Price Stability

Price Stability
• Inflation & Deflation
• Types of Inflation
• Causes of Inflation
• AD & AS framework to explain inflation.
• Measurement of Inflation (CPI & WPI)
• Headline vs Core inflation
• Threshold Inflation
• Phillips Curve (Short Run & Long Run)
• Economic Impacts of Inflation
• Fiscal and Monetary Policy to control inflation
• Is inflation good for the economy?
 Inflation (4.48% in OCT)
 “A general increase in prices”
 “Too much money chasing too few goods”
 During Inflation the purchasing power of money
or Value of Money is less.
 The Value of money decreases. Vm=
Value of money means how many units we can purchase with 1 rupee.
Vm is inversely related with price. When price increases Vm decreases.
 Deflation: When aggregate price falls
 Types of Inflation
Creeping Inflation (Low Inflation):
 When the rise in price is very slow. Galloping Inflation:
 Annual increase in price less than 3%.  Price is extraordinarily high
Walking Inflation:  Price rises 20-50% per annum
 Price rises moderately
 Inflation is in single digit Hyper Inflation:
 Price rises by 3-10% per annum  rapid, excessive, and out-of-control
Running Inflation:  Above 50% per annum
 When Price Rises Rapidly
 Price rises 10-20% per annum
 Measurement of Inflation
Consumer Price Index (CPI)
• CPI measures changes in the price level of a weighted average basket of consumer goods and
services purchased by household.
• This is the retail inflation.
• Retail inflation= 4.48% OCT-21
Base Year: 2011-12 Base Year CPI (2011-12) : 100
Ex: suppose the aggregate price of all the goods increases by 10% from 2011-12 to 2012-
13. Then the CPI (2012-13) = 110
Wholesale Price Index (WPI)
WPI measures the wholesale price inflation.
Wholesale inflation = 1.48% OCT-20
GDP Deflator: inflation also measured based on GDP deflator. See National Income
Chapter.
GDP deflator = (Nominal GDP/ Real GDP)*100
 Consumer Price Index (CPI)
List of 2011-12 Weightage Weighted Price 12-13 Weighted Price
Commodities ( Actual (Commodity (11-12) ( Actual Price) (12-13)
price) wise) P x Weightage
Rice 50 35% 17.5 55 19.25
Oil 100 20% 20 102 20.4
Milk 30 10% 3 31 3.1
Fruits 80 10% 8 100 10
Vegetables 40 25% 10 60 15
Total Weighted
Price
100%
58.5 67.75
CPI
100 115
CPI & Inflation
Year Index Number Inflation Rate

Base Year (11-12) 100 ----

2012-13 102 2%

2013-14 103 1%

2014-15 108 4.9%

2015-16 109 0.9%

2016-17 115 5.5%

 Inflationary Gap
 It is a situation in the economy when the current GDP exceeds the potential
level of GDP.
 it means the economy is producing above its sustainable limits
 Aggregate demand is outstanding the aggregate supply
 In this case inflation and price rises.
 Causes of Inflation
Demand Pull Inflation Vs. Cost Push Inflation
• Demand Pull: Price rises due to increases in aggregate
demand (AD). Demand side inflation. Demand causes
inflation.
• Cost Push: Price rises due to cost of production rises &
Aggregate supply (AS) decreases. Supply side inflation.
When Supply decreases price rises.
Demand Pull Inflation:
• When the Aggregate Demand (AD) in the economy
increases(C+I+GE+X-M), Aggregate price rises.
Causes of Demand pull inflation
AD rises due to many reasons like:
Increase in Money supply
Decreases in interest rate
Increases Disposable income due to low income tax
Increase in Public/Govt. Exp. Increases
Decrease in corporate tax
Increase in Export
 Demand Pull Inflation
• When the Money Supply or
disposable Income of the
people etc increases, the
Aggregate demand also
increases
• AD curve shifts from AD to
AD1.
• Aggregate Price rises from P1
to P2
 Cost Push Inflation
 When the cost of production rises, Aggregate Supply (AS)
decreases & price rises.
Causes of Cost push inflation:
Rise in Wages/Salaries
Rise in Raw Material price
Rise in fuel cost
Rise in taxes
Decreases in subsidies
Done upto 2nd Dec
 Cost-Push Inflation
• When cost of production
increases, The supply
decreases.
• The aggregate supply curve
shifts to left from AS to AS1.
• Price increased from P1 to P2
Other Supply side Causes of inflation:
1. Natural Calamities
2. Industrial Disputes/Strikes
3. Artificial Scarcities: Scarcities are created by hoarders
and speculators.
4. Increases in export: Domestic supply decreases due
to higher export.
 Expected inflation is the inflation component that
economic agents expect to occur.  the rate at which
consumers, businesses, investors, govt etc—expect prices to
rise in the future 
Unexpected inflation is the surprise component
of inflation which people haven’t expected.
 Inflation at a higher or lower rate than had been expected.
 If the expected rate of inflation has been taken into account in arriving at wage
agreements and loan contracts, inflation higher than expected transfers purchasing
power from workers to employers or from lenders to borrowers;
 inflation lower than expected transfers purchasing power from employers to workers
or from borrowers to lenders.
Threshold Inflation & GDP growth
• Threshold inflation is optimal growth level of inflation.
Ex: Threshold inflation = 6% in India.
• GDP growth rate increase's if the inflation rate rises up to
6%. It is maximum when 6%.
• Beyond the threshold level GDP growth decreases.
 
Headline Inflation Core Inflation
• Headline inflation is the • It excludes food and energy
overall inflation. prices (e.g., oil and gas)
• It is the raw inflation • Inflation without food &
measured by CPI. energy.
• It includes commodities such
as food and energy prices
(e.g., oil and gas), which tend
to be much more volatile and
prone to inflationary spikes
Phillips Curve
Short-Run & Long-Run
 Phillips Curve
Phillips curve states the relationship between the
unemployment rate & inflation rate.
• Trade off between unemployment rate & inflation
• Inverse relation between Unemployment Rate & Inflation
• High unemployment Low level of income Low AD
Price is low
• Low unemployment High level of income High AD
Price is high
When the unemployment rate is high, the employment is less, income is less,
demand is less & price is less.
 Short-Run Phillips Curve
• Philips curve slopes downward
• Trade off between unemployment Short-Run Phillips Curve
& inflation
• In the short-run the economy
operates below its full
employment level.
• If the unemployment rate rises,
the employment decreases,
Income decreases, demand
decreases & price decreases.
• Phillips curve slopes down ward
due to inverse relation between
unemployment & inflation.
 Long-Run Phillips Curve
 Long-Run Phillips Curve is Vertical
Straight Line.
 No Trade-Off between Unemployment
Rate & Inflation Rate in the Long-Run
 In the Long-Run, unemployment rate
stays more or less steady regardless of
inflation rate.
 IN the long-run economy operates its
natural level, potential level or full
employment level.
 Natural unemployment is the minimum
unemployment level in the long run.
When demand =supply of labour.
Stagflation: It is a special or rare situation in the
economy when there is High Inflation + High
Unemployment rate.

Stagflation = Stagnant Economic growth + High Inflation

• During 1980’s most of the economy suffered for
stagflation due to oil shock.
• Due to high oil price, cost of production increased, price
increased, production decreased, employment level
decreased & unemployment increased.
Impacts or Consequences of
Inflation
 Impacts of Inflation
• Decrease in Purchasing power
• Menu Cost rises: Menu costs are the costs that come with changing
prices of product. Ex: the additional cost to a restaurant having to
reprint all its menus for price updates. The additional cost to a
retailer to change the price tags to update new price.
When menu costs are high in an industry, price adjustments will
usually be infrequent
• Raises cost of borrowing (interest rate): to control inflation RBI
increases the interest rate to banks to reduce money supply, banks
also increases the interest rate.
• Export decreases: Due to rise in domestic price export falls.
Impacts Cont…….
• Currency or exchange rate depreciates: When export decreases, the
supply of dollar decreases, those who exports they get dollars, those
who imports they need dollars to pay. The dollar supply decreases &
the dollar value appreciates & rupee value depreciates.
• Trade deficit rises: export falls and import rises due to high domestic
price.
• Reduces employment & GDP growth: when the inflation rises, to control inflation
RBI increases interest rate to reduce money supply, as a result investment, employment
& GDP decreases.
During high inflation AD decreases which creates unemployment in the economy. GDP also
decreases due to less AD.
• Debtors grainer & creditors loser: When prices rise, the value of money falls.
Though debtors return the same amount of money, but they pay less in terms of goods
and services.
 Control or Target of Inflation
Role of Govt. (Fiscal Policy)
Role of RBI (Monetary Policy)
Role of Govt. (Fiscal Policy)
• Increases Taxes
• Decreases public spending's
Role of RBI (Monetary policy)
The RBI main target here is to increase the interest rate, to reduce
the money supply, to reduce the credit creation, to reduce the
aggregate demand in the economy.
• RBI increases the reserve requirements of Commercial bank.
(increases CRR & SLR). Bank creates less credit.
• Increases the interest rate ( short term-Repo & reverse repo
rates, Long Term-Bank Rates) to discourage commercial banks to
borrow more from RBI and provide more loans to public.
Note: Will discuss the rates in detailed in specific chapters of monetary
policy & fiscal policy
 is a little inflation good for the
economy?
• A moderate amount of inflation is generally considered to
be a sign of a healthy economy
• because as the economy grows, demand for stuff
increases. This increase in demand pushes prices
a little higher as suppliers try to create more of the thing
that consumers and businesses want to buy.
Inflation Targets: 4 (+ - 2)
Accordingly, in a notification on March 31, 2021, the Central
Government, in consultation with the RBI, retained the inflation target
at 4 per cent (with the upper tolerance level of 6 per cent and the lower
tolerance level of 2 per cent) for the 5-year period April 1, 2021 to March
31, 2026.