15B11HS211 Economics
Inflation
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Second Semester
2017
15B11HS211 Economics
Definition
• Inflation is a state of persistent rise in prices
this does not mean that all prices must be rising during a
period of inflation –some prices may even be falling; but
the general trend must be upward
It is a process of rising prices & not a state of high prices
15B11HS211 Economics
Measuring Inflation
• Inflation is the rate of change in the price level
• If the price level in the current year is ‘P1’ & in the
previous year is ‘Po’, then inflation for the current year is
(P1 – Po)/ Po x 100
15B11HS211 Economics
Inflation Measures
• Inflation is usually measured based on
certain indices.
• Broadly, there are two categories of
indices for measuring inflation i.e.
Wholesale Prices Index
Consumer Prices Index
15B11HS211 Economics
Types of Inflation according to its pace:
• MODERATE INFLATION – occurs when prices are rising
slowly (we might classify this as single-digit annual
inflation rates è0-10 % per year)
• GALLOPING INFLATION - occurs when prices start
rising at double-or-triple digit rates (20, 100 % a year)
• HYPERINFLATION – the extraordinary price increase (at
annual rate of 100 % or more prevailing in a nation for at
least one year)
15B11HS211 Economics
Causes and Theories of Inflation
• Some economists assert that inflation is caused by
increase in demand in a situation of given aggregate
supply →demand pull inflation
According to classical economists, the increase in
demand is caused by an increase in money supply
According to Keynes it is increase in total spending
& not in money supply which is responsible for
increase in demand
• A group of economists contend that inflation is caused by
an increase in cost of production that results in a fall in
aggregate supply →cost-push inflation
• Others believe that inflation results from an
amalgamation of demand & cost elements → mixed
inflation
15B11HS211 Economics
The two main Causes of inflation
The Demand-Pull inflation → originates from demand side
of the economy
• A sustained rise in the price level caused by increases
in aggregate demand.
• If aggregate monetary demand for domestic output
exceeds the value of the full employment output at
current prices, then the price level will rise
The Cost-Push inflation → originates from supply side of
the economy
• An increase in production costs leading to an increase in
prices
• It is caused by rising cost of production independently of the
excess demand in the market
15B11HS211 Economics
Demand Pull Inflation
– Demand –pull inflation –When there is excess
AD for goods and services
–Since supply can’t match in the short run,
businesses respond by raising prices to
increase their profit margins
–Demand-pull inflation associated with the boom
phase of the cycle
15B11HS211 Economics
So, what causes it?
• A reduction in direct or indirect taxation. If direct
taxes are reduced consumers will have more
disposable income causing demand to rise
• Rapid growth of the money supply as a
consequence of increased borrowing
• Rising consumer confidence and an increase in the
rate of growth of house prices
• Faster economic growth in other countries
15B11HS211 Economics
Cost push inflation
•Leads to inward shift in Supply Curve
•Firms raise prices to protect their profit margins –better
able to do this when demand is price inelastic
•“Wages often follow prices”
• Causes:–External shocks (commodity price fluctuations)
–A depreciation in the exchange rate
–Acceleration in wages / unit labour costs
15B11HS211 Economics
Deflation
• A sustained decrease in the price level.
• Deflation is a contraction in the supply of
circulated money within an economy, and
therefore the opposite of inflation.
Disinflation
A reduction in the rate of inflation.
15B11HS211 Economics
Reflation
It is a moderate degree of inflation that is
deliberately undertaken to relieve depression
Stagflation
It a situation in which a high rate of inflation
prevails simultaneously with a high rate of
unemployment or stagnant economic condition.
It is a combination of inflation & stagnation
15B11HS211 Economics
Policies to reduce inflation
1. Monetary policy
2. Fiscal policy
15B11HS211 Economics
1. Monetary Policy
• Monetary policy is the most important tool for
maintaining low inflation.
• Aim is to reduce money supply through higher interest
rate and hence reduce inflation.
• Higher interest rates reduce consumer spending
because:
– It increases the cost of borrowing, discouraging consumers
from borrowing and spending.
– It makes ‘savings’ more attractive
– It reduces the disposable income of those with mortgages.
– It increases the value of the exchange rate leading to lower
exports and more imports.
15B11HS211 Economics
2. Fiscal policy
Fiscal policy is the means by which a government
adjusts its spending levels and tax rates to monitor
and influence a nation's economy.
In case of inflation government uses fiscal policy in
following ways-
• Increase taxes to suck money out of economy
• Reduce government spending to reduce money in
circulation