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Published in: Economics


Gaurav. H / Ahmedabad

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  1. In Inflation flation What is Inflation
  2. Introduction • Inflation is defined as a sustained increase in the price level or a fall in the value of money. When the level of currency of a country exceeds the level of production, inflation occurs. • Value of money depreciates with the occurrence of inflation.
  3. Introduction Inflation - Definition The increase in the amount of money necessary to obtain the same amount of product or service before the inflated price was present; Social Phenomena where too much money chases too few goods/services; Harmful impact because the purchasing power of the currency changes downward in value.
  4. Introduction ' Inflation is commonly understood as a situation of substantial, and general increase in the level of prices of goods and services in an economy and a consequent fall in the value of money over a period of time. When the general price level rises, value of money falls and as such each unit of currency buys fewer goods and services. Consequently, inflation reflects a reduction in the purchasing power per unit of money. A chief measure of price inflation is the inflation rate which expresses percentage change in a general price index (normally the consumer price index) over time,
  5. Mathematically, rate of inflation can be expresses as Rate of inflation : x 100 percent Where Pt and are price level at two time periods respectively, Price level is the average of pricesi
  6. Monetarists' View Monetarists' View: Monetarists assert that inflation has always been a monetary phenomenon. The quantity theory of money, simply stated, says that any change in the amount of money in a system will change the price level. This theory begins with the Fisher 's equation of exchange: MV = PT
  7. Monetarists' View Where, M represent total quantity of money V is velocity of circulation of money (i.e. average number of time each unit of money is spent for the purchase of goods and services during a given time period). P represents general price level T refers to the total volume of transactions (real value final goods and services)
  8. Monetarists' View • Here MV represents supply of money PT represents demand for money. By manipulation, P = MV Assuming V and T as given, price level varies in directly in proportion to the quantity of money (M). Thus, if supply of money increases , there is inflation or rise in prices.
  9. Keyenes' View • Inflation occurs when price rises after the stage of full employment is reached in the economy, with no corresponding rise in employment and output.
  10. Definition According to C.CROWTHER, "Inflation is State in which the Value of Money is Falling and the Prices are rising." • In Economics, the Word inflation Refers to General rise in Prices Measured against a Standard Level of Purchasing Power.
  11. Definition Definition of inflation ; a greater increase in the supply of money or, credit than In the production oods and services, resulting in Nigher prices and a fall in the purchasing power of money
  12. Definition According to classical writers inflation is a situation when too much money chases too few goods. It is an imbalance between money supply and Gross Domestic Product. As per Keynes inflation is an imbalance between aggregate demand and aggregate supply. • In an economy, if the aggregate demand For goods and services exceeds aggregate supply, then Prices will go on rising.
  13. Inflation EVERYONE IS $0 RICH gogovv
  14. Causes • Primary causes: When demand for a commodity in the market exceeds its supply, the excess demand will push up the price ('demand-pull inflation').
  15. Causes When factor prices rise, costs of production rise ('cost-push inflation') • Let us now discuss in detail the various causes that may bring about inflation.
  16. Causes Cause of Inflation peopie of 1. Demand Pull 1. ß(ack Money 2. Disposibte Income 3. Dearness Allowance 4. RBI's Monetary Policy Production *nit 2. Cost Push 1. Wages 2. Taxes 3. Raw Material! 4. Profit Margin Causes of Inflation E.rchan.c Rate • 8 n. Demand-pull inflation is • inflation initiated by an increase in aggregate demand. AS Aggregate output (income), Y Cost-push, or supply- side, inflation is inflation caused by an increase in costs. ASO Aggregate (Ritput (income), Y
  17. Various Causes That May Bring Increase in public spending Deficit financing of Government spending Increased velocity of circulation About Inflation. Government s spending is an important part of total spending in any modern economy. It is an important determinant of aggregate demand. In less developed economes, Government expenditure has shown an upward trend. This has created inflationary pressure on the economy. Government spending Increases beyond what can be financed by taxation, In order to be able to Incur the extra expenditure the Government resorts to deficit financng. For instance, it prints money and spends it. This adds to the pressure of inflation. Total use of money = money supply by the Government x velocity of circulation of money. In boom phase, people spend money at a faster rate. The velocity of circulation of money IS increases.
  18. Various Causes That May Bring Population growth Hoarding Genuine shortage Exports Trade unions About Inflation It increases total demand in the market, The pressure of excess demand will create inflation, Excess demand is sometimes artificially created by hoarders, They stockpile commodities They do not release them to the market, This leads to excess demand and inflation. If the factors of production are in short supply, production will be affected. Supply will be less than demand, prices will rise. If the total output of a commodity is not sufficient to meet both domestic and foreign demand, Then exports will create inflation in the domestic economy, By demanding on increase in the wage rate, they increase the cost of production,
  19. Various Causes That May Bring Tax reduction • Imposition of indirect taxes Price-rise in international market Non. economic reasons About Inflation Governments sometimes reduce taxes to gain popularity, This leaves more money in people's hands, This leads to inflation if there is no corresponding increase in production, Government may imposes indirect taxes (such as excise duty, value-added tax Then producers or sellers raise the product prices to keep their profits unchanged. The imported price of some commodities or factors of production may rise in the 'world market. It would lead to inflation in the domestic market, For instance, at times of natural calamities (fiood) crops are destroyed, reducing the supply of agricultural products, Prices of these commodities tend to increase,
  20. Forms of Inflation • Inflation may be of different forms, such as— ' Demand Pull Inflation When in an economy aggregate demand exceeds aggregate supply. Aggregate demand may increase due to an increase in money supply, or money income or public expenditure. The idea of demand inflation is associated with full employment when supply cannot be altered.
  21. Demand Pull Inflation •Demand-pull inflation is caused by increases in aggregate demand due to increased private and government spending, etc. Demand inflation encourages economic growth since the excess demand and favourable market conditions will stimulate investment and expansion.
  22. Demand Pull Inflation q, Output
  23. Demand Pull Inflation ' In this graph SS and DD are aggregate supply and demand curves. Op and Oq are equilibrium price and equilibrium output. Due to exogenous causes demand curves shifts right-wards to At the current price Op, demand increase by qq But supply is Oq, Excess demand qq Put pressure on price, which gradually rises from Op to Op At this price a new equilibrium is achieved where Demand=Supply, The excess demand is eliminated by fall in demand and rise in supply arising out of rise in price
  24. Cost Push Inflation • Inflation may originate from supply side also. • Aggregate demand remaining unchanged, a fall in aggregate supply due to exogenous cause, may lead to increase in price level.
  25. Cost Push Inflation • Cost-push inflation, also called "supply shock inflation," is caused by a drop in aggregate supply (potential output). This may be due to natural disasters, or increased prices of inputs. For example, a sudden decrease in the supply of oil, leading to increased oil prices, can cause cost-push inflation. Producers for whom oil is a part of their costs could then pass this on to consumers in the form of increased prices.
  26. Cost Push Inflation Output
  27. Cost Push Inflation ' In this graph, the starting point is the equilibrium price(Op)and output (Oq). If aggregate supply has fallen, the SS curve shifts leftward to S At price Op now supply will be Oq But demand Oq. This will push prices high till a new equilibrium is reached at Op At the new price there will be no excess demand. ' Inflation is thus a self limiting phenomenon.
  28. Open Inflation Open Inflation The continuous rise in price level is visible in the naked eye. • One can see the annual rate of increase in the price level.
  29. Galloping Inflation • Galloping Inflation e: Very Rapid Inflation which is almost impossible to reduce. GALLOPING INFLATION When inflation rises 10%. The economy becomes unstable and goverment leaders lose credibility.
  30. Forms of Inflation Repressed Inflation There is excess demand. The excess demand is prevented from increasing price level by some repressive measures. The measures taken by the government like price control, rationing etc. Hyper Inflation The price level goes on rising at a very fast rate. Often there happens hourly increase in price level. ' It often leads to demonetization.
  31. Forms of Inflation Repressed Inflation: when government actively intervenes to check the rise in price level by resorting to price controls and rationing of scarce items in the economy. Gives rise to profiteering, black marketing, hoarding and corruption on a large scale. Hyperi when prices increase rapidly as a currency loses its value. flation
  32. Hyperinflation What is Hyperinflation? In economics, hyperinflation occurs when a country experiences very high, accelerating, and perceptibly "unstoppable" rates of inflation. Two things happen as a consequence: 1. 2. General price level of goods and services increase, meaning currency loses real value. The real values of economic items generally stay the same.
  33. ? “ e.o ? … sh with wheelbarrows ? · ? ? ? … ? ? ? ? It-I ? ? ? Il-lgh money HYPERINFLATION Hyperinflation
  34. Forms of Inflation Creeping Inflation The price level increases very slowly over a period of time. Moderate Inflation The rise in price level is neither too fast nor too slow.
  35. Creeping Inflation Creeping inflation 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 percent per annum. A mild inflation is generally considered a necessary condition of economic growth. Moderate Inflation: When the rate of inflation is very low, say in the range of 1% to 20%, it is moderate inflation.
  36. Forms of Inflation True Inflation It takes place after full employment of all factor inputs in an economy. • In a situation of full employment, the National output becomes perfectly inelastic. Here more money will lead to higher prices and not more output. Semi-inflation A country may experience inflation arising from bottlenecks, even before full employment. There maybe inflationary price rise in some sectors of the economy.
  37. Impacts of Inflation • Inflationary pressure in an economy my generate good effects on the economy, particularly in case of 'creeping' or 'walking' inflation. • • • Positive Effects (if inflation rate is 2% to 4%) Increase in production due to inflation. Increases the employment opportunities in the country. Enhances the process of economic development. Increases the economic activities that may cause to inventions and innovations. Profit of the producers also increases when there is normal inflation.
  38. Impacts of Inflation Effects of inflation Positive effects Benefit to inflators Early and first recipients of the inflated money Big cartels, destroys small sellers Borrowers • Inflation may reduce the severity of economic recessions Tobin effect (can increase investment ) Negative effects Hoarding Distortion of relative prices Increased risk Higher uncertainties • Income diffusion effect • Existing creditors will be hurt Fixed income recipients will be hurt Increased consumption ratio at the early • stages of inflation Lowers national saving • Illusions of making profits Causes mal-investment, tax bracket & business cycles Currency debasement Rising prices of imports
  39. Favourable Impacts (a) Higher profits : Profits of the producers are generally favourably affected by inflation, because They can sell their products at higher prices, (b) Higher investment : The entrepreneurs and investors get added incentives to invest in productive Activities during inflation, since they can earn higher prices. (c) Higher production : If productive investment grows during inflation, it would lead to higher Production of various goods and services in the economy.
  40. Favourable Impacts (d) Higher employment and income :lncrease in the output of different goods during inflation would Also mean increasing demand for various factors of production. So, it is expected that employment And income opportunities will also increase during inflation. (e) Possibility of higher income for the shareholders : During inflationary periods, if the companies earn Higher profits, they can declare dividends for their share-holders. Hence, the dividend income of The shareholders may also rise during inflation.
  41. Favourable Impacts (f) Gain for the borrowers :lnflation means a decrease in the value or purchasing power of money. If the rate of interest to be paid by the borrower is less than the inflation rate, the borrower will gain. • Because the real value of the money returned by the borrower is actually less than that of the Money borrowed earlier.
  42. Unfavourable Impacts Negative Effects It is difficult for consumers to purchases more goods. It generates very bad effects on the poor labor force. Inflation reduces the living standard and purchasing power of people. It is harmful for creditors. Inflation reduces the purchasing power.
  43. Unfavourable Impacts ' (a) Fall in the real income of fixed-income groups: Real income means purchasing power of money income [Real income = (money income ) / (price level), I Given the money income of the fixed income groups, the real income will fall during inflation. Hence, inflation affects workers, salaried People and pension-earners adversely. (b) Inequality in the distribution of income : The profit incomes of businessmen and entrepreneurs increasing during inflation while the real income of the common salaried people declines, So, In equality in the distribution of income become acute during inflation,
  44. Unfavourable Impacts • c) Upsets the planning process : When prices of goods, materials, and factor services increase continuously, then more money has to be spent for the completion of any investment project taken Up during any planning period. If more financial resources cannot be raised by the Government (through savings or taxation), plan targets are to be curtailed. (d) Increase in speculative investment :lf the price level rises at a fastrate, speculative investment (say, purchasing shares, land, gems, etc. just for speculative purposes )may increase in the economy for earning quick profits. These types of investments do not help in the creation of productive Capital in the economy.
  45. Unfavourable Impacts (e) Harmful impact on capital accumulation : If the price-rise becomes chronic, people prefer Goods to money (because the real value of money will fall in future). They also prefer immediate consumption to consumption in future. So, their desire to save is reduced. When both ability and willingness to save become less, a smaller amount of fund becomes available for further investment. As a result, it creates a harmful impact on capital accumulation, since capital accumulation in an economy depends on the growth of investment.
  46. Unfavourable Impacts (f) Lenders will lose : We have already indicated that borrowers will gain during inflation. Forth is same reason, lenders will lose during inflation. Because, they are actually receiving an amount having Lower value(or purchasing power)than before. (g) Harmful impact on export income :lf the prices of export items also increase during inflation, their Demand in the foreign market may fall. This leads to a fall in the export income of a country.
  47. Control of Inflation To control demand- pull inflation To control cost-push inflation Monetary measures Fiscal policy Direct control Other measures If the supply of money in the economy can be decreased, prices will fall. If 'the government withdraws paper notes and coins from circulation, the money supply will decrease, The lionis share of 'the total money supply is bank deposits or bank credit. If we can reduce the rate of lending by banks. we can reduce the total supply of money significantly, The Central bank of a country can reduce the lending of commercial banks by raising the bank rate and reserve requirements of banks, by open market sales of securities, etc The policy of changing tax rates or the rate of Government expenditure. An inflationary gap anses when aggregate demand exceeds the maximum potential supply in an economy. To overcome, the following types of fiscal measures can be undertaken — A decrease in the Government expenditure; or, • A decrease in the Government transfer payments; or • An increase in taxes imposed by the Government; or, • A combination of all these measures. — These are regarded as contractionary fiscal policies. such measures as wage 'freeze, putting upper limits on the prices of SUCh important 'inputs as electricity. coal, steel, etc. These measures are: • augmenting the supplies of commodities in the domestic market by increasing imports. • increasing domestic production, etc,
  48. Control of Inflation N cap,vrv, F i!tnl F.pç«ditvrç Increcw! ?n Saving 1 Budqejr- Rana i3f?epx?l Wuçc
  49. Control of Inflation Monetary policy Credit Control Dernonetization of Currency Issue of Nevv Currency Fiscal policy Reduction in Unnecessary Expenditure Increase in Taxes Increase in Savings Surplus Budgets Public Debt Other Measures To Increase Production Rational VVage Policy Price Control
  50. Measures To Control Inflation Monetary Measures: Monetary policy refer to polices adopted by monetary authorities aim at reducing and absorbing excess supply of money in an economy. the central bank of the country may exercise various quantitative and qualitative techniques of credit control to check inflation. The following are some of the anti- inflationary monetary measures: The volume of currency money may be reduced either by withdrawing a part of the notes already issued or by avoiding large scale issue of notes.
  51. Monetary Measures Restrictions on bank credits by setting higher cash reserve ratio Increasing bank rate and other interest rates ' Sale of Government securities in the open market by central bank. Prescribing a higher margin that bank and other lenders must maintain for the loans granted by them against stocks and shares. Regulation of consumers credit Rationing of credit etc
  52. Fiscal Measures Fiscal measure to control inflation relates to government policy with respect to its receipts and expenditure. The following are some of the important anti-inflationary fiscal measures: • Reduction in the volume of public expenditure. Rise in the levels of taxes, introduction of new taxes and bringing more people under the coverage of taxes.
  53. Fiscal Measures More internal borrowings by public authorities Postponing the repayment of debt to people Control on the volume of deficit financing Preparation of a surplus budget Incentive to savings Tariffs should be reduced to increase imports and thus allow a part of the increased domestic money income to leak out Inducing wage earners to buy voluntarily government bonds and securities
  54. Direct Or Administrative Measure • Direct controls refer to the regulatory or administrative measures taken by the government directly with an objective of controlling rise in prices. Some of them are as follows:
  55. Direct Or Administrative Measure Expansion in the volume of domestic output so as to meet the ever increasing rise in the demand for them Direct control of prices and introduction of rationing Control of speculative and gambling activities Wage -profit freeze by adopting appropriate wage- profit policy
  56. Direct Or Administrative Measure Control of population because if population is controlled, it is possible to keep a check on demand for goods and services Exhortations: Exhortations implies authoritative persuasions, publicity campaigns, national saving campaign, requests to trade union to volunteer resisting demand for rise in wages, to companies to restrict dividend distributions and to management to increase productivity and output.
  57. Effects of Inflation on Production and Distribution of Wealth Effects on Production: • Inflation may or may not result in higher output. Below the full employment stage, inflation has a favourable effect on production. In general, profit is arising function of the price level. ' An inflationary situation gives an incentive to businessmen to raise prices of their products so as to Earn higher doses of profit.
  58. Effects on Production Such a favourable effect of inflation will be temporary if wages and production costs rise very rapidly. Inflationary situation may be associated with the fall in output, particularly if inflation is of the cost- Push variety. There is no strict relationship between prices and output. • An increase in aggregate demand will increase both prices and output, but a supply shock will Raise prices and lower output.
  59. Effects of Inflation on Production Effects of Inflation on Adverse effect on Capital Formation Reduction in savings as cost of living rises — less savings will lead to less investment & poor capital formation Production distortion — inflation distorts production by diverting resources to the production of non-essential goods (higher profit margin) from essential goods (lower profit margin) Hoarding & black Marketing Speculation Profit Orientation & Quality Deterioration
  60. Effects of Inflation on Production and Distribution of Wealth Effects on Distribution of Wealth: ' During inflation, usually people experience rise in incomes. ' Some people gain during inflation at the expense of others. ' Some individuals gain because their money incomes rise more rapidly than the prices Some lose because prices rise more rapidly than their incomes during inflation.
  61. Effects of Inflation on Production and Distribution of Wealth Effect of Inflation on Distribution of Income & Wealth People who invest in shares or bonds will gain more due to higher profits earned by firms On the other hand, people investing in assets reaping fixed income (Fixed Deposit etc) will be in loss Farmers benefits from inflation as they would earn more on the products produced. It will also increase the cost of production but rise in price is more than rise in cost. However, the advantage is gained by rich farmers than poor farmers Thus, inflation redistributes income in favour of businessmen, debtors & farmers at the expense of fixed income group, creditors
  62. The following categories of people are affected by inflation differently Creditors and debtors Bond and debentureholders Investors Salaried people and wage- earners Barrowers gan and lenders lose during inflation. When debts are repaid their real value declines by the price level increase and, hence, creditors lose, The borrower now welcomes inflation since he will have to pay less in real terms than when it was borrowed. The borrower is given 'dear' rupees, but pays back rupees. Bondholders earn fixed interest income. These people suffer a reduction in real income when prices rise, Beneficiaries from life insurance programmes are also hit badly since real value of savings deteriorate, People who put their money in shares during inflation are expected to gain since the possibility of earning business profit brightens, Higher profit induces owners of firms to distribute profit among Investors or shareholders. Anyone earning a fixed income is damaged by inflation. Wage rate increases always lag behind price increases. Inflation results in a reduction in real purchasing power of fixed income earners. People earning flexible Incomes may gain during Inflation,
  63. The following categories of people are affected by inflation differently Profit-earners gain from inflation. Seeng inflation, businessmen raise the prices of the r products. Profit•earners, This results in a bigger profi speculators and black marketeers Speculators dealing in business in essential commodities usually stand to gain by inflation, Bock marketers are also benefited by Inflation,
  64. How Is Inflation Measured? The 2 ways of Measuring Inflation are CPI A roeasure Of price changes in consurner goods ar-vd ser— vices such as gasoline. food. clothing and autornobiies- The CPI rneasures price change rrorn the perspective of the purchaser. A fagoity Of indexes that rneasure the average change over tirne in setting prices by dornestic producers of goods and ser— vices. PPts rneasure price change frorn the perspective of the sel I ere
  65. How Is Inflation Measured? u The Producer Price Index (PPI) measures the average change over time in the selling prices received by domestic producers of goods and services The Consumer Price Index (CPI) measures the average change over time in the prices paid by urban consumers for a defined market basket of consumer goods and services
  66. How Is Inflation Measured? Consumer price index Pertains to cost of living Basket consists of consumer goods and services Capital and intermediate goods excluded Prices include VAT Producer price index Pertains to cost of production Basket consists of goods only (no services) Capital and intermediate goods included Prices exclude VAT
  67. References • Engineering Economic Analysis —NPTEL • Engineering Economics • Fundamentals of Economics and Management Institutes of Cost Accountants of India Modern Economics : Dr. H. L. Ahuja Principles for Macro-economics- C Rangarajan
  68. Inflation · ·