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Introduction

Money - important in all economies because it is a means


of exchange for producing, selling, and buying goods and
services.

Usefulness of money [or Utility of money] to an economy


depends on its stability. Inflation and deflation are the
factors that control stability of money.
Concept of Inflation and
Deflation
Inflation- A rise in the general level of prices
of goods and services in an economy over a
period of time

Inflation reflects a loss in the purchasing or


buying power of money.
Deflation
A decrease in the general price level of goods
and services in an economy over a period of
time.
Money increases in its "buying" or
"purchasing" power.
A chief measure of price inflation is the
inflation rate, the annual percentage change in
a price index over time. eg. CPI(Consumer
Price Index)
Causes of inflation
Normally inflation may be caused due to :

Fluctuations in real demand for goods and


services.
Scarcity
Growth of money supply.

High rates of inflation and hyperinflation are


caused by an excessive growth of the money
supply.
Causes of deflation
Fall in the price of goods and services.

But, prolonged fall in prices causes fall in


wages and eventually economic depression.
Consequently, the supply of money shrinks,
creates a vicious 'deflationary spiral' of
negatives, including declining profits, closing
factories, shrinking incomes and employment
Effects of Inflation and
deflation
High inflation causes :
Decrease in real value of money.
Hoarding ( black market ).
Favours holders of illiquid assets such as property.
Deflation causes:
burden on borrowers and holders of various
illiquid assets.
Favour to savers and holders of liquid assets and
currency.
Effects and Causes
Effects and causes will be explained in detail
later
Inflation vs Deflation
Inflation and deflation are both parts of a
properly functioning economy occurring in
cycles or may happen simultaneously.

Some prices [ prices of some goods ] may


increase and some may decrease at same
time.

It is ideal to have a low inflation rate (~3%).


Inflation vs Deflation
Low inflation reduces the severity of economic
recessions by allowing to adjust the rapid
changes and stabilizing the economy.

The task of keeping the rate of inflation low


and stable is usually given to monetary
authorities. eg. Reserve Bank of India.
Related Terminology
Monetary Inflation: an increase in the money
supply.
Disinflation - a decrease in the rate of inflation.
Hyperinflation - an out-of-control inflationary
spiral.
Stagflation - a combination of inflation, slow
economic growth and high unemployment.
Reflation - an attempt to raise the general level
of prices to counteract deflationary pressure.
CAUSES OF
INFLATION AND
DEFLATION
CAUSES OF INFLATION
Inflation rate - essentially dependent on the growth rate
of money supply.

short and medium term inflation -affected by supply and


demand pressures in economy
influenced by the relative elasticity of wages, prices and
interest rates in the economy
Causes of inflation:
monetarism and Keynesian.

Monetarism- prices and wages adjust quickly


Keynesian - prices and wages adjust at different rates
proposes - changes in money supply do not directly
affect prices
visible inflation -result of pressures in the economy
Demand-pull inflation
Demand-pull inflation - caused by increase in aggregate
demand due to increased spending
Demand inflation - constructive to a faster rate of
economic growth-stimulates investment and expansion
shortage of supply sellers increases the price-until
equillibrium between supply and demand
COST-PUSH (Supply shock)
INFLATION
Caused by a drop in aggregate supply-reasons-natural
disaster, increased price of input
Shortages/shocks to the available supply of a certain
product -causes a ripple effect through the economy-
results in raising prices - from the producer to the
consumer.
E.g.-sudden decrease in the supply of oil, leads to
increased oil prices- cause cost-push inflation
Built-in inflation
Economy at optimal level of production
Inflation accelerates as suppliers increase their prices
If GDP falls below its potential level-inflation decelerates-
suppliers attempt to fill excess capacity cuts prices
involves
1.workers trying to keep their wages up with prices
2.firms passing higher labour costs on to their
customers as higher prices
MONEY SUPPLY
Federal Reserve -does not control the money supply
adequately-growth at a faster rate than potential output of
economy or real GDP
this drives up prices leads to inflation
Low interest rates implies high levels of money supply
allows more investment in big business -eventually leads
to unsustainable levels of inflation as cheap money is
available
DEFLATION AND
CAUSES OF DEFLATION
Deflation -when the supply of money is not increased
as much as positive population growth and
economic growth
most notable cause-when the consumption supply
and demand curve is in a downswing
people -not buying products and services primarily
durable goods
REASONS FOR
DEFLATION
People DONT have money
Eg : person dont have job for an year
The low consumer spending index-pessimistic about own
financial future
Risks involved in investing, investors and buyers will
hoard money rather than invest
low central bank interest rates.
Deflation -caused by combination of
o 1..supply and demand for goods
o 2the supply and demand for money
supply of money going down
supply of goods going up
Demand-side causes
Growth deflation: decrease in the real cost of goods and
services- results in competitive price cuts
Cash building deflation: save more cash reducing
consumption-decreasing velocity of money.
Supply-side
Bank credit deflation: decrease in the bank credit supply
-increased perceived risk of defaults(private entries) -
contraction money supply-central bank
UNIT THREE

TYPES OF INFLATION AND


DEFLATION
TYPES OF INFLATION
Inflation may be classified into different types
based on the following :
Rate of inflation
Government reaction
Nature of time period of occurrence
Rate of inflation
Classified in to :
Walking or jogging inflation
Sneaking inflation
Hurtling inflation
Consecutive inflation
Twitchy inflation
Rate of inflation
Walking or jogging inflation
When inflation rate is between 3-7% per
annum or less than 10%,
i.e moderate price rise
This is a warning signal for govt. to enforce
control measures.
Rate of inflation
Sneaking inflation
When inflation rate is less than 3% per
annum
Such a rise in prices is regarded safe and
essential for fiscal development.
Consecutive inflation
When inflation rate is about 10-20% per
annum
Affect deprived and middle class
Strong monetary and fiscal measures
required to control so as to prevent hyper-
inflation
Rate of inflation
Hurtling inflation
When inflation rate is about 20-100% per
annum
Also called Runaway inflation

Twitchy inflation
when the rate of inflation becomes
immeasurable and completely
uncontrollable
total crumple of fiscal system for the reason
that the incessant drop in purchasing power
Government reaction
Classified into:
Open inflation

Repressed inflation
Government reaction
Open inflation :
When the government does not attempt to
prevent a price rise, it is called open inflation
During open inflation, free market is allowed to
ration the short supply of goods and distribute
them according to consumer's ability to pay.
Government reaction
Repressed inflation :
Happens when the government controls a
price rise.
As opposed to open inflation, this prevent
distribution through price rise under free
market mechanism and substitutes instead
a distribution system based on controls
..
Nature of time period of
occurrence
Classified into:
War-time inflation

Post-war inflation

Peace-time inflation
Nature of time period of
occurrence
War-time inflation:
Due to increased unproductive spending on
defence.
As commodities are required for war
emergencies, supply of goods is reduced in
market which causes inflation.

Post-war inflation occurs:


When war-time public debt is being repaid
Or when war-time taxation is withdrawn.
Peace-time inflation:
Due to increased government outlays on
capital projects having a long gestation period.
ie. Time gap between spending and gaining.
So , in planning era, thus, when government's
expenditure increases, prices may rise.
Misc. classification
Classified into:
Demand-pull inflation

Cost-pull inflation

Built-in inflation
Misc. classification
Demand-pull inflation:
caused by increases in aggregate demand due
to increased private and government
spending.

Cost-pull inflation:
caused by a drop in aggregate supply due to
natural disasters, or increased prices of inputs.
Also called supply shock inflation
Misc classification

Built-in inflation:
This concept can linked to a price/wage
spiral or a vicious circle.
It involves workers trying to keep their wages
up with prices , and firms passing these higher
labour costs on to their customers as higher
prices, leading to a 'vicious circle'.
Types of deflation
Cash Building
Deflation Growth Deflation
Bank Credit Deflation
Confiscatory Deflation
Types of deflation
Cash Building Deflation:
caused when people are saving more money,
which decreases the use of money but
increases the demand for money.
Cash building (hoarding) to save more cash by
a reduction in consumption causes deflation
Growth Deflation:
Occurs when there is a decrease in the
Consumer Price Index and an increase in the
supply of goods.
Due to competition, price of goods may
decrease, causing deflation
Types of deflation
Bank Credit Deflation:
when there is a decrease in the credit supply
of the bank, caused by bankruptcies.
Or when money supply decreases from a
nation's central bank.
Confiscatory Deflation:
This is due to freezing of bank deposits and
decrease of the money supply.
Freezing of banks/bank accounts happens due
to govt. action.
Effects of Inflation

Reduced monetary value

Uneven purchase parity

Inflation and Deflation 40


Positive Effects of
Inflation
Decrease in unemployment
Decrease in real interest rates
Increase in asset value

Inflation and Deflation 41


Negative Effects of
Inflation
Loss of purchasing power
Effect on savings
Effect on interest rates
Effect on international
competitiveness
Uncertainty
Labor unrest

Inflation and Deflation 42


Effects of Deflation
Decreasing nominal prices for goods
and services

Increasing buying power of cash


money and all assets denominated in
cash terms

hoarding

Benefits recipients of fixed incomes


Inflation and Deflation 43
Costs of Deflation

Unemployment
Effect of investment
Costs to debtors

Inflation and Deflation 44


UNIT FIVE

MEASUREMENT METHODS
MEASUREMENT METHODS
A measurement of change in price level is
required to have a stable economy.
Most widely used statistic to measure inflation
is consumer rice index (CPI) also referred to
as the retail price index (RPI) .
CPI or RPI is the index that measures the
average price change of various commodities
in the market.
Accurate measure of average price index is
difficult.
CPI or RPI
The prices of various commodities change in
different rates at different times.
So a representative list of typical
goods/services consumed by average
household is compiled into a basket.
A weightage is given to each item based on
the quantity consumed.
The change in the price of the basket is
termed as the CPI.
Need for CPI
CPI affects the budget planning in various levels
such as :
Govt.
Panchayat
Business
Individual
For eg. When there is a deflation, sellers try to
reduce the inventory of goods.
Or when there is inflation, entities try to obtain
more quantity of the goods than they really want.
Numerical Example
Consider a 'market basket' of weekly
expenditures of an average teenager:
Snack
Coke
Petrol
PRICE INDEX
AMOUNT PRICE PRICE PRICE
YEAR 1 YEAR 2 YEAR 3

SNACK 3 75 70 90

COLAS 8 CANS 25 30 30

PETROL 1 LITRE 75 100 90

COSE OF 500 550 600


THE
MARKET
BASKET
PRICE 100 110 120
INDEX
Indices
Stock market index is a measure of market
value of businesses and industries.
Gross Domestic Product
Wholesale Price Index
GDP
Measures the value of a nation's production
ofgoods and services for a period of time, usually a
year.
Care to be taken while arriving at GDP, as we do not

want to double count transactions.


For eg., If govt. added the value of iron and also
the value of the railway equipments made of iron
that would be double-counting.
Value added in each process is sales minus the
cost of raw materials and unfinished goods.
GDP
Value of transactions of 'second-hand' goods
should also not be counted.
Also, we don't count the financial transactions
such as sales of stocks and bonds.
As GDP measures the value of output, it can
increase for two distinct reasons.
because more goods and services are being
produced,
prices of goods and services have risen.
GDP

Numerical Example
YEAR 1 YEAR 1 YEAR 2 YEAR 2

GOOD OUTPUT PRICE OUTPUT PRICE

APPRICOAT 10 RS: 10 10 Rs: 55


S

ONION 10 RS: 200 12 Rs:5

CARROT 10 RS: 25 9 Rs.: 30


GDP
To eliminate the effects of changing prices,
one must compute real or constant-money
GDP which values the output at various time
periods with a set of fixed prices.
The two values of GDP for the second year
allow us to obtain a measure of inflation called
the implicit price deflator or the GDP deflator.
The formula for this index is:
Price Index = 100 x (Nominal GDP/Real GDP)
OTHER
WIDELY USED
INDICES
PRODUCER PRICE
INDEX
measures average changes in prices received by
domestic producers for their output
price subsidization, profits, taxes -cause the amount
received by the producer different from consumer
payment
PPI-measures the pressure put on producers by the
costs of their raw materials
passed on to consumers, or it could be absorbed by
profits
COMMODITY PRICE
INDEX
measure the price of a basket of commodities
price indices weighed by the relative importance of
the components to the all in cost of an employee.
Core price indices
food and oil prices - change quickly due to changes
in supply and demand conditions in the food and oil
markets-difficult to detect the long run trend in price
levels
core inflation- removes the most volatile
components (such as food and oil) from a broad
price index like the CPI.
core inflation - less affected by short run supply and
demand conditions in specific markets
OTHER MEASURES
GDP deflator -measure of the price of all the goods
and services included in GDP
Historical inflation -for the purpose of comparing
absolute standards of living,-economists have
calculated imputed inflation figures
Inflation data before the early 20th century -
imputed based on the known costs of goods, rather
than compiled at the time.
Asset price inflation -undue increase in the prices of
real or financial assets, EG:stock,real estate
Problems in
Measurement
Inflation-Basically a process of continuously rising
prices or falling value of money.
Indexes are devised to measure Inflation.
CPI(Consumer Price Index)- measures changes in
the price level of consumer
goods and services purchased by households.
CPI is a statistical estimate constructed using the
prices of a sample of representative items whose
prices are collected periodically.
Limitation in application:
Based on a fixed basket of goods, so not accurate
estimate of cost of living.
Substitution bias-Purchase of items changes
depending on the relative prices of items, ignores
customers preference to the items having less
increase in price.
Consumers substituting purchase of low priced items
for higher priced items.
Introduction of new items-The CPI uses only a fixed
basket of goods, the introduction of a new product
cannot be reflected.
Items are removed or added but it takes good deal
of time and difficult to compare.
Different purchasing habits-Basket used is for typical
household but not applicable for all.
Family with children vs. Elderly couple
Rich family vs. poor family
Change in quality-When CPI is computed, changes
in quality, value and desirability is not accounted.
Eg: Satisfaction increases for good X now than in
earlier periods and no change in price, cost of living
remains same but standard of living increases.
Limitation in
Measurement:
Errors in collection of data limits accuracy.
Impossible to collect the prices of all items bought by
all households in all possible locations.
Larger the sample, more accurate results.Time
consuming and Costly.
Variations in regional rates of inflation within a
country and National average.
Harmful for certain groups in a community.
Changes in producer prices and commodity prices
are not given due importance in the measurement
of inflation.
CONTROL MEASURES
DEFLATION
Reduction in Taxation
Redistribution of Income
Repayment of Public Debt
Subsidies
Public Works Programme
Deficit Financing
Reduction in Interest Rate
Credit Expansion
Foreign Trade Policy
Regulation of Production
INFLATION
Monetary Measures
I. Bank rate policy
II. Cash reserve ratio
Increase in Taxes
Increase in Savings
Surplus Budgets
Public Debt
Other Measures
I. To Increase Production
II. Rational Wage Policy
III. Price Control
IV. Rationing
JAPAN
Deflation -1990
Bank of Japan and govt. reduced interest rates .
Reasons for deflation can be said to include:
o Tight monetary conditions-interest rates
o Falling asset prices
o Insolvent companies- unrealised loss
o Insolvent banks
non performing.
Increase their cash reserves to cover their bad loans
o Fear of insolvent banks- treasury bonds
Inflation and Deflation in
Indian scenario
Inflation
o Domestic wholesale price index
o Export price index
o Import price index
o Overall wholesale price index
WPI three broad categories
o Primary articles food ,non-food articles, minerals
o Fuel, power, light and lubricants-coal, coke, lignite..
o Manufactured products -food products..
Factors that help to determine inflationary impacts:
o Demand factors
aggregate demand in economy has exceeded aggregate supply
o Supply factors
o External factors
Deflation
o After 3 decades india experienced deflation in 2009
o Delay in purchases
Measures taken : In late 2006 and early 2007
o RBI announced some measures to control inflation
o Increasing repo rates, cash reserve ratio(CRR) , reducing the rate of
interest on cash deposited in RBI
o Repo rates- had to pay higher interest rates for the money borrowed
banks increased the rate at which they lent to the customers
o Increased CRR reduced money supply in the system as banks had to
keep more money as reserves
CONCLUSION
Inflation is the opposite of deflation.
On the other hand, inflation favours short-term
consumption and borrowers and is a burden on
currency holders and savers.
Both inflation and deflation can negatively impact
the economy. However, most economists consider
the effects of moderate long-term inflation to be less
damaging than deflation.

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