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# Lec4inflation

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### Lec4inflation

1. 1. INFLATION Inflation means long term continuous rise in general price level of a country. General price level here means a weighted average of prices of various things bought and sold in an economy during a period by consumers producers etc. Weighted average means an average which is calculated taking into count the proportional relevance of each component rather than treating all the components equally. Example – India uses 435 commodities forits general price level calculation. On a broader level, the 435 commodities are grouped into, 1. Primary Articles 2. Fuel, Power, Light & Lubricants 3. Manufactured Products ,Primary articles have a weighatage of 22.02%. Fuel, Power, Light & Lubricants, which has a group weightage of 14.2%. Manufactured products have a weightage of 63.75 %. In India inflation rate data is reported every week by MOSPI ( Ministry of Statistics and Programme Implementation ). The data is reported on Thursday. INFLATION RATE Inflation rate is used to know the severness of price rise in an economy. Inflation rate is calculated as below – Inflation rate = Price in final period- Price in base period/ Price in base period. Since inflation rate is always calculated in percentage terms the above formula is to be multiplied by 100. If a particular item has a higher weight and its price rises, it will have a greater effect on the inflation rate. At the end of the day it depends on how much weight a particular item is assigned. For example in the case of India a small rise in the price of manufactured items will have more effect on inflation rate because these item have higher weightage. Inflation rate can be calculated using either the average retail price of commodities ( called Consumer Price Index) or average price of commodities used by wholesalers ( called Wholesale Price Index) Most countries use a consumer price index (CPI) while India uses a wholesale price index (WPI). As their names suggest, the CPI pertains to a set of items that a
2. 2. consumer consumes while the WPI is a basket particular to the wholesale market. In calculating average price level on the basis of CPI more weightage is given to food item in WPI these items have low weightage. IN WPI services are not included in CPI services like education fee, doctor’s fee, personal care fee etc. are included. In cae of WPI base year is 1993-94 in case of CPI base year is 1982. HEADLINE INFLATION Weekly inflation data reported in newpapers. CORE INFLATION Core inflation is a measure of inflation which excludes certain items that face volatile price movements e.g. food products and energy. Causes Of Inflation Inflation may be caused by reasons in the real sector or the monetary sector of the economy. In the real sector inflation may result either from the reasons operating on the demand side ( demand pull) of the economy or reasons operating on the supply side ( reasons which operate through cost) of the economy. Wage spiral, inflationary expectations, mark-up are some other reasons which may happen through the supply side. Monetary sector inflation may be caused by rise increase in the supply of money. 1. Demand-pull inflation refers to the idea that the economy actual demands more goods and services than available. This shortage of supply enables sellers to raise prices until an equilibrium is put in place between supply and demand. 2. The cost-push ( cost push inflation is called commodity inflation) theory , also known as quot;supply shock inflationquot;, suggests that shortages or shocks to the available supply of a certain good or product will cause a ripple effect through the economy by raising prices through the supply chain from the producer to the consumer. You can readily see this in oil markets. When OPEC reduces oil supply, prices are artificially driven up and result in higher prices at the pump. 3. Inflationary Expectation – Milton Freidman emphasized the important of inflationary expectation in creating more inflation. The theory works like this. In the late 1960s, Friedman argued that if the price rise was expected, unions would have demanded higher wages, so wages and prices would go up in un ison. The effect of inflationary expectation hen in the 1970s, the nightmare scenario that Friedman’s theory seemed to predict, came true. Inflation expectations were so deeply embedded, that in order to give a boost to jobs, prices had to rise by more than normal. This extra rise then became expected – and an upward spiral of ever-rising prices occurred, and so sophisticated did our expectations become, that unemployment
3. 3. actually started to rise. It was called stagflation. on inflation can work in various other ways also. 4. Wage Spiral.Even if wage earners do not expect any inflation inflation can artificially be created through a circular increase in wage earners demands and then the subsequent increase in producer costs which will drive up the prices of their goods and services ( this is also called wage spiral). This will then translate back into higher prices for the wage earners or consumers. As demands go higher from each side, inflation will continue to rise. Labour unionism causes such kind of inflationary pressure to happen. In India after 1920s with the birth of the Communist Party of India labour unionism has been on rise. The report of acceptance of the report of the Sixth Pay Commission by the government of India is expected to create pressure on inflation. 5.. Base Effect. A semblance of inflation can be created only if inflation rate is calculated with a base year in which prices were low. This is called base effect. This may not be real inflation. 6.Money supply plays a large role in inflationary pressure as well. Monetarist economists like Freidman feel that inflation is dominantly a monetary phenomenon. (He said: quot;Inflation is always and everywhere a monetary phenomenon.quot;) Monetary inflation was most famously seen in Weimar Germany during the 1920s, when the German government went crazy with the printing presses to the point where it took billions of marks to equal one dollar. This wiped out the savings of the middle class, most members of which were compensated with (worthless) quot;million markquot; notes, and eventually led to the rise of Hitler Monetary inflation is better advocated utilizing the equation of exchange and the quantity theory of money, the former, which is MV=PT (money supply x velocity of circulation = price levels x total transactions) and the latter, explains that the velocity of circulation be will equal to the level of transactions, therefore after removing them from the equation, only M=P remains, hence saying that any change in the money supply will bring about a change in the level of prices. TYPES OF INFLATION On the basis of rate inflation is categorized in the following – 1. Moderate inflation – a. creeping inflation ( less than 10 % per annum). B. walking inflation 10 % per annum) 2. Running inflation. ( more than 10 % up to 20% per annum) 3. Galloping inflation. ( more than 20% up to triple digit per annum) 4. Hyper inflation. ( more than 1000% per annum). Hyperinflation notably took place in Germany in 1920-1923. The German price index rose from 1 to 10,00,000,000 during January 1922 to November 1923. Zimbabwe these days is facing the same problem.