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Inflation - causes and measurement



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Types of inflation; causes of inflation; measurement of inflation

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Inflation - causes and measurement

  1. 1. INFLATION Unit 5.2 Prof. Prabha Panth 20 Dec 2018
  2. 2. Inflation • Inflation: persistent increase in the general price level over a period of time. • Inflation leads to decline in the purchasing power of money. Types of Inflation: 1. Speed of P increase: o Creeping Inflation: slow rate of increase (1 -3% p.a.) incentive for Private sector Investment. o Walking or Trotting Inflation: Ps↑ 3-6% p.a., or < 10% p.a. Warning signal of disequilibrium. 2
  3. 3. Inflation o Running Inflation: P level increases at 10 – 20% p.a. Affects poor and middle classes. o Hyper, Runaway ,or Galloping Inflation: P level rises by > 20%. P rises per day. Collapse of monetary system. 2. Other categories of Inflation: o Open inflation: Ps allowed to rise freely. o Suppressed inflation: by government through P controls, quotas, rationing. Leads to Black Market. o Ratchet inflation: Ps and wages not allowed to fall. Due to monopoly factors (e.g. P of petrol, gold), trade union pressure 3
  4. 4. Causes of Inflation 1. Demand Pull Inflation: o “Too much money chasing too few goods.” o Based on Fisher’s Quantity Theory of Money, • If Supply of Money with the public increases, • Demand for goods will increase, • Assuming no increase in Supply of goods, • Prices will rise. o Therefore to control inflation, supply of money with the public should be reduced. 4
  5. 5. 2. Cost Push Inflation: Increase in P level due to increase in costs of production. 1) Rise in Wages: due to trade union pressure. 2) Rise in Profits: due to higher “mark up.” 3) Rise in import Ps: such as Ps of petroleum, 4) Rise in indirect taxes: higher taxes passed on to consumers. D for higher incomes → higher Prices→ D for higher income. Leads to a Wage – Price Spiral. Inflation feeds on itself. D-pull and Cost-push inflation are interconnected. 5
  6. 6. 3. Development Projects: • Economic development: investment in Capital formation, heavy industries, infrastructure, • Creates employment, increases incomes, but no immediate increase in output. • Incomes increase, demand for basic consumer goods increases. • If supply does not increase, • Prices will rise. • E.g. inflation levels in India started rising since the II Plan. 6
  7. 7. Impact of Inflation 1. Distribution of Y: o Transfer of funds from wage and salary earners to industrialists, traders, real estate dealers, o Fixed income groups suffer the most – pensioners, daily wage earners, income from interest, value of savings falls. o Organised workers can recover through higher wages o Salaried workers – price indexed income (DA↑), but with a time gap. o Landlords gain, with rent increases. 7
  8. 8. 2. Impact on Production: o Misallocation of resources: diversion of investment from essentials to luxury goods. Further scarcity. o Hoarding and black markets: create artificial scarcity, drive up Ps. o Uncertainty: affects investment decisions and production. 3. Impact on Savings: o Money loses its value. People do not save, o Withdraw money and convert into real goods, o Demand increases, Prices increase. 8
  9. 9. 4. Impact on Government: o Value of government projects increases. o Investment in real terms falls (public sector allotments) o Actual production decreases. o To meet greater demand for salaries, more money required, o Diverted usually from welfare schemes. o Again impacts the poor. 5. Impact on Exports-Imports: o Value of Re depreciates, P of dollar increases, o $1 can buy more goods in India. (e.g. if $1 = Rs.40, prices increase, now $1 = Rs.55, it can purchase more Indian goods) o Exports are supposed to increase, o Imports to decrease 9
  10. 10. Measurement of Inflation 10
  11. 11. • Price Index shows changes in the purchasing power of money over time. • Used to compare price levels between time periods for a given economy or • Changes in price levels of different economies. • A higher index shows increase in the price level, and increase in the cost of living. 11 11 Price Index
  12. 12. Construction of Index Numbers 1. Purpose: to estimate changes in wholesale, retail, consumer prices, etc. 2. Based on above, to identify the goods to be included in the index. 3. Choice of base year: compare with which year. 4. Choice of weights: to show relative importance of the goods in the index. 12
  13. 13. Laspeyres’ index • How much money is needed in the present year (P1.Q0) to buy the same set of goods as in the base year, (P0.Q0)? • Uses base year Q as the weights. Total cost of base year quantities at current year prices Total cost of base year quantities at base year prices L index = ΣP1. Q0 x 100 ΣP0. Q0 13
  14. 14. Laspeyres’ index Goods 2010 P0 (Rs) 2010 Q0 P0.Q0 (Rs) 2011 P1 (Rs) P1.Q0 (Rs) Rice 30/ Kg 20 Kgs Rs.600 35/Kg Rs.700 Sugar 20/Kg 10 Kgs Rs.200 25/Kg Rs.250 Wheat 15/Kg 10 Kgs Rs.150 20/Kg Rs.200 Total Σ Rs.950 Rs.1150 L index = ΣP1. Q0 x 100 ΣP0. Q0 = 1150 x 100 = 1.21 x 100 = 121. 950 If base year 2010 price level was 100, current year’s P level is 121, showing that P level increase is = 121 – 100 = 21% 14
  15. 15. • Laspeyres’ index is the most commonly used index • The base year can be redefined regularly. • And goods included or removed. • The base year’s index value = 100, so o index value of current year < 100, fall in P-level o Index value of current year > 100, inflation 15
  16. 16. TYPES OF INDEX NUMBERS: 1. Wholesale Price Index (WPI): • Wholesale prices. • Excludes profits of middle men, markup, indirect taxes. • WPI used in India. • Estimated by Office of Economic Advisor, Ministry of Commerce, o 676 items (April 2010) – capital goods, consumer goods, and raw material inputs, o Latest Base year 2004-05 o WPI is estimated weekly, monthly, and annually. 16
  17. 17. Annual WPI - India 17 169
  18. 18. 2. Consumer Price Index (CPI): • WPI includes capital goods, excludes services. • In CPI only consumer goods included, at market prices. • Shows impact of inflation on standard of living of consumers. • CPI in India (base year 2010) are estimated for the following : • All India CPI • Industrial workers (IW), • Urban Non-manual Employees, (UNME) • Rural and Agricultural labourers (RL/AL) 18
  19. 19. • CPI (All India) covers 260 items, prices include all taxes. • 5 Broad categories included in CPI are: o food, o beverages and tobacco; o fuel and light; o housing; o clothing, footwear, and miscellaneous items. In July 2012 compared to 2010, o CPI all of India increased to 121.40, o Urban CPI to 119.90, and o Rural CPI to 122.60 19