inflation & deflation · measuring inflation. there are many methods to calculate inflation...

Monetary Economics

Chapter No # 5

Inflation & deflation

Instructor: M.N Nasrat

Outline

1. Definition of inflation;

2. Difference between price increases andinflation;

3. Characteristics of inflation;

4. Measuring Inflation;

5. Historic Inflation Rates;

6. Is Inflation Good or Bad?

7. Types of Inflation (causes);

8. Major Effects of Inflation;

9. Control of inflation (anti-inflationary policies)

10. Concept of stagflation

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Outline

11. Deflation

12. Deflation vs disinflation

13. Causes of deflation

14. Effects of deflation

15. Control of deflation (anti-deflationary policies)

16. Disinflation

17. Reflation

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Cont.

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Class activity:

How do you define inflation?

Definition

•Inflation is a state of persistent rise in prices.

•It is a process of rising prices & not a state ofhigh prices.

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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.

Definition

o According to C.Crowther, “Inflation is State inwhich the Value of Money is Falling and thePrices are rising.”

o Inflation is defined as a sustained increase inthe price level or a fall in the value of money.

o When the level of currency of a countryexceeds the level of production, inflation occurs.

o Value of money depreciates with theoccurrence of inflation.

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Difference between price increases and inflation

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2005 2010 2015 JAN FEB

Inflation is an increase in

the general price level.

A price increase is the

increase of any single

price.

Video

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Characteristics of inflation

a. inflation is a dynamic process which can beobserved only over a long period of time.

b. It is related to a rise in prices which ispersistent and continuous.

c. It is fundamentally an economic phenomenonas it originates within the economic system.

d. It is a monetary phenomenon which ischaracterized by an excessive supply of money.

e. It is always cumulative in character.

f. It is a condition of economic disequilibrium.

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Measuring Inflation

Inflation is the rate of change in the price level. If theprice level in the current year is ‘P1’ & in theprevious year is ‘Po’, then inflation for the currentyear is

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Inflation rate=(P1 – Po)/ Po x 100• P1 – price indices in current year• P0 – price indices in previous year

Rate of inflationThe annual percentage rate of change in the pricelevel, as measured, for example, by the CPI

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Example: Let's say that the price the average 32-inch flatscreen television was $400 last year but is $410this year. What's the annual rate of inflation for32-inch flat screen televisions?

Inflation Rate = ((P1 – P0)/P0) x 100 Inflation Rate = ((410-400)/400 x 100 Inflation Rate = (10/400) x 100 Inflation Rate = 0.025 x 100 Inflation Rate = 2.5%

Measuring Inflation

There are many methods to calculate inflationrate:

Consumer price index (CPI) - it measures thechanges in retail prices which may be moremeaningful from the consumer’s point of view. Inother words, the CPI measures price change fromthe perspective of the purchaser.

Wholesale price index (WPI) – it measures thechanges in wholesale prices which may be moremeaningful from the producer’s point of view.

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Measuring Inflation

Class activity:

1. How Are Prices Collected?

2. How Is the CPI Basket Chosen?

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Inflation in Afghanistan

https://tradingeconomics.com/afghanistan/inflation-cpi

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https://tradingeconomics.com/afghanistan/inflation-cpi

Historic Inflation Rates

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Class activity:

Is Inflation Good or Bad? And why?

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Is Inflation Good or Bad?

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Hurt by Inflation Helped by Inflation

• Lenders-People who lend money (at fixed interest rates)

• People with fixed incomes

• Savers

• Borrowers-People who borrow money

• A business where the price of the product increases faster than the price of resources

Types of Inflation

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Inflation has too many types, it categorize as

following

1. On The Basis Of Causes/origin

2. Anticipated VS unanticipated inflation

3. On The Basis Of rate Of Inflation

4. On the basis of government reaction

5. On the basis of the time period

1. On the basis of causes

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1. Demand Pull Inflation

2. Cost Push Inflation

3. Profit Induced Inflation

4. Budgetary Inflation

5. Monetary Inflation

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1. Demand Pull Inflation: Caused by increasing in

aggregate demand.

Factors

1) Increase in money supply.

2) Increase in the demand for goods by the govt.

3) Increase the income of various factor of

production.


As companies respond to higher demand with anincrease in production, the cost to produce eachadditional output increases, as represented by thechange from P1 to P2.

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That's because companieswould need to pay workersmore money (e.g.,overtime) and/or invest inadditional equipment tokeep up with demand. Justlike cost-push inflation,demand-pull inflation canoccur as companies pass onthe higher cost ofproduction to consumers tomaintain their profit levels. https://www.investopedia.com/articles/05/012005.asp

https://www.investopedia.com/articles/05/012005.asp

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in cost of

production, such as a rise in the cost of raw materials,rise in wages or rise in interest payment.

The graph below shows the level ofoutput that can be achieved at eachprice level. As production costsincrease, aggregate supplydecreases from AS1 to AS2 (givenproduction is at full capacity),causing an increase in the pricelevel from P1 to P2. The rationalebehind this increase is, forcompanies to maintain orincrease profit margins, they willneed to raise the retail price paid byconsumers, thereby causinginflation.



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Entrepreneurs

due to their monopoly position raise the profit

margin on goods.

Country covers the

budget deficits through bank borrowings and

creating new money.

Purchasing power of community increases without

a increase in production of goods.


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is caused by too

rapid increase in money supply.

Monetary inflation is a sustained increase in

the money supply of a country (or currency area).

Depending on many factors, especially public

expectations.


https://en.wikipedia.org/wiki/Money_supply

Class activity:

Which type of inflation more hurt the

economy of a country and why?

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1. Demand Pull Inflation

2. Cost Push Inflation

3. Profit Induced Inflation

4. Budgetary Inflation

5. Monetary Inflation

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Anticipated:Rate of inflation which majority of the individualsbelieve will occur. In other words, is an expected,predicted, steady long-term increase in general pricelevels.

Unanticipated: Rate of inflation which comes as a surprise tomajority of individuals or it is an unstable variableinflation in the general price level that was notpredicted or expected.Unanticipated inflation can be higher thananticipated inflation or lower.

2. Anticipated VS Unanticipated

Class activity:

What will be the major factors of

unanticipated inflation?

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1. Creeping inflation: General prices level increases

up to a rate of 2% per annum. It is generally

considered a necessary condition of economic

growth.

2. Walking inflation: The price rise is around 5%

annually or less than 10%. It has a warning signal for

the government to control it before it turns into

running inflation.

3. On the basis of rate of inflation

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3. Running inflation: When the annual rate of

rise in price is more than 10 per cent. Say, at the

rate of 10 – 20 per cent. This type of inflation

adversely affects the poor and the middle class

people.

4. Hyper inflation: It starts after the level of full

employment is reached. Price level rises very

rapidly within a short period.( 20 to 100 per cent)

3. On the basis of rate of inflation

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1. Open Inflation: is a situation where thegovernment does not make any attempt tocontrol the rising prices or when price risewithout government interruption. In such type ofinflation free market mechanism is allowed tooperate in the distribution of goods and services.

2. Suppressed Inflation: Suppressed inflationoccurs when the government imposes monetaryand fiscal control like price control, licensing, etc.to control inflation.

4. On the basis of government reaction

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War time inflation: Increasing governmentexpenditure on defense during the war time, thegovernment allocate substantial part of goods andservices produced for war.

Post-war time inflation: During the post war thedisposable income of the people increases as a resultof the withdrawal of war-time taxation. This will leadto continuous rise in the demand for goods andservices.

Peace time inflation: During the peace time ornormal period the government expenditure on thelong period capital projects increases.

5. On the basis of the time period

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Major Effects of Inflation

1. Effects on Production2. Effects on Distribution3. Debtors and Creditors4. Investors5. Farmers6. Wage Earners7. Middle Class and Salaried Persons8. Government9. Effect on long term contracts10. Effects on export and import11. Inflation sometimes leads to revolution

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It distorts the smooth functioningof price mechanism, hinderscapital formation, stimulatesspeculative activities, leads tomisallocation of productiveresources.In short, inflation invites businessto seek profits via manipulation ofmarkets rather than via efficientproduction.


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Prices of all factors donot rise in the sameproportion.Entrepreneurs stand togain more than wageearners or fixed incomegroups.Inflation is a kind ofhidden tax.


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During inflation when theprices rise (and the real valueof money goes down), thedebtors pay back less in realterms than what they hadborrowed, and thus, to thatextent they are gainers. On theother hand, the creditors getless in terms of goods andservices than what they hadlent and stand to lose to thatextent.


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Different kinds ofinvestors are affecteddifferently by inflation.Investors in shares,debentures and bondslose during inflation. It isbecause of the fact thatthe prices of thesesecurities fall.


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Farmers gain during inflation.The prices of farm products goup and the cost incurred bythem (like interest and taxes)either remain constant or donot increase much.farmers are generally debtorsand have to pay less in realterms, while the land revenueand taxes etc., do not risemuch.


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Wage-earners generally sufferduring inflation, However, wagesdo not rise as much as the rise inprices of those commodities,which the workers consume. Ifthe workers are organized, theymay not suffer much duringinflation but if they areunorganized like the agriculturallaborers, they may suffer more,as they may not find it easy toget their wages increased.


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The hardest hit are the personswho receive fixed incomes,usually called the middle class.Persons who live on savings,fixed interest or rent, pensioners,government employees, teachersetc., suffer during periods ofrising prices as their incomesremain fixed.


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1. In a mixed economy, the public sector isaffected by fluctuations in price level. Asprices rise, the government has to spendmore on goods and services including rawmaterials for carrying through theirproject.

2. Also government gains during inflationsince it is the largest borrower. The burdenof debt also fall.

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Class activity:

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Inflation causedhigh price of goodsand services, thusconsequentlyimport goes upthan export.

expo

rt

impo

rt


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Control of inflation

Inflation is a serious evil. It should be controlled in

the early stage itself. It brings suffering to most of

the people.

Measures to control inflation are called anti

inflationary measures. These measures are broadly

divided into three heads, namely:

1. Monetary measures2. Fiscal measures3. Non-monetary measures

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The following monetary measures are adopted bythe central bank of the country to control inflation.

1. Bank rate policy: Bank rate also known asdiscount rate is the minimum rate of interest atwhich the central bank of the country grants loansto commercial banks against approved securities.When the bank rate is raised the market rate ofinterest will also rise, credit is discouraged as itbecomes costly. So the borrowers are reluctant toborrow more. Hence they reduce their borrowings.


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2. Open market operation: During inflation the

central bank sells securities in the open market.

Commercial banks are forced to reduce loans

because the cash reserve of the commercial

banks fall, as a result investment falls, income

falls, demand for goods fall and finally price fall.


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3. Variation of cash reserve ratio: Cash reserve

ratio (CRR) is a certain percentage of the total

deposits to be kept as reserve by each commercial

bank with the central bank of the country. During

the inflation the central bank raise the cash

reserve ratio. If the cash reserve ratio is raised

commercial banks have to keep more cash with

the central bank.


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4. Selective credit controls: Selective credit

controls are otherwise called qualitative credit

control measures. These measures aim an

encouraging credit to essential industries and

at the same time discouraging credit to non-

essential industries.


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Fiscal measures to control inflation involve:

1. Reduction in Unnecessary Expenditure

2. Increase in taxes and imposing new taxes to check

inflationary pressures.

3. Increase in Savings – encourage people to save and

invest in government securities.

4. Surplus Budget to fight inflation

5. Stoppage of borrowing by the government.


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1. Control private investment by licensing,

essential industries;

2. Gov. should encourage the production of

goods,

3. Gov. should import the essential commodities,

4. Gov. should adopt a new wage-income policy.

5. Price control,


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Concept of stagflation

Stagflation means the coexistence of unemployment

and inflation in an economy.

Stagflation = stagnation + inflation

In means that an economy experiences on the one

side rapid rise in prices and, at the same time it

experiences on the other side decline in output (high

unemployment). Thus it is said that stagflation is the

coexistence of stagnation and inflation in the

economy.

Class activity:

What would be the causes of

stagflation?

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Video on stagflation:

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Video on stagflation:

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Deflation

Concept: Many people accept inflation as a fact of life.However, under certain economic situations, theopposite phenomenon actually takes place, and is knownas “deflation.”

Deflation is the reduction of prices of goods, andalthough deflation may seem like a good thing whenyou’re standing at the checkout counter, it’s not. Rather,deflation is an indication that economic conditions aredeteriorating. Deflation is usually associated withsignificant unemployment, which is only corrected afterwages drop considerably. Furthermore, businesses’profits drop significantly during periods of deflation,making it more difficult to raise additional capital toexpand and develop new technologies.

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https://www.moneycrashers.com/what-is-inflation-definition-causes-inflation-rate/

https://www.moneycrashers.com/what-is-national-us-unemployment-rate/

Video on deflation

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Deflation vs. disinflation

“Deflation” is often confused with “disinflation.”While deflation represents a decrease in the prices ofgoods and services throughout the economy,disinflation represents a situation where inflationincreases at a slower rate. However, disinflation doesnot usually precede a period of deflation. In fact,deflation is a rare phenomenon that does not occurin the course of a normal economic cycle, andtherefore, investors must recognize it as a sign thatsomething is severely wrong with the state of theeconomy.

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What Causes Deflation?

1. Change in Structure of Capital Markets:

When many different companies are selling the same goodsor services, they will typically lower their prices as a meansto compete. Often, the capital structure of the economywill change and companies will have easier access to debtand equity markets, which they can use to fund newbusinesses or improve productivity.

2. Increased Productivity:

Innovative solutions and new processes help increaseefficiency, which ultimately leads to lower prices. Althoughsome innovations only affect the productivity of certainindustries, others may have a profound effect on the entireeconomy.

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What Causes Deflation?

3. Decrease in Currency Supply:

As the currency supply decreases, prices willdecrease so that people can afford goods. Howcan currency supplies decrease? One commonreason is through central banking systems.

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inflation & deflation · measuring inflation. there are many methods to calculate inflation...

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