Inflation

Inflation & Deflation impact on economy

Introduction
Prices 2010 commodity Prices 1956

Rs.15/kg

rice

0.30/kg

Rs.12/kg

wheat

0.25/kg

300/kg

almond

3/kg

8/kg

potato

0.20/kg

Inflation, is an economic concept. The effect of inflation is the prices of everything going up over the years. A movie ticket was for a few paise in my Grandfather time. Now it is worth Rs.50. My Grandfather first salary for the month was Rs.400 and over he years it has now become Rs.75,000. This is what inflation is, the price of everything goes up. Because the price goes up, the salaries go up.

If you really thing about it, inflation makes the worth of money reduce. What you could buy in my Grandfather time for Rs.10, now a days you will not be able to buy for Rs.400 also. The worth of money has reduced! If this is still not clear consider this, when my Grandfather was a kid, he used to get 50paise pocketmoney. He used to use this money to go and watch a movie (At that time you could watch a movie for 50paise!) Now, just for the sake of understanding assume that my Grandfather decided in his childhood to save 50paise thinking, that one day when he becomes big, he will go for a movie. Many years pass. The year now is 2011. My Grandfather goes to the theater and asks for a ticket. He offers the ticket-booth-guy at the theater 50paise and asks for a ticket. The ticket booth guy says, I am sorry sir, the ticket is worth Rs.50. You will not be able to even buy a paan with the 50paise!!

 The moral of the story is that, the worth of the

50paise reduced dramatically.50paise could buy a whole lot when my Grandfather was a kid.Now,50paise can buy nothing. This is inflation.

Definitions:
According to crowthers inflAtion means a state in which the value of money is fAlling i.e. prices Are rising. According to pigou inflAtion Arises when money income is expanding more than proportionate to income eArning Activity.

According to prof. sAmuelson Inflation occurs when general level of prices & cost Are rising.

2 Types of Inflation

Demand-Pull Cost-Push

Demand-Pull Inflation

This type of inflation results when the four sectors (household, business, government, and foreign) collectively try to purchase more output that the economy is capable of producing. In general, increasing aggregate demand means buyers want more production than the economy is able to provide

Demand-Pull Inflation

E1

Example: U.S. government and General Motors want to buy more steel. U.S. Steel cant meet demand at E1

Cost-Push Type of Inflation

This type of inflation occurs when the cost of using any of the four factors of production (labor, capital, land, or entrepreneurship) increases. In general, higher production cost means the economy simply can't continue to supply the same production at the same price level. If buyers want the production, they must pay higher prices.

Cost-Push Type of Inflation

E1

Workers at Ford got a pay raise. More workers want new cars, but Ford cannot make more cars, so they raise price.

What is the rate of inflation?

As we said earlier, the prices of everything goes up over time and this is called inflation. The question is: By how much do the prices go up? At what rate do the prices do up? The rate at which the prices of everything go up is called the "rate of inflation". For example, if the price of something is Rs.100 this year and next year the price becomes approximately Rs.104 then the rate of inflation is 4%. If the price of something is Rs.80 then after a year with a rate of inflation of 4% the price go up to (80 x 1.04) = 83.2
s

CONT

So, when you make an investment, make sure that your rate of return on the investment is higher than the rate of inflation in your country. In our county India, for the year 2005-2006 the rate of inflation was 4% (Which is really low and amazing!). This rate keeps changing every year. The finance minister generally gives the official statement on the inflation rate of the country for a particular year.

12

14

16

10

0
1940 1950

1960
1970

1980
1981

1982
1983 1984 1985 1990 1991 1992 1993 1994 1995 2000 2001 Inflation %

Inflation %

REASONS OF INFLATION

Lack of balance in the countrys budget Financial problems, financing the deficit of money by printing Sudden increase in production costs Significant increase in the level of energy resources Faulty structure of the economy Exported goods far exceeding imported ones Too many monopolies in the economy Imported inflation

Effect on economy as well as our self

Inflation affects you directly when you go to the grocery store but find that a hundred dollars doesn't get you the same amount as it

did last year. Many people hang on to their money & stop spending on many non-essential items because of fear. Houses & Cars begin to depreciate.

Cont
Business starts to dry up & employers find themselves cutting down on staff.
Our fixed income gets depleted & we find

ourselves having to survive on even less. The quality or standard of life that many have grown, downgrades as a direct result of inflation.

Inflation is Bad for

People on fixed incomes: welfare, retirees, college students etc. Creditors (people who lend money): being paid back in less valuable money Savers: if inflation rate is higher than the interest that they earn.
If

inflation is 3% annually, then getting 2% on your savings account is not helping

Inflation is Good for

Debtors (people in debt):

paying

back loans in less valuable money

Interest

rate on loan is 4% on money borrowed 5 years ago, but inflation running 5% bank is not happy Historically this was why farmers wanted inflationthink Populist movement and Wizard of Oz story

Owners of assets (land, homes, cars etc.):

increase

in value more than the inflation rate

Property

value is rising 20% in last 5 yrs on land I bought on Lake Michigan, but inflation is running 2.5% annually

Discussion question
Why is inflation bad?

 Unanticipated inflation is bad because it makes the economy behave like a giant casino. Gains and losses occur because of unpredictable changes in the value of money. If the value of money varies unpredictably over time, the quantity of goods and services that money will buy will also fluctuate unpredictably. Resources are also diverted from productive activities to forecasting inflation. Unanticipated inflation leads to : a) Redistribution of income, borrowers and lenders b) Too much or too little lending or borrowing

The Economic Impacts of Inflation

Redistribution of Income and wealth among different groups Distortion in relative prices and outputs of different goods, or sometimes in output and employment for the economy as a whole.

Deflation
A general decline in price often caused by a reduction in the supply of money or credit. Deflation can be caused also by decrease In government , personal or investment spending. Deflation has the side effect of increased unemployment.

Causes of deflation
Decreasing money supply.
Increasing supply of goods. Decreasing demand of goods. Increasing demand for money.

OTHER TERMS
DEFLATION - a falling in general level of prices DISINFLATION - the reduction of rate of inflation HYPERINFLATION - an out-of-control inflationary spiral STAGFLATION - high inflation combined with economic stagnation and unemployment

Fishers Theory
Higher inflation leads to similarly higher nominal interest rates When inflation rate increases by 1%, nominal interest rate is also about 1 percentage higher Real interest rates do not change much

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