Inflation is defined as a general increase in prices and fall in the purchasing value of money. It can be caused by excess demand (demand-pull) or increases in production costs (cost-push). Inflation is measured using price indices like the CPI and WPI. Effects of inflation include impacts on production, income distribution, and economic growth. Monetary, fiscal, and physical policies can be used to control inflation.

1. Inflation
Definition, Causes, Measurement,
Consequences and Corrective Actions

2. Some definitions
The state in which value of money is falling, i.e.
price is rising. Prof Crowther
Criticisms:
– Every increase in price level is inflationary and has
harmful consequences.
– Emphasized the symptom rather than the cause of the
disease – fails to explain why price level increases

3. Other Definitions
 Issue of too much money
Prof Hawtrey
 Too much currency in relation to physical volume of
business being done.
Prof Kermmerer
 Inflation is too much money chasing too few goods.
Prof Coulbourn

4.  Therefore, increase in average price levels is
referred to as Inflation.
Problem
 Prices rise faster than income
 Standard of living declines

5. Deflation Defined
 Declining price levels
 Associated with recession

6. Types of Inflation

7. Based on speed
Creeping inflation: mildest form of inflation –
makes the economy dynamic.
 Prices rise slowly
 Industry and trade receive stimulus and the
country develops economically.
 According to some economists, price level
should rise by approx. 2% annually under
creeping inflation.

8. Walking:
Rate of increase of price-level gets further accelerated – rises by
approx 5% annually. If proper control is not exercised, it can
easily assume the form of running inflation.
Running:
• price-level rises by approx 10% annually.
Galloping or Hyperinflation:
Prices rise every minute and there is no upward limit to which it
may rise in course of time.
– Lord Keynes has called it true inflation.
– This type invariably occurs after the point of full employment.
Price rises by 16% and more.
Examples are the Great Inflation of Germany after First World
War, and Great Chinese Inflation after the Second World War.

9. Theories of Inflation

10. Demand-Pull Inflation
Inflation is caused by an excess of demand (spending)
relative to the available supply of goods and services at
existing prices.
– The Classical - the key factor is the money supply. The quantity
theory of money => only an increase in money supply is capable
of raising the general price level.
– In Modern income theory, means an excess of aggregate
demand relative to the economy’s full employment output level.
– Prices rise in response to an excess of aggregate demand over
existing supply of goods and service => caused by an increase in
quantity of money
– May also be caused when MEC or MPC goes up causing an
increase in expenditures and hence prices.

11. Demand Pull Inflation
S
Price level
D2
D1
P2
D0
P1
P0 S
Y0
Real Income

12. Cost Push Inflation
 This theory maintains that prices, instead of being
pulled-up by excess demand, are pushed-up as a
result of a rise in the cost of production.
 Prices rise on account of a rise in the cost of raw
materials, especially wages.
 Some producers, group of workers, or both,
succeed in raising the prices for either their
product or services above the levels that would
prevail under more competitive conditions

13.  Inflation of the cost-push type originates in
industries, which are relatively concentrated,
and in which, sellers can exercise considerable
discretion in the formulation of both prices and
wages.
 It may not be possible in an economy
characterized by pure competition.

14. S
D2
D1
D0
P1
P0
S1
S0
Y2 Y1 Y0

15. MEASUREMENT OF INFLATION

16. General Price Level
Weighted average of individual goods’ prices.
n
Pt = S wi Pit
i=1
wi >= 0
S wi = 1

17. Example
Suppose there are only 3 goods in the economy, with
their prices in 1999 and weights as follows:
Goods Price Weight
Rice Rs. 15 / kg 0.6
Shirt Rs. 200 / piece 0.3
House (room) Rs.1000 / mon 0.1

18. General price in 1999
P99 = 0.6 (15) + 0.3 (200) + 0.1 (1000) = Rs. 169
Note: the general price is merely a concept. There is
nothing particular that you can buy for Rs. 169.

19. Weights
The weights for the various component items are
determined by the relative significance of that item
in all the items during the base period.
Qi0 Pi0
Wi = ------------------
Σ Qi0 Pi0
i
where Qi0 and Pi0 are the quantity and price of the
good ‘i’ in the base period.

20. Price Index
 A Price Index is expressed as the current price
in relation to its value in the base period.
 Thus, price index for period t is defined as:
PIt = Pt / P0

21. Example
Price of shirt in base year, say 1991 was Rs. 120
and in 1999 it was Rs.200, the price index
PI 99 = Rs. 200 / Rs. 120 = 1.67

22. About Price index
 An index helps to compare the data without
worrying about the unit of measurement.
 Price Index of 1.67 indicates that between 1991
and 1999, price of shirt has increased by 67 %.
 Index numbers are usually written with a base
value = 100 (above number has to be multiplied
by 100).

23. Price index of general price
weighted average of various prices
Pit
PIt = Σ Wi ------
Pi0

24. Measuring the Inflation
 It means the rate of change in general price (P or
PI) per year, expressed in percentages.
 Thus the simple inflation rate in period t (Pt) over
the last one year is given by:
Pt – P t-1
Pt = ------------------ x 100
Pt-1
If it is compounded once in a year only.

25. If compounding is done on a continuous basis:
Pt
Pt = ln ------ x 100
Pt-1
Where ln stands for natural logarithm.

26. Example
If the general price index rises from, say, 150 in
1998 to 160 in 1999,
the simple inflation rate during 1998-99 = 6.67%
{(160-150)/150 x 100}
and the continuous compounded inflation rate =
6.45 % {ln (160/150) x 100}.
In practice, the annual compounding rate is often
used.

27. Effects of Inflation

28. Effects on Production
 Mild inflation is beneficial to the economy.
 Hyperinflation disrupts the economy: discourages savings =>
capital accumulation falls. Drives out foreign capital already
invested in the economy.
 Volume of production will fall not only on account of fall in
capital accumulation, but also due to the uncertainty.
 Pattern of production may change.
 Seller’s market => result in deterioration of the quality of goods
produced. Give impetus to speculative activities.
 Most serious: disrupts the smooth functioning of the price
mechanism.

29. Effects on Distribution
Results in redistribution of income and wealth.
 Debtors & Creditors: Debtors are gainers – they borrowed
when purchasing power of money was high and return the loans
when pp of money is low due to rising prices. Creditors are
losers – receive less in real terms
 Wage & Salary Earners: wages do not rise proportionally with
rise in cost of living. If they are well organized in trade unions,
they may not suffer much.
 Farmers: gain – prices of farm products go up while costs
incurred do not go up to the same extent – time lag between rise
in prices and costs. Farmers are generally debtors and can repay
their debts in terms of less purchasing power.

30.  Fixed income groups: hardest hit – persons who live on past
savings, pensioners, interest and rent receivers suffer most during
inflation.
 Entrepreneurs: Inflation is a boon – whether manufacturers,
traders, merchants and businessmen – rising prices serve as a tonic
for business enterprise – experience windfall gains as the prices of
their inventories (stocks) suddenly go up. Also gain as their costs
(on wages, raw materials, etc) do not go up as rapidly as prices.
 Investors: of two types
(a) Invest in equities (shares) – Dividends on equities increase
with increase in prices and corporate earnings.
(b) Invest in fixed interest- yielding bonds and debentures –
income from bonds remain fixed and as such they have much to
lose during inflation. Frequently, the value of their savings is
largely, if not completely, wiped out as a result of depreciation in
the value of money.

31. Measures to Control Inflation

32. Monetary Policy
Measures adopted by the Central Bank such as
 Increase in re-discount rates: increases the cost of
borrowing for business and consumer spending and
discourages excessive activity based on borrowed
funds
 Sale of government securities in the open market:
mops up excessive purchasing power from the public
 Increase in reserve ratios: cash reserve ratio and
statutory liquidity ratio; and
 Adjustments in selective controls: consumer credit
control and higher margin requirements, etc.

33. Fiscal Policy
 Government Expenditure: during inflation, effective
demand increases far too much due to unregulated private
spending. To counteract this, the government should reduce
its own expenditure to the minimum.
 Taxation: the problem is to reduce the size of the disposable
income in the hands of the general public The rates of
existing taxes should be increased while new taxes should be
imposed.
 Public Borrowing: the objective is to take away from the
public excess purchasing power. Public borrowing may be
voluntary or compulsory.

34. Fiscal Policy (Contd…)
 Debt Management: refers to public borrowing and
repayment – the government borrowing may assume the
form of borrowing from non-bank public through sale of
bonds and securities, which will curtail consumption and
private investment.
 Overvaluation: of domestic currency in terms of foreign
currencies will serve as an anti-inflationary measure as
(i) it will discourage exports and thereby result in an
increased availability of good and services at home, (ii)
encourage imports – add to domestic stock of goods and
services, (iii) by lowering the price of foreign inputs, it
will help in checking the upward cost-price spiral.

35. Physical Policy
Expansion of output: increased production is the best antidote to
inflation – steps should be taken to increase output of those
goods, which seem to be extremely sensitive to inflationary
pressures by shifting resources.
Wage Policy: wage increase has to be controlled – wages should
be allowed to rise only if there is an increase in the
productivity, i.e. output per worker. In such a situation,
higher wages will not give rise to higher costs and hence to
higher prices.
Price Control and Rationing: the objective of price control is to
lay down the upper limit beyond which, the price of a
particular commodity will not be allowed to rise. Demand
can also be controlled through rationing of essential
commodities.

36. Unemployment: Some Concepts

37. Unemployment
 In physical terms
Up = Population – employed people
 In economic terms
U = workforce – employed people
where
workforce = population – people not employed =
population employable (15-58 yrs)

38. Kinds of Unemployment
Voluntary and Hidden
 Voluntary : willful unemployment –
may arise due to laziness, obsession
with wealth and/or leisure – not
considered an economic threat
 Involuntary : forced unemployment –
caused by paucity of employment
opportunities – an economic issue

39. Open and Hidden
Open Unemployment
 Frictional : unemployment when in
between two jobs (for better
prospects) – prevalent in developed
countries where jobs are very
demanding and they are available in
plenty for capable persons – healthy,
not an economic problem.

40. Kinds (cont….)
 Cyclical : caused by business cycles and
economic fluctuations – serious problem
 Structural : mismatch between vacancies
and skills of unemployed people; mismatch
between location of unemployed and
vacancies – requires retraining and
additional skill sets; mobility

41. Hidden
 Disguised : when several people share a
particular work at a given time and/or when
such work is spread over time. Marginal
product of withdrawn workers is zero.
 Seasonal : some occupations are
seasonal, e.g. farming
 Underemployment : number of hours
worked is less than the full employment
hours’ norms. Part-time workers in
industries and services and full time workers
in agriculture suffer from such a malady.

42. Full Employment
 Literally, it means zero unemployment.
 Economists regard voluntary unemployment
as no unemployment and the frictional
unemployment as “not bad.” Thus, when the
unemployment rate is close to say 3-4%,
economists call it a “full employment”
situation.
 Voluntary unemployment is hard to quantify
and the full frictional unemployment is
estimated to be around 3-4 %, particularly in
the developed countries.

43.  Demand for and supply of labour are
sensitive to the wage rate - full
employment is also defined as the
situation where the demand for labour
equals the supply of labour in the
economy at a given wage rate.
 Full employment is a situation where
the number of people unemployed
equals the number of vacancies that is
untenable.

44. MEASURING
 Consumer Price Index (CPI)
• Impact on household
• Basis of Cost-of-Living Adjustments (COLA)
 Producer Price Index (PPI)
• Impact on business
 GDP Deflator
• Impact on household, business, and gov’t.