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UNIT 4 and UNIT 5

Inflation and Business Cycles

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 Introduction
• Inflation refers to a considerable and persistent increase in the general price level.
• Inflation is a persistent and appreciable rise in the general level or average of prices’.

• What is a Desirable Rate of Inflation

• A moderate rate of inflation is considered to be desirable and acceptable

• Studies suggests : A price rise of 2–3 per cent per annum in the developed countries and 4–5
per cent per annum in the developing economies is generally considered as the desirable rate
of inflation.

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 Measures of Inflation
• Price index level
• The change of price index level within time is the rate of
inflation.

1. Consumer price index

2. Wholesale price indexes OR Producer price indexes
3. Commodity price indexes

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 India’s Inflation Trends
The Consumer Price Index (CPI) inflation rate for October 2025 is
expected to fall to a multi-year or even a series low, projected to be in the
range of 0.4% to 0.6%.
Key factors contributing to this expected decline include:
•A favorable base effect.
•A sharp decline in food prices, particularly in vegetables like tomatoes,
onions, and potatoes.
•Moderation in global commodity prices.
•The impact of the government's Goods and Services Tax (GST) rate
rationalization.
For comparison, the provisional CPI inflation rate in September 2025 was
1.54%.
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 Basket of Goods
• Ministry of Statistics and Programme Implementation
(MOSPI) –Classifies the goods.

CPI -299 Goods in basket.

• WPI –Goods in Basket : 697 items include the primary article,

fuel, and manufactured products.

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 Measuring Inflation

• There are two common methods of measuring inflation:

• (i) by percentage change in Price Index Numbers (PIN), and

• (ii) ) by change in GNP Deflator.

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To measure inflation using a deflator, you can use the formula Inflation Rate = [(GDP Deflator for Current Year - GDP Deflator for Base Year) / GDP
Deflator for Base Year] x 100. The GDP deflator itself is calculated by dividing the economy's nominal GDP by its real GDP and multiplying by 100, which
gives a measure of price changes for all goods and services produced domestically.
How to measure inflation using the GDP deflator
Calculate the GDP Deflator for each year:
Find the Nominal GDP for the year, which is the total value of goods and services at current prices.
Find the Real GDP for the year, which is the total value adjusted for inflation (at constant prices).
Use the formula: GDP Deflator = (Nominal GDP / Real GDP) x 100.
Calculate the inflation rate:
Take the GDP deflator for the current year and the GDP deflator for the base year.
Use the formula: Inflation Rate = [(GDP Deflator for Current Year - GDP Deflator for Base Year) / GDP Deflator for Base Year] x 100.
Example
Year 1 (Base Year):
Nominal GDP = $100 billion
Real GDP = $100 billion
GDP Deflator = ($100 billion / $100 billion) x 100 = 100
Year 2:
Nominal GDP = $105 billion
Real GDP = $102 billion
GDP Deflator = ($105 billion / $102 billion) x 100 = 102.94
Inflation Rate (Year 1 to Year 2):
Inflation Rate = [(102.94 - 100) / 100] x 100 = 2.94%
Why use a deflator?
The GDP deflator provides a comprehensive measure of inflation because it includes all goods and services produced in an economy, unlike the
Consumer Price Index (CPI) which only tracks a specific basket of consumer goods.
This makes it a useful tool for understanding how prices have changed across the entire domestic economy and for seeing how much of an increase in
GDP is due to actual increased production versus just higher prices.
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Consumer Price Index (CPI)
• The CPI measures the price increases of a particular basket of goods and services.

(1) Selection of the Base Year (CPI = 100)

(2) Selection of CPI basket, Example of Consumer Basket, weightage (to measure the
importance of one item in the basket)

(3) Collection of data on prices

(4) India's CPI inflation easing to 0.4-0.6% in Oct on softer commodity prices

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 Wholesale price index (WPI)
▪Wholesale price index is a measure of changes in the prices
charged by manufacturers and wholesalers.
▪ Wholesale price indexes measure the changes in commodity prices at
a selected stage or stages before goods reach the retail level; the prices
may be those charged by manufacturers to wholesalers or by
wholesalers to retailers or by some combination of these and other
distributors.

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 Illustration
• To illustrate the measurement of inflation, let us use price index numbers in India in the first decade of the
21st century.
• The WPI (2004–05 = 100) for ‘all commodities’ increased from 143.3 in 2010–11 to 156.1 in 2011–12.

Calculate the inflation rate in the year 2011-12 from the base year
and the previous year.

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 Anticipated Or Unanticipated.
• An important distinction in the analysis of inflation is whether the price increases anticipated or
unanticipated
• Suppose that all prices are rising at 3 percent each year and everyone expects this trend to continue.
Would there be any reason to get excited about inflation?
• Would it make any difference if both the actual and the expected inflation rates were 1 or 3 or 5
percent each year?

• Economists generally believe that anticipated inflation at low rates has little effect on economic
efficiency or on the distribution of income and wealth. People would simply be adapting their
behavior to a changing monetary yardstick.

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 Unanticipated
• An unexpected jump in prices will impoverish some and enrich others.

• How costly is this redistribution? Perhaps “cost” does not describe the problem.
The effects may be more social than economic.

• An epidemic of burglaries may not lower GDP, but it causes great distress.

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 Illustration
•If your income goes up from Rs 30,000 to Rs 35,000 and
inflation is 8%, are you better or worse off?
Ans:
• Take the difference and divide by the original number
• Rs5,000/Rs30,000 = 16.7%
•You are better off because your real income has increased
by 16.7-8=8.7%

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 Inflation Types
• On the basis of rate of increase in the general price level, inflation is classified as follows.

➢Moderate inflation

➢Galloping inflation

➢Hyper inflation

➢Open and Suppressed Inflation.

➢Wage and Asset

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 Moderate Inflation
• Moderate Inflation When the general level of price rises at a moderate rate over a long period of
time, it is called moderate inflation or creeping inflation. The ‘moderate rate’ of inflation may vary
from country to country. However, a ‘single digit’ rate of annual inflation is called ‘moderate
inflation’ or ‘creeping inflation.’

• A single-digit annual inflation rates

• When prices are relatively stable, people trust money because it retains its value
from month to month and year to year
• People are confident that the relative prices of goods they buy and sell will not get
too far out of line.
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 Galloping Inflation

• Galloping Inflation - Inflation in the double-digit or triple-digit range of 10 to

200 percent per year is called galloping inflation or “very high inflation.”

• Galloping inflation is relatively common, particularly in countries suffering from weak government
,war and other economic issues.

• Galloping inflation is from 10% to 200%.

• Example : Argentina, Chile, and Brazil, had inflation rates of 50 to 700 percent per year in the 1970s and
1980s.

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 Hyper Inflation
Hyper Inflation - A price rise at more than a three-digit rate per annum
is called ‘hyper inflation’.
• ‘Hyper inflation is often defined as inflation that exceeds 50 per cent
per month
• Example : Post First world war -Germany suffered from hyper inflation in 1922
and 1923, when wholesale price index shot up by ‘100 million percent between
December 1922 and November 1923.
• Confederacy during the Civil War: People used to go to the stores with money in
our pockets and come back with food in our baskets. At the time of recession
people go with money in baskets and return with food in our pockets. Everything
is scarce except money!

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 Open and Suppressed Inflation

➢Open Inflation - When there is no control on the rising prices and prices are free to find their own
level, the inflation under this condition is called open inflation.

➢Suppressed Inflation : In spite of control measures by the government , prices do rise and inflation
does take place but at a rate lower than the potential rate in the open system. This kind of inflation is
called suppressed inflation.

• Such situation is followed by existence of scarce commodities, shadow economy etc.

• Example : For example, the 7–8 per cent inflation in India in 2008 was virtually a suppressed inflation.

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Types of Inflation…
Wage Inflation Asset Inflation
Wage inflation is when workers' pay rises fasterAsset inflation occurs in any asset class
than the cost of living. This occurs in three when the asset prices experience high
situations. First, is when there is a shortage of
levels of price rise.
workers. Second, is when labor unions negotiate Good examples are housing, oil and
ever-higher wages. Third is when workers gold.
effectively control their own pay. It is generally overlooked by the central
banks and other inflation-watchers
Of course, everyone thinks their wage increases when the overall rate of inflation is low.
are justified. But higher wages are one element But the subprime mortgage crisis and
of cost-push inflation. That can drive up the subsequent global financial crisis
prices of a company's goods and services. demonstrated how damaging unchecked
asset inflation can be.
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 Core Inflation and Super Core Inflation
• Core inflation is the change in the costs of goods and services but does not
include those from the food and energy sectors.
• Food and energy prices are exempt from this calculation because their
prices can be too volatile or fluctuate wildly.
• Core inflation is important because it's used to determine the impact of
rising prices on consumer income.
• Super Core Inflation : It is the measure of inflation calculated after
deducting the gold and silver price inflation from the core inflation.

• Why Food and Energy Prices Are Excluded

• Food and energy are staples, meaning demand for them doesn't change
much even as prices rise.
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 Inflation , Disinflation ,Deflation

• Inflation refers to a considerable and persistent increase in the general

price level.

• Disinflation means a decline in the rate of inflation.

• Deflation means a fall in the general price level below the base-year
level.

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 Nominal and Real Inflation
• Nominal and Real interest rate

• Real Interest rate =Nominal interest rate –Inflation

• Interest rates in the economy closely follow Inflation.

• Very Important for investors and borrowers.

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 Effects of Inflation on Different Sections of Society
Book –Dwivedi

• Wage Earners -Organised labour market .

• Producers :Depends on input and output prices.

• Fixed Income Class

• Borrowers and Lenders

• Government

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 Effect of Inflation on Employment

• Economic growth and employment go hand in hand.

• It may thus be construed that inflation has promotional effect on employment. It is a widely accepted
view that a moderate rate of inflation helps economic growth which creates additional
employment opportunities.

• Since inflation affects growth variables – savings, investment and profits – favourably, it affects
employment favourably too.

• The economists have found that the greater the rate of investment, the greater the rate of
employment until the economy reaches the full employment level.

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 Causes of Inflation
Cost-push inflation Built-in inflation (or
Demand-pull inflation
(or supply-shock) Anticipated inflation)
Arises when aggregate demand in an It is a type of inflation It is induced by adaptive
economy outpaces aggregate supply. It caused by large increases expectations, often linked to
involves inflation rising as real gross in the cost of important the "price/wage spiral“
domestic product rises and goods or services where It involves workers trying to
unemployment falls. This is commonly no suitable alternative is keep their wages up with
described as "too much money chasing available. prices and then employers
too few goods". Possible causes of cost- push passing higher costs on to
Possible causes of demand-pull inflation: inflation: (i) Imperfect consumers as higher prices as
(i) Excessive investment expenditures; (ii) competition; (ii) increases part of a "vicious circle.“
Excessive growth of consumption in indirect taxes. (iii)
expenditures; (iii) Low-cost loans; (iv) Tax rising factor prices;
cutting; (v) Augmentation of government (iv)rising import
expenditures vi) Increase in autonomous
Prices.
investment.
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 Demand Pull
• Increase in government spending given the tax revenue;

• Cut in tax rates without change in the government expenditure;

• Increase in autonomous investment;

• Downward shift in the saving function;

• Upward shift in export function; and

• Downward shift in the import function.

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 Cost Push –Supply Side Factors
• Wage-push Inflation : Increase in money wages causes an equal increase in the cost of
production.

• Profit-push Inflation : Supply-side factor that causes inflation is the use of

monopoly power by the monopoly and oligopolistic firms to raise their price to
enhance their profit margin

• Supply-shock Inflation : The sudden rise in the OPEC oil prices during 1970s due
to Arab-Israel war is the famous example of the supply shock. During the mid and
late 1970s, the problem of inflation had become a global phenomenon because the
OPEC had more than quadrupled the oil prices between 1972 and 1974.

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 Inflation Caused due to shifts in AD & AS

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Effects of Inflation
Redistribution Social Impact
Impact on Economy Balance
Effect of of Inflation
Inflation
• Inflation affects • Socially poor • Fall of real product bellow potential product
recipients of fixed persons suffer from • Changes in the structure of
income firstly (nominal inflation more then consumption (consumers are buying
incomes remain same rich cheaper goods)
but the real value of • In case of fixed currency exchange rate higher
income drop) exports are incited.
• Inflation affects the • Inflation deforms prices
purchasing power of • Inflation causes higher costs and makes
wages that don’t economy less efficient
follow the rise of • Creeping and anticipated inflation has
prices positive effect on economy and stimulates
• Inflation causes economic growth
diminishing value of • High inflation and not anticipated inflation are
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savings serious problems in economy. 29
 Economic impacts of inflation
1. Inflation can cause unemployment when the uncertainty of inflation leads to
• lower investment and lower economic growth in the long term.
2. Inflationary growth is unsustainable leading to a boom and bust economic cycle.
3. Inflation leads to decline in competitiveness and lower export demand, causing
• unemployment in the export sector (especially in a fixed exchange rate).
4. There is no direct link between unemployment but often we see a trade-off e.g. in
a period of strong economic growth and falling unemployment, we see a rise in
inflation.
5. A period of high and volatile inflation discourages firms from investing.
Because inflation is high, firms are less certain investment will be profitable.

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 Effects of Inflation on Different Sections of Society

• Producers : In general, product prices rise first and faster than the cost of production. Therefore, profit
margin increases and producers gain.
• The product prices rise first due to demand-pull factors such as rise in money supply, rise in income (as was
the case in India in 2007 and 2008), or supply bottlenecks. Input prices remaining the same, profit margin
increases. This creates additional demand for inputs pushing the input prices up, though at different rates and
with different time lags. During the period of inflation, there is a time-lag between the rise in
• output prices and rise in input prices,
• Fixed Income class : The people of the fixed-income category are the net losers during the periodof
inflation. The reason is that their income remains constant even during the period of inflation, but the prices
of goods and services they consume increase. As a result, the purchasing power of their income, i.e., their real
income, gets eroded in proportion to the rate of inflation. For example, suppose that a person earns a fixed
annual income of ` 100,000 and that the rate inflation is 10 per cent. It means that if he spends his total
income, he can buy goods and services worth only ` 90,000 at the prices in the current year.
• Borrowers : In general, borrowers gain and lenders lose during the period of inflation.

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 Effects of Inflation on Different Sections of Society

• Government - inflation increases revenue yields from both, the direct and indirect taxes.

• corporate income tax, revenue increases during the period of inflation on account of two factors. First, during
the period of inflation, output prices increase generally faster than the input prices. Therefore, the total profit
increases.
• Consequently, the yield from the corporate income tax increases. Even if output and input prices increase at the
same rate, the volume of nominal profit increases. This increases the tax yield.

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 Most governments want stable prices and low inflation.

• The main reasons given include the following

• Inflation causes uncertainty and stifles business investment.

• Not all incomes rise in line with inflation – the poor and those on fixed incomes suffer the most.

• In extreme cases of inflation, the function of money may break down, resulting in civil unrest.

• Inflation distorts the working of the price mechanism and is thus a market imperfection.

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 Conclusion
• A moderate rate of inflation is conducive to economic growth and that, in the short run, there is a
positive relationship between moderate rate of inflation and economic growth.

• Government should take appropriate steps to control inflation

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 Quiz 1
• Inflation encourages investment in a national economy.

• In cost-push inflation, cost rises are ‘exogenous’. What does that mean?

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 False
• Inflation tends to discourage investment in a national economy in a number of ways. This includes a

loss in confidence by both domestic and international investors

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 Measures to control Inflation

Measures to control Inflation

Monetary Policy Fiscal Policy Price Controls Supply Side Policies

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 Measures to Control Inflation

• Monetary Policy
• It forms one of the major policy to control inflation-typically by
interest rates as well as by adjusting the money supply.

• The boost in interest rate would automatically make people borrow

less and spend less, so that total demand will be curbed and that in
turn will reduce the rates.

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 Fiscal Policy

• Fiscal policies refer to government spending and taxation measures

that the government undertakes to influence the overall economic
activity.

• If the government reduces public expenditure or increases taxes,

demand would decrease, thereby easing inflationary tensions in the
economy.

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 Price Controls

• Direct government intervention through price controls is where limits

are enforced on price increases.

• These measures may provide immediate relief in periods of rising

prices but could result in shortages and other distortions in the
market if not subjected to strict control

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 Supply-Side Policies

• Supply-side policies are the policies related to an increase in the

productive capacity of an economy.

• This exercise is aimed at increasing the supply of goods and services

produced. Raising productivity and lowering unit production costs can
moderate the inflation by allowing the supply to meet the demand.

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 Business Cycle
Is the economy getting better or worse?

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 Micro vs. Macro
• Microeconomics: The study of personal, or small finances.
• Individuals, families or businesses

• Macroeconomics: The study of economic systems on a large

scale
• National or Global economies

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 What does the GDP tell us?
• If the GDP is larger than last year the economy is expanding (getting bigger)
• If the GDP is smaller, the economy is shrinking (getting smaller)
• Great Depression 1930s
• Global recession 2008
• Pandemic hit economies – 2020

[Link]
recession-since-world-war-
ii#:~:text=According%20to%20World%20Bank%20forecasts,shrink%20by%205.2%25%20this%20year.&text=That%20
would%20represent%20the%20deepest,June%202020%20Global%20Economic%20Prospects.

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 Business Cycle
• The Business Cycle allows people to understand the direction the
economy (GDP) is going (growing or shrinking) and plan
accordingly.

• The economy follows the Business Cycle regularly.

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 Phases of the Business Cycle
Expansion (Growing)
Peak (Top)
Contraction (Shrinking)
Trough (Bottom)

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 Business Cycle
Peak
Peak

Trough

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 Expansion
• During a period of expansion:
• Wages increase
• Low unemployment
• People are optimistic and spending money
• High demand for goods
• Businesses start
• Easy to get a bank loan
• Businesses make profits and stock prices increase

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 Peak
• When the economic cycle peaks:
• The economy stops growing (reached the top)
• GDP reaches maximum
• Businesses can’t produce any more or hire more people
• Cycle begins to contract

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 Contraction
• During a period of contraction:
• Businesses cut back production and layoff people
• Unemployment increases
• Number of jobs decline
• People are pessimistic (negative) and stop spending money
• Banks stop lending money

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 Trough
• When the economic cycle reaches a trough:
• Economy “bottoms-out” (reaches lowest point)
• High unemployment and low spending
• Stock prices drop

But, when we hit bottom, no where to go but up!

UNLESS….

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 Recession/Depression
• A prolonged contraction is called a recession (contraction for over
6 months)

• A recession of more than one year is called a depression

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 What keeps the Business Cycle Going?
• 4 variables cause changes in the Business Cycle:
1. Business Investment
When the economy is expanding, sales and profit keep rising, so
companies invest in new plants and equipment, creating new jobs and
more expansion. In contraction, the opposite is true

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 What Keeps the Business Cycle Going?
2. Interest Rates and Credit
Low interest rates, companies make new investments, adding jobs. When
interest rates climb, investment dries up and less job growth
3. Consumer Expectations
Forecasts of an expanding economy fuels more spending, while fear of a
recession decreases consumer spending

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 What keeps the Business Cycle Going?
4. External Shocks
External Shocks, such as disruptions of the oil supply,
wars, or natural disasters greatly influence the output
of the economy

Ex. COVID-19 to Plunge Global Economy into Worst

Recession since World War II

[Link]
covid19-economic-recession-global-compared/

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Various factors influence the business cycle. Some of them are as follows:

Consumer and Business Confidence

Confidence greatly impacts the cycle. When consumers and companies feel positive about the future, they are more inclined to
spend money and contribute to economic growth. When people lose confidence, they are less inclined to spend money, causing
the economy to stall.

Technological Advancements
Technological advancements may have a significant influence on the cycle. For example, the introduction of new technology can
boost productivity and economic growth, but the obsolescence of existing technologies might result in a drop in economic
activity.

Global Economic Conditions

Economic conditions in other countries might influence a country’s cycle of business. For example, the cycle of a country tha t
exports a lot of goods to, say, a major trade partner may be influenced by that partner’s recession.

Political Instability
War, social upheaval, and governmental changes may all have an impact on the economy.

Economic Policy
Economic policies of the government and central banks may have a significant influence on the cycle of business. Adjustments to
fiscal or monetary policy, such as changes in government expenditure, can impact economic activity.

Natural Disasters
Natural catastrophes like droughts, hurricanes and earthquakes can disrupt economic activity and affect the cycle of business.
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 Who Cares?????
• Why should you care about the business cycle and economy?

• Lots of reasons!

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 “Don’t quit that job!”
• If the economy is going into a contraction, jobs will become more
scarce. If you quit, you may not find another job!

• But, if the economy is in a period of expansion, jobs are readily

available. It may be a good time to switch careers.

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 “Should I make a big purchase?”
• Only if you know that you won’t lose your job in a contraction. So,
buy your house during an expansion.
HOWEVER,
• When the economy starts to slow down (contraction), interest
rates will decrease. Wait to buy a house until the rates drop to a
low point, if you are sure you won’t lose your job.

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 Quick Review!
• What phase of the business cycle do wages go up?
• Expansion

• What phase of the business cycle do wages go down?

• Contraction

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 Review cont.
• When are wages at their highest?
• Peak

• When are wages at their lowest?

• Trough

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 More Review
• When will borrowing decrease?
• Contraction

• When will borrowing increase?

• Expansion

• When will borrowing be at it’s lowest?

• Trough

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 Cntd.. Review!
• When will unemployment be at its lowest?
• Peak

• When will business profits be the highest?

• Peak

• When should you look for a new job?

• Expansion

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 Control Measures – Stabilization Policies

Fiscal Policy
Monetary Policy
Direct Controls

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Fiscal Policy
Recession: During a downturn, a government can use fiscal policy to stimulate demand by cutting taxes and
increasing government spending on infrastructure projects or social programs.
Expansion: To cool down an overheating economy and combat inflation, a government can decrease spending and
raise taxes to reduce the amount of money available in the economy.
Monetary Policy
Recession: The central bank can implement an expansionary policy by lowering interest rates, which encourages
borrowing and investment. Other tools include buying government securities and lowering the reserve requirements
for banks.
Expansion: To curb inflation, the central bank can enact a contractionary policy by raising interest rates, which makes
borrowing more expensive and slows down spending. The central bank can also sell securities or increase reserve
requirements.
Other control measures
Automatic Stabilizers: These are policies that automatically counteract economic fluctuations without active
intervention.
Progressive Tax System: Higher income earners pay a larger percentage of their income in taxes, which slows
spending during booms.
Unemployment Benefits: These provide income support during a recession, helping to stabilize consumption.
Regulatory Measures: Governments can implement regulations to prevent excessive speculation and ensure the
stability of the financial system.
Direct Controls: Some countries may use direct controls like price controls and rationing, although these are less
common in modern economies.
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 Thank You

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