inflation report.docx

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INFLATION

Inflation can be defined as a rise in the

general price level and therefore a fall inthe value of money. Inflation occurs whenthe amount of buying power is higher thanth e output of goods a nd services.

Inflation also occurs when the amount of moneyexceeds the amount of goods and services available.

As to whether the fall in the value of money willaffect the functions of money depends on th edegree of the fall.

Basically, refers to an increase in the supplyof currency or credit relative to the

availability of goods and services, resulting inhigher prices. Therefore, inflation can bemeasured in terms of percentages. The percentage

increase in the price index, as a rate per cent per unitof time, which is usually in years. The two basic priceindexes are used when measuring inflation, theproducer price index (PPI) and the consumer price

index (CPI) which is also known as the cost of livingindex number.



HOW INFLATION IS MEASURED

Inflation is normally given as a percentage andgenerally in yearsor in some instances quarterly and

is derived from the Consumer Price Index

(CPI).However, there are two main indices used to

measure inflation. The first is the Consumer Price

Index, or the CPI. The CPI is a measure of the price

of a set group of goods and services. The "bundle," as

the group is known, contains items such as food,

clothing, gasoline, and even computers. The amount

of inflation is measured by the change in the cost of

the bundle: if it costs 5% more to purchase the

bundle than it did one year before, there has been a

5% annual rate of inflation over that period based on

the CPI. You will also often hear about the "Core

Rate" or the "Core CPI." There are certain items in

the bundle used to measure the CPI that are

extremely volatile, such as gasoline prices. By

eliminating the items that can significantly affect the

cost of the bundle (in either direction) on a month-

to-month basis, the Correlate is thought to be a

better indicator of real inflation, the slow, but steady

increase in the price of goods and services.



The second measure of inflation is the Producer

Price Index, or the PPI. While the CPI indicates thechange in the purchasing power of a consumer, the

PPI measures the change in the purchasing power of

the producers of those goods. The PPI measures how

much producers of products are getting on the

wholesale level, i.e. the price at which a good is sold

to other businesses before the good is sold to aconsumer. The PPI actually combines a series of

smaller indices that cross many industries and

measure the prices for three types of goods: crude,

intermediate and finished. Generally, the markets

are most concerned with the finished goods because

these are a strong indicator of what will happen withfuture CPI reports. The CPI is a more popular

measure of inflation than the PPI, but investors

watch both closely



TYPES OF INFLATION

Subsequently, when either the prices of goods or

services or the supply of money rises; this is

considered as inflation. Depending on the

characteristics and the intensity of inflation, there

are several types, namely.

Creeping inflation

Trotting inflation

Galloping inflation

Hyper inflation

When there is a general rise in prices at very low

rates, which is usually between 2-4 percent annually,

this is known as creeping inflation. Whereas ,



trotting inflation occurs when the percentage has

risen from 5 to almost percent. At this level it is a

warning signal for most governments to take

measures to avoid exceeding double-digit figures.

Another type of inflation is the galloping inflation,

where the rate of inflation is increasing at a

noticeable speed and at a remarkable rate, usually

from 10-20 percent. However, when the inflation

rate rises to over 20% it is generally considered as

hyper inflation and at this stage it is almost

uncontrollable because it increases more rapidly in

such a little time frame.

The main difference between the galloping and

hyper inflation, is that hyperinflation occurs when

prices rise at any moment and there is no level to

which the prices might rise. During World War II

certain countries experienced a hyper inflation,

where the price index rose from 1 to over

1,000,000,000 in Germany during January 1922 to

November 1923.



. CAUSES OF INFLATION

Inflation comes in different forms and those at arefamiliar with the economic matters would observe

that there are trends in the way that prices are

moving gradual and irregular in relation to aggregate

sections of the economy. This suggest that there is

more than one factor that causes inflation and as

different sections of the economy develop it gives

rise to different types inflationary periods. The main

causes of inflation are:

Demand-pull Inflation

Cost push Inflation

Monetary inflation

Structural inflation



DEMAND-PULL INFLATION

Demand-pull inflation occurs when the consumers,

businesses or the governments’ demand for goodsand services exceed the supply; therefore the cost of

the item rises, unless supply is perfectly elastic.

Because we do not live in a perfect market supply is

somewhat inelastic and the supply of goods and

services can only be increased if the factors of

production are increased. The increase in demand iscreated from in increase in other areas, such as the

supply of money, the increase of wages which would

then give rise in disposable income, and once the

consumers have more disposal income this would

lead to aggregate spending. As a

As a result of the increase in prices for final goodsand services the employees realise that their incomeis insufficient to meet their standard of living

because the basic cost of living has increased. Thetrade unions then act as the mediator for theemployees and negotiate better wages andconditions of employment. If the negotiations aresuccessful and the employees are given the requested

wage increase this would further affect the prices of



goods and services and invariably affected. On theother hand, when firms attempt to increase theirprofit margins by making the prices more responsive

to supply of a good or service instead of the demandfor that said good or service. This is usually doneregardless to the state of the economy. This can beseen in monopolistic economies where the firm isthe onlySupplier or by entrepreneurs that are seeking alarger profit for their own self interests.

MONETARY INFLATION Monetary inflation occurs when there is an excessive supply of money. It isunderstood that the government increases themoney supply faster than the quantity of goodsincreases, which results in inflation. Interestingly asthe supply of goods increase the money supply has toincrease or else prices actually go down. When adollar is worth less because the supply of dollars hasincreased, all businesses are forced to raise prices

just to get the same value for their products.STRUCTURAL INFLATIONPlanned inflation that is caused by a government'smonetary policy is called structural inflation. This

type of inflation is not caused by the excess ofdemand or supply but is built into an economy dueto the government’s monetary policy. In developedcountries they are characterized by a lack ofadequate resources like capital, foreign exchange,



land and infrastructure. Furthermore, over-population with the majority depending onagriculture for their livelihood means that there is a

fragmentation of the land holdings. There are otherinstitutional factors like land-ownership,technological backwardness and low rate ofinvestment in agriculture. These features are typicalof the developing economies. For example, indeveloping country where the majorities of thepopulation live in the rural areas and depend on

agriculture and the government implements a newindustry, some people get employment outside theagricultural sector and settle down in urban areas.Because there might be an unequal distribution ofland ownership and tenancy, technological

backwardness and low rates of investments inagriculture inclusive of inadequate growth of thedomestic supply of food which corresponds with anincrease in demand arising from increasingurbanization and population prices increase. Food

being the key wage-good, an increase in its pricetends to raise other prices as well. Therefore, someeconomists consider food prices to be the major

factor, which leads to inflation in the developingeconomies. IMPORTED INFLATION Another typeof inflation is imported inflation. This occurs whenthe inflation of goods and services from foreigncountries that are experiencing inflation are



imported and the increase in prices for thatimported good or service will directly affect the costof living. Another way imported inflation can add to

our inflation rate is when overseas firms increasetheir prices and we pay more for our goodsincreasing our own inflation.

EFFECT OF INFLATION

Inflation can have positive and negative effects on an

economy . Negative effects of inflation include loss in

stability in the real value of money and other

monetary items over time; uncertainty about future

inflation may discourage investment and saving, 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 a

mitigation of economic recessions, and debt relief by

reducing the real level of debt. Most effects of

inflation are negative, and can hurt individuals and

companies alike, below are a list of negative and

“positive” effects of inflation:



NEGATIVE EFFECTS ARE:

Hoarding (people will try to get rid of cash before itis devalued, by hoarding food and other

commodities creating shortages of the hoarded

objects).

Distortion of relative prices (usually the prices ofgoods go higher, especially the prices of

commodities).

Increased risk - Higher uncertainties (uncertainties

in business always exist, but with inflation risks are very high, because of the instability of prices).

Income diffusion effect (which is basically an

operation of income redistribution).

Existing creditors will be hurt (because the value of

the money they will receive from their borrowers

later will be lower than the money they gave before).



Fixed income recipients will be hurt (because while

inflation increases, their income doesn’t increase,

and therefore their income will have less value over

time).

Increased consumption ratio at the early stages of

inflation (people will be consuming more because

money is more abundant and its value is not lowered

yet).

Lowers national saving (when there is a high

inflation, saving money would mean watching your

cash decrease in value day after day, so people tend

to spend the cash on something else).

Illusions of making profits (companies will think

they were making profits while in reality they’re

losing money if they

don’t take into consideration the inflation rate when calculating profits).



Causes an increase in tax bracket (people will betaxed a higher percentage if their income increases

following an inflation increase).

Causes mal-investment (in inflation times, the datagiven about an investment is often deceptive andunreliable, therefore causing losses in investments).

Causes business cycles (many companies will haveto go out of business because of the losses theyincurred from inflation and its effects).

Currency debasement (which lowers the value of acurrency, and sometimes cause a new currency to be

born)

Rising prices of imports (if the currency is debased,

then it’s purchasing power in the internationalmarket is lower).



"POSITIVE" EFFECTS OF INFLATION ARE:

It can benefit the inflators (those responsible for theinflation)

It be benefit early and first recipients of the inflatedmoney (because the negative effects of inflation arenot there yet).

It can benefit the cartels (it benefits big cartels,destroys small sellers, and can cause price controlset by the cartels for their own benefits).

A high inflation rate is undesirable because it hasnegative consequences. However, the remedy forsuch inflation depends on the cause. Therefore,government must diagnose its causes beforeimplementing policies.

MONETARY POLICY Inflation is primarily amonetary phenomenon. Hence, the most logicalsolution to check inflation is to check the flow ofmoney supply by devising appropriate monetary



policy and carefully implementing such measures.To control inflation, it is necessary to control totalexpenditures because under conditions of

fullemployment, increase in total expenditures will be reflected in ageneral rise in prices, that is,inflation. Monetary policy is used tocontrol inflationand is based on the assumption that a rise in pricesis due to excess of monetary demand for goods andservices by the consumers/households e becauseeasy bank credit is available to them. Monetary

policy, thus, pertains to bankingand creditavailability of loans to firms and households, interestrates, public debt and its management, and themonetary standard. Monetary management is aimedat the commercialbanking systems, and through thisaction, its effects are primarily felt in the economy asa whole. By directly affecting the volume of cashreserves of the banks, can regulate the supply ofmoney and credit in the economy, therebyinfluencing the structure of interest rates and theavailability of credit. Both these, factors affect thecomponents of aggregate demand and the flow ofexpenditure in the economy.The central bank’s

monetary management methods, the devicesfordecreasing or increasing the supply of money andcredit for monetary stability is called monetarypolicy. Central banksgenerally use the threequantitative measures to control thevolume of credit



in an economy, namely:1.Raising bank rates2.Openmarket operations and 3.Variable reserveratioHowever, there are various limitations on the

effective working of the quantitative measures ofcredit control adapted by the centralbanks and, tothat extent, monetary measures to controlinflationare weakened. In fact, in controllinginflation moderate monetary measures, bythemselves, are relatively ineffective. On the otherhand, drastic monetary measures are not good for

the economicsystem because they may easily sendthe economy into a decline.In a developing economythere is always an increasing need for credit. Growthrequires credit expansion but to check inflation,thereis need to contract credit. In such an encounter, the

best course is to resort to credit control, restrictingthe flow of credit into the unproductive, inflation-infected sectors and speculativeactivities, anddiversifying the flow of credit towards the mostdesirable needs of productive and growth-inducingsector.It should be noted that the impression that the rateof spendingcan be controlled rigorously by the

contraction of credit or money supply is wrong in thecontext of modern economic societies. Inmoderncommunity, tangible, wealth is typically represented

by claims in the form of securities, bonds, etc., ornear moneys, asthey are called. Such near moneys



are highly liquid assets, and they are very close to being money. They increase the generalliquidity ofthe economy. In these circumstances, it is not

sosimple to control the rate of spending or totaloutlays merely by controlling the quantity of money.Thus, there is no immediateand direct relationship

between money supply and the price level,as isnormally conceived by the traditional quantitytheories.When there is inflation in an economy,monetary restraints can, inconjunction with other

measures, play a useful role incontrollinginflation.FISCAL MEASURESFiscalpolicy is another type of budgetary policy in relationtotaxation, public borrowing, and publicexpenditure. To curve theeffects of inflation andchanges in the total expenditure, fiscalmeasures

would have to be implemented which involvesanincrease in taxation and decrease in governmentspending. Duringinflationary periods thegovernment is supposed to counteract anincrease inprivate spending. It can be cleared noted that duringa period of full employment inflation the aggregatedemand in relation to the limited supply of goods

and services is reduced tothe extent that governmentexpenditures are shortened. Along with publicexpenditure, governments must simultaneouslyincrease taxes that would effectively reduce privateexpenditure,in an effect to minimise inflationary



savings. Additionally, private savings have a strongdisinflationary effect onthe economy and an increasein these is an important measure for controlling

inflation. Government policy should therefore,includedevices for increasing savings. A strongsavings drive reduces thespendable income of theconsumers, without any harmful effectsof any kindthat are associated with highertaxation.Furthermore, the effects of a large deficit

budget, which is mainly responsible for inflation, can

be partially offset by covering thedeficit throughpublic borrowings. It should be noted that it is onlygovernment borrowing from non-bank lenders thathas adisinflationary effect. In addition, public debtmay be managed insuch a way that the supply ofmoney in the country may becontrolled. Thegovernment should avoid paying back any of its pastloans during inflationary periods, in order to preventanincrease in the circulation of money. Anti-inflationary debt management also includescancellation of public debt held by thecentral bankout of a budgetary surplus.Fiscal policy by itself maynot be very effective in combatinginflation; therefore

a combination of fiscal and monetary tools canworktogether in achieving the desired outcome.

DIRECT MEASURES OF CONTROL



Another control measure that was suggested is thecontrol of wages as it often becomes necessary in

order to stop a wage-pricespiral. During gallopinginflation, it may be necessary to apply awage-profitfreeze. Ceilings on wages and profits keepdowndisposable income and, therefore the totaleffective demand for goods and services.On the otherhand, restrictions on imports may also helptoincrease supplies of essential commodities and

ease theinflationary pressure. However, this ispossible only to a limited extent, depending upon the

balance of payments situation.Similarly, exports mayalso be reduced in an effort to increasetheavailability of the domestic supply of essentialcommodities sothat inflation is eased. But a country

with a deficit balance of payments cannot dare tocut exports and increase imports,because the remedy

will be worse than the disease itself.In overpopulatedcountries like India, it is also essential to check thegrowth of the population through an effective familyplanning programme, because this will help inreducing the increasing pressure on the general

demand for goods and services. Again,the supply ofreal goods should be increased by producingmore.Without increasing production, inflation justcannot be controlled.Some economists have evensuggested indexing in order tominimise certain ill-



effects of inflation. Indexing refers to monetarycorrections through periodic adjustments in moneyincomes of the people and in the values of financial

assets such as savingsdeposits, which are held bythem in relation to the degrees of price rise.Basically, if the annual price were to rise to 20%,themoney incomes and values of financial assets areenhanced by 20%, under the system ofindexing.Indexing also saves the government frompublic wrath due tosevere inflation persisting over a

long period. Critics, however, donot favour indexing,as it does not cure inflation but rather it encouragesliving with inflation. Therefore, it is a highlydiscretionary method.In general, monetary andfiscal controls may be used to repressexcess demand

but direct controls can be more useful when they areapplied to specific scarcity areas. As a result, anti-inflationary policies should involve variedprogrammes and cannot exclusively depend on aparticular type of measure only.

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