INFLATIONINFLATION

WHAT IS INFLATION ?WHAT IS INFLATION ?

• InflationInflation is a rise in general level of is a rise in general level of prices of goods and services in the prices of goods and services in the country over a period of time.country over a period of time.

• As the cost of goods and services As the cost of goods and services increase, the value of a currency increase, the value of a currency declines because you won't be able to declines because you won't be able to purchase as much with that currency as purchase as much with that currency as you could have last month or last year.you could have last month or last year.

HOW IS INFLATION HOW IS INFLATION MEASURED ?MEASURED ?

• Wholesale Price Index ( WPI )Wholesale Price Index ( WPI )

• Consumer Price Index ( CPI )Consumer Price Index ( CPI )

• GDP DeflatorGDP Deflator

WHOLESALE PRICE INDEXWHOLESALE PRICE INDEX

The The Wholesale Price IndexWholesale Price Index (WPI) was (WPI) was first published in first published in 19021902. It consists of over . It consists of over 2,400 commodities.2,400 commodities.

The The Wholesale Price IndexWholesale Price Index or WPI is the price or WPI is the price of a representative basket of wholesale goods. of a representative basket of wholesale goods.

The Wholesale Price Index focuses on the price of The Wholesale Price Index focuses on the price of goods traded between corporations.goods traded between corporations.

CONSUMER PRICE INDEXCONSUMER PRICE INDEX

CPI is a measure of a weighted average of prices CPI is a measure of a weighted average of prices of a specified set of goods and services of a specified set of goods and services purchased by consumers. purchased by consumers.

It is a price index that tracks the prices of a It is a price index that tracks the prices of a specified basket of consumer goods and services, specified basket of consumer goods and services, providing a measure of inflation.providing a measure of inflation.

Most developed countries uses this index.Most developed countries uses this index.

WEIGHT EDGE TO WPI WEIGHT EDGE TO WPI AND CPIAND CPI

GDP DEFLATORGDP DEFLATOR

GDP Deflator refers to the ratio GDP Deflator refers to the ratio between GDP at current prices and between GDP at current prices and GDP at constant prices.GDP at constant prices.

GDP Deflator =GDP Deflator =

CLASSIFICATION OF INFLATIONCLASSIFICATION OF INFLATION

CORE INFLATIONCORE INFLATIONHEADLINE INFLATIONHEADLINE INFLATION

CAUSES OF INFLATIONCAUSES OF INFLATION

•Demand Pull InflationDemand Pull Inflation

•Cost Push InflationCost Push Inflation

DEMAND PULL INFLATIONDEMAND PULL INFLATION

Demand-pull inflation is an inflation that results from an initial increase in aggregate demand.

• Demand-pull inflation in short runDemand-pull inflation in short run

• Demand-pull inflation in long runDemand-pull inflation in long run

DEMAND-PULL INFLATION IN DEMAND-PULL INFLATION IN SHORT RUNSHORT RUN

In the above diagram AD shifts to AD’ because In the above diagram AD shifts to AD’ because of increase in demand & that result in of increase in demand & that result in increase of price level from P to P’ & increase of increase of price level from P to P’ & increase of real GDP from Y to Y’ . real GDP from Y to Y’ .

DEMAND-PULL INFLATION IN DEMAND-PULL INFLATION IN LONG RUNLONG RUN

• Starting from full employment, an increase in aggregate demand shifts the AD curve rightward.

• Real GDP increases, the price level rises.

• The higher level of output means that real GDP exceeds potential GDP.

• The SRAS curve shifts leftward.

• Real GDP decreases back to potential GDP but the price level rises further.

• Aggregate demand keeps increases and the process just described repeats indefinitely.

• Demand-pull inflation occurred in the United States during the late 1960s and early 1970s.

COST PUSH INFLATIONCOST PUSH INFLATION

Cost-push inflation develops because the higher Cost-push inflation develops because the higher costs of production factors decreases in costs of production factors decreases in aggregate supply ( the amount of total aggregate supply ( the amount of total production ) in the economy.  Because there  production ) in the economy.  Because there  are fewer goods being produced (supply are fewer goods being produced (supply weakens)  and demand for these goods remains weakens)  and demand for these goods remains consistent, the prices of finished goods consistent, the prices of finished goods increase (inflation)increase (inflation)

There are two main sources of increased costs• An increase in the money wage rate• An increase in the money price of raw materials,

such as oil.

COST PUSH INFLATION IN COST PUSH INFLATION IN SHORT RUNSHORT RUN

In the above diagram SRAS shifts to SRAS’ In the above diagram SRAS shifts to SRAS’ because of decrease in supply & that result because of decrease in supply & that result in increase of price level from P to P’ & in increase of price level from P to P’ & decrease of real GDP from Y to Y’ .decrease of real GDP from Y to Y’ .

COST PUSH INFLATION IN COST PUSH INFLATION IN LONG RUNLONG RUN

• A rise in the price of goods decreases short-run aggregate supply and shifts the SRAS curve leftward.

• Real GDP decreases and the price level rises a combination called stagflation.

• The initial increase in costs creates a one-time rise in the price level, not inflation. To create inflation, aggregate demand must increase.

• The increase in aggregate demand shifts the AD curve rightward. Real GDP increases and the price level rises again.

• Cost-push inflation occurred in the United States during 1974–1978.

EFFECT OF INFLATIONEFFECT OF INFLATION• Effect on Economic DevelopmentEffect on Economic Development : Rapid rise in : Rapid rise in

prices is detrimental to the process of growth and prices is detrimental to the process of growth and development as, it adversely impacts the rate of development as, it adversely impacts the rate of saving and investment.saving and investment.

• Effect on Foreign InvestmentEffect on Foreign Investment : Price rise has an : Price rise has an adverse effect on the foreign investment in the adverse effect on the foreign investment in the country. Foreign investors do not invest in those country. Foreign investors do not invest in those countries where the value of money tends to countries where the value of money tends to constantly eroding.constantly eroding.

• Adverse Effect on the People with Fixed IncomeAdverse Effect on the People with Fixed Income : : Price rise has an adverse effect on the people Price rise has an adverse effect on the people with fixed income. On account of rise in price with fixed income. On account of rise in price level, the real value of their monetary income level, the real value of their monetary income goes down. They can buy less goods than before. goes down. They can buy less goods than before. Their standard of living fallsTheir standard of living falls

• Increase in CostIncrease in Cost : Cost of projects (both private & : Cost of projects (both private & public sector) tends to ramp up due to rise in public sector) tends to ramp up due to rise in prices. As a result, plan layouts had to frequently prices. As a result, plan layouts had to frequently revised to achieve the stipulated targets. revised to achieve the stipulated targets. However, when the planners fail to find additional However, when the planners fail to find additional resources, plan targets are to be sacrificed.resources, plan targets are to be sacrificed.

• Adverse Impact on Balance of PaymentsAdverse Impact on Balance of Payments : Owing : Owing to inflation, exports become expensive. Domestic to inflation, exports become expensive. Domestic goods lose their competitiveness in the goods lose their competitiveness in the international market. Exports, therefore, tend to international market. Exports, therefore, tend to fall. On the other hand, imports tend to become fall. On the other hand, imports tend to become relatively cheaper. Accordingly, balance of trade, relatively cheaper. Accordingly, balance of trade, and therefore, balance of payments tend to and therefore, balance of payments tend to become unfavorable .become unfavorable .

• InequalityInequality : A situation of consistent rise in the : A situation of consistent rise in the price level tends to aggravate inequality in the price level tends to aggravate inequality in the distribution of income & wealth. Often, it is distribution of income & wealth. Often, it is observed that during inflation profits tend to rise observed that during inflation profits tend to rise faster than wages. Accordingly, while the faster than wages. Accordingly, while the capitalists accumulate wealth and capital, the capitalists accumulate wealth and capital, the proletariats suffer deprivation. proletariats suffer deprivation.

POLICY OF GOVERNMENT TO POLICY OF GOVERNMENT TO CHECK INFLATIONCHECK INFLATION

• Monetary Policy Monetary Policy

• Fiscal PolicyFiscal Policy

• Price PolicyPrice Policy

MONETARY POLICYMONETARY POLICY

Monetary policy refers to that policy Monetary policy refers to that policy through which the government or Reserve through which the government or Reserve Bank of India controls the supply of Bank of India controls the supply of money , availability of money and the money , availability of money and the rate of interest in order to attain a set of rate of interest in order to attain a set of objectives focusing on the price stability and objectives focusing on the price stability and economic growth of the country. Monetary economic growth of the country. Monetary measures focuses on controlling the supply measures focuses on controlling the supply of money as the most patent means of of money as the most patent means of checking inflation.checking inflation.

Instrument of Monetary Instrument of Monetary PolicyPolicy

• Bank RateBank Rate

• Open Market OperationOpen Market Operation

• Cash Reserve RatioCash Reserve Ratio

• Statutory Liquidity RatioStatutory Liquidity Ratio

Bank RateBank Rate

Rate of interest or rate of discount Rate of interest or rate of discount that the Reserve Bank charges from that the Reserve Bank charges from the member bank on the loans given the member bank on the loans given to them is called bank rate. to them is called bank rate.

Open Market OperationsOpen Market Operations

Open market operations is yet Open market operations is yet another technique adopted by the another technique adopted by the Reserve Bank for quantitative Reserve Bank for quantitative credit control. This means that the credit control. This means that the bank controls the flow of credit bank controls the flow of credit through the sale and purchase of through the sale and purchase of government securities in the open government securities in the open market. market.

Cash Reserve RatioCash Reserve Ratio

The Cash Reserve Ratio (CRR) The Cash Reserve Ratio (CRR) refers to this liquid cash that banks refers to this liquid cash that banks have to maintain with the Reserve have to maintain with the Reserve Bank of India (RBI) as a certain Bank of India (RBI) as a certain percentage of their demand and percentage of their demand and time liabilities. time liabilities.

Statutory Liquidity RatioStatutory Liquidity Ratio

Statutory Liquidity Ratio (SLR) is a term used Statutory Liquidity Ratio (SLR) is a term used in the regulation of banking in India. It is in the regulation of banking in India. It is the amount which a bank has to the amount which a bank has to maintain in the form of cash , gold or maintain in the form of cash , gold or approved securities.approved securities.

FISCAL POLICYFISCAL POLICY

Fiscal policy  is the means by which Fiscal policy  is the means by which a government adjusts its levels a government adjusts its levels of spending in order to monitor of spending in order to monitor and influence a nation's economy. and influence a nation's economy.

Instrument of Fiscal PolicyInstrument of Fiscal Policy

• Taxation PolicyTaxation Policy

• Government Expenditure PolicyGovernment Expenditure Policy

• Deficit FinancingDeficit Financing

Taxation PolicyTaxation Policy

Taxation forces the people to save for Taxation forces the people to save for the government. The government the government. The government uses taxation as a powerful uses taxation as a powerful instrument to increase or instrument to increase or decrease the real purchasing decrease the real purchasing power of the people. power of the people.

Government Expenditure Government Expenditure PolicyPolicyAggregate demand is influenced by Aggregate demand is influenced by

government expenditure. On account government expenditure. On account of increase in public ( government ) of increase in public ( government ) expenditure there is increase in expenditure there is increase in aggregate demand and vice versa. aggregate demand and vice versa. Public expenditure can be of two Public expenditure can be of two types:types:

• Public expenditure incurred to buy goods Public expenditure incurred to buy goods & services& services

• Public expenditure incurred on transfer Public expenditure incurred on transfer paymentspayments

Deficit FinancingDeficit Financing

It refers to financing of the deficit in It refers to financing of the deficit in government budget. When the government budget. When the government meets its budgetary deficit government meets its budgetary deficit by borrowing from the Central Bank, it is by borrowing from the Central Bank, it is called deficit financing.called deficit financing.

PRICE POLICYPRICE POLICY

Price policy refers to the policy Price policy refers to the policy of directing, regulating and of directing, regulating and controlling the relative price controlling the relative price structure of the economy in such a structure of the economy in such a manner that it favorably impacts manner that it favorably impacts the macro economic parameters the macro economic parameters like ; consumption , saving, like ; consumption , saving, investment, production, etc.investment, production, etc.

Instrument of Price PolicyInstrument of Price Policy

• Price controlPrice control

• Administered priceAdministered price

• Procurement price Procurement price

• Support priceSupport price

• Dual pricingDual pricing

Price ControlPrice Control

Prices of certain essential goods Prices of certain essential goods are controlled with a view to are controlled with a view to ensuring their availability to ensuring their availability to vulnerable sections of the society . vulnerable sections of the society .

Administered priceAdministered price

In case of certain public sector enterprises In case of certain public sector enterprises and departmental undertakings, producing and departmental undertakings, producing goods & services of intermediate goods & services of intermediate consumption, policy of ‘administered consumption, policy of ‘administered price’ is pursued as an instrument of price price’ is pursued as an instrument of price policy.policy.

Procurement priceProcurement price

It refers to price fixed by the government at It refers to price fixed by the government at which it procures a part of the farmer’s which it procures a part of the farmer’s produce to run its PDS (Public produce to run its PDS (Public Distribution System).Distribution System).

Support priceSupport price

Support price is that price which is offered Support price is that price which is offered by the government to the farmers for by the government to the farmers for the purchase of their surplus output.the purchase of their surplus output.

Dual pricingDual pricing

Dual pricing is another important instrument Dual pricing is another important instrument of price policy in India. It implies sale of of price policy in India. It implies sale of certain commodities (like kerosene oil at certain commodities (like kerosene oil at present, and cement and sugar in the present, and cement and sugar in the recent past) at the controlled price to recent past) at the controlled price to vulnerable sections of the society and at vulnerable sections of the society and at the open market price to the others.the open market price to the others.

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