Inflation

Presented By
Tanseer Ahamed
Lecturer, Department Of Economics
United International University
For Any Queries: ahamedtanseer@gmail.com
 INFLATION
• Inflation occurs when the money supply increases without a corresponding increase in the
production of goods and services.
• Money Supply vs. Goods Supply: If the supply of money grows while the supply of goods
remains stagnant, the purchasing power of money decreases. This leads to an increase in
the general price levels of goods and services.
• Nature of Inflation: Inflation is not an abrupt event but a sustained trend. It is characterized
by a continuous rise in prices and a steady decline in the purchasing power of money over
time.
• Broad Impact: Inflation is not defined by the price increase of a single commodity. It refers to
the overall upward movement in the prices of most goods and services in the economy.
Summary: Inflation represents the broad and consistent rise in the general price level of goods
and services, affecting the economy's overall purchasing power.
 Is Inflation Good or Bad?
1. Moderate Inflation
Definition:
• A controlled and steady increase in the general price level, typically around 2%–3% per year.
Advantages:
• Encourages Spending and Investment: People are more likely to spend and invest rather than hoard money, stimulating
economic growth.
• Wage Growth: Often accompanied by gradual wage increases, maintaining purchasing power.
Central Banks’ Role:
• Most central banks worldwide aim for this modest inflation rate to ensure economic stability and growth.

2. Hyperinflation
Definition:
• An extremely rapid and out of control rise in prices, often exceeding 50% per month.
Disadvantages:
• Erosion of Purchasing Power: Money loses its value quickly, making it difficult for consumers to afford basic goods and
services.
• Economic Instability: Creates uncertainty, discourages investment, and can lead to a loss of confidence in the currency.
• Social Unrest: Can result in widespread dissatisfaction and social turmoil as living costs become unsustainable.
 Is Inflation Good or Bad?
3. Deflation
Definition:
• A decrease in the general price level of goods and services.
Disadvantages:
• Delayed Spending: Consumers may postpone purchases, anticipating lower prices in the future, which can reduce
overall demand.
• Increased Real Debt Burden: The real value of debt increases, making it harder for borrowers to repay loans.
• Economic Recession: Prolonged deflation can lead to reduced production, layoffs, and a downward economic spiral.

Central Banks’ Perspective:

Targeting Moderate Inflation:
• Most central banks aim for a 2%–3% inflation rate as it balances the benefits of economic growth with the risks of
excessive price increases.

Summary:
•Balanced Inflation: A moderate level of inflation is generally beneficial, promoting economic growth and stability.
•Excessive Inflation and Deflation: Both high inflation and deflation pose significant risks, including reduced purchasing power,
economic instability, and potential recession.
 Causes of Inflation
1. Demand-Pull Inflation
Definition: Demand-pull inflation occurs when the aggregate demand in an economy outpaces aggregate supply, leading to a
general increase in prices.
Key Factors:
•Increase in Money Supply:
• When more money circulates in the economy, consumers have greater purchasing power, increasing overall demand.
•Aggregate Demand (AD) Formula:
• AD = C + I + G + NX

Impact of Each AD Component:

•Consumption (C): An increase in household spending boosts overall demand.
•Investment (I): Higher business investments enhance demand for capital goods and services.
•Government Spending (G): Increased government expenditures inject more money into the economy, raising demand.
•Net Exports (NX): A rise in exports or a decrease in imports increases net exports, elevating aggregate demand.

•Deficit Spending:
• Government expenditures exceed revenues, injecting additional money into the economy and boosting demand.
•Expansion of Bank Loans:
• Increased availability of credit encourages both consumers and businesses to spend and invest more.
•Fixed Aggregate Supply:
• When aggregate supply remains constant while aggregate demand increases, upward pressure on prices ensues.
 Causes of Inflation
2. Cost-Push Inflation
Cost-push inflation arises when the costs of production increase, leading producers to raise prices to maintain profit margins.
Key Factors:
Worker Dissatisfaction and Strikes: Labor unrest can disrupt production, reducing supply and increasing costs.
Increase in Salaries and Wages: Higher wages elevate production costs, prompting businesses to pass these costs onto
consumers through higher prices.
Rising Utility Costs: Increases in the prices of essential services like electricity, gas, and water raise overall production expenses.
Supply Chain Disruptions: Any factor that increases the cost of raw materials or intermediate goods can lead to higher final
product prices.

3. Structural Weaknesses in the Market System

Structural issues within the market can create inefficiencies and monopolistic behaviors that contribute to inflation.
Monopolies: Single suppliers can control prices due to lack of competition, leading to higher prices.
Cartelization: Groups of producers may collude to set higher prices, reducing competition and keeping prices artificially high.
Rent-Seeking Behavior: Firms may engage in practices that seek to increase their profits without contributing to productivity,
such as lobbying for favorable regulations.
Syndicates: Organized groups may manipulate market conditions to their advantage, affecting supply and pricing.

4. Natural and Man-Made Disasters

Events like earthquakes, floods, and hurricanes can destroy infrastructure, reduce agricultural output, and disrupt trade. Wars,
terrorism, and industrial accidents can similarly disrupt economic activity and supply chains, leading to scarcity and higher
prices.
 Effects of Inflation
Impact on Income and Wealth Distribution
a. Low-Income Individuals and Pensioners
• Explanation: Those with fixed or limited incomes are more vulnerable to rising prices.
• Impact: Their purchasing power decreases, making it harder to afford essential goods and services.

b. Consumers and Buyers

• Explanation: General consumers face higher costs for everyday items.
• Impact: Increased cost of living can lead to reduced discretionary spending and lower overall consumption.

c. Producers and Businesses

• Explanation: Mild inflation supports a healthy economic environment where businesses can grow sustainably, adapt to
changing costs, and reward their stakeholders.
• Impact: By enabling gradual adjustments in prices and wages, mild inflation contributes to overall economic stability,
benefiting producers.

d. Lenders and Borrowers

• Explanation: Inflation affects the real value of money lent and borrowed.
• Impact:
• Lenders: Receive repayments that are worth less in real terms.
• Borrowers: Benefit as they repay debts with money that has diminished value.
 Effects of Inflation

e. Taxpayers
• Explanation: Inflation can influence tax liabilities and government revenue.
• Impact:
• Due to inflation, the real value of taxes collected by governments decreases.

f. Farmers
Impact on Farmers
•Land-Owning Farmers:
•Benefit from Mild Inflation:
• Increased Land Values: Inflation can lead to higher property values, enhancing the wealth of landowners.
• Higher Crop Prices: Rising prices for agricultural products can increase revenues for farmers who own land.
•Landless Farmers:
•Adversely Affected by Inflation:
• Increased Costs: Higher prices for seeds, fertilizers, and other inputs can strain their limited resources.
• Reduced Purchasing Power: Inflation erodes their ability to afford essential goods and services, worsening their
economic situation.
 Effects of Inflation
3. Impact on Foreign Trade
•Explanation:
• Inflation can alter a country’s trade balance by affecting export and import prices.
•Impact:
• Decreased Competitiveness: Higher domestic prices make exports more expensive and less attractive to foreign buyers.
• Increased Imports: Imported goods become relatively cheaper, potentially worsening the trade deficit and harming
domestic industries.

4. Social and Political Impacts

•Explanation:
• Inflation can have profound effects on societal stability and political landscapes.
•Impact:
• Social Unrest: Rising prices can lead to dissatisfaction and protests among the population.
• Political Pressure: Governments may face increased pressure to implement policies to control inflation, which can lead to
political instability or changes in leadership.
• Erosion of Trust: Persistent inflation can erode trust in economic institutions and the government’s ability to manage the
economy effectively.
 Tools for Controlling Inflation
Monetary Policy
CRR- Cash Reserve Requirement/Rate/Ratio : The amount of reserves that banks are required to keep on hand by a central
bank; changing the reserve ratio is a tool of monetary policy, but it is rarely changed and is rarely used to conduct monetary
policy.

Open Market Operations (OMO): The buying and selling of securities, such as bonds, by a central bank to change the money
supply.
Sell Securities: Reduces money supply to control inflation.
Buy Securities: Increases money supply to stimulate the economy.
Usage: Primary tool for managing money supply and inflation.

Bank Rate/Minimum Lending Rate: The name given to the interest rate that the BB sets on loans that the BB makes to banks;
changing the discount rate is a tool of monetary policy, but it is not the primary tool that central banks use.
 Fiscal Policy
Fiscal Policy and Inflation
•Fiscal Policy involves adjusting government spending (G) and taxation (T) to influence the economy.
•Excessive Government Spending is a major cause of inflation.

Key Fiscal Tools:

1.Reducing Government Expenditure
• Explanation: Decreasing public spending lowers overall demand in the economy.
• Impact: Helps to cool down economic activity and reduce inflationary pressures.

2. Imposing Additional Taxes

• Explanation: Increasing taxes takes disposable income away from consumers.
• Impact: Reduces consumer spending, thereby decreasing aggregate demand and controlling inflation.

3. Government Borrowing
•Explanation: Raising funds through borrowing can help manage budget deficits without increasing spending.
•Impact: Helps control the money supply and prevents excessive demand that can lead to inflation.

4. Promoting Savings
• Explanation: Encouraging individuals to save more reduces the amount of money circulating in the economy.
• Impact: Lower money circulation decreases aggregate demand, aiding in inflation control.
 Direct Measures to Control Inflation
1. Fixing Maximum Prices
Setting maximum price limits on essential goods prevents prices from rising excessively, ensuring affordability for consumers.
This measure helps control inflation by curbing price gouging and maintaining stable cost levels for basic necessities.

2. Increasing Production Levels

Boosting the production of goods and services increases supply, meeting rising demand without pushing prices higher.
Enhanced production helps stabilize prices and supports economic growth by ensuring that supply keeps pace with consumer
needs.

3. Price Control and Rationing Systems

Implementing price controls regulates the cost of essential commodities, while rationing ensures fair distribution during
shortages. These measures prevent excessive price increases and ensure that all segments of the population have access to
necessary goods.

4. Wage Control
Regulating wage increases helps prevent a wage-price spiral, where rising wages lead to higher production costs and,
subsequently, higher prices. Wage control maintains the balance between income growth and price stability, mitigating
inflationary pressures.

5. Establishment of Fair Price Sale Centers

Creating fair price sale centers ensures that consumers can purchase essential goods at regulated prices. These centers help
protect low-income households from price hikes and promote equitable access to necessary products.
 Measurement of Inflation: CPI
Definition of CPI
The Consumer Price Index (CPI) measures the average change in prices paid by consumers for a fixed basket of goods and
services over time. It serves as a key indicator for assessing inflation and cost of living adjustments.

Formula Explanation
CPI is calculated using the formula:
CPI = (Σ Pₙ Q₀) / (Σ P₀ Q₀)
Where:
•Pₙ = Current prices of goods
•P₀ = Base period prices of goods
•Q₀ = Quantity of goods in the base period
This formula compares the cost of the basket in the current period to the base period, indicating the level of price changes.

Example Calculation of CPI and Inflation Rate

Product Quantity (Q₀) Base Year Price (P₀) Current Year Price (Pₙ)

Rice 10 kg $40/kg $50/kg

Milk 5 liters $30/liter $35/liter
Bread 20 loaves $15/loaf $18/loaf
 Measurement of Inflation: CPI
Definition of CPI
The Consumer Price Index (CPI) measures the average change in prices paid by consumers for a fixed basket of goods and
services over time. It serves as a key indicator for assessing inflation and cost of living adjustments.

Formula Explanation
CPI is calculated using the formula:
CPI = (Σ Pₙ Q₀) / (Σ P₀ Q₀)
Where:
•Pₙ = Current prices of goods
•P₀ = Base period prices of goods
•Q₀ = Quantity of goods in the base period
This formula compares the cost of the basket in the current period to the base period, indicating the level of price changes.

Example Calculation of CPI and Inflation Rate:

Calculate the Consumer Price Index (CPI) for the current year and determine the inflation rate based on the given data.

Product Quantity (Q₀) Base Year Price (P₀) Current Year Price (Pₙ)

Rice 10 kg $40/kg $50/kg

Milk 5 liters $30/liter $35/liter
Bread 20 loaves $15/loaf $18/loaf