.4
13 Sao Tome and Principe 23 71 Turkey 10.4
14 Sri Lanka 22.6 72 Tanzania 10.3
15 Jamaica 22 73 Namibia 10.3
16 Azerbaijan 20.8 74 Mozambique 10.3
17 Tajikistan 20.5 75 Chad 10.3
18 Pakistan 20.3 76 Paraguay 10.2
19 United Arab Emirates 20 77 Lebanon 10
20 Nicaragua 19.8 78 Georgia 10
21 Cambodia 19.7 79 Indonesia 9.9
22 Yemen 19 80 Saudi Arabia 9.9
23 Egypt 18.3 81 Mauritius 9.7
24 Eritrea 18 82 Philippines 9.3
25 Kazakhstan 17 83 Madagascar 9.2
26 Congo, 16.7 84 Armenia 9
27 Ghana 16.5 85 Bangladesh 8.9
28 Sudan 16 86 Panama 8.8
29 Haiti 15.5 87 Togo 8.7
30 Latvia 15.4 88 Chile 8.7
31 Syria 15.4 89 Malawi 8.7
32 Rwanda 15.4 90 Laos 8.6
33 Qatar 15.1 91 Argentina 8.6
34 Guinea 15 92 Ecuador 8.3
35 Jordan 14.9 93 Macedonia, 8.3
36 Belarus 14.8 94 India 8.3
37 Russia 14.1 95 Guyana 8.3
38 Uzbekistan 14 96 Saint Pierre 8.1
39 Bolivia 14 97 Uruguay 7.9
40 Costa Rica 13.4 98 Benin 7.9
41 Afghanistan 13 99 Romania 7.8
42 Turkmenistan 13 100 East Timor 7.8
43 Marshall Islands 12.9 101 Nepal 7.7
44 Moldova 12.8 102 Equatorial Guinea 7.5
45 Maldives 12.8 103 El Salvador 7.3
46 Iceland 12.7 104 Bosnia and Herzegovina 7.3
47 Botswana 12.6 105 Mauritania 7.3
48 Swaziland 12.6 106 Bahrain 7
49 Oman 12.5 107 Colombia 7
50 Zambia 12.4 108 Cape Verde 6.8
51 Bulgaria 12.3 109 Iraq 6.8
52 Angola 12 110 Congo, 6.6
53 Uganda 12 111 Puerto Rico 6.5
54 Trinidad and Tobago 12 112 Singapore 6.5
55 Sierra Leone 11.7 113 Suriname 6.4
56 Nigeria 11.6 114 Belize 6.4
57 West Bank 11.5 115 Solomon Islands 6.3
58 Gaza Strip 11.5 116 Cote d'Ivoire 6.3
59 Guatemala 11.4 117 Czech Republic 6.3
60 Honduras 11.4 118 Macau 6.2
119 Croatia 6.1
120 Hungary 6.1

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 179 Montenegro 3.4
180 Austria 3.2
181 Saint Helena 3.2
16 182 Man, Isle of 3.1
183 Comoros 3
121 Saint Vincent 6.1 184 Gibraltar 2.9
122 Samoa 6 185 France 2.8
123 Gambia 6 186 Bermuda 2.8
124 China 5.9 187 Wallis and Futuna 2.8
125 Tonga 5.9 188 Palau 2.7
126 Peru 5.8 189 Dominica 2.7
127 Senegal 5.8 190 Germany 2.7
128 Slovenia 5.7 191 Montserrat 2.6
129 Brazil 5.7 192 Portugal 2.6
130 Barbados 5.5 193 Netherlands 2.5
131 Thailand 5.5 194 Mali 2.5
132 Malaysia 5.4 195 Guam 2.5
133 Anguilla 5.3 196 Bahamas, The 2.4
134 Cameroon 5.3 197 Canada 2.4
135 Gabon 5.3 198 Switzerland 2.4
136 Mexico 5.1 199 Virgin Islands 2.2
137 Djibouti 5 200 Micronesia, 2.2
138 Tunisia 5 201 Cook Islands 2.1
139 Bhutan 4.9 202 Netherlands Antilles 2.1
140 Fiji 4.8 203 British Virgin Islands 2
141 Korea, South 4.7 204 Saint Lucia 1.9
142 Slovakia 4.6 205 Monaco 1.9
143 Israel 4.6 206 Faroe Islands 1.8
144 Belgium 4.5 207 Mayotte 1.7
145 Algeria 4.5 208 Antigua and Barbuda 1.5
146 Saint Kitts and Nevis 4.5 209 New Caledonia 1.4
147 Australia 4.4 210 Japan 1.4
148 Cayman Islands 4.4 211 French Polynesia 1.1
149 Hong Kong 4.3 212 Greenland 1
150 Malta 4.3 213 Liechtenstein 1
151 Poland 4.2 214 Central African Republic 0.9
152 Spain 4.1 215 Brunei 0.3
153 Finland 4.1 216 Kiribati 0.2
154 Greece 4.1 217 Niger 0.1
155 Ireland 4.1 218 Mariana Islands -0.8
156 Turks & Caicos Islands 4 219 San Marino -3.5
157 New Zealand 4
158 Niue 4
159 Vanuatu 3.9
160 Andorra 3.9
161 Morocco 3.9
162 Norway 3.8
163 Guinea-Bissau 3.8
164 Tuvalu 3.8
165 United States 3.8
166 Jersey 3.7
167 Grenada 3.7
168 Falkland Islands 3.6
169 United Kingdom 3.6
170 Taiwan 3.5
171 Sweden 3.5
172 Denmark 3.4
173 Cuba 3.4
174 Albania 3.4
175 Aruba 3.4
176 Guernsey 3.4
177 Italy 3.4
178 Luxembourg 3.4
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 Conclusion
After reading this report, you should have some insight into inflation and its
effects. You now know that inflation isn't intrinsically good or bad, the causes
of inflation and the impact of it.

Some points to remember:

 Inflation is a sustained increase in the general level of prices for goods

and services.
 When inflation goes up, there is a decline in the purchasing power of
money.
 Variations on inflation include high inflation, hyperinflation and low
inflation.
 Two theories as to the cause of inflation are demand-pull inflation and
cost-push inflation.
 When there is unanticipated inflation, creditors lose, people on a fixed-
income lose, "menu costs" go up, uncertainty reduces spending and
exporters aren't as competitive.
 Lack of inflation (or deflation) is not necessarily a good thing.
 Inflation is measured with a price index.

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 18

Bibliography

Macroeconomics theory and application by G.S.Gupta -3rd edition

www.scribd.com
www.investopedia.com
www.aneki.com
www.indexmundi.com
www.wikipedia.com
www.tradingeconomics.com

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