Inflation

Definition

Inflation is a state of persistent rise in prices Note: this does not mean that all prices must be

rising during a period of inflation –some prices may even be falling; but the general trend must be upward

It is a process of rising prices & not a state of high prices

Measuring Inflation

Inflation is the rate of change in the price level

If the price level in the current year is ‘P1’ & in the previous year is ‘Po’, then inflation for the current year is

(P1 – Po)/ Po x 100

Suppressed & Open Inflation

Inflation is a state of disequilibrium at which aggregate demand exceeds aggregate supply at the existing prices, causing a rise in general price level.

But sometimes an inflationary situation does not exhibit increases in the price level, if price controls & rationing are introduced by the government. Such a situation is called suppressed inflation

As soon as these controls are withdrawn, prices start rising & inflation becomes an open inflation

Causes (and theories) of inflation Some economists (both Keynes & Classical

economists) assert that inflation is caused by increase in demand in a situation of given aggregate supply →demand inflation

According to classical economists, the increase in demand is caused by an increase in money supply

According to Keynes it is increase in total spending & not in money supply which is responsible

Causes (and theories) of inflation contd..

A group of economists contend that inflation is caused by an increase in cost of production that results in a fall in aggregate supply →cost-push inflation

Others believe that inflation results from an amalgamation of demand & cost elements → mixed inflation

Causes (and theories) of inflation contd.. It is also argued that inflation may be

the result of downward inflexibility of prices, rigidity in the intersectoral relations & emergence of excess demand in some sectors, even if aggregate demand equals aggregate supply in the economy as a whole→ structural/ sectoral demand shift inflation

Causes (and theories) of inflation contd.. Ackley shows that inconsistent price &

wage mark-ups can generate an endless wage-price spiral in the absence of increase in productivity of labour. Prices are fixed by applying some standard mark-ups over the costs of direct materials & labour & wages are also administered on the basis of a fixed mark-up over the cost of living of the working class. The inflation generated by the mark-ups applied by business & by labour is called mark-up inflation

Causes (and theories) of inflation contd.. Ackley’s theory of mark-up inflation is based

on the concept of income inflation developed by Duesenberry & others.

This inflation arises from efforts of different economic groups to increase or maintain their real incomes by raising their monetary incomes during the periods of full employment. With output not being raised if one group tries to raise its share while the other groups attempt to maintain their real income, then prices tend to rise

The two main theories of inflation The Demand-Pull inflation → originates

from demand side of the economyIf aggregate monetary demand for domestic output exceeds the value of the full employment output at current prices, then the price level will rise (fig text book)

The Cost-Push inflation → originates from supply side of the economyIt is caused by rising cost of production independently of the excess demand in the market (fig text book)

The Demand-Pull inflation-view of Classical Economists

The analysis of this begins with the Classical quantity theory of money which states that price level depends directly & proportionately on the supply of money –

Ms ↑→excess demand for output at existing prices →price level of the economy ↑ (given full employment)

The Demand-Pull inflation-Keynesian view

An economy might experience demand inflation even when quantity of money remains constant Argument

Moreover, if Ms ↑ then P remains unaffected if the additional Ms is absorbed in L2 (r) or if there is underemployment equilibrium to start with → tie between quantity of money & level of aggregate demand is broken

With Ms constant if AD ↑ → prices ↑ (given full employment) → r ↑ (given Ms) → L2(r) ↓→ L1(Y) ↑

As r ↑ → I (r) ↓. But it cannot remove the excess demand unless L2(r) = 0Thus, price level might rise even without rise in Ms

Keynes’ inflationary gap

If total expenditure in the economy exceeds the value of full-employment level of output at current prices, then the gap between the two is the inflationary gap

It is so called because this gap causes price to rise

Figure to explain inflationary gap

(C+I + G)’’

C+I+G

(C+I+G)’A

B

C

Yf Ym Y

Rea

l Exp

endi

ture

AS

Explanation of the figure

Let Yf be the full employment level of output at current prices

If AD curve in the economy is given by (C+ I + G) then equilibrium occurs at full employment level

If AD curve shifts to (C+ I + G)’ for some reason AD > AS & there is an inflationary gap in the product market. The size of this gap is AB (in fig) which is equal to AD – AS at full employment

If AD curve shifts to (C+ I + G)’’ for some reason AD < AS & there is an deflationary gap of the magnitude BC in the product market.

Explanation of inflationary gap In the figure AD = C + I + G = total

expenditure on the aggregate output of the nation. An upward shift in any one of these components or a combination of these three in a situation of full employment can produce inflationary gap

If foreign trade is added to (C + I + G) then an increase in net exports (X – M) can also produce such a gap

Facts about inflationary gap

Any increase in autonomous expenditure in a situation of full employment can produce inflationary gap at current prices → P ↑

Inflation continues as long as the gap between the real planned expenditure & the full employment level of real output exists

The price rise cannot eliminate this gap because real expenditure is independent of the price level

So inflation continues without limit, till the indirect effects of rising prices are sufficient to eliminate the gap

Some of the Indirect Effects of price rise on inflationary gap Ms remaining constant as P↑ M/P↓ → r↑→ I ↓ →

inflationary gap ↓

Inflationary process leads to a redistribution of income against fixed income groups & in favour of the profit earners. If MPC of former > MPC of latter, then aggregate consumption ↓ → inflationary gap ↓

If foreign trade is considered then higher domestic prices → M ↑ & X ↓ → (X – M) ↓ → inflationary gap ↓

As P ↑→ real value of cash balances ↓ → C ↓. This is called the real balance effect or Pigou effect

Limitations of Keynesian inflationary gap

Inflationary gap analysis is essentially static but inflation is a dynamic process.

Inflationary gap analysis contributes nothing directly to the analysis of the time rate of inflation

Inflationary gap analysis cannot explain the inflationary price rise that occurs when there considerable unemployment in the economy

Yf is assumed to be fixed at a certain level. This is not always true. As P↑→ W/P ↓→ N & real output Y ↑. If however, P↑ → equi proportionate W ↑ → W/P comes back to original level & N & Y remains fixed

The Cost-Push inflation In modern economy wages are not strictly market-determined

prices, but are administered prices → wages can rise even if there is no excess demand for labour or even there is unemployment

If rate of increase in wage rate > rate of increase in productivity, the wage cost per unit of output increases

The employers now are less willing to supply goods at the existing price level → supply of goods ↓

Fall in supply is not accompanied by a fall in demand → product prices rise & this rise continues till the original W/P restored

Note: when W ↑→ employers actually raise price instead of lowering supply & raising prices as a consequence. This is spontaneous inflation

Wage-Price Spiral When W ↑ → P ↑ → cost of living of the

workers ↑ Again when W ↑ → P ↑ → real wage rate ↓ Both the consequences lead the trade

unions to claim a higher money wage If this claim is granted by employers, there

is a second round price inflation caused by the cost factor

Thus, there is a wage-price spiral

W ↑ → P ↑ → W ↑ → P ↑

Types of Cost Push Inflation

Wage -push inflation→ cost inflation stemming from trade union pressure on wage rate

Profit - push inflation→ inflation caused by monopolistic practices of the managers of firms who increase prices even in the absence of increase in demand or rising costs

Inflation if there is excess demand in some sectors without no excess demand in other sectors → excess demand in some sectors→ P↑→ excess demand for labour → W ↑ here → trade union in other sectors will demand W ↑. If this claim is granted W ↑ in these sectors with no excess demand → cost inflation

Objections to cost inflation

A continuing cost inflation is virtually impossible unless the monetary authorities pursue an expansionary monetary policy

Explanation: if a rise in general level of wages & prices is not accompanied by a proportionate increase in Ms → real aggregate demand ↓ → unemployment → end to inflationary wage rise

Note: the level of unemployment sufficient to eliminate the inflationary wage increase should be fairly high

The Philips Curve

Done in separate ppt

Concepts of Deflation, Disinflation,Reflation & Stagflation Deflation – is a condition of falling prices on

account of insufficient effective demand. Results in a continuous fall in level of economic activity & growing unemployment

Disinflation – it is a process of lowering costs & prices when they are excessively high. Brings down inflationary trend in prices without causing unemployment

Concepts of Deflation, Disinflation, Reflation & Stagflation Reflation – is a moderate degree of inflation

that is deliberately undertaken to relieve depression

Stagflation – a situation in which a high rate of inflation prevails simultaneously with a high rate of unemployment or stagnant economic condition. It is a combination of inflation & stagnation

Effects of inflation

Effects on Production Effects on Income distribution Other Effects

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Control of Inflation

Monetary Measures Fiscal Measures Other Measures

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Inflation & Economic Development

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Inflation in India

Assignment – refer text