Lecture 15

Pre-read: https://www.cnbc.com/2023/07/19/uk-inflation-rate-slides-to-7point9percent-in-june-below-
expectations.html#:~:text=Economists%20polled%20by%20Reuters%20had,expected%208.7%25%20re
ading%20of%20May.

Post Read: Shyamal Roy: Chapter 2: 52-61

Official Data Base https://eaindustry.nic.in/default.asp

 Understanding inflation
• A sustained and appreciable increase in general price levels of goods and commodities.

• Value of money declines.

• Refers to issue of too much currency- Too much money chasing too few goods.

• But, not all increases in money supply will lead to inflation.

• In an economy suffering from recession, ↑ in money supply will increase output and employment.
• In such cases increases in money supply only beyond full employment will cause inflation.

• 2 main types
• Demand pull
• Cost Push

Core inflation is the underlying inflation rate excluding volatile food and energy prices.

Deflation The SHOCKING Truth About Deflation's Impact on the Economy (youtube.com)
 Deflation & its Costs
• Reasons: Shrinking money supply, lowered AD & higher business efficiency with no increases in money SS

• Consequences:
• Consumers delay purchases

• Rise in real value of debt.

• Real wage unemployment. With falling, prices firms can’t afford workers

• Borrowing are discouraged and savings encouraged: Due to Higher real interest rates ( Since Interest rates
cannot be zero, with Inflation ↓, the effective real interest rate ↑)

• Deflationary cycle. Lower DD → Lower prices & wages → Lower AD & unemployment
 Types of Inflation rate
Whole Sale price Index
◦ Measures Inflation at the producer level (Known as Producer Price Index)
◦ Price Index used to measure change in average price level of specified basket of goods traded in
the market at wholesale prices.

Consumer Price Index (US)

◦ Measures Inflation at the consumer level (Also known as Cost of living index)
◦ Price index which tracks the weighted average of price of a specified market basket of common
consumer/ capital goods and services consumed by an average citizen in a specified time period
at retail prices.
 Differences
WHOLESALE PRICE INDEX CONSUMER PRICE INDEX
Measures inflation at final stage @ Wholesale
Measures inflation at each stage @ Retail prices
prices

Published monthly or quarterly

Published weekly

Published by Central Statistic Office, Ministry of

Published by Office of Economic Advisor,
Statistics & Programme Implementation
Ministry of Commerce & Industry, GOI.

Includes 448 rural & 460 urban products like

Includes Urban sector & covers 697 products
education, communication housing & medical care
including fuel, power & manufacturing

Used by 157 countries with big countries included like

Used by few countries like India (before 2014)
US, UK, France etc
 Calculation of Consumer Price Index
Calculation for CPI for a Single Commodity: Wheat
Price of wheat in base year (2004-05)= Rs 5.75
Price of wheat in the year 2009-10= Rs 6.10

CPI in 2009-10 = (Price of wheat in 2009-10) – (Price of wheat in 2004-05) / (Price of wheat in 2004-05) X 100

Rate of Inflation = 6.10-5.75/5.75 X 100= 6.09 %

Since CPI for base year= 100, CPI for 2009-10= 100+6.09= 106.09; 6.09% increase in prices
Calculation for CPI for a Basket of Commodities:
 Types & Causes of Inflation
A. DEMAND PULL B. COST PUSH

➢Demand Side Factors: Continuous ↑ in AD→ Firms ➢Supply Side Factors: Continuous ↑ in costs (can
respond by partly ↑ prices and partly by ↑output. occur independently of AD) → Firms respond by
➢ Price rise depends on the level of employment- partly ↑ prices & partly by ↓ output.
closer the economy to FE- the more the price ↑. ➢ Price rise will depend on EOD- inelastic DD
(price ↑ possible without affecting sales).
➢In demand pull- output and employment tends to ↑
with price rise. ➢In cost push- output and employment tends to ↓
with price rise (Stagflation).
➢Reasons for Demand Pull Inflation
➢ War period ➢Reasons for cost push inflation
➢ Increase in expenditure during Planning period ➢ Wage push by Trade unions
➢ Increase in consumption expenditure ➢ Profit push by monopolists
➢ Increase in exports ➢ Tax Push
➢ Reduction in taxation ➢ Increases in International commodity prices
➢ Economic Growth ➢ Temporary SS shocks (bad harvest) & Long
term SS shocks (depletion of natural
➢ Repayment of past internal debts resources).
➢ Rapid growth of population
 Effects of Inflation
A. INCOME B. RE-DISTRIBUTION C. OUTPUT & D. SOCIAL EFFECTS E. LONG RUN ECONOMIC
DISTRIBUTION OF WEALTH EMPLOYMENT GROWTH
• Loss of public
Debtors (G) & Creditors (L) ◦Money value of its assets •↓ Savings & K formation •Reallocation of
or debts faith
Wage & salary earners resources from
•↓ in production
• Sense of production of consumer
Fixed Income groups/ Rent grievance and
Earners •Loss of investor confidence & goods to capital goods
heartache
exodus of foreign K
Entrepreneurs
• Social conflict •Redistribution of goods
•Pattern of production changes
Farmers & services from pvt to
from essentials to luxuries
• Blow to business public sector if inflation
Investors: In Equity shares or
morality and caused by ↑ in money SS
Fixed interest yielding bonds •Predominance of seller’s
and debentures ethics
market affecting quality of goods to finance government
Bond prices & inflation are • Corruption budget deficits-inflation
•Hoarding & Black marketing/
inversely related. acts as tax- ↓ value of real
(During Inflation- Interest @ ↑- speculative activities
assuming bond price of Rs 100 money balances held by
@ 4% interest rate- an ↑ in •Disrupts the smooth functioning people + falls more
market interest @ due to
of price mechanism heavily on poor.
inflation say 8%- causes bond
prices to ↓ to Rs 50; if mkt
interest @ 2% - price of bond ↑ •Decline in terms of trade
to Rs 200).
 Re-distribution Effects of Inflation: Nominal & Real Income
• Nominal income: Income with inflation. Real income: Income adjusted for inflation.

• During Inflation, Nominal Y does not rise at the same pace as the price level.- Leads to redistribution in favor
of some and against some.

• If Nominal Y ↑ at the same % as Inflation/ price index: Real income = Nominal income
• If price levels ↑ by 6 % and nominal Y ↑ by 6 %, your real income will remain unchanged.
• But with price levels ↑ by 6% & nominal Y ↑ by 10%→ Real Y will ↑ only by 4% over the period; if nominal
Y ↑ by 2 % & Inflation by 10% ; real income will ↓ by 8%.

• Anticipated & Unanticipated Inflation: Net Gains/ Losses depends on whether the inflation was anticipated
((Evil effects can be ↓) or unanticipated.
• Anticipated inflation: Creditors can also charge an inflation premium (higher nominal interest based built in
expectation of higher future inflation rate)
• Unanticipated inflation: Hurts fixed income receipts, savers & creditors & helps flexible income receivers &
Debtors

• Factors Affecting Inflation: Price Expectations (Pe, Money Supply & Interest rates)
• Price Expectations:: Higher Price expectation drive up actual inflation: Higher Pe= 8% →People increase
prices by 8% → thus Ie= I
• Money Supply: Inflation is a monetary Phenomenon: Higher prices cannot be sustained if money SS is
constant in response to ↑ transaction demand for money.
• Interest Rates: Nominal Interest rate i= r (Real interest rates) + πe
• During Recession: Price expectations are low → Inflation is low → Interest rates are low.
• During Prosperity: Price expectations are high → Inflation is high → Interest rates are high.
 Other costs of Inflation
▪Menu costs- change in price labels, catalogues or on menus or adjust time slot machines.

▪Resources- Increase in services of accountants, financial experts, monetary policy

measures etc

▪Continuous calculation by households & businesses to calculate the difference

between real and nominal values of price, wages & interest rates.

▪Continuous trade-offs by citizens between investments in stock & shares (to

minimise the harmful effect of inflation) or keeping liquid cash (as more money needed
frequently to make transactions during inflation)- so frequent trips to banks, phone
calls or internet transfers.

▪Opportunity cost of time, resources and efforts- could be put to producing valuable
goods & services.

Dangers of Hyperinflation such as in Germany in early 1920s & in Venezuela in 2016!

 Quantity Theory of Money

➢Proposed by US Economist Irving Fisher in 1911.

➢Main Propositions: Qty of money has a large impact on the economy- will ↑ economic activity or ↑ price level.
➢Value of money is determined by the money SS [P = f(M)] and will be affected proportionately. If Money SS
doubles→ Price level/ Inflation will double (value of money falls).
➢Equation of Exchange: Exchange value of money is determined like any other good, with supply and demand.
MV= PT
SS of money used for transactions purposes = Value of goods sold in the economy
M=Quantity of money V=Transaction Velocity of money
P= price level T=Volume of output traded/ Transactions undertaken

➢ Assumption: V & T remain fixed in the SR; Therefore changes in M causes changes in Price Levels.
➢ Velocity is determined by payment habits, nature of the banking system, density of population, rapidity of
transportation.
➢ T is determined by Economic Activity; Assumption of Say’s Law- Economies operate at Full employment.
➢
Numerical Illustration: Suppose M= Rs 1000, V= 4, P= 2 and T= 2000; Given MV= PT, 1000(4)= 2(2000); Hence
stock of money for transaction purposes = Value of goods sold in the economy.

If M increases by 50%→ M= Rs 1500; Price will also rise by 50% from 2 to 3%

1500(4)= 3(2000); 6000= 6000
 Fisher Equation: Income Version
Fisher’s Income Version: People wish to hold cash to finance transactions and for security against
unforeseen needs. Demand for money is proportional to his real income.

(Money Supply) MV= PY (Nominal Income/ GDP) where V= Income velocity of money

#2. Suppose M (Money Supply) = $10 bn , Y (Real GDP) = $100 bn/year , P (Price level index) = 1.1.
Calculate income velocity of circulation of money

Given MV= PY, thus V= 1.1 x 100bn/ 10 bn= 11 times

If P=1 → Real GDP=Nominal GDP= $100 bn, V= PY/ M = 1* 100 bn/100 bn= 1

With velocity = 1 (money income changing hands once only).

If M= $1, Real Income Y= $100 bn V= PY/ M = 1*100 bn/ 1= 100 bn

With velocity=100 bn ( money income changing hands 100 bn times).

 Match the Columns
1.Disinflation Price level ↑ when the economy recovers from recession based on value of inflation

2.Deflation Rate of inflation + Rate of unemployment

3.Reflation Aggregate demand > Aggregate supply (at full employment level)

4.Creeping inflation Moderate rate of inflation (3-7%)

5.Walking/Trotting inflation Due to structural problems like infrastructural bottlenecks

6.Running/Galloping inflation Covers all commodities

7.Stagflation Rate of inflation is high (>10%)

8.Misery index Based on items whose prices are non-volatile; Excludes food and fuel Items

9.Inflationary gap Aggregate demand > Aggregate supply. Here govt will not allow rising of prices.

10.Suppressed / Repressed inflation Reduction in the rate of inflation

11.Core inflation Inflation + Stagnation

12.Headline inflation Persistent decrease in the price level (negative inflation)

13.Structural inflation When the rate of inflation is low (up to 3%)