Inflation

Learning objectives & outcomes

• What it is?
• Causes
• How is inflation measured
• Features, Types, and effects
What it is?

• Inflation is a sustained rise in overall price levels.

• Persistent increase in the general price level

• Too much money chasing too few goods

-Coulbourn

• A state in which the value of money is falling

- Crowther
Causes of Inflation
Demand-Pull Inflation
Inflation that is initiated by an increase in aggregate demand. It occurs when the
demand for goods or services is higher when compared to the production capacity.
The difference between demand and supply (shortage) result in price appreciation.
Cost-push inflation, or supply-side
Inflation caused by an increase in costs. Increase in prices of the inputs (labour, raw
materials, etc.) increases the price of the product.
Expectations (Built-in Inflation)
Expectation of future inflations results in Built-in Inflation. A rise in prices results in
higher wages to afford the increased cost of living. Therefore, high wages result in
increased cost of production, which in turn has an impact on product pricing. The
circle hence continues.
Money Supply
An increase in the money supply can lead to an increase in the aggregate price
level.
Causes of Inflation
Demand-pull inflation occurs when aggregate demand in an economy rises too
quickly. This can occur if a central bank rapidly increases the money supply
without a corresponding increase in the production of goods and service.
Demand outstrips supply, leading to an increase in prices.
Stagflation
Occurs when output is falling at the same time that prices are rising.
Example of Higher Oil Prices
• Higher oil prices have driven price
increases across sectors of the global
economy.
• In 2020-2022, oil inventories have hit
low levels, causing prices to rise amid
surging COVID-19 reopening demand
and lagging supply.
• Rising oil prices take money out of the
pockets of consumers and businesses.
Supply Chain Disruptions
• Supply chains worldwide drastically slowed
since the emergence of the coronavirus in
early 2020 due to disruptions in shipping
and labor.
• This has caused shortages in materials and,
in turn, higher prices for goods.
• The war in Ukraine has contributed to
supply disruptions and higher prices.

• Economists view oil-price hikes as a

“tax” that can affect economic
conditions.
The term "inflation tax" refers to the penalty for retaining currency during a period of
high inflation. It is a form of taxation in which the government alters the money supply.
When the supply of money expands, the value of existing money decreases, resulting
in a form of tax on existing money holders.
Why should price change matter to us?
• Why do we have to study the Price effect?
• Unpredictable price changes has significant change in economic behaviour of
people?

Consumption: Salaried groups? Retirees?

Savings: Where do you save? Leading to lower investment?
Firms : Higher production and possibly some more investments in the next quarter?
Banks : Lending behavior could change?
Net exports: Can significantly influence the behaviour of imports: What you will
import?

This means a inflation create a correction in the spending, which could

lead to lower spending or higher spending causing disequilibrium in the market.
What are the steps to calculate price change?
Step 1: Calculate the price ( Cost of living index)
Step 2: Calculate the percentage change in price index ( Inflation)

Which price I should take?

• It should be representative in nature.
• It must be high frequency so that I can track on regular basis.

Three price indices:

• GDP deflator
• CPI
• WPI
GDP Deflator
The GDP price deflator shows how much a change in GDP relies on changes in
the price level.

The GDP deflator is calculated as follows:

Nominal GDP
GDP deflator =  100
Real GDP
GDP is the value of all final goods and services:

P1xQ1+P2xQ2+P3xQ3+…..
Nominal GDP measures these values using current prices.
Real GDP measure these values using the prices in a base year (constant prices)
Base year is 2011-12
 Real GDP controls for inflation
Changes in nominal GDP can be due to: changes in prices
changes in quantities of output produced

Changes in real GDP can only be due to changes in quantities, because real GDP is
constructed using constant base-year prices.
 Consumer Price Index (CPI) & Inflation rate
CPI is a measure of the overall level of prices faced by consumers

Uses:
• Tracks changes in the typical household’s cost of living.
• Adjusts many contracts for inflation e.g. D.A.
• Used by RBI to decide monetary policy stance.
How the CPI is compiled
1. Consumers surveyed to determine composition of the
average consumer’s “basket” of goods with around 450
items.
2. Every month, field investigators collect data on prices of all
items in the basket; compute cost of basket.

3. CPI in any month equals

Cost of basket in that month
X 100
Cost of basket in base period

Base year for CPI is 2012

Wholesale Price Index (WPI) & Inflation rate
• A measure of the overall level of market prices
• Tracks changes in wholesale prices
• WPI calculation:

1. Wholesale prices of 676 items are tracked every week

2. Composition of the basket depends on the contribution of
each item to value of economic output
3. WPI in any month equals
Cost of basket in that month
X 100
Cost of basket in base period

Base year for WPI is 2012

 Which is the more reliable Price Index?

Which one is more ‘comprehensive’? CPI & WPI have a fixed basket, but
GDP deflator is more comprehensive

Which one ignores imported consumer goods? CPI includes prices of

imported consumer goods, ignored by WPI, GDP deflator

Which one ignores services? CPI includes prices of services, ignored by WPI

However, CPI might overstate inflation by ignoring shift of households to

cheaper substitutes
Types of Inflation
Based on the rate of inflation
• Creeping inflation – If the rate of inflation is low (upto 3%)
• Walking/Trotting inflation – Rate of inflation is moderate (3-7%)
• Running/Galloping inflation – Rate of inflation is high (>10%)
• Hyper Inflation – Rate of inflation is extreme
Other types
• Deflation - Sustained decrease in price level
• Disinflation- Decrease in inflation
• Stagflation - A combination of high inflation and low growth
Why is Inflation unpopular?
• Higher prices erodes our purchasing power
• But higher prices also translates into higher income
• But nominal income may not keep up with inflation leading to
lower real income
• People suffer from “Money illusion”
• Money illusion posits that people have a tendency to view their wealth and income in
nominal rupee terms, rather than recognize their real value, adjusted for inflation.
• ‘Dosa Economics’ from Raghuram Rajan:
• https://www.youtube.com/watch?v=N9NBTAmtaPY

• Other effects of inflation:

• Creditors lose but debtors' gain
• Uncertainty creates ‘menu costs’