inflation and deflation
DESCRIPTION
economicsTRANSCRIPT
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INFLATION AND DEFLATION
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INTRODUCTION
Inflation and deflation are both far-reaching titanic forces that spread out and greatly influence returns across all major financial markets.
The usefulness of money to an economy depends on its stability.
Inflation and deflation hurt an economy because people can’t count on the value of their money.
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CONCEPT OF INFLATION AND DEFLATION
Inflation
A consistent increase in the prices of goods and services over time is known as inflation.
• During inflationary times, money loses its "buying" or "purchasing" power, and it takes more units of currency to purchase the same units of goods or services.
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• The basic cause of inflation is the creation of too much money by the government.
• This situation occurs when there is a more rapid increase in the quantity of money than in the output of goods and services.
• Inflation's effects on an economy are various and can be simultaneously positive and negative.
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Deflation
• A consistent decrease in the prices of goods and services over time is known as deflation.
• During deflationary times, money increases in its "buying" or "purchasing" power, and it takes less units of currency to purchase the same units of goods or services.
• It occurs when the annual inflation rate falls below zero percent (a negative inflation rate), resulting in an increase in the real value of money.
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BASIC AND RELATED DEFINITIONS
• Various Definitions for Inflation:
According to the Crowthers : “Inflation means a state in which the value of money is falling i.e., prices are rising”
According to Pigou: “ Inflation arises when money income is expanding more than in proportionate to income earning activity”
According to Prof. Samuelson : “ Inflation occurs when the general level of prices and cost are rising”
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• Disinflation– a decrease in the rate of inflation.
• Hyperinflation – an out-of-control inflationary spiral.
• Stagflation – a combination of inflation, slow economic growth and high unemployment.
• Reflation– an attempt to raise the general level of prices to counteract deflationary pressure.
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INFLATION VS DEFLATION
• Today, most economists favor a low, steady rate of inflation.
• Deflation causes a burden on borrowers and holders of various illiquid assets and is favorable for savers and holders of liquid assets and currency.
• On the other hand, inflation favors short-term consumption and borrowers and is a burden on currency holders and savers.
• Both inflation and deflation can negatively impact the economy. However, most economists consider the effects of moderate long-term inflation to be less damaging than deflation.
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CAUSES OF INFLATION
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CAUSE 1: DEMAND RELATED Rate of inflation accelerates:
aggregate demand > goods and services available
This shortage of supply enables sellers to raise prices till equilibrium between supply and demand.
Constructive to a faster rate of economic growth -
EXCESS DEMAND FAVORABLE MARKET CONDITIONS
INVESTMENT & EXPANSION
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CAUSE 2: COST RELATED
“SUPPLY SHOCK INFLATION”
Causes: Natural disasters Increased prices of inputsHoarding (recession)
Shortage of products causes ripple effect through economy by raising prices through supply chain
Example:
Decrease in oil supply increased oil prices Producers (who use oil) passes this to consumers as increased prices.
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CAUSE 3: BUILT-IN INFLATION
A GDP level where economy is at optimal level of production
GDP > potential level Inflation accelerates suppliers increase prices
GDP < potential level inflation decelerates suppliers cut prices
Workers demand higher wages to stay above the rate of inflation
Firms pass higher labor costs onto customers as higher prices
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CAUSE 4: MONEY SUPPLY
Central banks influence money supply: makes money cheaper / expensive by varying interest rates
If money supply not controlled, it may grow at rate faster than GDP. This will drive up prices and hence, inflation.
Low interest rates
High level of money supply
Allows more investment in big business
Unsustainable levels of inflation as cheap money is available
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CAUSES OF DEFLATION
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CAUSE 1: DEMAND-SIDE CAUSES
Consumption supply and demand curve is in a downswing
Meaning people in the country are not buying products and services (most notably durable goods).
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Two primary reasons for non-consumption:
1. GROWTH DEFLATION:
People do not have money due to unemployment.
Scenario:
Money supply not increased at rate of positive population ` growth and economic growth
Available amt of hard currency per person falls
Money scarce
Purchasing power of unit of currency increases
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Two primary reasons for non-consumption:
2. CASH BUILDING (HOARDING) DEFLATION:
Low consumer spending index, people pessimistic about financial future
Deflation is related to risk (scenario):
Risk-adjusted return on assets drops to negative
Investors and buyers hoard currency than invest it, even in the most solid of securities
Produces a liquidity trap
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CAUSE 2: SUPPLY-SIDE CAUSES
BANK CREDIT DEFLATION:
Central bank initiates higher interest rates (to 'control' inflation), thereby popping an asset bubble
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TYPES OF INFLATION
There are basically 4 different classifications for inflation.Based on Rate of InflationBased on CauseBased on the Government ReactionBased on the Nature of Time Period of Occurrence
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BASED ON THE RATE OF INFLATION
Sneaking Inflation
•Small or sneaky
•Annual rise less than 3 percent per annum
•Safe and essential
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Walking or jogging Inflation•Moderately•Annual rise between 3-7%•Warning signal for the government Consecutive Inflation•Fast•Annual rise of 10-20% per annum•Affects deprived and middle class•Requires strong monetary measures
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Twitchy Inflation
•Also called hyper inflation
•Immeasurable and completely uncontrollable.
•Prices increase many times every day.
Hurtling inflation
•Very rapid
•Annual rise of more than 20-100%
•Also called runaway inflation.
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GRAPHICAL REPRESENTATION
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BASED ON THE CAUSE OF INFLATION
Demand-pull inflation
- caused by increase in aggregate demand
Cost-push inflation (supply shock inflation)
- caused by a drop in aggregate supply (potential
output)
Built-in inflation (Hangover inflation)
-caused by adaptive expectations
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BASED ON GOVERNMENT REACTION
Open Inflation
Govt. does not attempt to prevent price rise
Free market mechanism
Repressed Inflation
Govt. interrupts Price rise
Price control and rationing
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BASED ON TIME PERIOD OF OCCURENCE
War Time Inflation
Post War Inflation
Peace Time Inflation
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TYPES OF DEFLATION
Cash Building Deflation
Growth Deflation
Bank Credit Deflation
Confiscatory Deflation
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POSITIVE EFFECTS OF INFLATION
Decreasing unemployment rates Drop in real interest rates Increasing value of assets Room to manoeuvre
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NEGATIVE EFFECTS OF INFLATION
Loss of purchasing power Effect on saving Effect on interest rates Effect on international competition Uncertainty Hoarding Labour unrest
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COSTS OF DEFLATION Effect on investment Cost to debtors Unemployment
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MEASUREMENT METHODS
Consumer price index
List of the typical goods and services consumed by the average household. grouped into a number of different Categories.
The prices of these items are measured each month to calculate the change in the price of the “basket”.
The change in the price of the basket is reflected in the measure called the consumer price index.
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Gross Domestic Product
measures the value of a nation's output of goods and services for some period of time, usually a year.
not the only measure of output--the Federal Reserve, for example, publishes an index of industrial production
but the GDP has become a favorite among economists because it is the most comprehensive of output measures.
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Other widely used price indices for calculating price inflation include the following:
Producer price index
Commodity price index
Core price index
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PROBLEMS IN MEASUREMENT
As we have seen, there are a number of methods to measure inflation . Some of them are
•Consumer Price Index (CPI)•Producer Price Index (PPI)•Employment Cost Index (ECI)•Gross Domestic Product Deflator (GDP Deflator)•BIS International price program
All these measuredifferent aspects of inflation
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Since CPI is a convenient way to compute the cost of living and the relative price level across time , and as it is based on a fixed basket of goods, it does not provide a completely accurate estimate of the cost of living.
The limitations with the CPI are either
limitations in applications or limitations in measurement
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LIMITATIONS IN APPLICATION
1) Introduction of New Items -
As time goes on, new items enter into the basket of goods and services purchased by the typical consumer.
Since the CPI uses only a fixed basket of goods, the introduction of a new product cannot be reflected. Items are removed or added to be more representative of the typical household’s demand. However, this takes a good deal of time.
Moreover, if the items in the basket are changed, then this limits the ability of analysts to make comparisons from one time period to another.
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2) Substitution Bias –
As the prices of goods and services change from one year to the next, they all do not change by the same amount.
The number of specific items that consumers purchase changes depending upon the relative prices of items in the fixed basket.
The intuitive phenomenon of consumers
substituting purchase of low priced items for higher priced items is not accounted for by the CPI.
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3) Differences in purchasing habits.
The basket used in any country represents the purchasing habits of a “typical” household, but this will not be applicable to all people.
The purchasing habits of different people will vary greatly.
For example, the “basket” of a family with children will be very different from that of an elderly couple. Similarly, the “basket” of a rich family will be different from that of a poor family.
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4) Change in quality-
When an item in the fixed basket of goods used to compute the CPI increases or decreases in quality, the value and desirability of the item changes.
For example, if some good X becomes much more satisfying than in earlier time , but the price of X does not change, then the cost of living would remain the same
5) Seasonal changes of prices- Prices may change for a variety of reasons that are
not sustained.
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LIMITATIONS IN MEASUREMENT
1. There may be errors in the collection of data that
limit the accuracy of the final results. The larger the sample, the more accurate will be the results, but this is time-consuming and very costly.
2. Countries measure their rate of inflation in
different ways, and include different components. This can make it problematic to make international comparisons.
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LIMITATIONS IN MEASUREMENT (Contd....)
3) There may be variations in regional rates of inflation within a country. This will be harmful if the group has a higher cost of living and beneficial for those whose spending costs are less than the average.
4) The CPI only measures changes in consumer prices. The changes in producer prices and commodity prices are not given due importance in the measurement of inflation.
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CONTROL MEASURES FOR DEFLATION
Reduction in Taxation Reduce the number and burden of taxes levied on
commodities This will increase the purchasing power of the
people
Redistribution of Income Redistribution of income and wealth from the rich
to the poor
Repayment of Public Debt The government can repay the old public debts This will increase the purchasing power of the
people and push up effective demand.
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Subsidies The government should give subsidies to induce
the businessmen to increase investment
Reduction in Interest Rate The monetary authority of a country reduced the
interest rate This stimulates investment and thereby expands
economic activity in the economy
Credit Expansion The central bank and the commercial banks
adopt a credit expansion to promote business and industry in the country
Bank credit should be made easily available to the entrepreneurs for productive purposes
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VIVEK S NAIR?????
Foreign Trade Policy The government should adopt such a foreign
trade policy to increase exports, and, on the other hand, reduce imports
This will solve the problem of overproduction, and help overcoming deflation
Regulation of Production Production in the economy should be regulated in
so that the problem of over-production does not arise
Attempts should be made to adjust production with the existing demand to avoid over-production.
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CONTROL MEASURES FOR INFLATION
1. Monetary measures bank rate policy Increased cost of borrowing which reduces
commercial banks borrowing from the central bank.
The flow of money from the commercial banks to the public gets reduced
Open Market Operations Central bank sells the government securities to the
public through the banks
Credit Control Central bank raises the bank rates, sells securities
in the open market, raises the reserve ratio etc.
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Issue of New Currency The most extreme monetary measure is the
issue of new currency in place of the old currency
Under this system, one new note is exchanged for a number of notes of the old currency
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2. Fiscal Measures Reduction in Unnecessary Expenditure Government should reduce unnecessary expenditure
on non-development activities in order to curb inflation
Increase in Taxes The rates of personal, corporate and commodity taxes
should be raised and even new taxes should be levied The government should reduce import duties and
increase export duties
Increase in Savings This will tend to reduce disposable income with the
people, and hence personal consumption expenditure The government should float public loans carrying
high rates of interest, start saving schemes with prize money, or lottery for long periods etc
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Surplus Budgets Government should give up deficit financing and
instead have surplus budgets It means collecting more in revenues and
spending less
Public Debt Stop repayment of public debt and postpone it to
some future date till inflationary pressures are controlled within the economy
Instead, the government should borrow more to reduce money supply with the public
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3. Other Measures To Increase Production Increase the production of essential consumer
goods like food, clothing, kerosene oil, sugar, vegetable oils, etc
If there is need, raw materials for such products may be imported on preferential basis to increase the production of essential commodities
All possible help in the form of latest technology, raw materials, financial help ,subsidies, etc. should be provided to different consumer goods sectors to increase production
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Rational Wage Policy Increase in wages to increase in productivity This will control wage and at the same time
increase productivity, and hence production of goods in the economy
Price Control Price control means fixing an upper limit for the
prices of essential consumer goods They are the maximum prices fixed by law and
anybody charging more than these prices is punished by law
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RationingIt aims at distributing consumption of scarce
goods to make them available to a large number of consumers
Applied to essential consumer goods like wheat, rice, sugar, kerosene oil, etc. meant to stabilise the prices of necessaries and assure distributive justice
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CASE STUDY:INFLATIONPAKISTAN
•concentrated on the food and energy
•40% increase in wheat price in Pakistan would cause 2 percentage
point increase in national poverty.
•lower income groups in Pakistan tended to experience higher inflation
rates than higher income groups
•the low income group having income up to Rs5,000 suffered an
inflation rate, on average, of 15.17% during 2008/10
• 13.95% for income group earning above Rs12,000, during 2008/10
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CAUSES
•floods and sporadic rains
• weak currency
• flattening yield growth of major crops
• low productivity gains
•increasing costs of agriculture inputs
• population syndrome
• energy shortage
•stocking of essential items
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REMEDIES
• making Pakistan Agriculture Research Council more vibrant and
result oriented
• broad-based productivity gains
•timely import of essential food items to soften prices
• effective support price mechanism and encouraging corporate-
framing concept
•strong checks on food cartels and hoardings
•building water reservoirs
• improving farm-to-market road networks
• scientifically maintaining storage capacity of agri-produce
• regional trade liberalisation
• broadening of the safety nets for the poor
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•Deflation started in the early 1990’s.
•The Bank of Japan and the government have tried to eliminate
it by reducing interest rates,.
•but did not create a sustained increase in broad
money and deflation persisted.
• In July 2006, the zero-rate policy was ended.
JAPAN
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•Fallen asset prices. When assets decrease in value, the money supply
shrinks, which is deflationary.
•Insolvent Companies
•Insolvent banks
•Fear of insolvent banks: Japanese people are afraid that banks will
collapse so they prefer to buy gold or Treasury bonds instead of saving
their money in a bank account.
•Imported deflation: Japan imports Chinese and other countries'
inexpensive consumable goods, raw materials.
CAUSES
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MEASUREMENT OF INFLATION IN INDIA
WPI (Wholesale Price Index) •Gives the price of a representative basket of wholesale goods. •To measure change in average price level• WPI index released weekly on every Thursday•Focus on price of goods traded between corporations•Helps in analyzing microeconomic and macroeconomic conditions
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CALCULATION OF WPI IN INDIA
•No of items used
435 items (Base year -1993-94)676items (Base year 2004-05)
This consists of
•Primary Articles (weight of 22.0253) – 22% Index•Fuel, Power, Light, and Lubricants (weight of 14.2262) - 14% Index•Manufactured Products (weight of 63.7485) – 64% Index
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REASONS FOR HIGHER INFLATION RATE IN INDIA
Uncertainty of the monsoons• Agricultural product supply decreases• Increase in priceHike in fuel prices Increases manufacturing cost
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MEASURES TAKEN TO CURB INFLATION
During 2006-07 RBI announced the following measures Increasing repo ratesIncreasing Cash Reserve RatioReducing rate of interest on cash deposited by banks
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PERSPECTIVES
Traditional anti-inflationary measures
Changing interest rates slows down economic growth
Showed economic mismanagement