Inflation

Inflation in Market Inflation in Market EconomiesEconomies

Causes and ControlCauses and Control

Presented by: Bharat JhalaniPresented by: Bharat Jhalani

July 2008July 2008

ContentsContents

Meaning Meaning Inflation and UnemploymentInflation and Unemployment Inflation and InvestmentsInflation and Investments Measures of InflationMeasures of Inflation Causes of InflationCauses of Inflation Controlling InflationControlling Inflation Hyper-inflation Hyper-inflation

MeaningMeaning

One of the most important economic One of the most important economic concepts is concepts is inflation.inflation.

InflationInflation is a rise in general level of prices is a rise in general level of prices of goods and services over time.of goods and services over time.

As the cost of goods and services As the cost of goods and services increase, the value of a currency is going increase, the value of a currency is going to go down because you won't be able to to go down because you won't be able to purchase as much with that currency as purchase as much with that currency as you could have last month or last year. you could have last month or last year.

Inflation and UnemploymentInflation and Unemployment

Modern economists believe that inflation is Modern economists believe that inflation is inversely related to unemployment.inversely related to unemployment.

As inflation decreases, unemployment is As inflation decreases, unemployment is expected to rise and vice-versa.expected to rise and vice-versa.

Inflation and InvestmentsInflation and Investments

Inflation is greatly feared by investors because it Inflation is greatly feared by investors because it grinds away at the value of your investments.grinds away at the value of your investments.

If you invest $.100 in a 1-year CD that will re 5% If you invest $.100 in a 1-year CD that will re 5% over that year, you will be giving up $100 right over that year, you will be giving up $100 right now for $105 in 1 year. If over the course of that now for $105 in 1 year. If over the course of that year there is an inflation rate of 6%, the year there is an inflation rate of 6%, the purchasing power of $100 has decreased by $6, purchasing power of $100 has decreased by $6, and you have actually lost ground! (Of course, and you have actually lost ground! (Of course, the capital gains tax you pay on your "gain" will the capital gains tax you pay on your "gain" will increase this loss.) increase this loss.)

Measures of InflationMeasures of Inflation

Inflation is measured by calculating the Inflation is measured by calculating the percentage rate of change of a price percentage rate of change of a price index, which is called the index, which is called the inflation rate.inflation rate.

This rate is calculated by mainly two This rate is calculated by mainly two different price indices: different price indices:

1. Wholesale price index 1. Wholesale price index

2. Consumer price index 2. Consumer price index

Wholesale price indexWholesale price index

WPI is the index that is used to measure WPI is the index that is used to measure the change in the average price level of the change in the average price level of goods traded in wholesale market.goods traded in wholesale market.

India uses the WPI to calculate and then India uses the WPI to calculate and then decide the inflation rate in the economy.decide the inflation rate in the economy.

WPI does not properly measure the exact WPI does not properly measure the exact price rise an end-consumer will experience price rise an end-consumer will experience because, as the name suggests, it is at the because, as the name suggests, it is at the wholesale level.wholesale level.

Consumer price indexConsumer price index

CPI is a measure of a weighted average of CPI is a measure of a weighted average of prices of a specified set of goods and prices of a specified set of goods and services purchased by consumers. services purchased by consumers.

It is a price index that tracks the prices of a It is a price index that tracks the prices of a specified basket of consumer goods and specified basket of consumer goods and services, providing a measure of inflation.services, providing a measure of inflation.

Most developed countries uses this index.Most developed countries uses this index.

CausesCauses

There are three major types of inflation There are three major types of inflation categorized by the causes:categorized by the causes:

1. Demand-pull inflation1. Demand-pull inflation

2. Cost-push inflation2. Cost-push inflation

3. Built-in inflation3. Built-in inflation

Demand-pull inflationDemand-pull inflation

inflation caused by increases in aggregate inflation caused by increases in aggregate demand due to increased private and demand due to increased private and government spending, etc. government spending, etc.

Demand inflation is constructive to a faster Demand inflation is constructive to a faster rate of economic growth since the excess rate of economic growth since the excess demand and favourable market conditions demand and favourable market conditions will stimulate investment and expansion.will stimulate investment and expansion.

Supply shock inflationSupply shock inflation

caused by drops in aggregate supply due to caused by drops in aggregate supply due to increased prices of inputs increased prices of inputs

E.g.: Take for instance a sudden decrease in the E.g.: Take for instance a sudden decrease in the supply of oil, which would increase oil prices. supply of oil, which would increase oil prices. Producers for whom oil is a part of their costs Producers for whom oil is a part of their costs could then pass this on to consumers in the form could then pass this on to consumers in the form of increased prices. of increased prices.

supply-shock inflation involves a trickle down supply-shock inflation involves a trickle down effect that will cause changes in many sectors of effect that will cause changes in many sectors of the marketplace the marketplace

Built-in inflationBuilt-in inflation

induced by adaptive expectations, often induced by adaptive expectations, often linked to the "price/wage spiral" because it linked to the "price/wage spiral" because it involves workers trying to keep their involves workers trying to keep their wages up (gross wages have to increase wages up (gross wages have to increase above the CPI rate to net to CPI after-tax) above the CPI rate to net to CPI after-tax) with prices and then employers passing with prices and then employers passing higher costs on to consumers as higher higher costs on to consumers as higher prices as part of a "vicious circle."prices as part of a "vicious circle."

SeigniorageSeigniorage

The “revenue” raised from printing money The “revenue” raised from printing money is called seigniorage (pronounced SEEN-is called seigniorage (pronounced SEEN-your-ige)your-ige)

To spend more without raising taxes or To spend more without raising taxes or selling bonds, the govt can print money. selling bonds, the govt can print money. Higher the money supply, higher the Higher the money supply, higher the inflation. inflation.

ControlsControls

Inflation is a hydra header monster. It Inflation is a hydra header monster. It cannot be controlled by taking a single cannot be controlled by taking a single measure. However, if monetary and fiscal measure. However, if monetary and fiscal measures are wisely coordinated, it can measures are wisely coordinated, it can greatly help in controlling the continuous greatly help in controlling the continuous process of rising prices.process of rising prices.

Monetary policyMonetary policy

Monetarists emphasize increasing interest Monetarists emphasize increasing interest rates (slowing the rise in the money rates (slowing the rise in the money supply) to fight inflation. supply) to fight inflation.

Rates consists of:Rates consists of:

1. CRR1. CRR

2. Bank rate2. Bank rate

3. Repo rate3. Repo rate

4. Reverse Repo rate4. Reverse Repo rate

Fiscal policyFiscal policy

Keynesians emphasize reducing demand Keynesians emphasize reducing demand in general through fiscal policy.in general through fiscal policy.

Increase taxes so less disposable incomeIncrease taxes so less disposable income Reduce government spending to reduce Reduce government spending to reduce

demand.demand. changing the import and export dutieschanging the import and export duties

Exchange rateExchange rate

By strengthening local currency against By strengthening local currency against dollar will boost imports while discouraging dollar will boost imports while discouraging exporters.exporters.

Through selling of dollars. Through selling of dollars. Example:- In the week ending June 13, Example:- In the week ending June 13,

RBI sold almost $5 billion from its reserves RBI sold almost $5 billion from its reserves in the open market. in the open market.

Budgetary measuresBudgetary measures

The budgetary deficit should be kept low The budgetary deficit should be kept low level.level.

The government should give special The government should give special attention to the production of cottons, attention to the production of cottons, wheat, vegetables, edible oil etc. it will wheat, vegetables, edible oil etc. it will have soothing effects on inflating.have soothing effects on inflating.

Hyper-inflationHyper-inflation

Zimbabwe: 355,000%!Zimbabwe: 355,000%!

The inflation in Zimbabwe for the month of The inflation in Zimbabwe for the month of March 2008 rose to 355,000%! Yes, March 2008 rose to 355,000%! Yes, 355,000 per cent! It more than doubled 355,000 per cent! It more than doubled from the February figure of 165,000%.. from the February figure of 165,000%..

Contd.Contd.

Almost 80% of the nation is unemployed. Almost 80% of the nation is unemployed. The Zimbabwean central bank has The Zimbabwean central bank has

introduced $500 million bearer cheques introduced $500 million bearer cheques (or currency notes) for the public, and $5 (or currency notes) for the public, and $5 billion, $25 billion, $50 billion agro-billion, $25 billion, $50 billion agro-cheques for farmers. cheques for farmers.

The nation had introduced $250 million The nation had introduced $250 million bearer cheques.bearer cheques.

Contd.Contd.

A sausage sandwich sells for Zimbabwean A sausage sandwich sells for Zimbabwean $50 million. $50 million.

A 15-kg bag of potatoes cost Zimbabwean A 15-kg bag of potatoes cost Zimbabwean $260 million. $260 million.

But then, Zimbabwean $50 million is But then, Zimbabwean $50 million is roughly equal to US$ 1roughly equal to US$ 1