introduction

Inflation
 Inflation
• This is the process by which the price level rises and
money loses value.
• There are two kinds of inflation:
• a) Demand pull
• b) Cost push
 Demand pull inflation
• Demand pull inflation may be due to :
a) Increase in money supply
b) Increase in government purchases
c) Increase in exports
 Cost push Inflation
• Cost push inflation may arise because of :
a) Increase in money wage rates
b) Increase in money prices of raw materials.
 Hyper inflation
• Extremely rapid or out of control inflation.
• There is no precise numerical definition to
hyperinflation.
• Price increases are so out of control that the concept
of inflation is meaningless.
• The most famous example of hyperinflation occurred
in Germany between January 1922 and November
1923.
• By some estimates, the average price level increased
by a factor of 20 billion!
 Money and Prices During Hyperinflations

(a) Austria (b) Hungary

Index Index
(Jan. 1921 = 100) (July 1921 = 100)
100,000 100,000
Price level
Price level
10,000 10,000
Money supply
Money supply
1,000 1,000

100 100
1921 1922 1923 1924 1925 1921 1922 1923 1924 1925

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 Stagflation
• A condition of slow economic growth and relatively
high unemployment accompanied by inflation.
• This happened to a great extent during the 1970s,
when world oil prices rose dramatically, fueling sharp
inflation in developed countries.
• At least some central banks have expressed concern
over inflation even as the global economy seems to be
slowing down.

 
 Money Supply, Money Demand, and the Equilibrium Price Level

Value of Price
Money, 1/P Money supply Level, P

(High) 1 1 (Low)

3
/4 1.33

A
/
12 2

Equilibrium Equilibrium
value of price level
money
14
/ 4
Money
demand
(Low) 0 (High)
Quantity fixed Quantity of
by the Fed Money

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 The Effects of Excess Money Supply

Value of Price
Money, 1/P MS1 MS2 Level, P

(High) 1 1 (Low)

1. An increase
3
/4 in the money 1.33
2. . . . decreases supply . . .
the value of
3. . . . and
money . . . A
12
/ 2 increases
the price
level.
B
14
/ 4
Money
demand
(Low) (High)
0 M1 M2 Quantity of
Money

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 How is inflation measured?
• WPI (Wholesale Price Index)
• India- the only major country that uses WPI
(1st published in 1902)
• What is WPI?
• The WPI number is a weekly measure of
wholesale price movement for the economy
 WPI- The Indian Example

• Indian government constructed its present

WPI way back in 1993-94 (1993-94 series
replacing 1981-82 bases) by making a basket
of 435 commodities
• Laspeyres formula employed
• The 100-point index is subdivided into three
groups
Major Groups:
• I. Primary Articles (98 items)- 22.02 %
• Food Articles, Non-Food Articles, Minerals
• II. Fuel, Power, Light & Lubricants (19 items)
- 14.23 %
• III. Manufactured Products (318 items)
- 63.75 %
• Food Products
• Beverages, Tobacco & Tobacco Products
• Textiles… etc
• The Office of the Economic Advisor (OEA)
compile the WPI numbers on weekly basis
• On Friday inflation figures are announced
• The working group on WPI, headed by
Planning Commission member Abhijit Sen, has
worked out a new index
• The base year of the new index :2000-01
• The basket of commodities- around 1200
• To Reflect the post-liberalisation consumption
pattern
 Consumer Price Index (CPI)
• A measure of the average price of consumer goods
and services purchased by households (1st published
in 1970)
• CPI indicates the change in the purchasing power of
the consumer
• CPI for Industrial Workers (CPI-IW),
• CPI for Agricultural Labourers / Rural Labourers (CPI
-AL/RL),
• CPI for Urban Non-Manual Employees (CPI-UNME)
• Published on a monthly basis
• Producer Price Index (PPI)
• Measures average changes in prices received
by domestic producers for their output
• Service Price Index (SPI)
• The share of the service sector in the (GDP)
gone up from 28% (1950) to over 50%
• Necessitates representation of Services in the
price index
 Discussion question
• Why is inflation bad?
• Unanticipated inflation is bad because it makes
the economy behave like a giant casino.
• Gains and losses occur because of unpredictable
changes in the value of money.
• If the value of money varies unpredictably over
time, the quantity of goods and services that
money will buy will also fluctuate unpredictably.
• Resources are also diverted from productive
activities to forecasting inflation.
• Unanticipated inflation leads to :
a) Redistribution of income, borrowers and lenders
b)Too much or too little lending or borrowing
 The Economic Impacts of Inflation

• Redistribution of Income and wealth among

different groups
• Distortion in relative prices and outputs of
different goods, or sometimes in output and
employment for the economy as a whole.
 THE COSTS OF INFLATION
• Shoe leather costs
• Menu costs
• Tax distortions
• Confusion and inconvenience
• Arbitrary redistribution of wealth
Shoe leather costs

• Shoe leather costs are the resources wasted when

inflation encourages people to reduce their money
holdings.
• Inflation reduces the real value of money, so people
have an incentive to minimize their cash holdings.
• Less cash requires more frequent trips to the bank
to withdraw money from interest-bearing accounts.
Menu costs

• Menu costs are the costs of adjusting prices.

• During inflationary times, it is necessary to
update price lists and other posted prices.
• This is a resource-consuming process that
takes away from other productive activities.
Inflation-Induced Tax Distortion

• The income tax treats the nominal interest

earned on savings as income, even though
part of the nominal interest rate merely
compensates for inflation.
• The after-tax real interest rate falls, making
saving less attractive.
 Taming Inflation
Monetary policy- Bank rate policies, Open
Market operations, Reserve requirement ratios
Fiscal policy-taxation, public borrowing, public
expenditure
Direct Control-Fixing ceiling prices of the
products, Rationing.
Miscellaneous methods-Controlling
Wages, Controlling population growth
 The Effects of Monetary Injection

Value of Price
Money, 1/P MS1 MS2 Level, P

(High) 1 1 (Low)

1. An increase
3
/4 in the money 1.33
2. . . . decreases supply . . .
the value of
3. . . . and
money . . . A
12
/ 2 increases
the price
level.
B
14
/ 4
Money
demand
(Low) (High)
0 M1 M2 Quantity of
Money

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