Types of inflation; causes of inflation; measurement of inflation

1. INFLATION
Unit 5.2
Prof. Prabha Panth
20 Dec 2018

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.
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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
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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.
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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.
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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.
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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.
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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.
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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
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10. Measurement of Inflation
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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.
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Price Index

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.
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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
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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%
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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
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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.
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17. Annual WPI - India
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169

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)
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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
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