Inflation

Dr. Abdul Salam Lodhi

salam@buitms.edu.pk
 Inflation and it causes
 Inflation: a general rise in the price level of goods and services and a
continuous drop in the value of money over a period of time in an
economy is called inflation.
 Or Inflation is a sustained upward movement in the aggregate price
level that is shared by most products.
 When the general price level rises, each unit of currency buys fewer
goods and services; consequently, inflation reflects a reduction in the
purchasing power per unit of money.
 A loss of real value in the medium of exchange and unit of account
within the economy.
 The common measure of inflation is the inflation rate, the annualized
percentage change in a general price index, usually the consumer price
index, over time.
 General price index is measured through a basket of goods and services.
 What is basket of goods
 A basket of goods refers to a fixed set of consumer goods and services
whose price is evaluated on a regular basis, often monthly or annually.
 This basket is used to track inflation in a specific market or country, so
that if the price of the basket of goods increases by 2% in a year,
inflation can thus be said to be 2%.
 The goods in the basket are meant to be representative of the broader
economy and are adjusted periodically to account for changes in
consumer habits.
 A basket of goods is a constant set of general goods produced in an
economy whose prices are tracked over time.
 The basket is used to measure inflation over time, such as with the
consumer price index (CPI).
 The items in the basket are updated and changed periodically to keep
up with current consumer habits in order to best represent the broader
economy.
 Types of Inflation

 1 Demand Pull inflation

 2 Cost Push Inflation/Wage Push Inflation
 3 Monetary Inflation
 4 Imported Inflation
 5 Hyper inflation
 Demand Pull inflation
 Demand Pull Inflation arises when the aggregate demand goes
up rapidly than the aggregate supply in an economy. In simple
terms, it is a type of inflation which occurs when aggregate
demand for products and services outruns aggregate supply
due to monetary factors and/or real factors.
 Demand-pull inflation is the upward pressure on prices that
follows a shortage in supply. Economists describe it as "too
many dollars chasing too few goods."
 Demand-pull inflation is a tenet of Keynesian economics that
describes the effects of an imbalance in aggregate supply and
demand. When the aggregate demand in an economy strongly
outweighs the aggregate supply, prices go up.
 Cast push Inflation
 Definition: Cost push inflation is inflation caused by an
increase in prices of inputs like labour, raw material,
etc.
 The increased price of the factors of production leads to a
decreased supply of these goods.
 Monetary Inflation
 Monetary inflation is a sustained increase in the money supply of a country.
Depending on many factors, especially public expectations, the
fundamental state and development of the economy, and the transmission
mechanism, it is likely to result in price inflation, which is usually just
called "inflation", which is a rise in the general level of prices of goods and
services.
 MV x PY
 The monetarist explanation of inflation operates through the Quantity
Theory of Money, {\displaystyle MV=PY} where M is the money supply, V is
the velocity of circulation, P is the price level and Y is total transactions or
output.
 As monetarists assume that V and Y are determined, in the long run, by
real variables, such as the productive capacity of the economy, there is a
direct relationship between the growth of the money supply and inflation.
 Conti..
 The mechanisms by which excess money might be translated into
inflation are examined below. Individuals can also spend their excess
money balances directly on goods and services. This has a direct impact
on inflation by raising aggregate demand.
 Also, the increase in the demand for labour resulting from higher
demands for goods and services will cause a rise in money wages and unit
labour costs. The more inelastic the aggregate supply in the economy, the
greater the impact on inflation.
 The increase in demand for goods and services may cause a rise in
imports.
 Although this leakage from the domestic economy reduces the money
supply, it also increases the supply of money on the foreign exchange
market thus applying downward pressure on the exchange rate. This may
cause imported inflation.
 Imported Inflation

 Imported inflation is a general and sustainable price

increase due to an increase in costs of imported
products.
 This price increase concerns the price of raw materials
and all imported products or services used by companies
in a country. Imported inflation is also referred to as cost
inflation.
 Hyper Inflation

 In economics, hyperinflation is used to describe situations

where the prices of goods and services rise uncontrollably
over a defined time period.
 In other words, hyperinflation is extremely rapid
inflation.
 Inflation and unemployment
 Unemployment and inflation are two economic concepts widely used
to measure the wealth of a particular economy.
 Or Unemployment and inflation are two economic determinants that
indicate adverse economic conditions.
 Unemployment is the total of country’s workforce who are employable
but unemployed.
 On the other hand, inflation is the increase in prices of goods and
services available in the market.
 Economic analysts use these rates or values to analyze the strength of
an economy.
 It’s been found that these two terms are interrelated and under
normal conditions have a negative relationship between two
variables.
 What is unemployment
 The unemployment rate is the percentage of employable people in a
country’s workforce. The term employable refers to workers
 who are over the age of 16;
 they should have either lost their jobs or have unsuccessfully sought
jobs in the last month and
 must be still actively seeking work.
 The formula used to calculate unemployment rate is:
 Unemployment rate = number of unemployed persons / labor force.
 If the unemployment rate is high, it shows that economy is
underperforming or has a fallen GDP.
 If the unemployment rate is low, the economy is expanding.
 Unemployment rate sometimes changes according to the industry.
 Expansion of some industries creates new employment opportunities
resulting in a drop in the unemployment rate of that industry.
 Types of unemployment
 There are few types of unemployment.
 Structural unemployment: the unemployment that occurs when changing
markets or new technologies make the skills of certain workers obsolete.
 Frictional unemployment: the unemployment that exists when the lack
of information prevents workers and employers from becoming aware of
each other. This is usually a side effect of the job-search process, and may
increase when unemployment benefits are attractive.
 Cyclical unemployment: type of unemployment that occurs when there is
not enough aggregate demand in the economy to provide jobs for
everyone who wants to work.
 Employment is often people’s primary source of personal income.
 So employment impacts the consumer spending, standard of living and
overall economic growth.
 Relationship between Unemployment and
Inflation
 As mentioned above, the relationship between Unemployment and Inflation was
initially introduced by Alban William Philips.
 Phillips curve demonstrates the relationship between the rate of inflation with
the rate of unemployment in an inverse manner.
 If levels of unemployment decrease, inflation increases.
 The relationship is negative and not linear.
 Graphically, when the unemployment rate is on the x-axis, and the inflation
rate is on the y-axis, the short-run, Phillips curve takes an L-shape.
 Phillips curve is the schedule showing the relationship between the
unemployment and inflation rates.
 The Phillips curve postulate a trade-off between inflation and unemployment:
lower the rate of unemployment can be achieved, but only at the cost of higher
rates of inflation.
 While there is a short run tradeoff between unemployment and inflation, it has
not been observed in the long run.
 Phillips Curve
 When unemployment rises, the inflation rate will possible to fall. This is because:
 If the unemployment rate of a country is high, the power of employees and unions
will be low.
 Then, it is hard for them to demand their labor power and wages because employers
can rent other workers instead of paying high wages.
 Thus, wage inflation is likely to be subdued during the period of rising
unemployment.
 This will reduce the cost of production and reduce the price of goods and services.
 This causes a decrease in the demand pull inflation and cost push inflation.
 High unemployment is a reflection of the decline in economic output.
 Thus, businesses experience an increase in increase in volume goods not sold and
spare capacity.
 In a recession, businesses will experience a greater price competition.
 Therefore, a lower output will definitely reduce demand pull inflation in the
economy.
Thanks