Notes on Inflation
What is Inflation?
Inflation is a rising general level of prices.
Inflation reduces the “purchasing power” of money.
Examples:
It takes $2 to buy what $1 bought in 1982.
It takes $6 to buy what $1 bought in 1982.
When inflation occurs, each dollar of income will buy fewer goods than before.
Formula: where:
V = Purchasing Power
I = Income
P = Price Level
Who Benefits and Who is Hurt by Inflation?
Beneficiaries of Inflation:
Borrowers: People who borrow money benefit because they repay the loan with money that is worth less than when they borrowed it.
Businesses: A business benefits if the price of its product increases faster than the price of its resources.
Hurt by Inflation:
Lenders: People who lend money (at fixed interest rates) are hurt because the money they are repaid is worth less than when they lent it.
People with Fixed Incomes: Inflation erodes the purchasing power of fixed incomes.
Savers: The real value of savings decreases.
Cost-of-Living-Adjustment (COLA):
Some workers have salaries that mirror inflation.
They negotiate wages that rise with inflation.
Important Terms
Shrinkflation:
When the price stays the same, but firms reduce the size of the good.
Effectively a price increase.
Disinflation:
A fall in the inflation rate.
Prices are increasing at a slower rate.
Deflation:
A fall in prices.
A negative inflation rate.
Stagflation:
Inflation and unemployment increase simultaneously.
Consumer Price Index (CPI)
The most commonly used measurement of inflation for consumers.
Formula:
The base year is given an index of 100 (e.g., 2012).
Data Collection: NSO (National Statistical Office).
Data is collected from 310 Towns, includes 299 items
Example:
1997 Market Basket: Movie is $6 & Pizza is $14, Total = $20 (Index of Base Year = 100)
2009 Market Basket: Movie is $8 & Pizza is $17, Total = $25 (Index of 125)
This means inflation increased 25% between ’97 & ‘09.
Wholesale Price Index (WPI)
Measure of changes in the prices charged by manufacturers and wholesalers (OEA - Office of Economic Adviser).
Wholesale price indexes measure the changes in commodity prices at a selected stage or stages before goods reach the retail level (related to GST?).
The index basket of the WPI covers commodities falling under the three major groups namely Primary Articles, Fuel and Power, and Manufactured products.
The index basket of the present 2011-12 series has a total of 697 items including.
It ignores the service sector which has a large contribution to GDP.
Difference between WPI and CPI
WPI data is published by the Office of Economic Adviser, Ministry of Commerce and Industry.
CPI data is published by the National Statistical Office (NSO), Ministry of Statistics and Programme Implementation (MoSPI).
The base year for WPI is 2011-12, while the base year for CPI is 2012.
WPI takes into account the change in the price of goods only, while CPI takes into account the change in the price of both goods and services.
Classical View on Inflation
According to classical economists or monetarists, inflation is caused by an increase in the money supply, which leads to a rightward shift in the negative sloping aggregate demand curve.
Given a situation of full employment, classicists maintained that a change in the money supply brings about an equi-proportionate change in the price level.
That is why monetarists argue that inflation is always and everywhere a monetary phenomenon.
Keynesian View on Inflation
Keynesians do not find any direct link between money supply and price level causing an upward shift in aggregate demand.
According to Keynesians, aggregate demand may rise due to a rise in consumer demand, investment demand, government expenditure, net exports, or a combination of these four components of aggregate demand.
Given full employment, such an increase in aggregate demand leads to upward pressure in prices. Such a situation is called Demand-Pull Inflation (DPI).
Inflation Types: Cause Based
Demand-Pull Inflation:
Rising demand in the economy.
Cost-Push Inflation:
Increase in costs (e.g., rising oil prices).
Wage-Inflation:
Inflation caused by rising real wages.
Imported Inflation:
Inflation caused by the rising price of imports (e.g., due to devaluation).
Core Inflation:
Inflation rate excluding temporary factors.
Hyperinflation:
Inflation of over 1,000% a year.
Demand-Pull Inflation
“Too many dollars chasing too few goods.”
Demand increases, but supply stays the same. What is the result?
A shortage driving prices up.
An overheated economy with excessive spending but the same amount of goods.
Demand-pull inflation is a tenet of Keynesian economics that describes the effects of an imbalance in aggregate supply and demand.
Demand-Pull Inflation Diagram
Illustrates how demand exceeding supply leads to higher price levels after full employment.
DPI appears after full employment
Increases in total spending
Cost-Push Inflation
Inflation in an economy may arise from the overall increase in the cost of production. This type of inflation is known as cost-push inflation.
The cost of production may rise due to an increase in the prices of raw materials, wages, etc.
Who is responsible?
Minimum wage laws or trade unions?
A wage-price spiral comes into operation.
Firms are to be blamed also for the price rise since they simply raise prices to expand their profit margins.
Thus, we have two important variants of CPI:
wage-push inflation
profit-push inflation.
Diagram showing cost-push inflation
Illustrates how a decrease in supply/SRAS leads to leftward shift and increase in price level.
Wage Push Inflation
Rising wages tend to cause inflation. In effect, this is a combination of demand-pull and cost-push inflation.
Rising wages increase costs for firms, and so these are passed onto consumers in the form of higher prices.
Also, rising wages give consumers greater disposable income and therefore cause increased consumption and AD.
Imported Inflation
A depreciation in the exchange rate will make imports more expensive. Therefore, the prices will increase solely due to this exchange rate effect.
A depreciation will also make exports more competitive so will increase demand.
Core Inflation
One measure of inflation is known as ‘core inflation.’
This is the inflation rate that excludes temporary ‘volatile’ factors, such as energy and food prices.
True Inflation
During full employment, the output of goods and services cannot be increased any more.
Any increase in total spending or total quantity of money during full employment causes the prices to rise persistently, and such inflationary price-rise is called true inflation.
Partial Inflation
Sometimes inflation may appear even before the stage of full employment on account of the short supply of some essential factors, for which the production or supply of goods and services cannot be increased proportionately with the increase in spending or quantity of money.
Deficit-Induced Inflation
Inflation which is the outcome of the new issue of paper notes for financing government’s war or development expenditures is designated as deficit-induced inflation.
During war or development planning, the government is often compelled to print new paper notes for covering huge budget deficits.
Open Inflation
Inflation is said to be ‘open’ when the government and the monetary authorities of a country do not take any measure to control the spending of the people.
The people spend their increased incomes freely.
As a result, there occurs a sharp rise in demand and prices.
If the people are allowed to spend their larger incomes on goods freely, prices will continue to rise sharply.
Suppressed Inflation
Inflation, on the other hand, becomes suppressed or repressed when the government and the monetary authorities do not allow the prices to rise to a high level.
For many reasons, they take measures to control the spending of the larger incomes through various methods, such as price control and rationing of consumption in respect of some essential goods and control of investment expenditures.
Types of Inflation Based on Rates
Creeping Inflation (1-4%):
When the rate of inflation slowly increases over time.
For example, the inflation rate rises from 2% to 3%, to 4% a year.
Creeping inflation may not be immediately noticeable, but if the creeping rate of inflation continues, it can become an increasing problem.
Walking Inflation (2-10%):
When inflation is in single digits – less than 10%.
At this rate – inflation is not a major problem, but when it rises over 4%, Central Banks will be increasingly concerned.
Walking inflation may simply be referred to as moderate inflation.
Running Inflation (10-20%):
When inflation starts to rise at a significant rate.
It is usually defined as a rate between 10% and 20% a year.
At this rate, inflation is imposing significant costs on the economy and could easily start to creep higher.
Galloping Inflation (20%-1000%):
This is an inflation rate of between 20% up to 1000%.
At this rapid rate of price increases, inflation is a serious problem and will be challenging to bring under control.
Some definitions of galloping inflation may be between 20% and 100%.
There is no universally agreed definition, but hyperinflation usually implies over 1,000% a year.
Hyperinflation (> 1000%):
This is reserved for extreme forms of inflation – usually over 1,000%, though there is no specific definition.
Hyperinflation usually involves prices changing so fast that it becomes a daily occurrence, and under hyperinflation, the value of money will rapidly decline.