INFLATION In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time. Inflation can also be described as a decline in the real value of money—a loss of purchasing power.
INFLATION RATE A chief measure of price inflation is the inflation rate, which is the percentage change in a price index over time. When the general price level rises, each unit of currency buys fewer goods and services. Economists generally agree that high rates of inflation and hyperinflation are caused by an excessive growth of the money supply.
INFLATION RATEThe rate of inflation is the percentage change in price level:Rate of inflation (year t ) price level (year t ) – price level (year t-1)= X 100 price level (year t-1)
INFLATION RATE Inflation is usually measured by calculating the inflation rate of a price index, usually the Consumer Price Index. The Consumer Price Index measures prices of a selection of goods and services purchased by a "typical consumer". The inflation rate is the percentage rate of change of a price index over time.
INFLATION RATE For example, in January 2007, the U.S. Consumer Price Index was 202.416, and in January 2008 it was 211.080. The formula for calculating the annual percentage rate inflation in the CPI over the course of 2007 is
EFFECTS OF INFLATION ON ECONOMY Inflation can cause adverse effects on the economy. For example, uncertainty about future inflation may discourage investment and saving. Inflation may widen an income gap between those with fixed incomes and those with variable incomes. High inflation may lead to shortages of goods as consumers begin hoarding them out of concern their prices will increase in the future.
EFFECTS OF INFLATION ON ECONOMY Low or moderate inflation may be attributed to fluctuations in real demand for goods and services, or changes in available supplies such as during scarcities, as well as to growth in the money supply. The consensus view is that a sustained period of inflation is caused when money supply increases faster than the growth in productivity in the economy.
HOW TO MINIMIZE INFLATION RATE? The task of keeping the rate of inflation low is usually given to monetary authorities who establish monetary policy. Generally today these monetary authorities are the central banks that control the size of the money supply through the setting of interest rates, through open market operations, and through the setting of banking reserve requirements.
PRICE INFLATION The relationship between the over-supply of bank notes and a resulting depreciation in their value was noted by earlier classical economists such as David Hume and David Ricardo. who examined and debated to what effect a currency devaluation (later termed monetary inflation) has on the price of goods (later termed price inflation).
DIFFERENT STRAINS OF INFLATION Like diseases, inflations exhibit different levels of severity, which are classified into three categories:1. Low inflation2. Galloping inflation3. Hyper inflation
1. LOW INFLATION It is characterized by prices that rise slowly & predictably. It is defined as single-digit annual inflation rates. Prices are relatively stable, people trust money because it retains value from month to month & year to year. People are willing to write long-term contracts in money terms because they are confident that relative prices of goods they buy or sell will not get too far out of line.
2. GALLOPING INFLATION Inflation in double-digit or triple-digit range of 20, 100 or 200 per year is called Galloping Inflation or very high inflation. It is relatively common in countries suffering from weak governments, war or evolution. For example, many Latin American countries, like Argentina, Chile & Brazil, had 50 to 700% per year in 1970s & 1980s.
2. GALLOPING INFLATION Once country enters in galloping inflation, serious economic distortions arise. Generally, most contracts get indexed to a price index or a foreign currency like $. Money loses its value very quickly, People hold only the bare-minimum amount of money needed for daily transactions. Financial markets wither away Capital flees abroad
2. GALLOPING INFLATION Financial markets wither away Capital flees abroad People hoard goods, Buy houses, & Never lend money at low nominal interest rates.
3. HYPERINFLATION A third & deadly strain takes when Hyperinflation strikes. Nothing good can be said about a market economy: prices are rising a million or even trillion percent per year (e.g. during civil war). It took place in Weimar Republic of Germany in 1920s, price level rose from 1 to 10,000,000,000.
Anticipated VS Unanticipated Inflation Anticipated Inflation (expected rate of inflation) : inflation at low rates --- has little effect on economic efficiency or on the distribution of income & wealth. People would simply be adapting their behaviour to changing monetary yardstick.
Anticipated VS Unanticipated Inflation Unanticipated Inflation: inflation rate is more than expected inflation rate. In more stable economies like United States, the impact of Unanticipated inflation is less dramatic An unexpected jump in prices will impoverish some & enrich others. This situation will make redistribution of wealth. How costly is this redistribution does not describe the problem. The effects may be more social than economic.
The Economic Impacts of Inflation Inflation affects the distribution of income & wealth because of differences in the assets & liabilities. When people owe money, a sharp rise in prices is a windfall gain for them. Suppose, you borrow $100,000 to buy a house & annual fixed-interest mortgage payments are $10,000.
The Economic Impacts of Inflation If a great inflation doubles all wages & incomes. Your nominal mortgage payment is still $10,000 per year, but its real cost is halved. You need to work only half to make your payment. Inflation has increased your wealth.
The Economic Impacts of Inflation But if you are a lender and have assets in fixed-interest rate mortgage or long-term bonds, The unexpected rise in prices will leave you the poorer because the dollars repaid to you are worth much less than the dollars you lent. The major redistributive impact of inflation comes through its effect on the real value of people’s wealth. Unanticipated inflation redistributes wealth from creditors to debtors.
Impacts on Economic Efficiency Redistribution of incomes, inflation affects the real economy in two specific areas:1. It can harm economic efficiency, &2. It can affect total output.
CAUSES OF INFLATION Inflations occur for many reasons. Some inflations come from demand side (Demand-pull). Other, from supply side (Cost-push).
DEMAND-PULL INFLATION Demand–pull inflation occurs when aggregate demand (AD) rises more rapidly than the economy’s productive potential, pulling prices up to equilibrate aggregate supply & demand. One important factor behind demand-pull inflation is rapid money-supply growth. Increases in the money supply increases AD, which in turn increases price level.
COST-PUSH INFLATION Inflation resulting from rising costs during periods of high unemployment and slack resources utilization is called Cost-push inflation.
DEFLATION Deflation occurs "when prices are declining over time”. This is the opposite of inflation; when the inflation rate (by some measure) is negative, the economy is in a deflationary period." Deflation makes money relatively more valuable than the other goods in the economy.
DEFLATIONIn common usage deflation is generallyconsidered to be "falling prices".But there is much more to it than that.Often people confuse deflation withdisinflation or with Depression (as in"the Great Depression"). These threeterms are related but not synonymous.
DEFLATION Deflation is "a decline in general price levels, often caused by a reduction in the supply of money or credit. Deflation can also be brought about by direct contractions in spending, either in the form of a reduction in government spending, personal spending or investment spending.
WHAT CAUSES DEFLATION? Deflation can occur because of a combination of four factors: The supply of money goes down. Demand for money goes up. The supply of other goods goes up. Demand for other goods goes down.
CAUSES Deflation generally occurs when the supply of goods rises faster than the supply of money.
INFLATION VS DEFLATION If the quantity of money increases to $200 (without increasing the quantity of goods) the price of the goods will increase to $2.00 --- that is inflation. If, the quantity of money decreases to $500 the price will fall to 5% (deflation).
INFLATION VS DEFLATION The money supply can also be reduced if someone on our island hoards half of it and refuses to spend it on anything no matter what. This is the second part of the definition (reduction in spending).
IS DEFLATION GOOD OR BAD? What happens if the quantity of goods available increases? What if instead of having ten items we build ten more? We now have twenty items and only $10. 00 so once again each item is worth 50¢.
IS DEFLATION GOOD OR BAD? This form of deflation is the good type because if prices go down because the goods can be manufactured more cheaply this ends up increasing everyones wealth. Everyone assumes that deflation is bad because the last major deflation that we had was during the "Great Depression" so deflation and Depression are synonymous in many peoples minds.
IS DEFLATION GOOD OR BAD? Actually, deflation itself is neither good nor bad. It depends on the cause of the deflation whether people will suffer or rejoice. If prices go down due to increase in supply of goods because of lower cost of production while supply of money remains constant, it is good. An example of this is in the late 1800s as the industrial revolution dramatically increased productivity.
IS DEFLATION GOOD OR BAD? If deflation is caused by a decreasing supply of money as in the great depression, that would be bad. The stock market crash sucked all the liquidity out of the market place, the economy contracted, people lost their jobs and then banks stopped loaning money because people were defaulting. The problem compounded as more people lost their jobs and money supply fell further causing more people to lose their jobs, etc. etc.
STAGFLATION It is a situation where each level of inflation is accompanied by more unemployment. For example, many years of 1970s experienced inflation & unemployment or in a word, stagflation. The data of 1972-74 & 1977-80 periods.
AGGREGATE SUPPLY SHOCKS What caused stagflation of 1970s & early 1980s? A series of cost shock or aggregate supply shocks caused stagflation in these years. A series of supply shocks, including sharply increased energy costs, higher agricultural commodity prices, higher input prices, diminishing productivity growth & inflationary expectations shifted the aggregate supply curve leftward.
AGGREGATE SUPPLY SHOCKS If we look at cost-push inflation model, a decrease aggregate supply causes unemployment rate & the price level to vary directly. The result of aggregate supply shock --- stagflation --- a higher price level accompanied by a decline in real domestic product.
AS SHOCK (Leftward As Shift) AS3 Price AS1 level E 3 E1 AD1 Output levelA leftward AS shift always decreases output andprices will rise. This will be rampant stagflation.
Rightward AS Shift Price AS1 level AS2 E1 E2 AD1 Output levelIf there is a rightward shift in the aggregate supplycurve then both inflation and unemployment can bereduced. Harcourt