inflation and its effects to the economy

1. Lecturer – S. M. Irshad
BA in Social Sciences (OUSL)
MA in Economics (KU) India, in progress
Dip. in Governance, Democratization & Public Policy(CISS)
E-mail – irshad.sahabdeen@yahoo.com
11

2. 6. Student Analyses the Changes of
the Price Levels that Affect the
Macroeconomic Function.
Describing Measures of General Price
Level
Investigates Price Indices that ,measure
the changes in the price level in Sri
Lanka.
Types and concepts of Inflation.
Causes and effects of the Inflation.
2

3. Introduction
Economic and price stability is a situation where
there are no wide fluctuations in the general price
level in an economy which helps to achieve
sustainable economic growth. When the prices
fluctuate at a low rate, they would not have any
significant influence on economic decisions of
participants of an economy, viz. households and
firms. Therefore, stable prices would not distort the
economic decisions regarding what to produce and
how to produce, thus enabling efficient allocation of
resources in the economy leading to economic
stability.
3

4. Price Stability is the economic term used to refer to
a situation where the general price level covering
Consumer goods remains unchanged or if it does
change, it happens at a low rate so that it is not strong
enough to make any significant influence on
economic decisions of participants in an economy,
viz. households and firms.
We encounter prices in different forms in our daily
activities as buyers or sellers when we get engaged in
consumption, investment, production or trade. In a
market economy, price changes are a common
phenomenon depending on the demand for and
supply of goods and services. Since prices change in
both directions and in different magnitudes, it is
difficult to figure out the general movement in prices
by examining each individual price change in4

5. General Price Level
The price level is usually examined through a
“basket of goods” approach, in which a collection of
consumer based goods and services are examined in
aggregate; changes in the aggregate price over time
will push the index measuring the basket of goods
higher.
Price levels provide a snapshot of prices at a given
time, making it possible to review changes in broad
price level over time.
As price rises (inflation), or fall (deflation),
consumer demand for goods is also affected,
which leads broad production measures like
gross domestic product higher or lower. 5

6. Measuring the Price Level
Absolute Prices / Money Prices – is the
price of a product measured in terms of
money. E. g. – if the price of 1 kg of carrots is
Rs 50, that is the absolute price.
Relative Price – the price of a particular
good expressed in relation to the price of
another good. E.g.- if the price of 1 kg of beans
is Rs 25, the relative prices of the two
products are as follows;
6

7.  Relative Price of Carrots = Price of Carrots
Price of Beans
= 50/25 = 2.
Relative Price of Beans = Price of Beans
Price of Carrots
= 25/50 = 0.5
In an inflationary situation, relative prices of
product may change, relative to the general price
level.
7

8. As we are more interested in the general
increase (or decrease) in prices, rather than
the increase (or decrease) in the price of a
particular good or service, it is necessary to
find a measure that will capture the in the
general price level. The general price level is
measured by a statistical tool called a Price
Index.
A price index is simply a weighted average of
prices of a basket of selected goods and
services where weights represent the relative
importance of each item as reflected in its
relative share in the total value of the basket. 8

9. There are different price indices, e.g., Consumer
Price Indices (CPIs),
Wholesale Price Indices (WPIs) and Producer
Price Indices (PPIs), which measure the overall
trends in price movements at different stages of the
process, from production to final consumption.
9

10. However, CPIs are the most widely used price
indices, as their changes represent the price
movements faced by most people in a society as
consumers. Nevertheless, computation of WPIs and
PPIs is also important, as their movements are
leading indicators of future movements of consumer
prices.
A consumer price index measures the general
movements of prices of a representative basket of
consumer goods and services. Based on a survey of
the spending patterns of consumers, goods and
Services are included in the basket and relative
weights are assigned to them according to their
relative importance in the total expenditure, i.e.,
goods and services that account for larger portions of
the total expenditure of consumers are assigned
greater weights.
10

11. Colombo Consumers’ Price Index (CCPI).
The Colombo consumers price index (1952 =100)
had been used as the official of CPI of Sri Lanka,
from 1953 to November 2008 when a new Colombo
consumer price index was introduced. the weights
for consumer items in the old CCPI was based on
the average household expenditure of a sample of
455 working class households determined by the
Colombo family budget survey of 1949 – 1950, and
revalued at the annual average prices of 1952 which
was considered as the base year.
11

12. In Sri Lanka, the official price index currently used is
the Colombo Consumers’ Price Index (CCPI). It is
constructed based on the spending patterns of the
lowest 40 per cent of households, ranked by their
monthly income, within the Colombo Municipal area
in 1952.
The Department of Census and Statistics (DCS), which
compiles the official price index, has introduced a new
index, the Sri Lanka Consumers’ Price Index
(SLCPI) to overcome some of the weaknesses in the
CCPI such as the outdated basket of goods and
services, and the limited coverage of income groups
and geographical area. The SLCPI is based on the
spending patterns of the lowest 80 percent of
households ranked according to monthly income in
the entire country, excluding the Northern and the
Eastern provinces, between 1995 and 1997.
12

13.  However, it is yet to be adopted as the official price
index. As in any developing country, the CCPI and
the SLCPI assign a large weight (about 65 percent) for
food and beverages, reflecting the spending pattern of
the average consumer in Sri Lanka.
There are two other indices available to measure
movements in the general price levels in Sri Lanka:
the Wholesale Price Index (WPI), which captures the
price movements at the primary market level and the
Gross Domestic Product (GDP) deflator, which is
the broadest measure of the general price level
covering all goods and services included in the
computation of GDP in the country.
13

14. Consumer Price Index (CPI) in Sri Lanka decreased
to 170 Index Points in April of 2013 from 170.80 Index
Points in March of 2013. Consumer Price Index (CPI)
in Sri Lanka is reported by the Central Bank of Sri
Lanka.
Historically, from 1985 until 2013, Sri Lanka
Consumer Price Index (CPI) averaged 62.61 Index
Points reaching an all time high of 170.80 Index
Points in March of 2013 and a record low of 10.80
Index Points in September of 1985. In Sri Lanka, the
Consumer Price Index or CPI measures changes in
the prices paid by consumers for a basket of goods
and services. This page includes a chart with
historical data for Sri Lanka Consumer Price Index14

15. 15

16. Colombo Consumers’ Price Index (CCPI)
2010, 2011 and 2012
(2006/07=100)
Month
Index Monthly Change %
Year-on-Year
Change %
Annual Average
Change %
2010 2011 2012 2010 2011 2012 2010 2011 2012 2010 2011 2012
January 140.4 149.2 154.8 1.9 1.4 0.3 7.1 6.2 3.8 3.2 6.1 6.5
February 141.1 151.3 155.4 0.5 1.4 0.4 7.5 7.2 2.7 3.3 6.1 6.1
March 139.8 150.6 158.8 -0.9 -0.5 2.2 7.2 7.7 5.5 3.4 6.2 5.9
April 138.4 150.6 159.8 -1.0 0.1 0.6 6.8 8.9 6.1 3.8 6.4 5.7
May 140.1 151.5 162.1 1.2 0.6 1.4 5.6 8.2 7.0 3.9 6.6 5.6
June 141.2 151.2 165.2 0.8 -0.2 1.9 5.1 7.1 9.3 4.3 6.7 5.8
July 141.2 151.7 166.7 0.0 0.4 0.9 4.4 7.5 9.8 4.6 7.0 6.0
August 141.4 151.3 165.7 0.2 -0.3 -0.6 5.0 7.0 9.5 4.9 7.1 6.3
September 142.6 151.7 165.5 0.8 0.3 -0.1 5.7 6.4 9.1 5.3 7.2 6.5
October 144.1 151.5 165.0 1.1 -0.1 -0.3 6.5 5.1 8.9 5.7 7.1 6.8
November 145.7 152.6 167.1 1.1 0.7 1.3 6.9 4.7 9.5 6.1 6.9 7.2
December 147.2 154.4 168.6 1.1 1.2 0.9 6.8 4.9 9.2 6.2 6.7 7.6
Source: Department of Census and Statistics
16

17. The CCPI increased by 1.3 per cent in November 2012 over
the previous month, with the Index increasing in absolute
terms to 167.1 from 165.0 in October 2012. The contribution
to the monthly increase in the Index came mainly from
price increases in the Food category (by 2.4 per cent).
The prices of many varieties of vegetables, red onions, big
onions, potatoes, coconuts, wheat flour and bread
increased during the month. However, a decrease in the
prices of eggs and some varieties of fresh fish, dried fish
and fruits was reported.
Within the Non-Food category, prices increased in the
sub-categories of Clothing and Footwear (by 0.4 per cent);
Housing, Water, Electricity, Gas and Other Fuels (by 0.4
per cent); Furnishing, Household Equipment and Routine
Household Maintenance (by 1.0 per cent); Transport (by
0.2 per cent) and Miscellaneous Goods and Services (by 0.4
per cent). Meanwhile, the prices in the sub-categories of
Health; Communication; Recreation and Culture; and
Education were unchanged during the month. 17

18. 18
0
2
4
6
8
10
Jan
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
Dec
Jan
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
Dec
Jan
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
Movements of the CCPI (2006/07=100)
Year-on-Year % Change Annual Average % Change
2010 2011
%
2012

19. Wholesale Price Index (WPI)
A wholesale price index generally reflects prices at
the primary market level. the primary market is the
1st
place where a major commercial transactions in
the chain of sales of a product takes place.
The WPI refers to a mix of agricultural and
industrial goods at various stages of production and
distribution, including import duties.
the Laspeyres formula is generally used to compute
the values.
19

20. The CBSL has been compiling the WPI since
1974 as a monthly series. the Laspeyres
formula is used with 1974 as the base year. an
overall price index and 13 commodity wise
subgroups are computed.
The price used for domestic products are
prices excluding discounts. in the case of
imported goods, the prices are CIF plus
customs duties.
The popular method for computing price
index is the Laspeyres Index and Formula.
20

21. Laspeyres suggested this index formula in 1871, in
calculating the price index, by assuming the below
formula.
i = individual item, p i0 = price at the base
period to be, p it = observation period to be, q
i0 = quantity at the base period to be.
21

22. GDP (Gross Domestic Product )Deflator
This is the most comprehensive price index. it
consists of all the goods and services that enter into
value added in the gross domestic product-GDP. this
formula as follows;
GDP Deflator = GDP at Current Prices X 100
GDP at Base Period Prices
(Constant)
22

23. This is also called an implicit price index or implicit
deflator. the term implicit is used because no price
index was used in calculating the real and nominal
GDP. on the same basis, a GNP deflator also can be
computed using the above formula.
Unlike the Laspeyres index, the GDP deflator dos not
use fixed weights. the current years bundle of goods is
used to compare the current years prices with those
prevailing in the base year.
The GDP deflator also has some shortcomings.
imaginary prices are used for certain transactions that
do not actually take place in the market. E.g. –
government services. this index does not reflect the
cost of living of the average households, because it
contains the prices of some goods that are not
consumed by them such as investments and exports
goods.
23

24. Inflation
Inflation – is the continuous increase in the
general price level over a period of time. it also
means a continuous fall in the value of money
or purchasing power of money.
The rate of inflation is usually measured in %
terms. inflation is a major problem faced by
many countries. high inflation also known as
galloping inflation or hyperinflation, which
makes money worthless.
24

25. In any real economy, one may observe that prices
are constantly changing. The price changes are of
two types. One is changes in relative prices of same
goods and services compared with others. The other
is changes in the general price level, with the price of
practically everything changing constantly. It is the
latter – a sustained upward movement in prices as a
whole is what we term as inflation.
Sri Lanka is presently experiencing high level of
inflation compared to other countries in the region.
It recorded 24.1% in October 2007 following a
recording bout of money printing of Rs. 45.2 billion
between May and September 2007. The index
measuring consumer prices reached an all-time high
of 19.6% in November 2007.
25

26. The percentage rate of change of a price index is the
inflation rate.
Suppose that a price index in a country was 200 in
1998 and 210 in 1999, the inflation rate between 1998
and 1999 was:
Inflation rate = (210 – 200)/200 = .05 = 5%
In other words, the country experienced a 5%
inflation rate. 26

27. Headline Inflation Measure
Headline inflation is a measures of the total
inflation within an economy and is affected
by areas of the market which may experience
sudden inflationary spikes such as food or
energy.
As a result, headline inflation may not
present accurate picture of the current state
of the economy. this differs from core
inflation, also called underlying inflation
,which excludes factors such as food and
energy costs.
27

28. Core Inflation/Underlying Inflation
The inflation arising from changes in the
food and energy prices are volatile and often
subject to temporary fluctuations caused by
supply shocks, mostly driven by weather
disturbances or external shocks and changes
in administered prices, tax policies which are
beyond the control of the monetary
authority.
28

29. Monetary authorities al over the world take
their monetary policy decisions on the basis of
underlying trend in inflation which is derived
by removing volatile components in a
consumer price index. the underlying trend in
inflation is known as core inflation.
There is no unique method of estimating core
inflation. many countries use exclusion
method to calculate the core inflation by
removing food and energy items from price
index.
In Sri Lanka also using the same method of
exclusion of food and energy items from the
new Colombo consumer rice index – CCPI. 29

30. Types of Inflation
Galloping Inflation / Running Inflation –
when the movement of price accelerate
rapidly, running inflation emerges. running
inflation may record more than 100% rise in
prices over a decade. thus when prices rise by
more than 10% a year, running inflation occurs.
Economists have not yet decided the range of
running inflation. but we may say that a double
digit inflation of 10 – 20 % per annum is a
running inflation. if exceeds that figure, it may
be called galloping inflation.
30

31. Creeping Inflation
Circumstance where the inflation of
a nation increasing slowly but
continuously over time.
this tend to be a typically pattern for
many nations. although the increase in
relatively small in the short term, as it
continues over time the effect will
become greater and greater.
31

32. Spiral Inflation
A Macroeconomic Theory to explain the
cause and effect relationship between rising
wages and rising prices, or inflation.
The wage price spiral suggests that rising
wages increase disposable income ,thus
raising the demand for goods and causing
prices to rise. rising prices causes demand for
higher wages which leads to higher
production costs and further upward pressure
on prices. 32

33. A Similar Definition;
“A continuous rise in prices
that is sustained by the
tendency of wage increases
and cost increases to react
on each other.”
- Merriam Webster Dictionary -
33

34. 34

35. Suppressed Inflation
Suppressed inflation is the inflation rate that
the temporary measures taken to prevent
inflation but eventually leads to inflation.
In such cases the provision of basic necessities
such as agricultural products is set by the
government by introducing price controls on
commodities.
It’s called Repressed Inflation, because prices
are suppressed through price controls. so in this
case price control is below the equilibrium price,
but over time inflationary pressures exerted all its35

36. Deflation & Deflationary Gap
Deflation – a general decline in prices of goods and
services, often caused by a reduction in the supply of
money or credit.
This occurs when the annual inflation rate falls below
0% , resulting in an increase in the real value of
money.
Deflation has the side effect of increased
unemployment since there is a lower level of demand
in the economy, which can leads to an economic
depression.
Central banks attempt to stop severe deflation
because it leads to economic depression, in an
attempt to keep the minimum price level in the
economy.
36

37. Deflationary Gap
This is shown by an aggregate
expenditure function which cuts the 45
angle line, where E = Y, at less than the
full employment level of national income.
The diagram below illustrates than an
unemployment equilibrium exists at Y1
and that there is a corresponding
deflationary gap of magnitude between
A,B at full employment at Yf.
37

38. Deflationary Gap. A – B.
38
EXPENDITURE
Y 1 Y f REAL
INCOME
AGGREGATE EXPENDITURE
DEFLATIONARY GAP
A
B
45

39. Disinflation
A slowing down in the rate of price
inflation. this is used to describe
instances when the inflation rate has
reduced marginally over the short term.
although it is used to describe periods of
slowing inflation.
During disinflation many prominent
prices, E.g.-oil, fuel, commodity,
property, food prices are falling. 39

40. Different Approaches To Analyze Inflation
inflation is an outcome of a
number of factors. these factors can
be categories namely;
Demand Shock – Demand Pull
Inflation
Supply Shock – Cost Push
Inflation.
40

41. Demand Shock Inflation
(Demand Pull)
Demand-pull inflation is inflation
that results from an initial increase in
aggregate demand.
A demand pull inflation can result
from any influence that increases
aggregate demand.
41

42. In a demand-pull inflation, initially
aggregate demand increases
real GDP increases above potential
GDP and the price level rises
money wages rise
the price level rises further and
real GDP decreases toward
potential GDP.
42

43. A one-time increase in aggregate
demand raises the price level but
does not always start a demand-pull
inflation.
For demand pull inflation to occur,
aggregate demand must persistently
increase.
The money supply must
persistently grow at a rate that
exceeds the growth rate of potential
GDP. 43

44. Demand-pull inflation exists when aggregate demand
(AD) exceeds aggregate output at full employment. The
excess demand for goods and services cannot be met in
real terms and therefore it is met by rises in the price of
goods.
The excess demand itself can be caused by autonomous
increases in government spending, investment,
consumption or exports. For instance, if consumption
increases due to an increase in national income or a fall
in income tax, and if the economy is already at full
employment, aggregate demand will increase as well as
the rate of inflation. The demand pull inflation can be
diagrammatically illustrated as follows:

45. The initial price level is 0P where the aggregate demand curve, AD,
meets the aggregate supply curve, AS. It should be noted that at
full employment level of output, YF, AS is perfectly inelastic. Hence,
an increase in aggregate demand curve to AD1 at full employment
causes an increase in the general price level to 0P1.

46. Supply Shock Inflation
(Cost Push)
Cost-push inflation is an inflation that
results from an initial increase in
costs.
The two main sources of cost-push
inflation are:
an increase in the money wage rate
an increase in the money prices of
raw materials

47. Cost-Push Inflation
In a cost-push inflation, initially
short-run aggregate supply
decreases
real GDP decreases below
potential GDP and the price level
rises
the economy could become stuck
in this stagflation situation for
some time.

48. Cost-Push Inflation
A one-time decrease in aggregate supply
raises the price level but does not always
start a cost-push inflation.
For cost-push inflation to occur,
aggregate demand must increase in
response to the cost push.
Just like the case of demand-pull
inflation, the money supply must
persistently grow at a rate that exceeds
the growth rate of potential GDP if an
inflation is to become persistent.

49. Cost push inflation occurs when increasing costs of
production are passed on to the consumers in the form
of higher prices. This is inflation from the supply side of
the economy. There are various factors leading to cost
push inflation. First and foremost, the cause of inflation
is attributed to an increase in wage costs.
It is a widely held view that as prices rise, so real wages
fall and this gives rise to another round of wage claims
so that eventually a wage price spiral develops. Most
cost-push theories are based on the existence of strong
trade unions that make use of their monopoly power in
the control of the supply of labour to push for wage
increases in excess of those required to offset rising
prices.

50. Besides, inflation may be transmitted into the local
economy from other countries suffering from
inflation. An increase in import prices for consumer
goods will affect the cost of living directly. Increased
import prices for fuel and industrial raw materials will
have a direct impact on production costs.
Furthermore, rising indirect taxes can be a major
cause of inflationary pressures in the economy. For
instance, an increase in sales tax or value added tax
will directly have the effect of raising market prices of
all goods and services. Rising costs shift the Aggregate
Supply curve (AS) upwards, thus, causing the general
price level to rise. This can be illustrated as follows:

51. The rising production costs shift the AS curve to the left from AS to
AS1. With an unchanged AD curve, this reduces the equilibrium
level of real income from 0Y to 0Y1 (thereby creating some
unemployment) and raises the price level from 0P to 0P1.

52. Effects Of Inflation
Inflation has various adverse effects on the economy.
some of them are listed below.
Inflation reduces the real value of money. It really means
rise in prices. therefore, one rupee can buy fewer goods
than earlier, this means the purchasing power of money or
the real value of the money ahs fallen.
People on fixed incomes are adversely affected by
inflation.
With high inflation , people try to hold less money and
they go to their banks more to withdraw money. The cost
of reducing money balances called as ‘shoe leather costs”.
Inflation distorts consumer behavior. As prices of
different goods rise at different degrees, inflation distorts
relative prices, as a result , consumer behavior also gets
distorted. This leads to a misallocation of resources.
52

53. Inflation disturbs business confidence, when
prices rise rapidly, businessmen find it difficult
to forecast economic behavior accurately.
Inflation weakens the export competitiveness
of the domestic economy. If the exchange rate
remains unchanged, rising domestic prices
make exports more expensive and imports
cheaper. This leads to a decline in exports and a
rise in imports resulting in a bigger trade
deficit. Such trade imbalances exert pressure
for an exchange rate depreciation or a free float.
53

54. Remedies for Inflation
As inflation has many adverse effects on the economy,
it’s important to take appropriate measures to control it.
In controlled economic regimes , various administrative
measures such as price controls are the key remedial
measure.
But in a liberalized economy such direct control are not
used. Instead the government and the monetary
authorities try to reduce inflationary pressures by
regulating the money supply. In particular, the budget
deficit, which is a major cause of monetary expansion,
needs to be curtailed. Recently CBSL has shifted its
policy focus to price stability with the intention of
‘inflation targeting’ as a major goal of monetary policy. 54

55. Review Questions
1. Define what is general price level and how they
measure?
2. What are price indices? Explain.
3. What is GDP deflator?
4. What is inflation and types of inflation? Explain.
5. What is deflation and inflationary gap?
6. Explain the difference between disinflation and
deflation.
7. What are the 2 main approaches to analyze inflation?
Explain.
8. What kind of remedial measures taken to control
inflation in an economy?
9. What are the effects of inflation? Explain. 55

56. ReferencesProf. S. S. Colombage.” Principles of Macroeconomics”
2006. The Open University Press, Nugegoda, Sri Lanka.
Richard G. Lipsy,” An Introduction to Positive
Economics” 7th
Low Price Edition ,1989, Butler & Tanner Ltd,
London.
Robert J. Gordon," Macroeconomics” 3rd
Edition,1984,
Little Brown & Company Canada Ltd, USA.
Robert H. frank, Ben S. Bernake, ”Principles of
Macroeconomics”, 2001. McGraw-Hill Companies Inc, New
York.
David. W. Pearce," The Dictionary of Modern
Economics” 2nd
Low Price Edition, 1985, Anchor Brendon
Ltd. UK.
Prasadini Dharmawardena, GCE A/ L Economics – New
Complete Text Books for grade 12 & 13, ESL Publishers.
Central Bank Reports 2009, 2010, 2011, 2012,Recent
Economic Development Reports from 2008, 2009, 2010,
2011, and 2012, Economics and Social Statistics form 2010,
2011, 2012.The Central Bank of Sri Lanka.
56