Session 11: Inflation Prof. A.T.

Outline
• Definition of Inflation
• Measuring the rate of Inflation
• Causes of Inflation
• Effects of Inflation
•Remedies
• Firm-level strategies to combat inflation
• Phillips Curve
• Business Cycle
 Definition of Inflation

•Inflation is defined as a continuous increase in the

average ( general) price level.
It results in a continuous fall in the value (purchasing
power) of money. A unit of money will buy less now
than before
• The degree of inflation can vary from mild inflation
to hyper – inflation.
 Measuring the rate of Inflation
Inflation is measured using a price index. For e.g.
Current year price level (P₂) = 126
Last year Price level (P₁ ) = 120
Inflation rate = Current Year Price Level – Last Year Price Level x 100
Last Year Price Level
= P₂ – P₁ x 100
P1
= 126 – 120 x 100
120
= 5%
(Source: Lipsey & Chrystal, 2011:356)
 Calculation of a Price Index
This is done through the consumer price index (CPI).
We compare the value of the std. basket of goods in the base year
vs. the current year.
Base Year Current Year
Commodity Price/Unit Qty. Value Price/Unit Value
Units (P.Q.) (P.Q)
A Rs. 5 100 Rs. 500 Rs.6 Rs.600
B Rs.10 50 Rs.500 Rs.12 Rs.600
Rs. 1000 Rs.1200

Base year Price Index = 100

Current Year Price Index = 1200 x 100 = 120
1000
The basket of goods is assumed to be constant.
 How a Retail Price Index (RPI) is constructed
Step 1 : Calculate the weights for the Price Index
Commodity Price/Unit (Rs) Qty (units) Expenditure (Rs) Proportional
PxQ Weight
A 5 50 250 0.5

B 2 75 150 0.3

C 1 100 100 0.2

Total 500 1.0

Weights represent the proportions of income spent on each item in the base year (e.g. year
2012). These weights are constant & applied to the price in each subsequent year (e.g.
2016, 2017 etc.)
 Step 2 : Calculate the Price Index

Commodity Weight Price (Rs) Price x Weight

2012 2017 2012 2017
A 0.5 5 6 2.5 3.0
B 0.3 2 2.4 0.6 0.72
C 0.2 1 1.2 0.2 0.24
1.0 3.3 3.96

Price Index (2012) = 3.3 x 100 = 100

3.3
Price Index (2017) = 3.96 x 100 = 120
3.3
Value of the Index in each year measures exactly how much the base year bundle of
goods would cost at that year’s price.
 Methods used to Measure Inflation Rate

(1) Point to Point (POP) change

(2) Annual Average (AA) change or
‘Moving Average’

(1) Point to Point (POP) change

It is the change of the index in a particular month compared to
the same month of last year (Aug.2015 against Aug. 2016)
POP can be taken as a leading indicator of the future trend of
the AA. If POP in a particular month is higher than the
corresponding POP of last year, then AA should rise & vice
versa.
 2) Annual Average (AA) or Moving Average
It is the change in the average of the index value of 12
preceding months including the month in reference compared
to the corresponding value of the index for last year.
i.e. Each month we count the index of that month plus the
preceding 11 months & average. Then we compare it with the
corresponding average for that period for last year.

Can prices rise, but inflation rate fall ? Yes. For e.g.
Jan 2014, P- index 100 & Jan 2015 = 120 so P ↑ by 20%
Apr 2014, P- index 110 & Apr 2015 = 126 so P ↑ by 16%
Rate of change over the year ended April 2015 has
declined from what it was at 20% in January to 16% in April
We say that the inflation rate has declined.
 Causes of Inflation – Continuous↑ in Prices
• Due to demand side factors (‘Demand Pull’ Inflation) OR
• Due to supply side factors (‘Cost Push’ Inflation)
1. Demand Pull Inflation (AD > As)
It is an upward pull of prices by excess demand.
Govt. finances its Dev. Projects by expanding money supply
(e.g. Central Bank prints money).
↑ in money supply ... ↑ AD ... ↑ Price level (Diagram)
It is a case of ‘ too much money chasing too few goods’.

Impact of an increase in money supply on the price level is

explained by the quantity theory of money ( Irving Fisher,
1911).
 Quantity Theory of Money (Irving Fisher, 1911)
MV = PT
M = Amount of money
V = Velocity of circulation
P = Average Price Level
T = No. of Transactions
V & T are assumed to be constant
Thus, ↑ in M leads to ↑ P
MV = PT is a truism. Amount of money used in transactions
is equal to total value of goods involved in transactions.
This equation is also written as MV = PQ, where Q refers to
output. At full employment, output is constant.
 Cost Push Inflation
2. Cost Push Inflation
It is an upward push of costs due to any of the following:
i. Increased prices of raw materials raises the COP. Also, a rise in
the price of imported oil will increase the COP.
ii. Wage-push inflation : An increase in money wages that are not
matched by increases in labour productivity will be inflationary.
iii. Profit-push inflation: The control of the market by a few
powerful sellers & price setting by them can lead to higher prices.
iv. Supply-shock inflation: Adverse weather conditions could result
in a shortage of agricultural commodities, leading to higher prices.
 Effects of Inflation
Effects on Individuals / Households
• Fixed income earners suffer. When prices rise, an individual’s income would buy a
smaller quantity of goods. It acts as a tax on the consumer.
• Pensioners suffer. They lack bargaining power.
• Ability of individuals to save is less because a greater proportion of income has to
be spent on consumption now.
• Debtors gain & creditors lose. When the debtor repays the loan, the real burden of
the debt is less.

Effects on Firms
•↑ COP ...↓ Profit margin (if selling price is not increased)
But, if price of final good is ↑, company sales will ↓ Profits will decline
• ↓ Co. Investment
•As local goods are high priced, competitiveness of export firms will decline.
• Industrial unrest can occur if companies do not accede to trade union demands for
higher wages.
• Less funds flow into the banking system for firms to borrow.
• Uncertainty in the economy due to inflation encourages short-term thinking and
planning by firms. Long term planning is discouraged.
 Effects on the National Economy
•Reduced investment by firms would slow down economic growth.
• Rising domestic price level leads to a fall in exports as local goods
will be high priced and less competitive in the export market. Imports
will be less costly resulting in an increase in imports. This leads to a
deficit in the BOP current account.
 Remedies for Inflation
1. To Counter Demand Pull Inflation
Monetary policy measures
↑ r ↓ AD (since ↓ C & ↓I )

Fiscal policy measures

↑ Income tax ... ↓ C
↑ VAT ... ↓ C
↑ Corp tax ... ↓ I
Also Govt. will reduce its expenditure (↓ G)

Direct measures
Price controls on essential goods. It is only a temporary
solution
 Continued
2. To Counter Cost-Push Inflation
-Incomes policy : A wage increase is given only if there is a
commensurate ↑ in productivity
- Price controls on essential goods (it is only a temporary
solution).

Can Central Bank control inflation?

CB cannot control the Retail Price Index (RPI). CB can control
aggregate demand (AD) by controlling the source of that
demand i.e. the total supply of money in the hands of the
public. If money supply is increased, public would use that
money to buy goods in excess of the available supply of
goods. This can lead to rising prices.
 Firm Level Strategies to Combat Inflation

- Be cost effective
- Convert slow moving inventory (stocks) into cash
- Negotiate with suppliers for better terms
- Delay payments to debtors, if possible
- Maintain a strong cash flow throughout
- Engage in promotions that emphasise benefits of
your product as against those of competitors
 Phillips Curve
Annual percentage
change in prices
Increase

Low High
0
Unemployment
Decrease

Phillips curve shows an inverse relationship between the

inflation rate and the level of unemployment.
When inflation is low, unemployment is high ; and
When inflation is high, unemployment is low.
 Supply – Side Policies
Supply side policies focus on increasing aggregate supply via.
• - ↓ marginal rate of tax
• - Training grants / subsidies for firms
• Labour reforms
• Infrastructure development
Diagram

• Is a falling price trend good for the economy?

If prices fall, and there is no corresponding decrease in the
cost of production, the producer’s profits decline.
He would lay off workers & unemployment would occur.
• Consumers benefit, but it would be short- lived, as they would not
have goods to consume in the next round.
The aim should be to raise income in real terms & not depress prices below
their cost of production.
 Business Cycle
B / cycle refers to the periodic fluctuations in the level of econ. activity (i.e.
employment & output)
Real GDP
Peak
Potential GDP
Peak
(Long term growth
trend)
Recovery
Recession
Trough
0 Time
Phase of B/
Cycle Recession Trough Recovery Peak
Variable
↓ (cons. durables)
↑ ↑ Fast
AD C Very Low
I ↓ (capital goods)
Business Confidence Low ( pessimism) Very Low Revives High (optimism)
Unemployment ↑ High & persistent ↓ ↓ ( Full Emp.)
Capacity Utilizn Low (idle capacity) Idle capacity ↓ Idle capacity Full capacity utilizn

Price Level Stable or ↓ ↓ ↑ Slowly ↑

Profits ↓ ↓ ↑ ↑
 Recession: Business Impact & Responses
Recession = 2 successive quarters of falling GDP.
Adverse Impact – on firms producing durable consumer goods
- on capital goods industry
- on construction industry
Less Impact – on service industries
- on non-durable consumer goods (FMCG)
industry
Benefits - Law firms specializing in bankruptcies benefit
- pawn brokers benefit
Booms & slumps are non-technical terms
Boom = An abnormally strong recovery
Slump/ Depression = A recession that is deep & long lasting
 Recession: Prescription for Firms
1. Be cost efficient
2. Convert slow moving inventory (stocks) into cash
3. Negotiate with suppliers for better terms.
4. Recovery of bad debts through aggressive efforts
5. Monitor competitors’ advertising. Engage in promotions
that emphasize benefits of your product e.g. quality,
convenience, durability, energy efficiency.
6. Trim operating expenditure e.g. travel, entertainment
7. Postpone new projects. Use slack period to do in-house
training & broaden employee skills
8. Hiring freeze
9. Reduce manufacture of low margin products