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Unit 6 - Notes

ECO113

Unit 6: Inflation

1. Concept of Inflation

Definition

Inflation is defined as a sustained increase in the general price level of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation reflects a reduction in the purchasing power per unit of money.

Key Characteristics

  • Process, not an event: It is a continuous rise in prices, not a one-time jump.
  • General Price Level: It refers to the rise in prices of most goods and services, not just a specific item (like onions or fuel).
  • Monetary Phenomenon: It is generally associated with an excessive supply of money relative to the supply of goods.

Types of Inflation (Based on Rate)

  1. Creeping Inflation: Mild inflation (up to 3% per year). Generally considered good for economic growth as it encourages production.
  2. Walking/Trotting Inflation: Prices rise moderately (3% to 10%). A warning signal to the government.
  3. Running/Galloping Inflation: Prices rise rapidly (10% to 20% or more). This destabilizes the economy.
  4. Hyperinflation: Prices skyrocket (over 50% per month). The currency becomes worthless (e.g., Germany in 1923, Zimbabwe in 2008).

Related Concepts

  • Deflation: A sustained decrease in the general price level (negative inflation).
  • Disinflation: A reduction in the rate of inflation (prices are still rising, but slower than before).
  • Stagflation: A situation of high inflation combined with high unemployment and stagnant demand.

2. Causes of Inflation

Economists generally categorize the causes of inflation into two main theories: Demand-Pull and Cost-Push.

A. Demand-Pull Inflation

This occurs when the aggregate demand for goods and services exceeds the aggregate supply at the current price level. It is often described as "too much money chasing too few goods."

Factors contributing to Demand-Pull:

  1. Increase in Money Supply: If the central bank prints more money, people have more cash to spend, driving up demand.
  2. Increase in Public Expenditure: High government spending on infrastructure or welfare increases household income and demand.
  3. Tax Reductions: Lower taxes increase disposable income, leading to higher consumption.
  4. Population Growth: More people leads to higher demand for essential goods.
  5. Export Boom: If a country exports heavily, domestic supply decreases while foreign income flows in, raising prices.

B. Cost-Push Inflation

This occurs when the costs of production increase, causing producers to raise prices to maintain profit margins. This affects the supply side.

Factors contributing to Cost-Push:

  1. Wage-Push: Strong trade unions may demand higher wages. If wage growth exceeds productivity growth, production costs rise.
  2. Profit-Push: Monopolistic firms may arbitrarily raise prices to increase profit margins.
  3. Raw Material Costs: An increase in the price of key inputs (e.g., oil shocks, electricity, imported components) raises the cost of all finished goods.
  4. Supply Shocks: Natural disasters, wars, or pandemics that disrupt the supply chain.

3. Measurement of Inflation

Inflation is measured using price indices. The three primary methods are CPI, PPI, and the GDP Deflator.

A. Consumer Price Index (CPI)

Measures the weighted average of prices of a basket of consumer goods and services (e.g., transportation, food, medical care) purchased by households.

  • Focus: Cost of living for the average consumer.
  • The Basket: A fixed list of goods representing average consumption patterns.
  • Calculation:

MATH
CPI = \left( \frac{\text{Cost of Basket in Current Year}}{\text{Cost of Basket in Base Year}} \right) \times 100

  • Inflation Rate Formula using CPI:

B. Producer Price Index (PPI)

Measures the average change over time in the selling prices received by domestic producers for their output.

  • Focus: Cost of production/wholesale level.
  • Difference from CPI: PPI measures price changes before they reach the consumer. It is often considered a leading indicator of CPI (if production costs rise, consumer prices usually follow).
  • Components: Includes raw materials, intermediate goods, and finished goods.

C. GDP Deflator

A measure of the level of prices of all new, domestically produced, final goods and services in an economy.

  • Focus: The entire economy (broadest measure).
  • Difference from CPI:
    • CPI uses a fixed basket of goods; GDP deflator allows the basket to change as the composition of GDP changes.
    • CPI includes imported goods; GDP deflator only includes domestic goods.
  • Calculation:

MATH
\text{GDP Deflator} = \left( \frac{\text{Nominal GDP}}{\text{Real GDP}} \right) \times 100

4. Control of Inflation (Solutions)

Controlling inflation requires a mix of Monetary, Fiscal, and other measures.

A. Monetary Policy (Central Bank Actions)

The Central Bank (e.g., Federal Reserve, RBI, ECB) manages money supply and interest rates to control inflation.

  1. Bank Rate / Repo Rate Policy: Raising interest rates makes borrowing expensive for commercial banks and consumers. This reduces money supply and dampens demand.
  2. Open Market Operations (OMO): The Central Bank sells government securities (bonds) in the open market. This sucks liquidity (cash) out of the banking system.
  3. Variable Reserve Ratios (CRR/SLR):
    • Cash Reserve Ratio (CRR): Increasing the percentage of deposits banks must keep with the Central Bank leaves less money for lending.
    • Statutory Liquidity Ratio (SLR): Increasing the amount of liquid assets banks must hold restricts lending capacity.
  4. Credit Control: Setting limits on the amount of loans banks can offer for specific purposes.

B. Fiscal Policy (Government Actions)

The government adjusts its spending and taxation levels.

  1. Reduction in Public Expenditure: Cutting spending on non-essential projects reduces the flow of money into the economy.
  2. Increase in Taxes: Raising direct taxes (Income Tax) reduces disposable income, thereby lowering consumption. Raising indirect taxes (VAT/GST) is usually avoided during inflation as it increases prices further.
  3. Public Debt Management: The government borrows more from the public (issuing bonds) to reduce the money supply in the hands of the public.
  4. Surplus Budget: Planning a budget where revenue exceeds expenditure.

C. Other Measures (Direct Action)

  1. Price Controls: Government sets a "price ceiling" for essential commodities (e.g., food, fuel).
  2. Rationing: Distributing scarce goods through fair price shops to prevent hoarding.
  3. Wage Freeze: Limiting wage hikes to prevent the wage-price spiral.
  4. Increasing Production: Incentivizing the production of essential goods to match demand.

5. Inflation Targeting

Concept

Inflation Targeting is a monetary policy framework where the Central Bank acknowledges that its primary goal is to maintain price stability. The bank publicly announces a specific target rate of inflation (e.g., 2% or a range like 2%–6%) and attempts to steer actual inflation toward that target.

The Framework

  1. Public Announcement: The government and Central Bank agree on a numerical target for inflation (usually measured by CPI).
  2. Institutional Commitment: Price stability becomes the primary objective of monetary policy.
  3. Information Inclusive Strategy: The Central Bank uses many variables (not just monetary aggregates) to decide on interest rates.
  4. Transparency and Accountability: The Central Bank must explain its decisions to the public and is held accountable if the target is missed.

Mechanism

  • If Inflation > Target: The Central Bank raises interest rates (tightens policy) to cool down the economy.
  • If Inflation < Target: The Central Bank lowers interest rates (loosens policy) to stimulate spending.

Advantages

  • Clarity: Provides a clear anchor for inflation expectations. Businesses and consumers can plan better.
  • Transparency: Reduces uncertainty in the financial markets.
  • Discipline: Prevents politicians from pressuring the Central Bank to print money for short-term gains (Election cycles).

Disadvantages

  • Rigidity: Focusing strictly on inflation might cause the Central Bank to ignore other important issues like unemployment or GDP growth.
  • Time Lag: Monetary policy takes time to work (6–18 months); targeting current inflation based on past data can be difficult.
  • Supply Shocks: It is ineffective against cost-push inflation (e.g., oil price hike) where raising interest rates hurts growth without lowering prices immediately.