INFLATION

Contents What is inflation: meaning Theories of inflation: four different theories Control measures How is inflation measured Effects of inflation Examples of inflation

INFLATION Inflation is nothing more than a sharp upward rise in price level. Too much money chasing, too few goods. Inflation is a state in which the value of money is falling i.e. prices are rising.

Theories of inflation Demand-pull inflation Cost-push inflation Quantity theory of money Phillips Curve

Demand-pull inflation Demand-pull inflation happens where there is 'too much money chasing too few goods'. Excessive growth in demand literally pulls prices up. Demand-pull inflation happens when the level of aggregate demand grows faster than the underlying level of supply. This may be easier to imagine, if you think of supply as the level of capacity. If our capacity to produce is growing at 3%, and the level of demand grows at the same rate or slower then we don't have a problem. We can produce all we need. However, if our capacity grows at 3%, but demand grows faster, then we have a problem. In effect we have 'too much money chasing too few goods', and we can't manage to produce all we need. Something has to give, and it is prices that are forced up, therefore causing inflation. We can see all this in the diagram below. As the aggregate demand curve shifts to the right, the price level rises - inflation.

Demand-pull inflation

Cost-push inflation If costs rise too fast, companies will need to put prices up to maintain their margins. This will cause inflation. Cost-push inflation happens when costs increase independently of aggregate demand. It is important to look at why costs have increased, as quite often costs are increasing simply due to the economy booming. When costs increase for this reason it is generally just a symptom of demand-pull inflation and not cost-push inflation. For example, if wages are increasing because of a rapid expansion in demand, then they are simply reacting to market pressures. This is demand-pull inflation causing cost increases. However, if wages rise because of greater trade union power pushing through larger wage claims - this is cost-push inflation. The aggregate supply curve shifts left because of the cost increase, therefore pushing prices up.

Cost-push inflation So why might costs get pushed up, causing inflation? There are a number of possible sources of rising costs. Wages If trade unions gain more power, they may be able to push wages up independently of consumer demand. Firms then face higher costs and are forced to increase their prices to pay the higher claims and maintain their profitability. Profits If firms gain more power and are able to push up prices independently of demand to make more profit, then this is considered to be cost-push inflation. This is most likely when markets become more concentrated and move towards monopoly or perhaps oligopoly.

Cost-push inflation Exhaustion of natural resources As resources run out, their price will inevitably gradually rise. This will increase firms' costs and may push up prices until they find an alternative source of raw materials (if they can). This has happened with fish stocks. Over-fishing has put many types of fish and fish-based products under extreme pressure, forcing their price up. In many countries equivalent problems have been caused by erosion of land when forests have been cleared. The land quickly becomes useless for agriculture. Taxes Changes in indirect taxes (taxes on expenditure) increase the cost of living and push up the prices of products in the shops. An example would be when the level of service tax was increased.

Cost-push inflation Imported inflation We now work in a very global economy and many firms import a significant proportion of their raw materials or semi-finished products. If the cost of these increases for reasons out of our control, then once again firms will be forced to increase prices to pay the higher raw material costs.

Cost-push inflation

Quantity theory of money excessive money supply growth can also be a cause of inflation. The quantity theory of money explains why this happens. The classical economists view of inflation revolved around this theory, and this theory was in turn derived from the Fisher Equation of Exchange. This equation says that: MV = PT where: M is the amount of money in circulation V is the velocity of circulation of that money P is the average price level, and T is the number of transactions taking place

Quantity theory of money The equation is in fact an identity/truism. It says that the amount of the money stock times the rate at which it is used for transactions will be equal to the number of those transactions times the price of each transaction. It will always be true, as it simply says that National Income will be equal to National Expenditure and basic macroeconomics tells us that this is true anyway. So nothing stunning there! However, what makes it important is what classical economists predicted from it. Classical economists suggested that V would be relatively stable and T would always tend to full employment. Therefore they came to the conclusion that: In other words increases in the money supply would lead to inflation. The message was simple; control the money supply to control inflation.

Phillips Curve The Phillips Curve is a relationship between unemployment and inflation discovered by Professor A.W.Phillips. The relationship was based on observations he made of unemployment and changes in wage levels from 1861 to 1957. He found that there appeared to be a trade-off between unemployment and inflation, so that any attempt by governments to reduce unemployment was likely to lead to increased inflation. The curve sloped down from left to right and seemed to offer policy makers with a simple choice - you have to accept inflation or unemployment. You can't lower both. Or, of course, accept a level of inflation and unemployment that seemed to be acceptable!

Phillips Curve

HOW TO CONTROL INFLATION Monetary Measures Fiscal Measures Other Measures

Measures to control inflation:: 1. Monetary measures- Classical economists are of the view that inflation can be checked by controlling the supply of money. Some of the important monetary measures to check the inflation are as under:   Control over money- It is suggested that to check inflation government should put  strict restrictions on the issue of money by the central bank. Credit control- Central bank should pursue credit control policy .In order to control the credit it should increase the bank rate ,raise minimum cash reserve ratio etc. It can also  issue notice to other banks in order to control credit

2.Fiscal measures- Measures taken by the government to control inflation. A: Decrease in public expenditure- One of the main reasons of inflation is excess public expenditure like building of roads ,bridges etc. Government should drastically scale down its non essential expenditure.   B-Delay in payment of old debts: Payment of old debts that fall due should be postponed for sometime so that   people may not acquire extra purchasing power. C-Increase in taxes : Government should levy some new direct taxes and raise rates of old taxes. D-Over valuation of money: To control the over valuation of money it is essential to encourage imports and discourage  exports                                                                                                                               

Other measures            1 Increase in the production- One of the major causes of the inflation is the excess of demand  over supply ,so those goods should be produced more whose prices are likely to rise rapidly .In order to increase production public sector should be expanded and private sector should be given more incentives. 2 Proper commercial policy- Those goods which are in scarcity should be imported as much as possible from other countries and their export should be discouraged. 3 Encouragement to savings –During inflation government should come out with attractive saving schemes. It may issue 5 or 10 year bonds in order to attract savings.

How is it Measured? Consumer Price Index Wholesale Price Index

Consumer Price Index CPI is a measure estimating the average price of consumer goods and services purchased by households. CPI measures a price change for a constant market basket of goods and services from one period to the next within the same area (city, region, or nation). It is a price index determined by measuring the price of a standard group of goods meant to represent the typical market basket of a typical urban consumer. The percent change in the CPI is a measure estimating inflation.

Wholesale Price Index WPI was published in 1902,and was one of the economic indicators available to policy makers until it was replaced by most developed countries by the CPI market. index in the 1970. WPI is the index that is used to measure the change in the average price level of goods traded in wholesale market. Some countries (like India and The Philippines) use WPI changes as a central measure of inflation.

Problems with WPI In present day service sector plays a key role in Indian economy. Consumers are spending loads of money on services like education and health. And these services are not incorporated in calculation of WPI. WPI measures general level of price changes either at level of wholesaler or at the producer and does not take into account the retail margins. Therefore we see here that WPI does give the true picture of inflation. WPI is supposed to measure impact of prices on business. But we use it to measure the impact on consumers. Many commodities not consumed by consumers get calculated in the index.

Weight edge to CPI & WPI

Inflation rate PI for a certain year - PI for a comparative year X 100

INFLATION RATES 2006-2007 2007-2008 Inflation 7.8 12.0 Food inflation 2006-2007 2007-2008 Inflation 7.8 12.0 Food inflation 10.3 17.6 Non-food inflation 6.2 6.8

EFFECTS OF INFLATION They add inefficiencies in the market, and make it difficult for companies to budget or plan long-term. Uncertainty about the future purchasing power of money discourages investment and saving. There can also be negative impacts to trade from an increased instability in currency exchange prices caused by unpredictable inflation. Higher income tax rates. Inflation rate in the economy is higher than rates in other countries; this will increase imports and reduce exports, leading to a deficit in the balance of trade.

EXAMPLES OF INFLATION Increase in the price of wheat Increase in the price of oil Increase in the price of rice Increase in the price of CNG Increase in the price of sugar

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