Inflation : Causes, Measurement, Consequences

and Control

Siddha Raj Bhatta

 Contents to be Covered
• Inflation : Meaning and Types
• Causes of Inflation
• Measurement of Inflation
• Inflation Trend in Nepal
• Drivers of Inflation in Nepal
• Can Monetary Policy control inflation?
• Impact of Inflation in the Economy
• Measures to Control Inflation
• Inflation, Deflation, Disinflation and Stagflation
• Is inflation really harmful?
• Trade-off between Inflation and Unemployment
 Meaning of Inflation
• Inflation : Inflation means a persistent and appreciable
rise in the general level of prices.
• Three things :
• Rise in the general /average price level
• Rise should be significant.
• Price rise should be continuous.
 Inflation Types
• Inflation Types : Can be divided as per different criteria.
• On the Basis of Cause :
• Demand pull and supply push inflation
• On the Basis of Speed :
• Creeping Inflation : 0-3 percent
• Walking Inflation : 3-10 percent
• Running Inflation : 10 -50 percent
• Hyperinflation : more than 50 percent
 Inflation Types
• Inflation Types : Can be divided as per different criteria.
• On the Basis of Time :
• War time and peace time inflation
• On the Basis of Government Role :
• Open and suppressed inflation
• On the Basis of Inducement :
• Profit Induced, Deficit Induced and Wage Induced Inflation
• On the Basis of Employment Level:
• Semi-inflation and true inflation
 Demand Pull Inflation
• Demand pull inflation arises when aggregate demand rises faster than
aggregate supply.
• Demand can rise due to
• 1. Monetary Factors
• Increase in money supply
• Availability of more credit
• Reduction in interest rate
• 2. Fiscal Policy Factors
• Increase in expenditure
• Reduction in taxes
• Increase in subsidies /transfer
 Demand Pull Inflation
• With the increases in demand
price level as well as output rises
initially. But after Y2, only price
rises.
• Any increase in price beyond p2 is
the true inflation originating from
increase in demand.
 Supply Push Inflation
• Supply push inflation occurs when aggregate supply falls either from the
increase in cost, fall in production or monopoly powers.
• Causes of Fall in Aggregate Supply
• Increase in wage rate in excess of increase in productivity
• Increase in taxes
• Increase in exchange rate
• Increase in profit rate by the firms
• Supply shocks
• Natural calamities, disasters
 Supply Push Inflation
• With the fall in supply, price level
rises from p1 to p2.
• It is supply side inflation.
 Why supply side inflation is more painful?
• Because in supply side inflation price rises whereas
output falls. As a result unemployment rises.
• Thus it is more painful.
 Structural Inflation
• In LDCs, inflation is more influenced by structural issues
such as :
• Infrastructure bottleneck
• Labor bottleneck
• Capital bottleneck
• Foreign exchange bottleneck
• Food bottleneck
• Market imperfections
 Theoratical Perspective on Inflation
• Classical QTM:
• Money supply has a direct and proportional relationship with
inflation.
• Keynesian View:
• Money supply may create inflation but true inflation starts only
after full employment.
• Monetarist View:
• Inflation is always and everywhere a monetary phenomenon.
• New-Classical view : Money supply is the main cause of
inflation even in the short run.
 Measurement of Inflation
• Inflation can be measured by using a number of indices
such as :
• Consumer Price Index
• Wholesale Price Index
• Producer's price Index
• GDP Deflator
• In Nepal, all measures are calculated but CPI is the
official measure of Inflation in Nepal.
 Measurement of Inflation
• CPI Compilation in Nepal:
• Selection of Goods and Services: 496 selected on the basis of
goods and services
• These goods are selected on the basis if 5th household survey
and represent 97 percent of the household budget.
• Selection of Market Centers : 60 market centers across the
country have been selected for the purpose of collection prices.
• Data Collection : Collected weekly, fortnightly, monthly and
quarterly.
• Method Used : Laspeyre's Geometric Index
 Inflation Trend
• Inflation moderated in the recent years.
• Average inflation in the last five years is 5.87 percent.
• Average food inflation is 5.36 percent.
• Anerage non-food inflation is 6.28 percent.
• During the three months of 2077/78, average inflation is 3.93
percent.
• We see that food inflation is high during the recent months
whereas non-food inflation is low.
 Inflation Trend
• Inflation driven by food inflation.
 Inflation Trend
• Y-o-Y inflation in Nepal.
 Effects of Inflation
• Inflation has positive as well as negative effects:
• Lower inflation has the following effects.
• Raises the income of the variable income groups.
• Benefits borrowers/debtors
• More return to shareholders
• Encourages investment.
• Encourages production.
• Helps generate employment : Phillips Curve
• Boosts economic growth.
• Saves the economy from recession.
 Effects of Inflation
• High inflation has the following negative effects.
• Reduces Purchasing Power :
• Redistributive Effect: Increases income inequality. During high
inflation, businessmen (rich) earn more profit whereas the
income of the wage earners do not increase at the same rate.
• Discourages Savings: Because saved amount will lost value.
• Discourages Investment : Less demand in the market.
• Raises the Cost of Borrowing : Interest rate rises along with the
increase in inflation .
• Interest rate = risk free rate+ inflation premium
 Effects of Inflation
• Inefficiency Cost : Forces us to change technique of
production. E.g. from labor intensive technique to capital
intensive technique which wastes resources.
• Second Cost of Inflation : Inflation invites another inflation
that goes like a spiral.
• Uncertainty Cost : Creates uncertainty about the future
prices.
• Inconvenience Cost : People are not willing to accept money.
They want commodities instead that creates inconvenience in
transactions.
 Effects of Inflation
• Tax cost of Inflation: with the rise in nominal income, more people are
pushed in the higher tax brackets that erodes their purchasing power.
• Reduces Competitiveness : Higher inflation makes our goods expensive
to international markets. It reduces exports and increases imports.
• Raises the cost of development projects
• Harms creditors
• Encourages speculative investment: people buy shares and invest in real
estate.
• Social Costs : Increases crimes, thefts
 Controlling Inflation
• Fiscal Measures :
• Raising Taxes
• Cutting unnecessary expenses
• Reducing transfer payments
• Raising public debt
• Postponing the payment of debt
• Reallocating resources to output and productivity
 Controlling Inflation
• Monetary Measures :
• Reducing liquidity/money supply
• Raising interest rates
• Restricting the availability of credit
• Credit Rationing
• Reallocating resources to productive sector
 Controlling Inflation
• Other Measures :
• Build skilled labor force and raise productivity (supply side
policies). These work in the long run only.
• Address the infrastructural bottlenecks
• Address the market imperfections : cartelling, black-marketing,
artificial shortage of goods
• Reindexing : Adjust wages as per inflation to save the loss in
purchasing power.
• Managing Inflation Expectations:
 Is inflation Really Harmful?
• Not always:
• As we saw lower inflation encourages investment and thus
boosts employment as well as economic growth.

• But,
• Higher inflation discourages savings as well as investment and
is thus harmful to everyone. No one gains from high inflation.
 How Much Inflation is Optimal for Nepal
• Several studies show that the optimal level of inflation in Nepal
is 6-7 percent.

• Thus, any inflation higher than 7 percent will be harmful to the

economy.
• That’s why NRB targets the inflation rate in the range of 6 to 7
percent.
 Drivers of Inflation in Nepal
• Increase in Demand from increase in remittance, increase in
money supply, lower interest rates and increased government
expenditure.
• Imported Inflation from India.10*1.6=16, 20*1.6=32
• Supply side constraints such as load shedding, infrastructural
bottlenecks, labor disputes, strikes and lockouts.
• Market Imperfections : such as cartels, syndicates, black
marketing, artificial shortage etc.
• Supply Shocks : such as flood, landslides, earthquake, border
lockout
 Can NRB control inflation Completely?
• No, NRB has monetary policy at its hands which is a demand
management policy.
• Thus NRB can control inflation coming from the demand side
but,
• It cannot control supply side constraints.
• It cannot address market imperfections.
• It can do less to manage the supply shocks.
• Since the last three factors are dominant in Nepalese case,
inflation sometimes goes out of the target set in monetary
policy.
 Deflation, Disinflation and Stagflation
• Deflation is just opposite of inflation.
• It is bad as it will bring recession in the economy.
• Disinflation means lowering the rate of inflation.
• Stagflation is a situation when the economy faces a conflicting
situation : recession on the one hand and inflation on the
other. It thus refers to a situation of rising inflation and rising
unemployment.
• Stagflation appeared in the world in the 1970's for the first
time.
 Tradeoff between Inflation and Unemployment
• As wages rise, inflation rises but at the same time more
people will join the job market to take benefit of the
higher wages.
• Thus, with higher inflation unemployment falls.
• This inverse relationship between inflation and
unemployment has been summarized by the Phillips
Curve.
 Tradeoff between Inflation and Unemployment
• Phillips curve shows non-linear
relationship between inflations
and unemployment.
• Policy implication : One has to
bear the cost of inflation to
reduce unemployment.
• This is called a trade-off.
 Tradeoff between Inflation and Unemployment
• Inverse relationship exists in the short
run only.
• In the long run, the Phillips curve
becomes vertical.
• Unemployment cannot be reduced by
creating inflation in the long run.
• Phillips curve is said to be dead in the
long run.
• This is the argument of monetarism.
Tradeoff between Inflation and Unemployment
 Tradeoff between Inflation and Unemployment

• The new-classical economists argue that Phillips curve is

dead even in the short run.
• Inflation has nothing to do with unemployment.
 Is there a Tradeoff between Inflation and
Unemployment in Nepal?
• Basically, the tradeoff seems to exist in Nepal.
• As wages rise, more people join the job market who were voluntarily
unemployed.
• Another way can be : when money supply goes up, interest rate goes
down in the short run. Producers are encouraged to produce more.
• As a result, unemployment temporarily goes down.
• However, it would work for voluntary unemployment only.
• In case of excess supply of labor that is already not able to find work ,
creating inflation may not create jobs.
• The empirical relationship cannot be verified due to lack of data.
 Why People Feel Inflaton to be Higher than the Actual
Figures Published?
• Inflation is the increase in the average level of prices , not the
price increase in few goods.
• It is the weighted average. Price rise of more important good
matters.
• Price rise of cities matter than the price rise in villages for
inflation.
• Use of averaging method matters.
Hyperinflation in the World
Hyperinflation in the World
Hyperinflation in the World
Thank You