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13, 2010INFLATIONARY INCIDENCE ON CONSUMER EQUILIBRIUM

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Lovely professional University

TERM PAPER

OF

MANAGERIAL ECONOMIES

TOPIC: INFLATIONARY INCIDENCE ON CONSUMER

EQUILIBRIUM.

SUBMITTED TO- SUBMITTED BY -

Mr. Ashish Sharma Manoj Kumar

ROLL NO. A19 (S1002)

REG. NO. 11003310

Date


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Acknowl dg m nt 3Introduction 4-10Objecti es of Stud 11Review ofLiterature 12-15Anal sis 16-17Methodolog 18Conclusion 19Bibliography 20


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ACKNOWLE MENT

It has been a great challenge but a plenty of learning and opportunities to gain huge

knowledge on the way preparing this term paper. I would not succeed without myteacher andmy friends .

Mr. ASHISH SHARMA who seemed to be with me always; and prepared to give me

feedback and guidelines whenever I needed it.

Thank You

SIR!

I hope we will find my working as interesting and knowledge earning. And it will be useful

for others wanting to learn aboutthe Inflationaryincidence on consumer equilibriu m.


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INTRODUCTION

B inf lation one generally means rise in prices. To be more correct inflation is persistent rise

in the general price le el rather than a once-for-all rise in it, while deflation is persistent

falling price. A situation is described as inflationary when either the prices or the supply ofmoney are rising, but in practice both will rise together. These days economies of all

countries whether underde eloped, de eloping as well de eloped suffers from inflation.

Inflation or persistent rising prices are major problem today in world. Because ofmany

reasons, first, the rate of inflation these years are much high than experienced earlier periods.

Second, Inflation in these years coexists with high rate of unemployment, which is a new

phenomenon and made it difficult to control inflation.

An inflationary situation is where there is too much money chasing too few goods. As

products/ser ices are scarce in relation to the money a ailable in the hands of buyers, prices

of the products/ser ices rise to adjust for the larger quantum of money chasing them.

Inflation is no stranger to the Indian economy. The Indian economy has been registering

stupendous growth after the liberalization of Indian economy. In fact, till the early nineties

Indians were used to ignore inflation. But, since the mid-nineties controlling inflation has

become a priority. The natural fallout of this has been that we, as a nation, ha e become

irtually intolerant to inflation. The opening up of the Indian economy in the early 1990s had

increased Indias industrial output and consequently has raised the India Inflation Rate. While

inflation was primarily caused by domestic factors (supply usually was unable to meet

demand, resulting in the classical definition of inflation of too much money chasing too fewgoods), today the situation has changed significantly.

Inflation today is caused more by global rather than by domestic factors. Naturally, as the

Indian economy undergoes structural changes, the causes of domestic inflation too ha e

undergone tectonic changes. The main cause of rise in the rate of inflation rate in India is the

pricing disparity of agricultural products between the producer and consumers in the Indian


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market. Moreover, the sky-rocketing of prices of food products, manufacturing products, and

essential commodities have also catapulted the inflation rate in India. Furthermore, the

unstable international crude oil prices have worsened the situation.


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CAUSES OF INFLATION

What exactly is the nature of this inflation which has the nation in its gri p? The different

causes ofinflation which are experienced in Indian economyin a large proportion would be:-

Demand-pull inflation: This is basically when the aggregate demand in an economy

exceeds the aggregate supply. It is also defined as `too much money chasing too few

goods. Bare-boned, it means that a countryis capable of producing only 100 items butthe

demand is for 105 items. Its a very simple demand-supply issue. The more demand there

is, the costlierit becomes. Much the same as the way real estate in the countryis rising.

Cost-push inflation: This is caused when there is a supply shock. This represents the

condition where, even though there is no increase in Aggregate Demand, prices may still

rise. I.e. non availability of a commodity would lead to increase in prices. This may happen

ifthe costs of especially wage cost rise.

Imported Inflation: This is inflation due to increases in the prices ofimports. Increases in

the prices of imported final products directly affect any expenditure-based measure of

inflation. They play an important role in driving the rise in domestic prices. The rise in the

global prices of crude oil and agricultural commodities, including food grains, and

industrial products, and setbacks to global economy resulting from sub-prime mortgage

disaster and US recession have contributed to Indias inflation.

OTHERCAUSES:

When the government of a country print moneyin excess, prices increase to keep upwith the increase in currency, leading to inflation.

Increase in production and labour costs, have a directimpact on the price ofthe finalproduct, resulting in inflation.

When countries borrow money, they have to cope with the interest burden. Thisinterest burden results in inflation.

High taxes on consumer products, can also lead to inflation. An increase in indirecttaxes can also lead to increased production costs.

Inflation can artificially be created through a circular increase in wage earnersdemands and then the subsequent increase in producer costs which will drive up the

prices oftheir goods and services. This will then translate backinto higher prices for

the wage earners or consumers. As demands go higher from each side, inflation will

continue to rise.


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MEASURING INFLATION

Inflation in India is mainly estimated on the basis of fluctuations in the wholesale price index

(WPI). The wholesale price index comprises of the following indices:

Domestic Wholesale Price Index (DWPI) Export Price Index (EPI) Import Price Index (IPI) O erall Wholesale Price Index(OWPI)

The new inflation index has already commenced.The index has changed the composition of the

Wholesale Price Index (WPI) series. The new data

series lowers weightage of the more olatile fooditems and correspondingly hikes that of coremanufacture,products.

The new series has incorporated consumer items

such as ice cream, mineral water, refrigerator,computer, and TV. The price olatility in theseitems is relati ely limited as compared to fuels orfood products. The data released by the Ministry ofCommerce and Industry is the first that uses thenew base year of 2004-05 and co ers a wider basket

of goods. The old series used 1993-94 as the base year. The release of the current series ofWPI with 1993-94 as its base will be discontinued. The new basket of the WPI has a broaderrepresentation of commodities, change in base year and lower weights accorded to primaryarticles.


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PROBLEMS OF INFLATION

It has been reported that the manufacturing capacity in India is running around 95 per cent,

which usually means itis running at full capacity. Therefore, when the price of manufactured

products is increasing, it means that demand is usually higherthan supply and thatis a clearcase of demand-pull inflation.

On the primary goods front, which consists of fruits, vegetables, food-grains etc, itis notthat

straight-forward. It has certainly been all overthe news thatthe prices of fruits and vegetables

are increasing and a trip to the supermarket or local grocery shop will testify to that.

Although it is a clear case of demand-pull inflation, on the other, it is also a bit of a supply

shock when one considers the fact that there is an abnormally high percentage of fruits and

vegetables that goes to waste because of the lack of cold-storage facilities. Some estimates

say 50 per cent of produce goes to waste and thatis a conservative number.

The fuel price hike is a straight example of cost push inflation. When OPEC (The

Organi ation ofthe Petroleum Exporting Countries) was formed, it squeezed the supply of oil

and this caused oil prices to rise, contributing to higher inflation. Since oil is used in everyindustry, a sharp rise in the price of oil leads to an increase in the prices of all commodities.

The in depth problems due to inflation would be:

When the balance between supply and demand goes out of control, consumers couldchange their buying habits, forcing manufacturers to cut down production.

Inflation can create major problems in the economy. Price increase can worsen thepoverty affecting low income household.

Inflation creates economic uncertainty and is a dampener to the investment climateslowing growth and finallyit reduce savings and thereby consumption.

The producers would not be able to control the cost of raw material and labour andhence the price ofthe final product. This could resultin less profit orin some extreme

case no profit, forcing them out of business.

Manufacturers would not have an incentive to invest in new equipment and newtechnology.

Uncertainty would force people to withdraw money from the bank and convertitintoproduct with long lasting value like gold, artefacts.

The imbalances inflation has created in the Indian economy:-

It has created a new rich class in social and political lives who are corruptthemselvesand also corruptthe overall society.

The increased prices reduced the capacity to save and people preferred presentconsumption to future consumption.

It has provided protection and subsides to industries which bred inefficiency. It has lead to misallocation of resources due to distortion of relative prices and finally

a redistribution of wealth from the poorto the rich. It disturbs balance of payments.


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AS INDIVIDUALS WHAT CAN WE DO TO STOP INFLATION?

Firstly save!!! As much of our money as possi ble should be saved. This will reduce the

demand on the economy and hopefully reduce inflation. Do not overuse daily essentials like

cooking gas, electricity etc. Cut down on inessentials when buying groceries. Look forcheaper alternatives to products that we normally buy.

Keep roads, highways, sidewalks, etc., beautified to help attracttourism and bring additional

monetary into a growing economy. Stop illegal immigration. Illegal activities reap the

benefits of the country but dont paytaxes. Government-backed investment schemes such as

Post Office Savings Schemes, Public Provident Funds (PPF) and National Savings

Certificates (NSC) are bestto invest in when inflation is slowlyinching up and we are only

looking at safety, not returns. Invest in short term deposits and funds, commodities and

property. This will help we to slowly reach our financial goals while safeguarding our hard-

earned money

OTHEREFFECT OF INFLATION

When the balance between supply and demand goes out of control, consumers couldchange their buying habits, forcing manufacturers to cut down production.

Inflation can create major problems in the economy. Price increase can worsen thepoverty affecting low income household.

Inflation creates economic uncertainty and is a dampener to the investment climateslowing growth and finallyit reduce savings and thereby consumption.

The producers would not be able to control the cost of raw material and labour andhence the price ofthe final product. This could resultin less profit orin some extreme

case no profit, forcing them out of business.

Manufacturers would not have an incentive to invest in new equipment and newtechnology.


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Steep increases in the costs of ingredients ha e contributed to high rates of food price

inflation in the Indian economy. And rising food prices ha e been one of the key reasons why

inflation in India is now amongst the highest in the world - on some estimates, food prices

account for half of the acceleration in consumer price inflation posing a policy dilemma for

the Indian central bank.


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OBJECTIVE OF STUDY

To know the impact ofinflation on the consumer. To know that consumer decision for purchasing atthe time ofinflation

To know that how consumer manage the daily needs purchase atthe timeofinflation.

To know that how inflation effectthe economy

To know that how consumers reduce their consumption atthe time ofinflation.


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REVIEW OF LITERATURE

1. MEASUREMENT OF CONSUMERGAINS FROM MARKETSTABILIZATION.

Wright D.Brain and Williams C. Jeffery(3 August 1988)in this article observed that partialequilibrium analysis is appropriate, there is little difference between exact measures of

consumer gains from market stabilization and approximations such as expected change in

marshallian or hicksian consumer surplus. Careful specification ofthe nature of stabilization

is more crucial than the choice of welfare measure. It is importantto represent correctlythe

demand curvature and supply response and to determine whether general equilibrium

responses can be ignored. In any event, an improved analytical approximation and a simple

numerical method for calculating the exact measures make it unnecessaryto rely on suspect

measures.

2. SEARCH ,STICKLY PRICES AND INFLATION:-

DImoand A.Peter(FEB.1992) in this article observed that equilibrium in a market with free

entry where consumers search and firms set prices on individual units ofthe commodity. The

prices attached to newly produced goods are continuously adjusted. Prices attached to

previously produced goods can only be changed at a cost. Thus inflation reduces the real

price of goods in inventory awaiting sale. The presence of previously priced goods lowers the

reservation price of customers. Thus, inflation cuts into the market power created bythe need

to search for the good. Consumer welfare is inverse $u$-shaped in inflation with a strictly

positive optimal inflation rate.

3. Inflation in India during the 80s: An Analytical Review:-

Samanta GP (Feb. 19, 1994) in this article observed that Structural constraints play a major

role in the movement ofthe general price level in developing countries like India. Thus the

inflationary dynamics in these countries cannot be explained purely as a monetary

phenomenon. Even aggregative analysis, taking demand and supply factors along with

monetaryvariables, has been found to be empirically unsatisfactory as quantifying the impact

of any one variable on sectoral prices is not easy. This study attempts a disaggregative

analysis by considering the structural variables first and then analysing the influence of

monetary aggregates on sectoral prices taking into accountthe time series properties of price

indices and specifying the sectoral price equations.


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4.How bestto model inflation in India:-

Balakrishnan pulapre (1 April 2002) in this article observed thatEconometric specifications

relating to two well-known explanations of inflation are generated and, using data from the

Indian economy, the principle of encompassing is broughtto bear upon the choice between

these. The results are conclusive for two tests, which is itself of interest because we have

non-nested models here and the tests could in principle have resulted in each model rejecting

the other. It appears then from the past experience of the Indian economy that the

policymaker is advised to consider sectoral price behaviour explicitly when attempting to

model the inflationary process.

5. COMMODITY PRICES, MONEY AND INFLATION:-

Browne Frank and Cronin David (11 April 2007) in this article observed that The influence

of commodity prices on consumer prices is usually seen as originating in commodity markets.

We argue, however, that long run and short run relationshi ps should exist between

commodity prices, consumer prices and money and thatthe influence of commodity prices on

consumer prices occurs through a money-driven overshooting of commodity prices being

corrected over time. Using a co integrating VAR framework and US data, our empirical

findings are supportive of these relationshi ps, with both commodity and consumer prices

proportional to the money supply in the long run, commodity prices initially overshooting

their new equilibrium values in response to a money supply shock, and the deviation of

commodity prices from their equilibrium values having explanatory power for subsequent

consumer price inflation.

6.COMPARING PARTIAL AND GENERAL EQUILIBRIUM ESTIMATESOF THE WELFARE COST OF INFLATION:-

Gillman Max (2 July 2007) in this article observed thatReserve banks worldwide have been

moving towards zero inflation policies. Confusion clouds the welfare cost of maintaining

such inflation policies despite the best attempts at clarification. Monetarytheory research has

shifted from partial to general equilibrium economies. This shift has left the partial

equilibrium estimates of the welfare cost ofinflation below most ofthe general equilibrium

estimates. Put on a comparable basis, partial equilibrium estimates compare more closely

with the general equilibrium estimates. Furthermore, evidence suggests thatintegration under

the money demand function appears applicable in general equilibrium economies. Finally, the

estimates depend on the elasticities of money demand and the underlying structural

parameters.


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7.Inflation targeting in India: issues and prospects

Jha Raghbendra (mar. 2008) in this article observed that evaluation the case for inflationtargeting (IT) in India. It states the objectives of monetary policy in India and argues that,with widespread poverty still present, inflation control cannot be an exclusive concern of

monetary policy. The rationale for IT is spelt out and found to be incomplete. The paperprovides some evidence on the effects of IT in developed and transition economies andargues that although IT may have been responsible for maintaining a low inflation regime, ithas not brought down the inflation rate itself substantially and or changed the volatility oftheexchange rate. Output movements in transition countries adopting IT have been higher thanin developed market economies. I discuss India's experience with using nominal targets for

monetary policy and why India is not ready for IT. Further, even if India's central bankwanted to, it could not pursue IT because the short-term interest rate does not have a

significant effect on inflation. The paper concludes by listing monetary policy options forIndia.

8.Competition and Price Variation When Consumers Are Loss Averse :-Heidhues, Paul, and Botond Koszegi. (Sept 2008) in this article observed that of price

competition with differentiated products by assuming that consumers are loss averse relative

to a reference point given by their recent expectations about the purchase. Consumers'

sensitivity to losses in money increases the price responsiveness of demand and hence the

intensity of competition at higher relative to lower market prices, reducing or eliminating

price variation both within and between products. When firms face common stochastic costs,

in any symmetric equilibrium the mark-up is strictly decreasing in cost. Even when firms face

different cost distributions, we identify conditions under which a focal-price equilibrium

(where firms always charge the same "focal" price) exists, and conditions under which any

equilibrium is focal.

9. The Misperception of Inflation by Irish Consumers:-

David Duffyin this article The Misperception of Inflation by Irish Consumers observed that

Perceptions and forecasts of inflation have the potential to impact on a range of economicoutcomes. We reveal large, systematic overestimation ofinflation by Irish consumers, whichvaries by social group. In contrast to previous work in this area, our models suggest theupward bias and the variation by social group should be considered substantially separate

phenomena. We also offer evidence that inflation misperceptions are linked to attitudes andintentions with respectto consumption and saving and, hence, are likelyto affect household

decision-making. The findings therefore raise issues regarding the relationshi p betweenfinancial literacy and consumer behaviour.


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10. Extracting information on inflation from consumer and wholesale prices and

the NKE aggregate supply curve.

Goyal Ashima and Tripathi Shruti in this article observed that Since consumer prices are a

weighted average ofthe prices of domestic and ofimported consumption goods, and producerprices feed into final consumer prices, wholesale price inflation should cause consumer price

inflation. Moreover, there should exist a long-term equilibrium relationshi p between

consumer and wholesale price inflation and the exchange rate. But we derive a second

relation between the price series from an Indian aggregate supply function, giving reverse

causality. The CPI inflation should Granger cause WPI inflation, through the effect of food

prices on wages and producer prices. These restrictions on causal relationshi ps are tested

using a battery of time series techniques on the indices and their components. We find

evidence of reverse causality, when controls are used for othervariables affecting the indices.

Second, both the identity and the AS hold as long-run co integrating relationships. There is an

important role for supply shocks. Food price inflation is co integrated with manufacturing

inflation. The exchange rate affects consumer prices. The insignificance of the demand

variable in short-run adjustment indicates an elastic AS. There is no evidence of a structural

breakin the time series on inflation. Convergence is slow, and this together with differential

shocks on the two series may explain their recent persistent divergence.


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ANALYSIS

After study on this topic I can understand thatthe inflation effectthe consumer decisions like

their consumption decision, saving decision and it effects the future expectation of buying.

Inflation always hurts our standard of living. Rising prices means we have to pay more for

the same goods and services. If our income increases at a slower rate as inflation, our

standard of living declines even if we are making more. Inflation's main consequence is a

subtle reduction in our standard of living.

Inflation doesn't affect everything equally. Gas prices can double while our home loses value.This makes financial planning more difficult.

Inflation is really bad for our retirement planning because our target has to keep gettinghigher and higher to pay for the same quality of life. In other words, our savings will buy

less. As a result, we will need to save more todayto pay for higher priced goods and servicesin the future. Since everything we buy today costs more, so we have less left-over income

available to save.

Inflation has another bad side-effect...once people start to expect inflation, they will spendnow rather than later. That's because they know things will only cost more later. Thisconsumer spending heats up the economy even more, leading to further inflation. Thissituation is known as spiraling inflation because it spirals out of control.

Inflation is importantif we are holding bonds or Treasury notes. These fixed price assets onlygive a fixed return each year. As inflation spirals fasterthan the return on these assets, they

become less valuable. As they become less valuable, people rush to sell them, furtherdepreciating theirvalue. As theirvalue becomes lower, the U.S. governmentis forced to offer

higherinterest rates to sell them at all. This increases mortgage interest rates.


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We should be wary, in this post, about cost-push inflation. With wages increasing and input

prices (thanks to oil/petrol/gasoline) increasing, prices consumers pay ha e to increase with

the costs-of-production. In turn we demand higher wages, and with a squeezed supp ly of

labour we can get them, sending prices higher still. Hence,inflation.

In the graph nicked from the textbook use, example economy has expanded beyond potential

real GDP (i.e. Full Employment). In the labour market this means more jobs than people(keeping it simple), dri ing up wages. In the consumer market it means more demand than

supply, dri ing up prices, which dri e up wages do you see the spiral In fact our economy

will not sustain unemployment below the Non-Accelerating Inflation Rate of Unemployment.

Thus we end up back at Full Employment in the graph, inexorably, but along the way we e

picked up positi e inflation.


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METHODOLOGY:-

The methodology used was secondary research. Data and findings from the research papers

and articles of other people was selected and reviewed. Brief review of all the articles and

papers studied has been given in the Review of Literature. These all articles were studied

deeplyto gather maximum knowledge ofthe Report on the topic Inflationaryincidence on

consumer equilibrium. Though no research has been done on the comparative Analysis of

inflationaryincidence on consumer equilibrium butthis paper collected data from the news

articles available from different sources.


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CONCLUSION

After studythis topic I found that Inflation directly affected to consumer equilibrium. Atthe

time of inflation increases the prices of commodities increases which reduce the purchasing

power ofthe consumers, and consumers have to reduce the consumption. Inflation hasanother bad side-effect...once people startto expectinflation, they will spend now ratherthanlater. That's because they know things will only cost more later. This consumer spending

heats up the economy even more, leading to further inflation. This situation is known asspiraling inflation because it spirals out of control.

After studythis topic I found there are some advantage and disadvantage ofinflation.

Advantage

People feel richer (moneyillusion). Unexpected inflation benefits borrowers Could be from extra growth in the economy or extra money which would lead to

lower unemployment rates.

If prices rise, then a currency devalues which would lead to growth in the exportsector.

DISADVANTAGE:-

Lower retain-able income due to higher expenditure. Expensive loans burdening those who have taken loans on floating rate and also

shelving or postponing plans of manyto most people.

Increase in raw materials might furtherincrease prices such that a lowerinflationnumber overall does not really mean lower price of final goods.

There is problem of complacency - with increase of fuel price auto prices forexample have goe up. Even ifthe prices come down later does anyone thinkthatthe

prices will be revised downwards.


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