Inflation is defined as a general rise in the price level of goods and services in an economy over time. It can be caused by demand-pull factors like increases in the money supply, or cost-push factors like increases in input prices. Low or moderate inflation is acceptable, while high inflation or hyperinflation causes economic distortions. Deflation is a general decline in price levels, often due to a reduction in the money supply or spending. While some types of deflation can be good, sustained deflation like that during the Great Depression is harmful to economies.

1. INFLATION
UNIT 12

2. 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.

3. 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.

4. INFLATION RATE
The 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)

5. 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.

6. 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

7. 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.

8. 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.

9. 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.

10. 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).

11. DIFFERENT STRAINS OF
INFLATION
 Like diseases, inflations exhibit
different levels of severity, which are
classified into three categories:
1. Low inflation
2. Galloping inflation
3. Hyper inflation

12. 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.

13. 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.

14. 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

15. 2. GALLOPING INFLATION
 Financial markets wither away
 Capital flees abroad
 People hoard goods,
 Buy houses, &
 Never lend money at low nominal interest
rates.

16. 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.

17. 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.

18. 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.

19. 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.

20. 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.

21. 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.

22. 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.

23. CAUSES OF INFLATION
 Inflations occur for many reasons.
 Some inflations come from demand side
(Demand-pull).
 Other, from supply side (Cost-push).

24. 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.

25. COST-PUSH INFLATION
 Inflation resulting from rising costs
during periods of high
unemployment and slack resources
utilization is called Cost-push
inflation.

26. 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.

27. DEFLATION
In common usage deflation is generally
considered to be "falling prices".
But there is much more to it than that.
Often people confuse deflation with
disinflation or with Depression (as in
"the Great Depression"). These three
terms are related but not synonymous.

28. 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.

29. 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.

30. CAUSES
 Deflation generally occurs when the
supply of goods rises faster than the
supply of money.

31. 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).

32. 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).

33. 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¢.

34. 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 everyone's 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.

35. 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 1800's as
the industrial revolution dramatically
increased productivity.

36. 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.

37. 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.

38. 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.

39. 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.

40. AS SHOCK (Leftward As Shift)
AS3
Price
AS1
level
E
3
E1
AD1
Output
level
A leftward AS shift always decreases output and
prices will rise. This will be rampant stagflation.

41. Rightward AS Shift
Price
AS1
level
AS2
E1
E2
AD1
Output
level
If there is a rightward shift in the aggregate supply
curve then both inflation and unemployment can be
reduced.
Harcourt