CHAPTER 5

INFLATION,DEFLATION AND
STAGFLATION
 INFLATION AND IT’S CAUSES
• Inflation is process; brings continuous increase in the general price level.
• Money continuously loose its value.
• Gardner Ackley: “Inflation is persistent and appreciable rise in general level or
average of prices”.
• Rising general price level does not mean that price of all good are necessarily
rising.
• During inflation the prices of some goods may constant and few other falling.
• Inflation even does not mean that price of goods rise evenly and proportionally.
• Inflation is continued upward movement in the general(average). level of price.
• Milton Friedman “Inflation is meant a steady and sustained rise in the price”.
 Two Causes of Inflation
Demand Pull Inflation
• Is also called Aggregate Demand inflation.

• According to J.M. Keynes “ demand pull inflation occurs from excess

demand for out put.

• When aggregate Demand increases faster than aggregate supply of

goods and service, the prices of goods tends to increase.

• It is the situation where aggregate demand persistently exceeds

aggregate supply of good at current prices so that the price level is
called pulled up inflation
 Sources of Rises in Aggregate Demand
• Monetarists explanation; Keynes and his followers.

• “ Inflation is always and every a monetary phenomena”.

• When central bank of the country prints and circulates more money into
economy than its demand, it will fuel demand pull inflation.

• The monetarists believe that if money supply increases beyond that

amount which house holds and firms want to hold, it will lead to increase
in aggregate demand.

• This excess increase in aggregate demand for goods and services, due to
higher spending, will pull the prices upward.
• Demand Pull operates in the following way.
•
Continued………………

• J.M Keynes and his associates regards demand pull inflation as NON
MONETARY PHENEOMENA.
• According to them “ may be more than one factors leading to persistent
upward shifts in the aggregate demand.
• E.g. domestic consumers may purchase more goods and services for
consumption due increase in their wealth.
• Business firms may invest more due to higher profit expectation or fall in
interest rate.
• The rise in demand can also be due to increase in government expenditures
• The foreign resident demand for the country’s good can also shift the
aggregate demand upward
• Or all above the given factors combining together shift the price level
upward.
Continued……..

• Demand pull inflation is explained where there is:

1. full employment in the economy
2. there is less than full employment in the economy

Demand Pull inflation and full employment: if the country’s

resources are fully employed and there is an increase in aggregate
demand for goods, it will lead to an upward movement in price.

Demand pull inflation where aggregate demand exceeds aggregate

supply of goods at full employment.
5.1 figure. Shows there is no rise in general price level in range 1.
The reason is that there are large number of human and property
resources which are lying idle.
They can be put back to work at the existing price.
Continued……..
• As demand continues to rise, the economy enters to stage 2 where
there a price and output rises.

• A total spending increases, the economy enters into stage 3.

• In the range 3, the economy is working at its full capacity. If there is

increase in aggregate demand from AD to AD1, it results in the rise of
general price level from OP to OP1 without increase in any real
output.
Continued………….
• Rise in aggregate demand when there is full employment may be due to
increase in income of workers OR

• A country is trying to achieve an export surplus resulting in the reduction of

supply of goods at home.

• Demand pull inflation may develop due to increase in the rate of capital
formation in the country OR

• Expansion of government spending by borrowing from central bank of the

country.

• The increase in aggregate demand will lead to upward movement of price.

Demand Pull Inflation at less than full Employment
• An increased in aggregate demand can result in a price in the general
price level at less than full employment.

• The rise in general price level occurs when out put can not be
increased I proportion to the rise in aggregate demand.

• The supply bottleneck can occur due to shortage of skilled labor,

skilled entrepreneur, specialized capital equipment.

• Figure 5.1 shows that rise in aggregate demand AD to AD1, the

general price level rises from OP to OP1. there is also increase in
output from OY to OY1
 Cost Push Inflation
• The second major cause of inflation is increase in the cost of production
of goods arising from reduction in aggregate supply of goods(Keynes).

• The cost push inflation describes a situation where the process of rising
prices is initiated and sustained by rising cost with push up the general
price level.

• Thus, the cost push inflation occurs when the prices are forced upward by
increase in the cost of factors of production and not by excess demand.
• It is inflation from the changes in the supply side of the economy which
increases the cost of production.

• The main sources of increased cost are as under.

 Continued…………………
• Increase in money wage rates: when the cost of living goes upward, workers
press for increase in wages. The increase in wages raises the cost of production
of goods and push up the price level.

• Profit push inflation: if the sources of certain commodity have monopoly or

near monopoly power in the market, they fix up higher profit margin arbitrary
without increase in any other element of cot. Even when a few powerful firms
increase the profit margins, the other smaller firms also tend to markup their
profit margin. Higher profit margin thus inflate the price level.

• Material push inflation: if there is increase in prices of some basic materials

such as gads, steel, chemicals oil etc., directly or indirectly used in all
industries. It causes an increase in the cost of production and then general price
level increase.
Continued…………..

• Higher taxes: if the government levies new taxes or raises the rates of
old taxes, the production generally shifts the burden of taxes on to the
consumers. The increase in the selling price of commodities push up
the inflationary trend in the economy.

• Rise in import prices: if the prices of imported goods increases, it

also contributes towards inflation.
 Remedies of Inflation
• The two factors ruins the economy permanently.

• First panacea for mismanagement nation is inflation of the currency

• Second WAR

• To avoid political unrest, social and economical effects on the

economy. Every government take measures to control inflation.

• Monetary policy

• Fiscal policy
 Monetary Policy
• Monetary policy influences the economy through changes in the
money supply and available credit .
• Monetary policy is adopted by central bank of the country.
• The monetary measures are grouped to gather under two heads, which
are used to control inflation.
• Quantitative controlss
• Qualitative controls
• They are open market operations
• Variation in bank rates
• Credit rationing
• Varying reserves requirement
• Consumer credit regulation
 Fiscal Policy
• Fiscal policy is a deliberate change in either government spending or taxes to
stimulate or slow down the economy.

• It is the budgetary policy of the government relating to taxes public expenditure,

public borrowing and deficit financing.

• Fiscal policy is based upon demand management such as raising, lowering the
level of aggregate demand by controlling various expenditures, government
expenditures, consumption expenditure, and investment expenditure.
 Main Fiscal Measures are

• Changes in Taxes: if any government brings changes in taxes rates, it can

help in stabilization of prices in the country.

• For example:

A decrease in tax rates, increases disposable income in relation to national

income. Hence consumption rises at every level of national income. With the
increase in aggregate demand for goods, the employment goes up in the county.

A rise in tax rates has the opposite effect. A rise in taxes rates causes decreases
in disposable income, creates a larger budget deficit and bring relief from
inflation.
Continued…………….

• Changes in Government Expenditures: if inflation is ta or above the

level of full employment in the country, the government can bring down
price level by curtailing its own unproductive expenditures.
• Public Borrowing: public borrowing is another factors for controlling
inflation. Public borrowing reduces the aggregate demand for goods and
price level.
• Balanced Budget Changes: a balanced budget decrease has a mild
contradiction effect on national income and hence bringing down the
price level.
• Control of deficit Financing: for financing the budget deficit, the govt
often resorts of deficit financing. The bank borrowing and printing of new
notes increase the money supply in the country and pushes up the price
level. Therefore, deficit financing should be avoided to control inflation.
 Other Measures

• Price support program

• Provision of subsidies

• Arrangement of easy availability of goods on hire purchase to stimulate

demand

• Imposing direct control on prices of essential items

• Rationing of essential consumer goods in case of acute emergency

holding of Friday and Sunday markets.
 Deflation

• It is opposite of inflation.

• Inflation means: If there is rise in general level of price then the value of
money declines.

• Deflation means: if the general price level falls, and value of money
increases.

• Deflation is that state of the economy where the value of money is rising or
prices are falling (Crowther).

• Deflation refers to situation where price level falls and brings increase in
unemployment, reduction in output, decrease in the income of people.
 Causes of Deflation
• Deflationary situation exists when the level of money income falls relatively to the
current supply of goods and services.

• Deflation occurs due to fall in the private investment

• or unfavorable balance of payments

• or continued government budgetary surpluses

• or sudden increase in total output,

• or by the action of central bank to raise the discount rate

• or by selling securities

• or due to combined effect all of these factors.

 Measures to control deflation

• Deflation can be controlled by fiscal and monetary measures.

• Prices can be stabilized more by fiscal measures than by monetary steps

(Keynes).

• The task of increasing the demand for goods and services could be done
by government by spending public spending, by reducing taxes

• By stimulating private investment

• Private consumption

• Or all of the above factors

 Effects of Deflation on Society
• Over population: when prices are falling, the producers buy material and
other inputs at higher prices and are forced to sell the products at lower
prices. It eventually results in over production of commodities.

• Traders lose: during deflation, the traders purchase goods at higher prices
and have to sell later on lower prices due to deflationary trends.

• Investing class: the equity holders lose during deflation and debenture
holders gain well when prices falls.

• Fixed income groups: the pensioners, wage earners, gain during deflation
as the wages and pensions do not decreases with the fall in prices.
Continued…………..

• Consumers: when the prices of the commodities fall, the consumers, whose
income is fixed gain.

• Creditors and debtors: during deflation, the creditors tend to gain and the
debtors tend to lose.

• Tax payers: the tax payer lose during deflation as the value of money rises in this
period.

• Private sector units: the private sector units suffer when their prices of goods
falls.

• Industrial unrest: during deflationary period, there are industrial disputes and
unrest in the industrial sector.
Continued….

• Pace of economic growth: during deflation, the pace of economic

growth gets a set back. It slows down. Reduction in output and
increases in unemployment retards economic growth.
 Reflation

• Reflation is situation of moderately rising general prices when efforts are

made by the government to lift the economy out of depression.

• The upward rise in general prices is characterized by expanding production,

rising consumers expenditures, replacement of old machinery, and increasing
profits.

• “Reflation is inflation deliberately taken to relieve a depression” (Cole, G.D.).

• In reflation rising prices are accompanied if a fires in output and employment.

 Similarities between inflation and reflation

• In inflation and reflation both, the money supply increases.

• Both results in upward movement of general price level.

Differences between inflation and reflation

• Inflation possess a serious problem of rising prices without any increases in

output and employment.

• Reflation is adopted by government as a deliberate policy.

• Reflation takes place below the level of full employment.

• Price rise very slowly under reflation, where there is rapid increase in the

general level of price under inflation.

 Disinflation

• Term disinflation is very popular with modern economist.

• In capitalist countries of the world, there is tendency of general prces

to go up.

• People are losing faith in the ability of money to keep its value.

• It is desire of every government that prices should remain at

reasonable level.

• The process or processes through which prices are brought without

causing unemployment and reducing output is called disinflation.
Continued…….
• There are no adverse effect of disinflation. It rather saves the economy

from the ill effect of inflation.

• Disinflation is always the direct result of deliberate policy of the

government.

• Disinflation occurs after the level of full employment is reached in the

economy.
 Stagflation
• Since 1960 advanced countries are facing twin problems: rising prices and
unemployment.

• Co-existence of inflation and unemployment.

• “ stagflation involves inflationary rise in prices and wages at the same time.
The people are unable to find job and firms are unable to find customers for
what their plants can produce (Samuelson).

• “stagflation is contraction or stagnation of a nation’s output accompanied by

rise in the price level (Michael Swan).

• It is more serious problem than inflation. When the economy is hit by

declining output and rising unemployment, it redistributes income in favor of
rich and creates unrest in the community with growing unemployment.
 Causes of stagflation
• Main factor causing stagflation in the economy is the “reduction in
aggregate supply of goods.

• When there is decline in the aggregate supply of goods, the price

level rises and the output and employment falls.

• The reduction in aggregate supply may be due to three sets of

factors.
• Resources cost
• Reduction in labor supply
• And government taxes.
 Causes of stagflation
• Resources costs: reduction in aggregate supply may be due to rise in
resource cost, price of raw material, rise in wages rates, imported
material. The rise in resources cost leads to rise in prices and reduction
in output.

• Reduction in labor supply: reduction in labor supply adversely affect

output of goods. If the reduction in labor supply is caused by rise in
money wages on account of string union or by a rise in the legal
minimum wage rate, there will be fall in output and employment and
price level rises.

• Increase in Taxes: if there is rapid increase in indirect taxes, it will raise

costs and prices of domestic goods. It reduces output and employment.
• See figure 5.3
 Measure to Control Stagflation

There are number of measures to control and slow down the general price level and

maintain higher employment.

• The government should make every effort that minimum wages are not raised

during stagflation.

• The firms which cooperate and maintain the wages below the target rates should

be properly rewarded by giving concession and reduction in business income tax.

• Those which allow wage increase above the target rates should be
asked to pay penalty tax.

• The increase in money wages should be linked with increase in

productivity.

• The personal and business taxes should be reduced to bring down the
costs of goods.
Continued…….

• Through manpower training, the supply of labor should be upgraged.

This will help in reducing unemployment.

• Transportation should be improved to provide facilitates for searching

out job in production areas.

• The government itself should take up development programs to create

jobs in the country.

 Kinds of inflation

• On the Basis of Rate of Inflation:

i. Creeping inflation: is a situation in which the rise in general price level is
at a very slow rate over a period of time. Under creeping inflation, the price
level rises up to a rate of 2% per annum. A mild inflation is generally
considered a necessary condition of economic growth.
ii. Walking Inflation: Walking inflation is a marked increase in the rate of
inflation as compared to creeping inflation. The price rise is around 5%
annually.
iii. Running inflation: Under running inflation, the price increase is about 8%
to 10% per annum.
iv. Galloping or Hyper Inflation: Galloping inflation is a full inflation.
Keynes calls it as the final stage of inflation. It is a stage of inflation which
starts after the level of full employment is reached. Here price level rises
very rapidly within a short period.
Continued……………

• On the Basis Degree of Control

i. Open Inflation: It is a stage when the rise in price level gets out of
control. Milton Friedman describe it as, “inflationary process in
which prices are permitted to rise without being suppressed by
government price control or similar measures.
ii. Suppressed Inflation: Under this type of inflation, the government
makes efforts to check and control the rise in price level through
price control and rationing.
When the price level is suppressed by the above short term
measures, it results in many evils such black marketing, hoarding,
corruption and profiteering.
Continued……..

• Inflation On the Basis Causes

i. Demand Pull Inflation: Inflation caused by increase in aggregate
demand, not matched by aggregate supply of goods, resulting in rise
of general price level, is called Demand Pull Inflation. Demand pull
inflation, to be more simple, occurs when the demand for goods and
services in the country is more than their supply. The effective
demand for goods increases due to many factors such as increase in
money supply, increase in the demand for goods by the government,
increase in the income of various factors of production etc. In Short,
the excessive increase in the money supply causes inflationary
conditions. Demand pull inflation is generally characterized by
shortage of goods and shortage of workers.
Continued ………..
ii. Cost Push Inflation: Cost push inflation occurs when the increasing
cost of production pushes up the general price level. Cost pull inflation
occurs when the economy is below full employment with prices rising
even though there is no shortage of goods. Cost push inflation is the
result of increase in wage costs unaccompanied by corresponding
increase in productivity, rise in import prices of goods, depreciation in
the external value of the currency, higher mark-up etc., etc.

iii. Profit Induced Inflation: It is infact classified under cost push

inflation. When entrepreneurs, due to their monopoly position raise the
profit margin on goods, it may cause profit push inflation.
Continued ……..
iv. Budgetary Inflation: When the government of a country covers the
deficits in the budgets through bank borrowing and creating new money
(Deficit financing), the purchase power of the community increases
without a simultaneous increase in the production of goods. This leads
to rise in general price level.

v. Monetary Inflation: Milton Friedman is of the firm view that

inflation is always and anywhere a monetary phenomenon. According to
him, inflation is caused by a too rapid increase in the money supply and
by nothing else.
Continued ……….
vi. Multi Casual Inflation: Inflation has a number of causes. It may be
caused by increase in money supply, excessive wage demands, excess
aggregate demand for goods, shortage of goods etc. The main cause of
inflation in one year may not be in the next year. Since inflation I multi
casual, therefore, a variety of policy measures are needed to deal with it.
Continued………..

• On the Basis Employment

i. Inflation can also be categorized on the basis of employment as (i)
Partial inflation and (ii) Full inflation. Partial inflation, according to
J. M. Keynes, takes place when the general price level rises due to
an increase in the cost of production of goods and partly due to rise
in supply of money before the full employment stage is reached.
ii. Full inflation: Full inflation prevails when the economy has reached
the level of full employment. Any increase in money supply beyond
full employment level will result in rise of price without any
increase in output and employment. It is also called as real
inflation.
Continued ……….
• Anticipated versus Unanticipated Inflation
i. Anticipated inflation is the rate of inflation which majority of the
individuals believe will occurs. When the rate of inflation (say 6%)
turns out to be the same (6%), we are then in a situation of fully
anticipated inflation.

ii. Unanticipated inflation is that which comes as a surprise to

majority of individuals. It can be higher or lower than the rate of
anticipated inflation.
 Inflation in Pakistan
• Inflation means a situation where the general price level in persistently
moving in upward.
• Since partition fro Bengal the general level prices is persistantly
increasing in Pakistan.
• Price remained volatile during decay of 1990’s; ranging from 5.7% to
13%.
• It happened Due to declining in economic growth, expansionary
policies, output setback, higher taxes.
• The inflation rate started decline from 1998 on wards due to improved
supply position of goods.
• See table in book page number 68.
 Causes of Inflation Pakistan

• There are two causes of inflation in Pakistan.

• Demand Pull Inflation

• Cost Push Inflation

 Demand Pull Inflation

Demand pull inflation is generated when aggregate demand for goods for all purpose-
consumption investment and government expenditure exceeds the supply of goods at
the current prices.
Main factors which led to demand induced inflation in the country are as follows.
Demand for non development expenditures: elected and non elected government in
Pakistan since 1947 have not been able to curb the non developmental expenditures.
The lavish expenditures by elected representative and the govt functionaries gave
contributed inflation.

Rapid monetary expansion: inflation is more or less monetary phenomena. In

Pakistan, the rate of growth in monetary assets is much higher than the growth rate of
GDP. The easy monetary policy adopted to kick start the economy is a major factor for
price hike in Pakistan.
Continued……..
• Deficit financing: due to lack of resources for economic development the
government has been resorting the deficit financing (bank borrowing, creation of
new currency) over the year. The excessive growth in money supply compared to
increase in output has resulted in inflation.

• Increase in workers remittances: during last few years there is rapid flow of
workers remittance in the country. 2001-02 it was 2.389 billion, 2006-2007
crossed 5 billion dollars. Workers remittances is back bone of the country. This
resulted in expansion in aggregate demand for goods and so there is general rise
in price level.
Continued……….

• Foreign economic assistance: For rapid economic development,

Pakistan has been receiving foreign aid since early 50’s. the foreign
debt outstanding is $38.8 Billion by April, 2007. The tied and untied
aid is mostly invested in the projects having long gestation period. The
output of goods, therefore, does not increase correspondingly with
the rise in income. Foreign economic assistance is, thus, also a
contributory factor in pulling up the general level of prices in the
country.
• Consumption habits: Pakistanis living in urban and rural areas are
mostly spendthrift. They are proud of spending money on the goods
which are used by the people in the advanced countries of the world.
The increased expenditure on clothes, foods, cosmetics, etc., have
added much to the inflationary pressure in the country.
Continued………

• Construction of houses: Since 1970, people are spending their savings

mostly on the purchase of land and construction of houses. The
unproductive expenditure on the construction of houses, plazas, etc.,
has also contributed to the rising trend in prices.
• Excessive speculation and hoarding: The investor class, since the
nationalization of industries, is generally shy of investing money in
capital intensive projects. They are mostly spending their resources on
speculation and hoarding of goods. The abrupt rise in the demand for
goods also results in the rise of price level of goods.
• Increase in wages: The rise in wages, salaries and bonuses etc. in the
annual budgets increase the purchasing power of the employees. With
the increase in the disposable income of workers, the prices of the
commodities go up.
Continued…………….
• Population explosion: The population is increasing a the rate of about
1.9% in Pakistan, the pressure of population has increased the
aggregate demand for commodities thus pulling up the general level of
prices in the country.
• Black money: Black money is the unaccounted money receipts. It is
generated through smuggling, tax evasion, price control etc. It is
estimated that annual generation of black money is about 25% of GNP
of the country. This huge amount pushes up the prices of land, houses,
cars, air-conditioners and other expensive items.
 Cost Push Inflation
1) Increase in wages: In Pakistan one of the factors leading to cost
push inflation is the rise in wages not backed by increase in
productivity. The compensatory wage increase and the rise in prices
are chasing each other at quite a rapid speed causing persistent rise
in the level of prices.
2) Rising prices of imported goods: The imported prices of POL,
chemicals, fertilizer, non-electrical machinery etc., have gone up in
the world market. The cost and so the prices of commodities using
the imported items have gone up in the country.
3) Increase in indirect taxes: for increasing the revenue, the
Government is heavily relying on indirect taxes. The increase in the
indirect taxes every year has given the general price level an
inflationary push.
Continued ………….
4) Rise in POL, Gas, Excise Duty: The multiplier effect of the rise in
POL, gas prices and sales tax on a number of items has greatly
contributed to the cost push effect.
5) Rise in support prices of agriculture crops: The Government raised
the support prices of cotton, wheat, sugarcane to protect the interests of
the farmers. This also has an inflationary impact on the economy.
 Devaluation of Money
• Devaluation of money meant the reducing the value of money or exchange rate of
national currency with respect to other foreign currencies.

• In 1946, with Breton wood system, the countries were allowed to make devaluation
of their currencies with the permission of IMF.

• Now a days a Breton wood system is abandoned.

• The countries have now adopted flexible exchange rate system.

• Under flexible exchange system, the rate of exchange between the countries is
determined by the demand for and supply of foreign exchange difference between
devaluation and depreciation.
 Continued………..

• If the economy is operating under a fixed exchange rate and it officially lowers
the price of its currency in foreign exchange market, it is referred as devaluation.

• Devaluation meant decrease in exchange rate system. It is the result of official

government action.

• If the country has a floating exchange rate and it allows the external value of its
currency to decrease due to market forces, it is called depreciation.

• Depreciation, thus, a fall in a rate of domestic currency with foreign currencies

in the free exchange market.
 Motives of Devaluation

• It Stimulate export of commodities.

• It restricts import demand for goods and services.

• It helps in creating a favorable balance of payments.

• 1930, during depression various countries devaluated their currency for the following
reason.

• Correcting over valuation of currencies.

• Embarking upon an anti-deflationary programmed by monetary and fiscal expansion

• Encouraging exports and shrinking imports so that a favorable balance of payment is

achieved.