inflation&deflation report

8/2/2019 inflation&deflation report

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Report: Economics & Management Seminar

INFLATION & DEFLATION

ALEENA ALEX

ANN ABRAHAM

ANEKHA SUNIL

DURGA NANDAKUMAR

KARTHIKA NAIR

KOLAR HARSHA

KRISHNA HARIDAS

LUJAIN K

MEGHA K

SHALINI S

B.Tech (Civil Engineering)

Department of Civil Engineering

NATIONALINSTITUTEOFTECHNOLOGYCALICUT

Calicut, Kerala 673 601

WINTER SEMESTER 2012


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CONTENTS

1.INTRODUCTION2.CAUSES3.TYPES4.EFFECTS5.MEASUREMENT6.PROBLEMS IN MEASUREMENT7.CONTROL MEASURES8.CASE STUDY9.INDIAN SCENARIO10. CONCLUSION11. REFERENCES


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1. INTRODUCTION

Money is important in all economies because it is a means of exchange for producing, selling,

and buying goods and services. The usefulness of money to an economy depends on its stability.

Inflation and deflation hurt an economy because people cant count on the value of their money.

Inflation and deflation are both far-reaching titanic forces that spread out and greatly influence

returns across all major financial markets. The outcome of the inflation or deflation question is

crucial for stock investors, bond investors, real-estate investors, and gold investors

1.1 Concept of Inflation and Deflation

Inflation-A consistent increase in the prices of goods and services over time is known as

inflation. During inflationary times, money loses its "buying" or "purchasing" power, and it

takes more units of currency to purchase the same units of goods or services.

The basic cause of inflation is the creation of too much money by the government. This situationoccurs when there is a more rapid increase in the quantity of money than in the output of goods

and services.

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.Deflation - a consistent decrease in the prices of goods and services over time is known as

deflation. During deflationary times, money increases in its "buying" or "purchasing" power,

and it takes less units of currency to purchase the same units of goods or services. Over time,

deflation increases the value of each unit of currency.-monetary capital projects It occurs when

the annual inflation rate falls below zero percent (a negative inflation rate), resulting in an

increase in the real value of money. The vicious cycle of declining demand and rising

unemployment often leads to an economic depression.

A fall in the price of goods and services increases the purchasing power of the people. This

might present a positive picture in the short run. However, if this effect extends, it leads to

deflation, adversely impacting the economy. With deflation, prices and wages begin to fall.

Consequently, the supply of money shrinks, resulting in even lower prices and wages. This

creates a vicious 'deflationary spiral' of negatives, including declining profits, closing factories,

shrinking incomes and employment and a rise in defaults on loans by individuals and companies.

Deflation creates a liquidity trap in the economy when lower interest rates fail to stimulate


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spending. Deflation usually occurs during recessionary times and tends to aggravate its negative

effects.

Inflation vs Deflation

Today, most economists favor a low, steady rate of inflation. Low (as opposed to zeroor negative) inflation reduces the severity of economic recessions by enabling the labor market to

adjust more quickly in a downturn, and reduces the risk that a liquidity trap prevents monetary

policy from stabilizing the economy. The task of keeping the rate of inflation low and stable is

usually given to monetary authorities. Generally, these monetary authorities are the central

banks that control monetary policy through the setting of interest rates, through open market

operations, and through the setting of banking reserve requirements.

Deflation causes a burden on borrowers and holders of various illiquid assets and is favorable for

savers and holders of liquid assets and currency.On the other hand, inflation favors short-term

consumption and borrowers and is a burden on currency holders and savers. Both inflation anddeflation can negatively impact the economy. However, most economists consider the effects ofmoderate long-term inflation to be less damaging than deflation.

1.2 History

Increases in the quantity of money or in the overall money supply (or debasement of the means

of exchange) have occurred in many different societies throughout history, changing with

different forms of money used. For instance, when gold was used as currency, the government

could collect gold coins, melt them down, mix them with other metals such as silver, copper or

lead, and reissue them at the same nominal value. By diluting the gold with other metals, the

government could issue more coins without also needing to increase the amount of gold used to

make them. When the cost of each coin is lowered in this way, the government profits. This

practice would increase the money supply but at the same time the relative value of each coin

would be lowered. As the relative value of the coins becomes lower, consumers would need to

give more coins in exchange for the same goods and services as before. These goods and

services would experience a price increase as the value of each coin is reduced.

Historically, infusions of gold or silver into an economy also led to inflation. From the second

half of the 15th century to the first half of the 17th, Western Europe experienced a major

inflationary cycle referred to as the "price revolution", with prices on average rising perhaps six

fold over 150 years. This was largely caused by the sudden influx of gold and silver from

the New World into Habsburg Spain. The silver spread throughout a previously cash-starved

Europe and caused widespread inflation. Demographic factors also contributed to upward

pressure on prices, with European population growth after depopulation caused by the Black

Death pandemic.


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By the nineteenth century, economists categorized three separate factors that cause a rise or fall

in the price of goods: a change in the value or production costs of the good, a change in theprice

of money which then was usually a fluctuation in the commodity price of the metallic content in

the currency, and currency depreciation resulting from an increased supply of currency relative

to the quantity of redeemable metal backing the currency. Following the proliferation of

private banknote currency printed during the American Civil War, the term "inflation" started to

appear as a direct reference to the currency depreciation that occurred as the quantity of

redeemable banknotes outstripped the quantity of metal available for their redemption. At that

time, the term inflation referred to the devaluation of the currency, and not to a rise in the price

of goods.

1.3 Basic and Related Definitions

1. Various Definitions for Inflation:

y According to the Crowthers Inflation means a state in which the value of money

is falling i.e., prices are rising

y According to Pigou, Inflation arises when money income is expanding more than

in proportionate to income earning activity

y According to Prof. Samuelson Inflation occurs when the general level of prices

and cost are rising

2. Disinflation a decrease in the rate of inflation.

3. Hyperinflation an out-of-control inflationary spiral.

4. Stagflation a combination of inflation, slow economic growth and high unemployment.

5. Reflation an attempt to raise the general level of prices to counteract deflationary

pressure.

2. CAUSES OF INFLATION & DEFLATION

2.1 Causes of Inflation

Inflation rate is essentially dependent on the growth rate of money supply. However, in the short

and medium term, inflation may be affected by supply and demand pressures in the economy,

and influenced by the relative elasticity of wages, prices and interest rates.

There are two streams of thought on the causes of inflation: monetarism and Keynesian. Inmonetarism prices and wages adjust quickly enough to make other factors merely marginal

behavior on a general trend-line. In the Keynesian view, prices and wages adjust at different

rates, and these differences have enough effects on real output to be "long term" in the view of

people in an economy.


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Keynesian economic theory proposes that changes in money supply do not directly affect prices,

and that visible inflation is the result of pressures in the economy expressing themselves in

prices.

The causes of inflation include:

1. Demand-pull inflation :

The Demand-pull inflation is caused by increase in aggregate demand due to increased

private and government spending and such. It states that the rate of inflation accelerates

whenever aggregate demand is increased beyond the ability of the economy to produce.

Hence, any factor that increases aggregate demand can cause inflation.

Demand inflation is constructive to a faster rate of economic growth since the excess

demand and favorable market conditions will stimulate investment and expansion.

Demand-pull inflation refers to the idea that the economy demands more goods and

services than available. This shortage of supply enables sellers to raise prices until

equilibrium is put in place between supply and demand.

2. Cost-push inflation:

Cost push inflation is also termed "supply shock inflation". It is caused by a drop in

aggregate supply (potential output). This may be due to natural disasters, or increased

prices of inputs. It suggests that shortages or shocks to the available supply of a certain

good or product will cause a ripple effect through the economy by raising prices through

the supply chain from the producer to the consumer.

For example, a sudden decrease in the supply of oil, leading to increased oil prices, can

cause cost-push inflation. Producers for whom oil is a part of their costs could then pass

this on to consumers in the form of increased prices.

Another example stems from unexpectedly high Insured Losses, either legitimate

(catastrophes) or fraudulent (which might be particularly prevalent in times of recession).

3. Built-in inflation:

Another concept of note is the potential output, a level of GDP, where the economy is atits optimal level of production given institutional and natural constraints. If GDP exceeds

its potential, the theory says that inflation will accelerate as suppliers increase their prices

and built-in inflation worsens. If GDP falls below its potential level, inflation will

decelerate as suppliers attempt to fill excess capacity, cutting prices and undermining

built-in inflation. It involves workers trying to keep their wages up with prices (above the

rate of inflation), and firms passing these higher labor costs on to their customers as


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higher prices .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 translate back into higher prices for

the wage earners or consumers. As demands go higher from each side, inflation will

continue to rise.

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

believe that if the Federal Reserve 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 high levels 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 of2007 is a very good example of this at

work.

The effect of money on inflation is most obvious when governments finance spending ina crisis, such as a civil war, by printing money excessively. This sometimes leads to

hyperinflation, a condition where prices can double in a month or less. Money supply is

also thought to play a major role in determining moderate levels of inflation. Banks

create money by making loans, but the aggregate volume of these loans diminishes as

real interest rates increase. Thus, central banks can influence the money supply by

making money cheaper or more expensive, thus increasing or decreasing its production.

2.2 Causes of Deflation

There can be many reasons why a deflation may unfold; however, there are some major ones.The most notable cause is when the consumption supply and demand curve is in a downswing,

meaning that people in the country are not buying products and services (most notably durable

goods). There are two primary reasons for non-consumption.

1. The people do not have disposable income and savings, that is, they do not have money.

People may not have money for a variety of reasons, such as being unemployed for at

least a year. Deflation is the natural condition of hard currency economies when the

supply of money is not increased as much as positive population growth and economic

growth. When this happens, the available amount of hard currency per person falls, in

effect making money scarce; and consequently, the purchasing power of each unit ofcurrency increases.

2. The low consumer spending index, meaning that they are pessimistic about their own

financial future. In more recent economic thinking, deflation is related to risk: where the

risk-adjusted return on assets drops to negative, investors and buyers will hoard currency

rather than invest it, even in the most solid of securities. This can produce a liquidity trap.


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Another common cause of deflation is low central bank interest rates. Central bank interest

rates, in a nutshell, influence inflation by regulating the amount of money circulating in the

economy by making loans cheap or expensive. In modern credit-based economies, deflation

may be caused by the central bank initiating higher interest rates (i.e., to 'control' inflation),

thereby possibly popping an asset bubble. In a credit-based economy, a fall in money supply

leads to markedly less lending, with a further sharp fall in money supply, and a consequent

sharp fall-off in demand for goods. The fall in demand causes a fall in prices as a supply glut

develops. This becomes a deflationary spiral when prices fall below the costs of financing

production. Businesses, unable to make enough profit no matter how low they set prices, are

then liquidated. Banks get assets which have fallen dramatically in value since their mortgage

loan was made, and if they sell those assets, they further glut supply, which only exacerbates

the situation. To slow or halt the deflationary spiral, banks will often withhold collecting on

non-performing loans. This is often no more than a stop-gap measure, because they must then

restrict credit, since they do not have money to lend, which further reduces demand, and so

on.

Deflation may be caused by a combination of the supply and demand for goods and the

supply and demand for money, specifically the supply of money going down and the supply

of goods going up.

Demand-side causes are:

y Growth deflation: an enduring decrease in the real cost of goods and services resulting in

competitive price cuts.

y Cash building (hoarding) deflation: attempts to save more cash by a reduction in

consumption leading to a decrease in velocity of money.

Supply-side causes are:

y Bank credit deflation: a decrease in the bank credit supply due to bank failures or

increased perceived risk of defaults by private entities or a contraction of the money

supply by the central bank.


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3. TYPES OF INFLATION & DEFLATION

3.1 According to Rate of Inflation

y Sneaking Inflation

When the rise in prices is very less like that of a small or sneaky it is termed sneaky inflation. In

terms of speed continued hikes in prices of annual rise of less than 3 percent per annum is

characterised as sneaking inflation. Such a rise in prices is regarded safe and essential for fiscal

development.

y Walking or jogging Inflation

When prices rise moderately and the annual inflation rate is a single unit, it is otherwise known

as the rate of rise in prices is in the transitional range of3 to 7 percent annum or less than 10

percent. Inflation at this rate is warning signal for the government to control it before it turns intorunning inflation.

y Consecutive Inflation

When prices increase fast, at a rate of speed of 10 to 20 % per annum it is termed as consecutive

inflation. Such inflation affects the deprived and middle classes unfavourably. Its control

requires strong monetary and fiscal measures otherwise it tends to hyper inflation.

y Twitchy Inflation

It is also characterised as hyper inflation by definite economists. In reality, twitchy inflation is a

condition when the rate of inflation becomes immeasurable and completely uncontrollable.Prices increase many times every day. Such as condition brings a total crumple of fiscal system

for the reason that the incessant drop in purchasing power of money.

y Hurtling inflation

When prices rise very rapidly at double or triple digit rates from more than 20 to 100 percent per

annum or more, it is usually called runaway called runaway or hurtling inflation.

3.2 Graphical Representation of Different Types of Inflation

The speed with which prices is likely to increase is demonstrated in the diagram below.

The curve S represents sneaking inflation when within a period of ten years the price

level has been represented to have increased by about 30%.

The curve W shows walking or jogging inflation when the price increased by more than

50 percent during 10 years.


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The curve C shows Consecutive inflation depicting a rise of about 100 percent in ten

years.

The precipitous curve T depicts the path of Twitchy inflation when prices increased by

more than 120 percent in less than one year.

3.3 Another Classification

Demand-pull inflation is caused by increases in aggregate demand due to increasedprivate and government spending, etc.

Cost-push inflation also called "supply shock inflation," is caused by a drop in aggregate

supply (potential output). This may be due to natural disasters, or increased prices of

inputs. For example, a sudden decrease in the supply of oil, leading to increased oil

prices, can cause cost-push inflation


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Built-in inflation is induced by adaptive expectations, and is often linked to the

"price/wage spiral". It involves workers trying to keep their wages up with prices (above

the rate of inflation), and firms passing these higher labour costs on to their customers as

higher prices, leading to a 'vicious circle'. Built-in inflation reflects events in the past, and

so might be seen as hangover inflation.

3.4 According to the Government Reaction

Open Inflation

When the government does not attempt to prevent a price rise, inflation is said to be open. Thus,

inflation is open when prices rise without any interruption. In open inflation, the free market

mechanism is permitted to fulfill its historic function of rationing the short supply of goods and

distribute them according to consumers ability to pay. Therefore, the essential characteristics of

an open inflation lie in the operation of the price mechanism as the sole distributing agent. The

post-war hyperinflation during the twenties in Germany is a living Example of open inflation.

Repressed Inflation

When the government interrupts a price rise, there is a repressed or suppressed inflation. Thus,

suppressed inflation refers to those conditions in which price increases are prevented at the

present time through an adoption of certain measures like price controls and rationing by the

government, but they rise on the removal of such controls and rationing. The essential

characteristic of repressed inflation, in contrast to open inflation, is that the former seeks to

prevent distribution through price rise under free market mechanism and substitutes instead a

distribution system based on controls. Thus, the administration of controls is an important feature

of suppressed Inflation . However, many economists like Milton and G.N.Halm opine that ifthere has to be any inflation, it is better open than suppressed. Suppressed inflation is condemned

as it breeds number of evils like black market, hierarchy of price controllers and rationing

officers, and uneconomic diversion of productive resources from essential industries to non-

essential or less essential goods industries since there is a free price movement in the latter and

hence are more profitable to investors.

3.5 According to the Nature of Time Period of Occurrence

War-Time Inflation

It is the outcome of certain exigencies of war, on account of increased government expenditure

on defense which is of an unproductive nature. By such public expenditure, the government

apportions a substantial production of goods and services out of total availability for war which

causes a downward shift in the supply; as a result, an inflationary gap may develop.


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Post-war Inflation

It is a legacy of war. In the immediate post-war period, it is usually experienced. This may

happen when the disposable income of the community increases, when war-time taxation is

withdrawn or public debt is repaid in the post-war period.

Peace-time Inflation

By this is meant the rise in prices during the normal period of peace. Peacetime inflation is often

a result of increased government outlays on capital projects having a long gestation period; so a

gap between money income and real wage goods develops. In a planning era, thus, when

governments expenditure increases, prices may rise.

3.6 Types of Deflation

Cash Building Deflation

This is caused when people are saving more money, which decreases the use of money but

increases the demand for money. In other words it can be said that Cash building (hoarding)

deflation attempts to save more cash by a reduction in consumption leading to a decrease in

velocity of money.

Growth Deflation

This is when there is a decrease in the Consumer Price Index and an increase in the supply of

goods.It is an enduring decrease in the real cost of goods and services resulting in competitive

price cuts.

Bank Credit Deflation

This is when there is a decrease in the credit supply of the bank, caused by bankruptcies, and a

contraction of the money supply from a nations central bank.

Confiscatory Deflation

This is the freezing of bank deposits and a decrease of the money supply. Confiscatory deflation

is a particular category of deflation. It is inflicted on the economy by the political authorities as ameans of obstructing an ongoing bank credit deflation that threatens to liquidate an unsound

financial system built on fractional reserve banking. Its essence is an abrogation of bank

depositors' property titles to their cash stored in immediately redeemable checking and savings

deposits.


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4. EFFECTS OF INFLATION & DEFLATION

4.1 Positive Effects of Inflation

The most well known positive effects of inflation are the trend of decreasing unemployment ratesas inflation rises. Others types are the drop in real interest rates and the increasing value of assets

as inflation increases. Many economists, many of which are Keynesians, agree that the rise in

inflation causes a drop in unemployment. After World War II inflation and unemployment

appeared to have an inverse relationship. This relationship allows the government to reduce

unemployment by allowing inflation to rise. Inflation in this case can be the lesser of two evils.

Other positives are that when inflation rises, real interest rates drop and assets become more

valuable. The real interest rate phenomenon can be described as the lower we want a real interest

rate to be the higher an inflation rate we would need in order to actualize that low real interest

rate.

The increasing value of assets is the last reason inflation is a good thing. The longer one holds on

to an asset in an inflationary period, the higher return when one goes to sell. Needless to say, this

type of inflation would be beneficial to any business

4.2 Negative Effects of Inflation

Loss of purchasing power: If the rate of inflation is 2%, then this means that the average price

of all goods and services in the economy has risen by 2%. If your income remains constant, then

you will not be able to buy as many goods and services as you could before the increase in theaverage price level. We say that there is a fall in real income, which means that there is a

decrease in the purchasing power of income. If your income is linked to the inflation rate, so that

you automatically get a 2% cost-of-living increase, then you will not face a fall in your real

income. This is the case for many jobs, particularly where there are strong unions. However,

many people have jobs that dont offer the security of inflation-linked incomes. This may be

because they are on fixed incomes or because they have weak bargaining power or because they

are selfemployed. Thus inflation reduces the purchasing power of their incomes, and will reduce

their living standards. It is important to realise that expectations about inflation are important.

Even when peoples incomes are linked to inflation, they can be negatively affected if the actual

rate of inflation turns out to be higher than the expected rate. For example, if the expected rate ofinflation is 1.5% and wages are therefore increased by 1.5%, then workers will lose purchasing

power if inflation turns out to be 2.5%.

Effect on saving: If you save $1,000 in the bank at 4% annual interest, then in one years time

you will have $1,040. If the inflation rate is 6%, then the real rate of interest (the interest rate

adjusted for inflation) will be negative, and your savings will not be able to buy as much as they


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could have in the previous year. You would have been better off spending the money rather than

saving it, because it will have lost some of its purchasing power. Therefore, we say that inflation

discourages saving. If people do want to save money, rather than spend on consumption, then

they may choose to buy fixed assets, such as houses or art. This means that there are fewer

savings available in the economy for investment purposes, and this has negative implications for

economic growth.

Effect on interest rates: Commercial banks make their money from charging interest to people

who borrow money from them. If there is a high rate of inflation, then banks raise theirnominal

interest rates in order to keep the real rate that they earn positive.

Effect on international competitiveness: If a country has a higher rate of inflation than that of

its trading partners, then this will make its exports less competitive, and will make imports from

lower-inflation trading partners more attractive. This may lead to fewer export revenues and

greater expenditure on imports, thus worsening the trade balance. It might lead to unemploymentin export industries and in industries that compete with imports.

Uncertainty: Not only might there be reduced investment due to a fall in the availability of

savings, and higher nominal interest rates, but firms may be discouraged from investing due to

the uncertainty associated with inflation. Again, this has negative implications for economic

growth.

Labour unrest: This may occur if workers do not feel that their wages and salaries are keeping

up with inflation. It may lead to disputes between unions and management.

4.3 Costs of deflation

Although as consumers we might be pleased to face falling prices, a significant number of

problems can be associated with a fall in the price level. In fact, economists might argue that the

costs of deflation are greater than the costs of inflation.

Unemployment: The biggest problem associated with deflation is unemployment. If aggregate

demand is low, then businesses are likely to lay off workers. This may then lead to a deflationary

spiral. If prices are falling, consumers will put off the purchase of any durable goods as they willwant to wait until the prices drop even further. This may be referred to as deferred consumption.

This will further reduce aggregate demand. If households become pessimistic about the

economic future, then consumer confidence will fall. Low consumer confidence is likely to

further depress aggregate demand. Thus a deflationary spiral may occur.


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Effect on investment: When there is deflation, businesses make less profit, or make losses. This

may lead them to lay off workers. Furthermore, business confidence is likely to be low, and this

is likely to result in reduced investment. This has negative implications for future economic

growth.

Costs to debtors: Anyone who has taken a loan (this includes all homeowners who have taken

a mortgage to buy their home) suffers as a result of inflation because the value of their debt rises

as a result of deflation. If profits are low, this may make it too difficult for businesses to pay

back their loans and there may be many bankruptcies. This will further worsen business

confidence.

5. MEASUREMENT METHODS

It is necessary to have some kind of an accurate measure of the increase in the price level. The

most widely used statistic to measure inflation is known as the consumer rice index (CPI). In

some countries, this is referred to as the retail price index (RPI). Not all prices change by the

same amount over a given period of time; for example, the price of chocolate might increase by

5% in a year, while the price of petrol might increase by 10%. Neither of these is an appropriate

measure of the change in the average price level. Statisticians in different countries around the

world have slightly different ways of measuring the rate of inflation, but the central idea is the

same. Simply put, they choose what is known as a representative basket of consumer goodsand services and measure how the price of this basket changes over time. When the price of the

basket increases, then this means that the average price level has risen.

It would be impossible to devise a measure of inflation that includes all goods and services

bought by consumers. In each country, the agency in charge of the compilation of economic data

creates a list of the typical goods and services consumed by the average household. These items

are grouped into a number of different categories. The prices of these items are measured each

month to calculate the change in the price of the basket. The change in the price of the basket

is reflected in the measure called the consumer price index. It is important to point out that some

of the goods and services consumed are far more important than others, because they take up alarger share of consumers income. Thus the categories are given a weight in the index to reflect

their importance in the average consumers income.

People consider the rate of inflation important because it affects their planning. They will spend

money differently if they expect a 20% annual price increase than if they expect stable prices.

For example, if prices are declining, holding inventories is expensive, and sellers will try to


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minimize inventories. The price at which people borrow and lend funds will also depend heavily

on what they expect to happen to prices.

The Department of Labor provides a simple, common-sense way to measure inflation, the

Consumer Price Index or CPI. The Labor Department has surveyed the purchasing patterns of

consumers to determine a group of about 400 items that buyers typically use. This shopping list

of400 items makes up a "market basket." Each month a host of price surveyors checks on the

prices of these items in cities across America. These results are then used to compute what the

market basket costs compared to what it cost in a base period.

A numerical example makes this procedure clear. Suppose a representative market basket of

weekly expenditures of teenagers is three hamburgers, eight colas, and one gallon of gasoline.

(Of course this is much too small a basket to be realistic, but this example illustrates the

procedure.) With the prices of year 1 shown in the table below, the cost of the market basket is

$5.00. In year2 two prices have risen and one has declined. Yet one can say that on the whole

the price level has risen because the cost of the market basket has risen to $5.50. This is an

increase of 10% (50/500 = 10%). From year2 to year3 prices change again, and the cost of the

market basket goes up by another $.50. In year3 the price level is 20% higher than it was in year

1 ([600 - 500]/500 = 20%), and 9.1% higher than in year2 ([600 - 550]/550 = 9.1%).

COMPUTING A PRICE INDEX

. AMOUNT PRICE YEAR 1PRICE YEAR

2

PRICE YEAR

3

Hamburgers 3 .75 .70 .90

Colas 8 cans .25 .30 .30

Gasoline 1 gallon .75 1.00 .90

Cost of the

Market Basket5.00 5.50 6.00

Price Index 100.00 110.00 120.00

To compute the price index, the cost of the market basket in any period is divided by the cost of

the market basket in the base period, and the result is multiplied by 100. In the table above, year

1 is the base year. The price index for year3 is:

Price Index = (P3/Pb) x 100 = (6.00/5.00) x100 = 120.00


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The price index tries to give in one number a general picture of what is happening to a great

many numbers. As the example shows, some prices may actually be declining while the price

index is rising. These prices were not ignored by the price index; rather their contribution was

less important to the overall result than the contribution of items whose prices rose.

The construction of a number of other important economic data series uses the method of the

price index. The Dow Jones Industrial Average, which many people watch to learn about what

the stock market is doing, uses a market basket of30 stocks. (Notice that the stock market is an

aggregated market made up of the markets for hundreds of individual stocks.) We will take a

brief look at the Index of Leading Economic Indicators which is now published by the

Conference Board. Other widely-reported indexes include the Index of Producer Prices (which

used to be called the Wholesale Price Index) published by the Commerce Department and the

Index of Industrial Production published by the Federal Reserve System.

Another important economic measurement is that of production, done with Gross Domestic

Product.

5.1 Gross Domestic Product

Gross Domestic Product, or GDP for short, measures the value of a nation's output of goods and

services for some period of time, usually a year. It is not the only measure of output--the Federal

Reserve, for example, publishes an index of industrial production--but the GDP has become a

favorite among economists because it is the most comprehensive of output measures.1

In arriving at GDP, the Commerce Department is careful not to double count transactions. If itcounted the sale of steel to General Motors from U.S. Steel and also the value of the cars that

GM produced, it would count the steel twice, once in an unfinished form, and once in a finished

form. In practice it avoids double counting by only including the value added at each stage of

production. Value added is sales minus the cost of raw materials and unfinished goods.

Neither does the Commerce Department count the sale of second-hand items. These were

counted when they were originally purchased, and to count them again would involve double

counting. Finally, it does not count financial transactions, such as the sales of stocks and bonds.

These transactions involve sales of ownership or debt and do not spring directly from the

production of final output. The total of all transactions not counted is much larger than the size ofGDP; the transactions of GDP are only a tiny fraction of total transactions of the economy.

Because GDP measures the value of output, it can increase for two distinct reasons. It can

increase because more goods and services are being produced, or it can increase because prices

of goods and services have risen. To eliminate the effects of changing prices, one must compute


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real or constant-dollar GDP which values the output of various time periods with a set of fixed

prices.

The table below contains output and price statistics for a simple economy that produces only

three goods. In the first year the value of output or GDP is $1000, and in the second year GDP is

$1120. These numbers are obtained by multiplying quantities by prices, and then summing the

resulting values. They give us current-dollar or nominal GDP, that is, the value of output

measured in prices that existed when the output was produced.

PRODUCTION AND PRICES

YEAR 1 YEAR2

GOODS OUTPUT PRICES OUTPUT PRICES

APRICOTS 10 $50 10 $55

BROCCOLI 10 $25 12 $25

CARROTS 10 $25 9 $30

GDP has risen by 12% from the first year to the second, but this increase is only partially due to

additional output. Part of the increase is due to changed prices. To get a measure that contains

only the increase in output, we can multiply the outputs of the second year by the prices of the

first year. When we add up these values, they total $1025. This number implies that if only the

quantities of output had changed and not the prices, GDP would have only increased from $1000

to $1025, a rise of 2.5%. Before the mid-1990s, this is the way in which the Commerce

Department computed real GDP. The procedure has gotten much more complex since then, and

if you want the details, click the "Explore" button at the bottom of the page.

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)

For the example in the table above, the price index will be 100x(1120/1025) = 109.27. This

index says that the price level rose a bit more than 9% from the first year to the second.


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Why does dividing current-dollar GDP by real GDP yield a price index? Since the same amount

of production is in both current and real GDPs, and the only difference between them is in prices.

The ratio of them tells how important those price changes are. 2

Notice that if any two of the variables in the above equation are known, one can solve for the

third using simple algebra. Also, notice that the GDP deflator is not identical with the CPI but

provides an alternative to the CPI as a measure of inflation. Over long periods of time, both

provide similar numbers, but they can diverge in shorter periods. For example, from 1974 to

1975 the deflator showed inflation increasing from a 5.9% rate to a 9.3% rate, while the CPI

showed it decreasing from an 11% rate to a 9.1% rate.

Other widely used price indices for calculating price inflation include the following:

y Producer price indices (PPIs) which measures average changes in prices received by

domestic producers for their output. This differs from the CPI in that price subsidization,

profits, and taxes may cause the amount received by the producer to differ from what the

consumer paid. There is also typically a delay between an increase in the PPI and any

eventual increase in the CPI. Producer price index measures the pressure being put on

producers by the costs of their raw materials. This could be "passed on" to consumers, or

it could be absorbed by profits, or offset by increasing productivity. In India and the

United States, an earlier version of the PPI was called the Wholesale Price Index.

y Commodity price indices, which measure the price of a selection of commodities. In the

present commodity price indices are weighted by the relative importance of the

components to the "all in" cost of an employee.

y

Core price indices: because food and oil prices can change quickly due to changes insupply and demand conditions in the food and oil markets, it can be difficult to detect the

long run trend in price levels when those prices are included. Therefore most statistical

agencies also report a measure of 'core inflation', which removes the most volatile

components (such as food and oil) from a broad price index like the CPI. Because core

inflation is less affected by short run supply and demand conditions in specific markets,

central banks rely on it to better measure the inflationary impact of current monetary

policy.

Other common measures of inflation are:

y GDP deflator is a measure of the price of all the goods and services included in gross

domestic product (GDP). The US Commerce Department publishes a deflator series for

US GDP, defined as its nominal GDP measure divided by its real GDP measure.

y Regional inflation The Bureau of Labor Statistics breaks down CPI-U calculations down

to different regions of the US.


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y Historical inflation Before collecting consistent econometric data became standard for

governments, and for the purpose of comparing absolute, rather than relative standards of

living, various economists have calculated imputed inflation figures. Most inflation data

before the early 20th century is imputed based on the known costs of goods, rather than

compiled at the time. It is also used to adjust for the differences in real standard of living

for the presence of technology.

y Asset price inflation is an undue increase in the prices of real or financial assets, such as

stock (equity) and real estate. While there is no widely accepted index of this type, some

central bankers have suggested that it would be better to aim at stabilizing a wider

general price level inflation measure that includes some asset prices, instead of stabilizing

CPI or core inflation only. The reason is that by raising interest rates when stock prices or

real estate prices rise, and lowering them when these asset prices fall, central banks might

be more successful in avoiding bubbles and crashes in asset prices.

6. PROBLEMS IN MEASUREMENT

Inflation has been defined as a process of continuously rising prices or equivalently, of a

continuously falling value of money.

Various indexes have been devised to measure different aspects of inflation. The CPI measures

inflation as experienced by consumers in their day-to-day living expenses; the Producer Price

Index (PPI) measures inflation at earlier stages of the production process; the Employment Cost

Index (ECI) measures it in the labor market; the BLS International Price Program measures it for

imports and exports; and the Gross Domestic Product Deflator (GDP Deflator) measures

inflation experienced by both consumers themselves as well as governments and otherinstitutions providing goods and services to consumers. The best measure of inflation for a given

application depends on the intended use of the data.

The CPI is generally the best measure for adjusting payments to consumers when the intent is to

allow consumers to purchase at today's prices, a market basket of goods and services equivalent

to one that they could purchase in an earlier period. But there are many limitations associated

with the measurement of CPI

6.1 Limitations in Application and Measurement of Inflation

While the CPI is a convenient way to compute the cost of living and the relative price level

across time, because it is based on a fixed basket of goods, it does not provide a completely

accurate estimate of the cost of living. The limitations with the CPI are either limitations in

applications or limitations in measurement


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6.1.1 Limitations in Application

Substitution Bias - The first problem with the CPI is the substitution bias. As the prices of

goods and services change from one year to the next, they all do not change by the same amount.

The number of specific items that consumers purchase changes depending upon the relative

prices of items in the fixed basket. But since the basket is fixed, the CPI does not reflect

consumer's preference for items that increase in price little from one year to the next. The

intuitive phenomenon of consumers substituting purchase of low priced items for higher priced

items is not accounted for by the CPI.

Introduction of New Items - The second problem with the CPI is the introduction of new items.

As time goes on, new items enter into the basket of goods and services purchased by the typical

consumer. Since the CPI uses only a fixed basket of goods, the introduction of a new product

cannot be reflected. Statisticians try to take into account changes in consumption habits by

making changes to the basket. Items are removed or added to be more representative of thetypical households demand. However, this takes a good deal of time. Moreover, if the items in

the basket are changed, then this limits the ability of analysts to make comparisons from one

time period to another. This is complicated by the fact that the quality of goods changes over

time.

Seasonal changes of prices-Prices may change for a variety of reasons that are not sustained.

For example, seasonal variations in the prices of food and volatile oil prices may lead to unusual

movements in the inflation rate and can be misleading. Statisticians make some effort to reduce

such distorting effects by identifying a core rate of inflation that uses the information of theconsumer price index but excludes food and energy prices.

Differences in purchasing habits - Measuring inflation using the consumer price index has one

main limitation. The basket used in any country represents the purchasing habits of a typical

household, but this will not be applicable to all people. The purchasing habits of different people

will clearly vary greatly.

For example, the basket of a family with children will be very different from that of an elderly

couple. Similarly, the basket of a rich family will be different from that of a poor family.

Change in quality-Another problem with the CPI is that changes in the quality of goods and

services are not well handled. When an item in the fixed basket of goods used to compute the

CPI increases or decreases in quality, the value and desirability of the item changes. For

example, if some good X becomes much more satisfying than in earlier time periods, but the

price of X does not change, then the cost of living would remain the same while the standard of

living would increase. This change would not be reflected in the CPI from one year to the next.


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6.1.2 Limitations in Measurement

There may be errors in the collection of data that limit the accuracy of the final results.

Because it would be utterly impossible to collect the prices of all items bought by all households

in all possible locations, it is necessary to take sample items in a sample of selected cities and a

sample of selected outlets. The layers of sampling are likely to lead to some degree of

inaccuracy. The larger the sample, the more accurate will be the results, but this is time-

consuming and very costly.

There may be variations in regional rates of inflation within a country. Although regional figures

are published, the national figure is the more widely-used measure, and this may not be an

accurate reflection for a particular area. If the national average is used as the basis for wage

negotiations or pension changes, then these might not accurately reflect the price changes for a

particular group. This will be harmful if the group has a higher cost of living than suggested by

the national average, and beneficial for those whose spending costs are less than the average.

Countries measure their rate of inflation in different ways, and include different components.

This can make it problematic to make international comparisons.

The CPI only measures changes in consumer prices. The changes in producer prices and

commodity prices are not given due importance in the measurement of inflation.

Until the 1930s, it was commonly believed by economists that deflation would cure itself. As

prices decreased, demand would naturally increase and the economic system would correct itself

without outside intervention.

This view was challenged in the 1930s during the Great Depression. Keynesian economistsargued that the economic system was not self-correcting with respect to deflation and that

governments and central banks had to take active measures to boost demand through tax cuts or

increases in government spending. Reserve requirements from the central bank were high

compared to recent times. So were it not for redemption of currency for gold (in accordance with

the gold standard), the central bank could have effectively increased money supply by simply

reducing the reserve requirements and through open market operations (e.g., buying treasury

bonds for cash) to offset the reduction of money supply in the private sectors due to the collapse

of credit (credit is a form of money).

With the rise of monetarist ideas, the focus in fighting deflation was put on expanding demand

by lowering interest rates (i.e., reducing the "cost" of money).

To fight deflation, attempts must be made to raise the volume of aggregate effective demand. It

will output, income and employment in the economy, Effective demand can be increased partly

by consumption expenditure and partly by increasing investment expenditure. Various measures

to increase consumption and investment expenditures in the economy.


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1. Reduction in Taxation:

The government should reduce the number and burden of various taxes levied on commodities.

This will increase the purchasing power of the people. As a result, the demand for goods and

services will increase. Moreover, sufficient tax relief should be given to businessmen to

encourage investment.

2. Redistribution of Income:

Marginal propensity to consume can be raised by a redistribution of income and wealth from the

rich to the poor. Since the marginal propensity to consume of the poor is high and that of the rich

is low, such a measure will help increasing the aggregate demand in the economy.

3. Repayment of Public Debt:

During deflation period, the government can repay the old public debts. This will increase the

purchasing power of the people and push up effective demand.

4. Subsidies:

The government should give subsidies to induce the businessmen to increase investment.

5. Public Works Programme:

The government should also directly undertake public works programme and thus increase

expenditure in public sector. Care should, however, be taken that the public works policy of the

government does not adversely affect investment in the private sector; it should supplement, and

not supplant, private investment. For this, it is important that only those projects should be

selected for the government's public works policy, which is either too big or not so profitable to

attract private investment.

6. Deficit Financing:

In order to have significant expansionary effects, the government's public works schemes should

be financed by the method of deficit financing, i.e,, by printing new money. The government

should adopt a budgetary deficit (excess of government expenditure over its revenue) and cover

this deficit through deficit financing. Deficit financing makes available to the government

sufficient resources for its developmental programmes without adversely affecting investment in

the private sector.

7. Reduction in Interest Rate:

By adopting a cheap money policy, the monetary authority of a country reduced the interest rate,which stimulates investment and thereby expands economic activity in the economy.

8. Credit Expansion:

The central bank and the commercial banks should adopt a policy of credit expansion to promote

business and industry in the country. Bank credit should be made easily available to the

entrepreneurs for productive purposes.


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9. Foreign Trade Policy:

To control deflation, the government should adopt such a foreign trade policy that, on the one

hand, increases exports, and, on the other hand, reduces imports. This kind of policy will go a

long way in solving the problem of overproduction, and help overcoming deflation.

10. Regulation of Production:

Production in the economy should be regulated in such a way that the problem of over-

production does not arise. Attempts should be made to adjust production with the existing

demand to avoid over-production.

In short, fiscal policy alone or monetary policy alone is not sufficient to check deflation in an

economy. A proper co- ordination of fiscal, monetary and other measures is essential to

effectively deal with the deflationary situation

7. CONTROL MEASURES

Until the 1930s, it was commonly believed by economists that deflation would cure itself. As

prices decreased, demand would naturally increase and the economic system would correct itself

without outside intervention.

This view was challenged in the 1930s during the Great Depression. Keynesian economists

argued that the economic system was not self-correcting with respect to deflation and that

governments and central banks had to take active measures to boost demand through tax cuts or

increases in government spending. Reserve requirements from the central bank were highcompared to recent times. So were it not for redemption of currency for gold (in accordance with

the gold standard), the central bank could have effectively increased money supply by simply

reducing the reserve requirements and through open market operations (e.g., buying treasury

bonds for cash) to offset the reduction of money supply in the private sectors due to the collapse

of credit (credit is a form of money).

With the rise of monetarist ideas, the focus in fighting deflation was put on expanding demand

by lowering interest rates (i.e., reducing the "cost" of money).

7.1 Control Measures of Deflation

To fight deflation, attempts must be made to raise the volume of aggregate effective demand. It

will output, income and employment in the economy, Effective demand can be increased partly

by consumption expenditure and partly by increasing investment expenditure. Various measures

to increase consumption and investment expenditures in the economy.


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1. Reduction in Taxation:

The government should reduce the number and burden of various taxes levied on commodities.

This will increase the purchasing power of the people. As a result, the demand for goods and

services will increase. Moreover, sufficient tax relief should be given to businessmen to

encourage investment.

2. Redistribution of Income:

Marginal propensity to consume can be raised by a redistribution of income and wealth from the

rich to the poor. Since the marginal propensity to consume of the poor is high and that of the rich

is low, such a measure will help increasing the aggregate demand in the economy.

3. Repayment of Public Debt:

During deflation period, the government can repay the old public debts. This will increase the

purchasing power of the people and push up effective demand.

4. Subsidies:

The government should give subsidies to induce the businessmen to increase investment.

5. Public Works Programme:

The government should also directly undertake public works programme and thus increase

expenditure in public sector. Care should, however, be taken that the public works policy of the

government does not adversely affect investment in the private sector; it should supplement, and

not supplant, private investment. For this, it is important that only those projects should be

selected for the government's public works policy, which is either too big or not so profitable to

attract private investment.

6. Deficit Financing:

In order to have significant expansionary effects, the government's public works schemes should

be financed by the method of deficit financing, i.e,, by printing new money. The government

should adopt a budgetary deficit (excess of government expenditure over its revenue) and cover

this deficit through deficit financing. Deficit financing makes available to the government

sufficient resources for its developmental programmes without adversely affecting investment in

the private sector.

7. Reduction in Interest Rate:

By adopting a cheap money policy, the monetary authority of a country reduced the interest rate,which stimulates investment and thereby expands economic activity in the economy.

8. Credit Expansion:

The central bank and the commercial banks should adopt a policy of credit expansion to promote

business and industry in the country. Bank credit should be made easily available to the

entrepreneurs for productive purposes.


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9. Foreign Trade Policy:

To control deflation, the government should adopt such a foreign trade policy that, on the one

hand, increases exports, and, on the other hand, reduces imports. This kind of policy will go a

long way in solving the problem of overproduction, and help overcoming deflation.

10. Regulation of Production:

Production in the economy should be regulated in such a way that the problem of over-

production does not arise. Attempts should be made to adjust production with the existing

demand to avoid over-production.

In short, fiscal policy alone or monetary policy alone is not sufficient to check deflation in an

economy. A proper co- ordination of fiscal, monetary and other measures is essential to

effectively deal with the deflationary situation

7.2 Control Measures of Inflation

We have studied above that inflation is caused by the failure of aggregate supplyto equal the

increase in aggregate demand. Inflation can, therefore, be controlled byincreasing the supplies

and reducing money incomes in order to control aggregate edemand. The various methods are

usually grouped under three heads: Monetary measures, fiscal measures and other measures.

7.2.1 Monetary MeasuresThe most important and commonly used method to control inflation is monetary policy of the

Central Bank. Most central banks use high interest rates as the traditional way to fight or prevent

inflation.

Monetary measures used to control inflation include:

Bank rate policy

Bank rate policy is used as the main instrument of monetary control during the period of

inflation. When the central bank raises the bank rate, it is said to have adopted a dear money

policy. The increase in bank rate increases the cost of borrowing which reduces commercial

banks borrowing from the central bank. Consequently, the flow of money from the commercial

banks to the public gets reduced. Therefore, inflation is controlled to the extent it is caused by

the bank credit.

Cash reserve ratio

Cash Reserve Ratio (CRR) : To control inflation, the central bank raises the CRR which reduces

the lending capacity of the commercial banks. Consequently, flow of money from commercial

banks to public decreases. In the process, it halts the rise in prices to the extent it is caused by

banks credits to the public.


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Open Market Operations

Open market operations refer to sale and purchase of government securities and bonds by the

central bank. To control inflation, central bank sells the government securities to the public

through the banks. This results in transfer of a part of bank deposits to central bank account and

reduces credit creation capacity of the commercial banks.

Credit Control

One of the important monetary measures is monetary policy. Thecentral bank of the country

adopts a number of methods to control the quantity andquality of credit. For this purpose, it

raises the bank rates, sells securities in the openmarket, raises the reserve ratio, and adopts a

number of selective credit controlmeasures, such as raising margin requirements and regulating

consumer credit. Monetary policy may not be effective in controlling inflation, if inflation is due

to cost-push factors. Monetary policy can only be helpful in controlling inflation due to demand-

pull factors.

Demonetization of Currency

However, one of the monetary measures is to demonetize currency of higher denominations.

Such a measure is usually adopted when there is abundance of black money in the country.

Issue of New Currency

The most extreme monetary measure is the issue of new currency in place of the old currency.

Under this system, one new note is exchanged for a number of notes of the old currency. The

value of bank deposits is also fixed accordingly. Such a measure is adopted when there is an

excessive issue of notes and there is hyperinflation in the country. It is very effective measure.

But is inequitable for its hurts the small depositors the most.

7.2.2 Fiscal Measures

Monetary policy alone is incapable of controlling inflation. It should, therefore, be supplemented

by fiscal measures. Fiscal measures are highly effective for controlling government expenditure,

personal consumption expenditure, and private and publicinvestment. The principal fiscal

measures are the following:

1. Reduction in Unnecessary Expenditure

The government should reduce unnecessary expenditure on non-development activities in order

to curb inflation. This will also put a check on private expenditure which is dependent upon

government demand for goods and services. But it is not easy to cut government expenditure

.Though economy measures are always welcome but it becomes difficult to distinguish between

essential and non-essential expenditure. Therefore, this measure should be supplemented by

taxation.


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2. Increase in Taxes

To cut personal consumption expenditure, the rates of personal, corporate and commodity taxes

should be raised and even new taxes should be levied, but the rates of taxes should not be so high

as to discourage saving, investment and production. Rather, the tax system should provide larger

incentives to those who save, invest and produce more. Further, to bring more revenue into thetax-net, the government should penalize the tax evaders by imposing heavy fines. Such measures

are bound to be effective in controlling inflation. To increase the supply of goods within the

country, the government should reduce import duties and increase export duties.

3. Increase in Savings

Another measure is to increase savings on the part of the people.This will tend to reduce

disposable income with the people, and hence personal consumption expenditure. But due to the

rising cost of living, people are not in a position to save much voluntarily. Keynes, therefore,

advocated compulsory savings or what he called `deferred payment' where the saver gets hismoney back after some years. For this purpose, the government should float public loans

carrying high rates of interest, start saving schemes with prize money, or lottery for long periods,

etc. It should also introduce compulsory provident fund, provident fund-cum-pension schemes,

etc. compulsorily. All such measures to increase savings are likely to be effective in controlling

inflation.

4. Surplus Budgets

An important measure is to adopt anti-inflationary budgetary policy.For this purpose, the

government should give up deficit financing and instead have surplus budgets. It means

collecting more in revenues and spending less.

5. Public Debt

At the same time, it should stop repayment of public debt and postpone itto some future date till

inflationary pressures are controlled within the economy. Instead, the government should borrow

more to reduce money supply with the public. Like the monetary measures, fiscal measures alone

cannot help in controlling inflation. They should be supplemented by monetary, non-monetary

and non fiscal measures.

7.2.3 Other Measures

The other types of measures are those which aim at increasing aggregate supply and reducing

aggregate demand directly.

1. To Increase Production

The following measures should be adopted to increase production:(i) One of the foremost

measures to control inflation is to increase the production of essential consumer goods like food,


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clothing, kerosene oil, sugar, vegetable oils, etc.(ii) If there is need, raw materials for such

products may be imported on preferential basis to increase the production of essential

commodities. (iii) Efforts should also be made to increase productivity. For this purpose,

industrial peace should be maintained through agreements with trade unions, binding them not to

resort to strikes for some time. (iv)The policy of rationalization of industries should be adopted

as a long-term measure. Rationalization increases productivity and production of industries

through the use of brain, brawn and bullion. (v) All possible help in the form of latest

technology, raw materials, financial help ,subsidies, etc. should be provided to different

consumer goods sectors to increase production.

2. Rational Wage Policy

Another important measure is to adopt a rational wage and income policy. Under hyperinflation,

there is a wage-price spiral. To control this, the government should freeze wages, incomes,

profits, dividends, bonus, etc. But such a drastic measure can only be adopted for a short period

and by antagonizing both workers and industrialists. Therefore, the best course is to link increasein wages to increase in productivity. This will have a dual effect. It will control wage and at the

same time increase productivity, and hence production of goods in the economy.

3. Price Control

Price control and rationing is another measure of direct control to check inflation. Price control

means fixing an upper limit for the prices of essential consumer goods. They are the maximum

prices fixed by law and anybody charging more than these prices is punished by law. But it is

difficult to administer price control.

4. Rationing

Rationing aims at distributing consumption of scarce goods so as to make them available to a

large number of consumers. It is applied to essential consumer goods such as wheat, rice, sugar,

kerosene oil, etc. It is meant to stabilise the prices of necessaries and assure distributive justice.

But it is very inconvenient for consumers because it leads to queues, artificial shortages,

corruption and black marketing. Keynes did not favour rationingfor it "involves a great deal of

waste, both of resources and of employment."

From the various monetary, fiscal and other measures discussed above, it becomes clear that to

control inflation, the government should adopt all measures simultaneously. Inflation is like ahydra-headed monster which should be fought by using all the weapons at the command of the

government.


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8. CASE STUDY

8.1 Inflation Case Study

8.1.1 Pakistan

The food price inflation is a worldwide phenomenon and Pakistani markets have also felt the

heat. The World Bank report on food inflation estimates that in March 2011, food index

remained 36% higher than last year. The IMF forecast for Gross Domestic Product (GDP)

growth rates and Inflation shows Pakistan continues to have double digit inflation well into 2012.

Both growth and inflation figures for Pakistan economy are disappointing when compared with

other South Asian countries and this also confirms that the economy is more vulnerable to both

exogenous and endogenous shocks.

The characteristic of recent inflation in Pakistan has been concentrated on the food and energy,

two items which impact the poor more and has deep cuts across the economy. The World Bank

estimates indicate that a 40% increase in wheat price in Pakistan would cause 2 percentage point

increase in national poverty.

Unfortunately, Pakistan has high concentration of households around the poverty line and food

takes close to half of total spending which make them very vulnerable to food price increases.

As a result, lower income groups in Pakistan tended to experience higher inflation rates than

higher income groups. The trends seem to continue; the low income group having income up to

Rs5,000 suffered an inflation rate, on average, of 15.17% during 2008/10 and of 13.95% for

income group earning above Rs12,000, during 2008/10.

The Economic Survey of Pakistan 2010/11 reckons, that overall food imports accounted for

13.5% of total imports in July,-March 2010/11. The floods and sporadic rains, weak currency,

flattening yield growth of major crops, low productivity gains, increasing costs of agriculture

inputs, population syndrome, energy shortage, and stocking of essential items, are further feeding

into inflationary pressure.

Remedies

To rein-in domestic demand and inflationary pressures, the State Bank of Pakistan has adopted a

tight monetary stance. The stance may be more effective when spending is interest sensitive.

However, it no way can help trim food inflation, given the elasticity of demand of food items.

Hence, besides, advocating demand side policies one should also not ignore the importance of

supply side of the economy.

Going forward measures such as; making Pakistan Agriculture Research Council more vibrant

and result oriented, broad-based productivity gains, timely import of essential food items to

soften prices, effective support price mechanism and encouraging corporate-framing concept,


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strong checks on food cartels and hoardings, building water reservoirs, improving farm-to-

market road networks, scientifically maintaining storage capacity of agri-produce, regional trade

liberalisation, and broadening of the safety nets for the poor are some helpful measures to meet

the challenge of rising food inflation.

8.2 Deflation: Case Study8.2.1 Hong Kong

Following the Asian financial crisis in late 1997, Hong Kong experienced a long period of

deflation which did not end until the 4th quarter of2004. Many East Asian currencies devalued

following the crisis.

The Hong Kong dollar however, was pegged to the US Dollar, leading to an adjustment instead

by a deflation of consumer prices.Thus, gap was filled by deflation of consumer prices.

The situation is worsened with cheap commodity goods from Mainland China, and weak

consumer confidence in Hong Kong.

This deflation was accompanied by an economic slump that was more severe and prolonged than

those of the surrounding countries that devalued their currencies in the wake of the Asian

financial crisis

According to Guinness World Records, Hong Kong was the economy with lowest inflation in

2003.

8.2.2 IrelandIn February 2009, Irelands Central Statistics Office announced that during January 2009, the

country experienced deflation, with prices falling by 0.1% from the same time in 2008.

This is the first time deflation has hit the Irish economy since 1960. Overall consumer prices

decreased by 1.7% in the month.

Minister for Finance Brian Lenihan has said that deflation must be taken into account when

Budget cuts in child benefit, public sector pay and professional fees are being considered. Mr

Lenihan said month-on-month there has been a 6.6% decline in the cost of living this year.

The Minister mentions the deflation as an item of data helpful to the arguments for a cut in

certain benefits. The alleged economic harm caused by deflation is not alluded to or mentioned

by this member of government. This is a notable example of deflation in the modern era being

discussed by a senior financial Minister without any mention of how it might be avoided.


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8.2.3 United KingdomDuring World War I the British pound sterling was removed from the gold standard. The

motivation for this policy change was to finance World War I; one of the results was inflation,

and a rise in the gold price, along with the corresponding drop in international exchange rates for

the pound. When the pound was returned to the gold standard after the war it was done on thebasis of the pre-war gold price, which, since it was higher than equivalent price in gold, required

prices to fall to realign with the higher target value of the pound.

The UK experienced deflation of approx 10% in 1921, 14% in 1922, and 3 to 5% in the early

1930s

8.2.4 United StatesMajor deflations in the US

There have been four significant periods of deflation in the United States.

y The first and most severe was during the depression from 1818-21 when prices of

agricultural commodities declined by almost 50%. The price of agricultural commodities

fell by almost 50% from the high in 1815 to the low in 1821, and did not recover until the

late 1930s, although to a significantly lower price level. Most damaging was the price of

cotton, the U.S.'s main export. Food crop prices, which had been high because of the

famine of 1816 that was caused by the year without a summer, fell after the return of

normal harvests in 1818. Improved transportation, mainly from turnpikes, and to a minor

extent the introduction of steamboats, significantly lowered transportation costs.

y

The second was the depression of the late 1830s to 1843, following the Panic of 1837,when the currency in the United States contracted by about 30%, a contraction which is

only matched by the Great Depression. This "deflation" satisfies both definitions, that of

a decrease in prices and a decrease in the available quantity of money.

y The third was after the Civil War, sometimes called The Great Deflation. It was possibly

spurred by return to a gold standard, retiring paper money printed during the Civil War.

y The fourth was between 19301933 when the rate of deflation was approximately 10

percent/year; part of the United States' slide into the Great Depression, where banks

failed and unemployment peaked at 25%.

The deflation of the Great Depression occurred partly because there was an enormouscontraction of credit (money), bankruptcies creating an environment where cash was in frantic

demand, and when the Federal Reserve was supposed to accommodate that demand, it instead

contracted the money supply by 30% in enforcement of its new real bills doctrine, so banks

toppled one-by-one (because they were unable to meet the sudden demand for cash)


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Minor deflations in the US

Throughout the history of the United States, inflation has approached zero and dipped below for

short periods of time (negative inflation is deflation). This was quite common in the 19th

century, and in the 20th century until the permanent abandonment of the gold standard for

the Bretton Woods System in 1948

. There has only been one period of deflation since, in2008-

2009.

Year-on-year, consumer prices dropped for six months in a row to end-August 2009, largely due

to a steep decline in energy prices. Consumer prices dropped 1 percent in October, 2008. This

was the largest one-month fall in prices in the US since at least 1947. That record was again

broken in November, 2008 with a 1.7% decline. In response, the Federal Reserve decided to

continue cutting interest rates, down to a near-zero range as of December 16, 2008. The United

States then began experiencing measurable deflation, steadily decreasing from the first measured

deflation of -0.38% in March, to July's deflation rate of -2.10%.

8.2.5 JapanDeflation started in the early 1990s. The Bank of Japan and the government tried to eliminate it

by reducing interest rates and 'quantitative easing', but did not create a sustained increase in

broad money and deflation persisted. In July 2006, the zero-rate policy was ended.

Systemic reasons for deflation in Japan can be said to include:

y Tight monetary conditions. The Bank of Japan kept monetary policy loose only when

inflation was below zero, tightening whenever deflation ends.

y Unfavorable demographics. Japan has an aging population (22.6% over age 65) that is

not growing and will soon start a long decline. The Japanese death rate recently exceededits birth rate.

y Fallen asset prices. In the case of Japan asset price deflation was a mean reversion or

correction back to the price level that prevailed before the asset bubble.

y Insolvent companies: Banks lent to companies and individuals that invested in real

estate. When real estate values dropped, these loans could not be paid. The banks could

try to collect on the collateral (land), but this wouldn't pay off the loan. Banks delayed

that decision, hoping asset prices would improve. These delays were allowed by national

banking regulators. Some banks made even more loans to these companies that are used

to service the debt they already had. This continuing process is known as maintaining an

"unrealized loss", and until the assets are completely revalued and/or sold off (and the

loss realized), it will continue to be a deflationary force in the economy

y Insolvent banks: Banks with a larger percentage of their loans which are "non-

performing", that is to say, they are not receiving payments on them, but have not yet

written them off, cannot lend more money; they must increase their cash reserves to

cover the bad loans.


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y Fear of insolvent banks: Japanese people are afraid that banks will collapse so they

prefer to buy (United States or Japanese) Treasury bonds instead of saving their money in

a bank account. This likewise means the money is not available for lending and therefore

economic growth. This means that the savings rate depresses consumption, but does not

appear in the economy in an efficient form to spur new investment. People also save by

owning real estate, further slowing growth, since it inflates land prices.

y Imported deflation: Japan imports Chinese and other countries' inexpensive consumable

goods (due to lower wages and fast growth in those countries) and inexpensive raw

materials, many of which reached all time real price minimums in the early 2000s. Thus,

prices of imported products are decreasing. Domestic producers must match these prices

in order to remain competitive. This decreases prices for many things in the economy,

and thus is deflationary.

9. INFLATION IN INDIAN SCENARIO

Inflation is no stranger to the Indian economy. In fact, till the early nineties Indians were used to

double-digit inflation and its attendant consequences. But, since the mid-nineties controlling

inflation has become a priority for policy framers.

The natural fallout of this has been that we, as a nation, have become virtually intolerant to

inflation. While inflation till the early nineties was primarily caused by domestic factors (supply

usually was unable to meet demand, resulting in the classical definition of inflation of too much

money chasing too few goods), today the situation has changed significantly.

Now that the inflation rate is around 11% in India, the question is why the inflation rate in India

is so high as compared to the other emerging and overheating market economies, like China,

Korea and Indonesia where inflation just touches a mere 3 per cent. There are a couple of

explanations for this-

Firstly, India has been very much underinvested as compared to China whose rate of investment

for the year2009 was 45 per cent as compared to Indias 37 per cent. This has been the key to

Chinas development, (currently fastest in the world) free from all scars of inflationary pressure.

India has always been subjected to uncertainty of the monsoons, particularly 2008 year, which

led to a sharp fall in agricultural produce, declining supply and thus shooting up the prices. Thisis called the Supply shock factor or the cost push inflation.

Another reason, intuitively named as the Policy Shock is responsible for inflation. Hike in fuel

prices, subject to the discretion of OPEC, increases the manufacturing cost of a number of

industries, which in turn shoots up the prices of their respective commodities.


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Apart from the above, there is another explanation, namely overheating: the supply capacity falls

short of demand. Now, overheating in India is a serious cause of worry because it certainly

implies that the economys current growth rate of8.4 per cent surpasses its potential or trend

growth rate. In this scenario, how can anyone in India dream of China-type-double-figure growth

rates unless and until infrastructure development is given some serious thought?

9.1 Measuring Inflation

Inflation in India is mainly estimated on the basis of fluctuations in the wholesale price index

(WPI).The wholesale price index comprises of the following indices:

y Domestic Wholesale Price Index (DWPI)

y Export Price Index (EPI)

y Import Price Index (IPI)

y Overall Wholesale Price Index (OWPI)

The WPI consists of about 435 items and has three broad categories. They are:-

y Primary Articles (weight of22.0253) 22% Index

y Fuel, Power, Light, and Lubricants (weight of 14.2262) - 14% Index

y Manufactured Products (weight of63.7485) 64% Index

For purposes of analysis and to measure more accurately the price levels for different sections

of society and as well for different regions, the RBI kept track of consumer price indices. The

average annual GDP growth in the 2000s was about 6% and during the second quarter (July-

September) of fiscal 2006-2007, the growth rate was as high as 9.2%. All this growth was bound

to lead to higher demand for goods. However, the growth in the supply of goods, especially food

articles such as wheat and pulses, did not keep pace with the growth in demand. As a result,

the prices of food articles increased. According to Subir Gokarn, Executive Director and Chief

Economist, CRISIL, "The inflationary pressures have been particularly acute this time due to

supply

inflation&deflation report

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