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 CausesEffects 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 DON’T have money • Eg : person don’t 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 2……the 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 inflationClassified 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 of money.

Government reaction

Classified into:● Open inflation● Repressed inflation

Government reactionOpen 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. classificationClassified into:● Demand-pull inflation● Cost-pull inflation● Built-in inflation

Misc. classificationDemand-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

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'.

Misc classification

Types of deflation● Cash Building● Deflation Growth Deflation● Bank Credit Deflation● Confiscatory Deflation

Types of deflationCash 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 deflationBank 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.

Inflation and Deflation 40

Effects of Inflation

Reduced monetary value

Uneven purchase parity

Inflation and Deflation 41

Positive Effects of Inflation

Decrease in unemployment

Decrease in real interest

rates

Increase in asset value

Inflation and Deflation 42

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 43

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 44

Costs of Deflation

Unemployment Effect of investment Costs to debtors

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

COMPUTING A PRICE INDEXAMOUNT PRICE

YEAR 1PRICE YEAR 2

PRICE YEAR 3

SNACK 3 75 70 90

COLAS 8 CANS 25 30 30

PETROL 1 LITRE 75 100 90

COSE OF THE MARKET BASKET

500 550 600

PRICE INDEX

100 110 120

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

APPRICOATS

10 RS: 10 10 Rs: 55

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 customer’s 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 rateso Falling asset priceso Insolvent companies- unrealised losso 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 indexo Export price index o Import price indexo Overall wholesale price index

• WPI – three broad categorieso Primary articles –food ,non-food articles, mineralso 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 supplyo Supply factorso External factors

• Deflation o After 3 decades india experienced deflation in 2009o Delay in purchases

• Measures taken : In late 2006 and early 2007o RBI announced some measures to control inflationo Increasing repo rates, cash reserve ratio(CRR) , reducing the rate of

interest on cash deposited in RBIo Repo rates- had to pay higher interest rates for the money borrowed

–banks increased the rate at which they lent to the customerso 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.