Submitted by: EllipseEnrol no:12IAME01V Sem, IMA Economics

Inflation means a sustained increase in the aggregate or general price level in an economy.

What is inflation?

Two major types that are generally accepted:1.Demand-Pull Inflation: This theory can be

summarized as "too much money chasing too few goods". In other words, if aggregate demand is growing faster than aggregate supply, prices will increase

Types of Inflation

Demand-Pull inflation

Associated with rises in the costs of an industry, or the economy generally.

The main reasons why costs might rise are (i) increases in wages and salaries (ii) increases in the cost of raw materials or oil

price shock (iii) increases in the price of imported goods

due to a fall in the value of the domestic currency or price rises in the country of origin

(iv) increases in indirect taxes (or reductions in government subsidies).

Cost-Push inflation

Cost-Push Inflation

Demand- Pull or cost –Push or both???????

Cause of inflation in India???????????

If inflation is unanticipated (e.g. People expect a lower inflation rate) then the costs will be more serious than if the inflation rate was expected.

More confusion and uncertainty in case of unanticipated inflation.

Anticipated or unanticipated inflation

Inflation erodes real income of the people. It redistributes income and wealth in favour

of some at the cost of others. i. Harms creditors ,fixed income groups,

wealth holders of cash, bonds and debentures.ii. Benefits borrowers, businessmen.

Loss of economic efficiency due to misallocation of resources.

Effects of inflation(unanticipated )

It serves as a disincentive to save. Leads to unproductive form of investment in

gold, jewellery, real estate, construction of houses etc.

Accentuates problem of poverty esp. In developing countries.

Decline in competitiveness. It adversely affects balance of payments,

thereby hampering economic growth.

Continued...

Shoe-leather costs: Frequent trips to bank causes the weathering of shoes,people hold less cash balances.

Menu costs-due to changing prices ;new catalogues have to be printed ,advertisement costs.

The costs of anticipated inflation

Consumer Price Index(CPI)-. The CPI is calculated by taking price changes for each item in the predetermined basket of goods and averaging them; the goods are weighted according to their importance. Changes in CPI are used to assess price changes associated with the cost of living relative to base year.

Sometimes referred to as "headline inflation.”

How is inflation measured??

CPI

Wholesale Price Index: An index that measures and tracks the changes in price of goods in the stages before the retail level. WPI report monthly to show the average price changes of goods sold in bulk, and they are a group of the indicators that follow growth in the economy.

Continued..

WPI vs CPI

GDP deflator-GDP deflator is a price index that measures the gross domestic product by adjusting the impact of changes in prices of goods and services to the true value of goods and services produced locally in the economy; more current, broader but not a good measure of cost living.GDP Deflator=(Nominal GDP/ Real GDP) *100

GDP deflator

Following the recommendations of Urjit Patel Committee report, The Reserve Bank of India (RBI) Governor had adopted the new Consumer Price Index (CPI) (combined) as the key measure of inflation for all policy purposes since April 2014.

Which of these measures used in India?

The concept of "inflationary gap" was originated by Keynes in his pamphlet, “How to pay for the War”.

The inflationary gap in the economy as a whole may be defined as the amount by which aggregate demand at full employment exceeds the output at full employment.

Contributes nothing directly to analysis of rate of inflation.

Keynesian Inflationary Gap

A useful theory of inflation-in presence of the gap-contributes to our understanding of current rate of inflation and factors affecting it.

Inflationary gap

• Monetary Policy: Higher interest rates to curb consumer demand • Fiscal Policy: A rise in the burden of taxation to reduce real disposable incomes • Supply-side Policy: Measures to increase productivity and efficiency. This leads to a rise in aggregate supply and reduces the amount of excess demand in the long run

Controlling an inflationary gap

A.W. Phillips arrived to the conclusion –an inverse relationship exists between unemployment and rate of inflation.

It is a downward sloping curve Higher rate of increase in aggregate

demand and a consequent higher rate of rise in price level associated with lower unemployment and vice versa.

Phillip’s curve

Phillip’s curve

Collapse of Phillips curve in USA (1971-1991)-both inflation and unemployment high during this period due to adverse supply shocks.

Continued..

Friedman challenged the concept of downward sloping Phillip’s curve.

According to his natural rate hypothesis, though there is trade off in the short run, no long run trade off exists between unemployment and inflation.

NRU –Rate at which the current number of unemployed is equal to the jobs available in the labour market .Full employment is said to prevail in this situation in spite of NRU.

Natural unemployment hypothesis :Friedman’s approach

In adaptive expectations theory ,any rate of unemployment can occur in the long run with natural rate of unemployment.

Adaptive expectations and Phillips curve

This theory said that expectations of inflation were equal to what actually happened, with some minor and temporary errors.  It rests on two basic elements:

1. Workers and producers are rational and will correctly anticipate the effects of govt. policies using relevant information.

2. Like classicals, they assume that all products and factor markets are highly competitive. As a result, wages and price highly flexible. Moreover, new information gets quickly in the demand and supply curves.

Long run Phillip’s curve: Rational expectations

The long run Phillips curve shows relationship between inflation and unemployment when actual inflation rate equals anticipated inflation rate.

Relationship between long and short run Phillip’s curve:

Measures to correct excess demand:1. Deflationary Fiscal PolicyReducing govt spending and increasing taxes to

lower AD.2.Deflationary monetary policy: raising interest

rates will deter investment and consumption.3. Use of selective credit control (bank rate

policy, open market variation and CRR variation; In India,changes in min margin against stock of commodities/securities most used.

Measures to control inflation

The inflation of 2009-2010 was mainly due to supply side issues. The measures taken by the govt included:

1.The govt. increased import of goods in short supply to check rise in prices of food grains, edible oils, sugar etc. by reducing custom duties.

2.Additional allocation of foodgrains for sale through PDS.

Continued...Tackling supply side inflation

3. Allocation of more wheat for release by FCI.

4. Ban on export of basmati rice, onions, edible oils,sugar,pulses

5.Distribution of imported goods at subsidised rates.

6. Increase in MSPs of key agricultural commodities to augment their production.

Continued..