Inflation Dynamics

Dr.Mrutyunjay Dash
Few words about inflation…

It is a process in which the general price level in a country

records a sustained and appreciable increase over a period of
time.
The increase is significant or appreciable. Slow rate of
increase [less than 2 % per annum] is considered with price
stability.
It has a time dimension/over a period of time generally taken
as one year.
It is a key indicator of the state of business environment and
economic performance.
Consumer Price Index (CPI):
It measures the cost of buying a standard basket of goods
and services at different points of time.
The standard basket is constituted to represent as closely
as possible the consumption pattern of the population.
It may include food and clothing, housing, entertainment,
electricity, fuel, and other common items of consumption in
day-to-day life.
Weights are to be given to each item for calculating
weighted average.
How the weight is decided?
Based on the proportion of the item in the total consumer
expenditure on the basket.
How to find out the proportion?
Extensive household surveys are conducted.
Calculation of Inflation Rate based on CPI
Pdt.Group Share in Basket Price Index Weighted Index
Expenditure 2002 2003

Food 0.10 100 110 11

Clothing 0.05 100 100 05
Housing 0.25 100 120 30
Fuel 0.10 100 110 11
Transportation 0.20 100 115 23
Education 0.30 100 125 38
Total 100 118
GDP Deflator: It is the numerical factor by which GDP value
at current prices discounted so that the impact of increased
prices in the valuation of GDP is removed and the real GDP
figure is arrived at.
GDP Rs 300bn -2002 ---Rs 390bn---2003
The general price level rises -20%
2002-Base year
Price index in 2002-100 ----120---2003
GDP Deflator 120/100=1.2
Real or inflation –adjusted GDP value for 2003
390/1.2=325bn
In nominal terms GDP rises by 30%[300-390]
But in real terms it is 8.3% [300-325]
Real GDP=Nominal GDP/GDP Deflator
Or GDP Deflator =Nominal GDP/Real GDP
Demand-Pull Inflation:
Inflation is caused by an excess of demand or spending
relative to the available supply of goods and services at
existing prices.
Inflationary Gap: As an excess of anticipated expenditures
over available output at base prices. This inflationary gap
measures the extent of excess demand.
Total output: Rs 3000 crores/ available for consumption in
exchange of money income.
If the economy injects Rs 5000 crores.
Tax paid Rs 800 crores
Net disposable income:Rs 4200 crores
Then the inflationary gap would be Rs 1200 crores.
How the inflationary gap can be bridged?
Increased Tax:
If 20%, then Net disposable income would be 4000.
[5000-20 % 5000]
Inflationary gap would be reduced by Rs 200 crores.
Increased Saving:
If 15% is saved then Net disposable income would be
4000-15% of 4000=Rs 3400
Inflationary gap would be further reduced to 3400-
3000=400
Increased Supply:
Existing supply can be increased to bridge the gap.
Inflation is a continual increase in the overall level of
prices. It is an increase in average prices that lasts at
least a few months. The most widely reported
measurement of inflation is the consumer price index
(CPI). The CPI compares the prices of a set of goods
and services relative to the prices of those same
goods and services in a previous month or year.
Changes in the prices of those goods and services
approximate changes in the overall level of prices
paid by consumers.
The core consumer price index is the average price of
the same set of goods and services, without including
food and energy prices, relative to the price of the set
without food and energy prices in a previous month
or year.
How the CPI is Calculated
 Assume that there are only three goods (instead of goods and services in
over 200 categories in the actual calculation) included in the typical
consumer's purchases and, in the base or the original year, the goods had
prices of $10.00, $20.00, and $30.00. The typical consumer purchased ten
of each good.
 In the current year, the goods' prices are $11, $24, and $33. Consumers
now purchase 12, 8, and 11 of each good.
 The CPI for the current year would be the quantities purchased in the
market basket in the base year (ten of each good) times their prices in the
current year divided by the quantities purchased in the market basket in the
base year times their prices in the base year.
 Thus [(10 x $11) + (10 x $24) + (10 x $33)] / [( 10 x $10) + (10 x $20) +
(10 x $30)] = $680 / $600 = 1.133. That is, prices in the current year are
1.133 times the prices in the original year. Prices have increased on average
by 13.3 percent. The quantities are the base year quantities in both the
numerator and the denominator.
 By convention, the indexes are multiplied by 100 and reported as 113.3
instead of 1.133.
 The base year index simply divides the prices in the base year (times the
quantities in the base year) by the prices in base year (times the quantities
in the base year). The base-year index then is 1.00; or multiplied by 100
equals 100.
Causes of Inflation
 Over short periods of time, inflation can be caused by
increases in costs or increases in spending. Inflation
resulting from an increase in aggregate demand or total
spending is called demand-pull inflation . Increases in
demand , particularly if production in the economy is near
the full-employment level of real GDP, pull up prices. It is
not just rising spending. If spending is increasing more
rapidly than the capacity to produce, there will be upward
pressure on prices.
 Inflation can also be caused by increases in costs of major
inputs used throughout the economy. This type of inflation
is often described as cost-push inflation . Increases in costs
push prices up. The most common recent examples are
inflationary periods caused largely by increases in the
price of oil. Or if employers and employees begin to expect
inflation, costs and prices will begin to rise as a result.
 Over longer periods of time, that is, over periods of
many months or years, inflation is caused by growth
in the supply of money that is above and beyond the
growth in the demand for money.
 Inflation, in the short run and when caused by
changes in demand, has an inverse relationship with
unemployment. If spending is rising faster than
capacity to produce, unemployment is likely to be
falling and demand-pull inflation increasing. If
spending is rising more slowly than capacity to
produce, unemployment will be rising and there will
be little demand-pull inflation.
 That relationship disappears when inflation is
primarily caused by increases in costs.
Unemployment and inflation can then rise
simultaneously.
Costs of Inflation
 Understanding the costs of inflation is not an easy task.
There are a variety of myths about inflation. There are
debates among economists about some of the more serious
problems caused by inflation.
 High rates of inflation mean that people and business have
to take steps to protect their financial assets from inflation.
The resources and time used to do so could be used to
produce goods and services of value. Those goods and
services given up are a true cost of inflation.
 High rates of inflation discourage businesses planning and
investment as inflation increases the difficulty of forecasting
of prices and costs. As prices rise, people need more dollars
to carry out their transactions. When more money is
demanded, interest rates increase. Higher interest rates can
cause investment spending to fall, as the cost of investing
increases. The unpredictability associated with fluctuating
interest rates makes customers less likely to sign long-term
contracts as well.
 The adage "inflation hurts lenders and helps borrowers" only
applies if inflation is not expected. For example, interest rates
normally increase in response to anticipated inflation. As a
result, the lenders receive higher interest payments, part of
which is compensation for the decrease in the value of the
money lent. Borrowers have to pay higher interest rates and
lose any advantage they may have from repaying loans with
money that is not worth as much as it was prior to the
inflation.
 Inflation does reduce the purchasing power of money.
 Inflation does redistribute income. On average, individuals'
incomes do increase as inflation increases. However, some
peoples' wages go up faster than inflation. Other wages are
slower to adjust. People on fixed incomes such as pensions
or whose salaries are slow to adjust are negatively affected
by unexpected inflation.
 Economists define the approximate unemployment
rate, at which there are not upward or downward
pressures on wages and price, as full employment rate
of unemployment.
 If unemployment falls to level below the full
employment rate, there will be upward pressure on
wages and prices. If unemployment rises to a very
high rate, there will downward pressure on wages and
prices or wages and prices will remain steady. In the
middle is a level, or more likely a range, where there is
not pressure on wages and prices to rise or fall.
 Economists do not know for certain what that
unemployment rate is, and even if they did, it does
change over time. A current consensus estimate is
that the full employment rate of unemployment is
currently between 4.0 and 4.7 or 4.8 percent of the
labor force being unemployed. That is if
unemployment were to fall to 4.0 percent of the
labor force or below, there will increased upward
pressure on wages and that may cause prices to
begin to increase.
 If unemployment were 6.0 percent, workers
competing for jobs may cause wages to fall. Costs of
producing fall and prices may fall. Or at least not
increase as rapidly.