INFLATION

PART-2
SanadamaliDissanayake

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2014 A/LEVEL
 6.3 STUDIES THE TYPES OF
INFLATION ANALYZING THE
CONCEPTS OF INFLATION
Inflation which characterizes an important dimension of macroeconomic instability is one of
the most familiar words in economics. Inflation has plunged countries into long periods of
instability. Central Bankers often aspire to known as inflation hawks.

Maintaining price stability is important because

1. More efficient allocation of resources

Allow anyone to make better decisions regarding what to produce and how to produce
thus enabling more efficient allocation of resources
2. Investors and savers would not demand a risk premium
Risk premium is expecting higher interest rates. This is expected because to
compensate for risks associated with long term savings and investments.
Continuous unstable prices are likely to result in demand for high risk premium discouraging
long term savings and investment.
Maintaining low and stable inflation is one of the primary goals of macro economic policy.

INFLATION

Inflation is sustained increase in the general level of prices of goods and services in an
economy.

Inflation is the increase in general price level results in decline in purchasing power of
money.

The upward movement of average prices of all goods and services combined that determine
the extent of inflation. Continuous increase in general price level is expected by the inflation
and temporary increase is not expected.

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 HYPER INFLATION

Hyperinflation refers to a situation where the prices rise at an alarming high rate. The prices
rise so fast that it becomes very difficult to measure its magnitude. However, in quantitative
terms, when prices rise above 1000% per annum (quadruple or four digit inflation rate), it is
termed as Hyperinflation.
During a worst case scenario of hyperinflation, value of national currency (money) of an
affected country reduces almost to zero. Paper money becomes worthless and people start
trading either in gold and silver or sometimes even use the old barter system of commerce.
Two worst examples of hyperinflation recorded in world history are of those experienced by
Hungary in year 1946 and Zimbabwe during 2004-2009 under Robert Mugabe's regime

DEFLATION

Deflation is continuing fall in the general price level. Deflation is also not desirable.

Ex: U.S. in 1930

IMPACT OF DEFLATION

1. Consumers delay their purchases , if they can anticipate lower price in the future
2. Less income generated by producers
3. Less economic activity due to discourage investment
4. Lower economic growth.
5. Increase in unemployment and poverty
6. Appreciation of foreign exchange rate
7. Discourage export and adverse impact on Balance of payment
The maximum situation in deflation is economic recession

DISINFLATION

Disinflation refers to a reduction in the rate of inflation. The price level is still rsing but the
rate of increase in the price levels becoming less and less.

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 INFLATION RATE

inflation is measured by price index numbers. The Rate of inflation is defined as the
percentage change in the average price level. It can be calculated for any given year by
subtracting the last years price index from this years price index, dividing that difference by
last years index and multiplying by 100 to express the result as a percentage.

Inflation rate (PI)= price index at current year(P1)- price index at previous year(P0)
Price index at previous year( P0)

Ex: If the base years price index is 100 and the current years price index is 110, the inflation
rate is. over the period.

The most widely used measure of inflation is Consumer Price Index.

Ex:

In Sri Lanka consumer price index in year 2015 and 2016 is given below. Calculate the
inflation rate in 2015.

2015 2016
Colombo price index

HEAD LINE AND CORE INFLATION

HEADLINE OR OVERALL INFLATION

This is a measure of total inflation within an economy. The headline inflation is relevant
measure when comparing purchasing power over two periods. This is important to
compare

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 1. Wages
2. Wealth
3. Rates of Returns
4. Government Transfer Payments such as social security payment and so on.

CORE INFLATION

The inflation arising from food and energy prices are volatile and often subject to
temporary fluctuations caused by

- Supply shocks mostly driven by

o Weather conditions
o External shocks
- Changes in administered prices
- Tax policies which are beyond the control of monetary authority.

Monetary authorizes all over the world take monetary policy decisions based on
underlying trend in inflation. This means inflation which is derived by removing volatile
components in a consumer price index. This is known as
.

The core inflation is less volatile and better reflection of interplay of supply and demand
in domestic product market. This better gauge of underlying inflation and tend to
emerge in the absence of supply shocks

Different countries use different methods to measure core inflation. Most of the
countries use Exclusion Method.

Exclusion Method

This method stripes out volatile categories of goods, food and energy products ,most
affected by seasonal factors or temporary supply conditions. this is popular because

- Simplicity of computation
- Easy understand ability by the public
- Derivability without delay
- Easy replication and verification by others.
- Increase in transparency and accountability in calculation

Sri Lanka also complies core inflation excluding food and energy.

CAUSES FOR INFLATION

Inflation creates as per the changes in aggregate demand and aggregate supply as well as
inelastic features of economic structure. There are three approaches can be identified related to
the reasons for the inflation.

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1. Demand pull inflation
2. Cost- push inflation
3. Structural inflation

DEMAND PULL INFLATION

Traditionally the reason for the inflation is considered as demand pull inflation. Demand-pull
inflation happens when the level of aggregate demand grows faster than the underlying level
of supply. This may be easier to imagine, if you think of supply as the level of capacity.

If our capacity to produce is growing at 3%, and the level of demand grows at the same rate
or slower then we don't have a problem. We can produce all we need. However, if our
capacity grows at 3%, but demand grows faster, then we have a problem. In effect we have
'too much money chasing too few goods', and we can't manage to produce all we need.
Something has to give, and it is prices that are forced up, therefore causing inflation. We can
see all this in the diagram below. As the aggregate demand curve shifts to the right, the price
level raises - inflation.

There are a variety of possible reasons for the increased aggregate demand, and to look at
these in more detail we need to look at the components of aggregate demand. Aggregate
demand is made up of all spending in the economy. It is:

AD = C + I + G + (X-M)
where C is consumer expenditure, I is investment, G is government expenditure, X is exports
and M is imports

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An increase in aggregate demand could therefore be because consumers are spending more,
perhaps because interest rates have fallen, taxes have been cut or simply because there is a
greater level of consumer confidence. It could be because firms are investing more in the
expectation of future economic growth. It could be that the government is boosting spending
on defence, health, education and so on. Or it could be because there is a boom in UK exports
to overseas. Whatever it is, it will be inflationary if demand grows faster than supply.

THE REASONS FOR THE INCREASE IN AGGREGATE DEMAND

1. Increase in government expenditure(investment and consumption expenditure)

2. Increase in private investment demand
3. Increase in private consumption demand
4. Increase in money supply
5. Increase in foreign demand

There are two views related to the demand pull inflation

1. According to the Monetarist View inflation created expansion of money supply

exceeding real product. Here confirms the inflation is monetary variable.
2. According to the Keynesian approach inflation created when the aggregate demand
exceeds the demand level related to the full employment.

MONETARIST VIEW

EXPLANATION OF INFLATION USING EXCHANGE EQUATION

The early version of the quantity theory of money predicted that the general price level is
positively related to the quantity of money. In such a way that changes in the quantity of
money causes proportionate changes in the price level.

Ex; doubling quantity of money would lead to doubling of the price level.

MV=PT MV=PY

M= amount of money

V= velocity of money P=Price level

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Y=Real Product T=No of transactions

ASSUMPTIONS

V and Y are constant

CONCLUSIONS

1. Because of V and Y are constant M money stock increases by 10% P price level
increase by 10%. Ie. There is positive relationship between money supply and
inflation.
2. Government expenditure finances the expansion of money supply results inflation.
3. It is important this analysis in forecasting long term trend of the price level

Milton Friedman assumed that there is stable demand function for money. On the basis that
argues that any increase in the general level of prices in order to maintain the stable ratio
between real money balances and real income. Friedman said inflation is always and
everywhere monetary phenomenon. In other words long run no inflation can occur without
accommodating increase in money supply. A greater availability of money in hands of the
people without commensurate increase in the availability of goods and services, is the
primary demand side factor contributing inflation. Inflation in the long run is caused by the
excessive monetary expansion compared with real economic growth.

KEYNESIAN VIEW

This is based on the effective demand model of income determination combined with the
expenditure-income-expenditure sequence. The so called inflationary gap occurs because at
full employment the desired level of real expenditure for consumption, investment and
government outlays exceeds the output which economy the economy is capable of producing.
Specifically the amount by which aggregate expenditure exceeds the full employment level of
output is known as Inflationary Gap. The effect of this inflationary gap would be up the
prices of economys fixed physical volume of production. Business as whole cannot respond
to this excess demand by expanding the real output, so demand pull inflation will occur.

As aggregate expenditure increases the price level generally begins to rise before full
employment is reached. As full employment is approached firms will forced to employ less

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efficient workers and this contributes to rising costs and prices. Following figure illustrates
the process of demand pull inflation in terms of aggregate demand ad supply

Furthermore demand shocks such as

- Stock market rally

- Expansionary policy such as central bank lowers interest rates
- Government raises spending
- Can temporarily boost overall demand and economic growth.

If however this in this demand exceeds economy's production capacity the resulting
strain on resources is reflected in demand pull inflation

COST PUSH INFLATION/SUPPLY SHOCK INFLATION

The theory of cost push inflation explains the rising prices in terms of factors which raise per
unit production cost. Rising per unit production cost squeezes profits and reduce the amount
of output firms are willing to supply at the existing price level. as a result the economy's
supply of goods and services declines and the price level rises. The major source of cost push
inflation is supply shocks. supply shocks that disrupt production such as

Natural disasters
Raise production costs such as
o high oil prices

can reduce overall supply and lead to cost push inflation.

Following figure illustrates the process of cost push inflation in terms of aggregate supply
and demand.

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 REASONS OF RISING COSTS.

WAGES

If trade unions gain more power, they may be able to push wages up independently of
consumer demand. Firms then face higher costs and are forced to increase their prices to pay
the higher claims and maintain their profitability.

PROFITS

If firms gain more power and are able to push up prices independently of demand to make
more profit, then this is considered to be cost-push inflation. This is most likely when
markets become more concentrated and move towards monopoly or perhaps oligopoly.

It is important to look at why costs have increased, as quite often costs are increasing simply
due to the economy booming. When costs increases for this reason it is generally just a
symptom of demand-pull inflation and not cost-push inflation. For example, if wages are
increasing because of a rapid expansion in demand, then they are simply reacting to market
pressures. This is demand-pull inflation causing cost increases.

THE REASONS FOR THE DECREASE IN AGGREGATE SUPPLY

1. Imposing indirect tax by the government

2. Increase in prices of factors of production
3. Increase in prices of raw materials
4. Increase in prices of imports
5. Increase in profits
6. Decline in production due to natural reasons or civil conflicts

The real world is more complex than the distinction between demand pull and cost push
inflation suggest. It is important to look at why costs have increased, as quite often costs
are increasing simply due to the economy booming. When costs increases for this reason it
is generally just a symptom of demand-pull inflation and not cost-push inflation. For
example, if wages are increasing because of a rapid expansion in demand, then they are
simply reacting to market pressures. This is demand-pull inflation causing cost increases.

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 STRUCTURAL INFLATION

Inflation arises due to inflexibilities in production, investment and international trade. This
type of inflation is mostly seen in developing countries.

Ex;

i) Face to natural disasters and declined in productivity of agricultural products

ii) Not adequate domestic and foreign investments

ECONOMIC IMPACTS OF INFLATION

1. Individual or a firm
a. Family who live with a subsidy
If a good subsidy in an inflationary situation the same quantity will received
and it will not impact for them.
If a financial subsidy received in an inflationary situation real value of
money drops and it will adverse for them.
b. Interest earner from a bank deposit
When there is a inflation real value of bank deposit will drops.
If the inflation rate is higher than the interest rate real interest rate will
negative. If it happens it is adverse for a interest earner from deposits
c. Fixed income earners( salaries/pension receiver)
It should be considered how much increase the financial salaries /pensions
compared to inflation
If financial salary or pension is increase lower rate compared with inflation
real salary will decrease
d. Creditor and debtor
Inflation is adverse for creditor compared to the debtor
When repayment the real value of loans has drops and it is adverse for
creditors and favourable for debtors
This also determined by the interest rate and inflation rate
e. Farmers
If the selling price of crops increase results in increase in money income.
But the real income increase determined by the following factors

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 the increase in rate of input prices such as fertilizer, seeds,
pesticides, tractor fare, rented labour,etc.
o if cost of production increase greater than the money
income real income will drops.
The increase in rate of prices of consumer goods purchase foe
consumption
o The prices of consumer goods increase in a higher rate
compared to the increasing rate of money income real
income will drops
f. Trader
In an inflation the selling price of the goods increase and they can sell at
higher price if there is previous stocks available. The increase in the gap
between purchase price and selling price results in increase in profits
Furthermore most vendors increase the price in unfair way and increase their
profit by increase in price of the product at a higher ratio than the increase
in input prices.
Ex: when 1kg of wheat flour increase by Rs.10 loaf of bread price increase
by Rs.8
3. Various economic variables
a. Imports
Due to inflation domestic prices of the goods increase compared to import
prices. Therefore domestic demand for imports will be increase.
Here it is assumed that domestic inflation is higher than external world
b. Exports
Due to the inflation increase in domestic prices and cost of production result
in increase in export price level.
Therefore the export competitiveness will decrease and export earnings will
decrease.
Here it is assumed that domestic inflation is higher than external world
c. Balance of payments
This discussion is based on domestic inflation rate and international inflation
rate

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 If the domestic inflation rate is higher the domestic prices of goods is higher
for the foreigners and result in drop in export competitiveness and exports
are discouraged. This results in balance of payment problems and
overvalue of external value of money
If the domestic inflation rate is lower the domestic prices of goods is lower
for the foreigners and result in increase in export competitiveness and
exports are encouraged .This results in favorable balance of payment. Here
exports and import elasticity impact.
d. Foreign exchange rate
If the domestic inflation rate is higher than the foreign countries foreign
exchange rate will increase. Therefore there may be overvaluing the
foreign exchange rate or depreciation of foreign exchange rate.
e. Savings
If the income cannot be increase compared to the inflation rate the ability to
save will drops
When there is inflation real interest rate falls and money savings will
discouraged
But the real savings such as goods or assets with material nature( land,
houses) will encouraged
f. Investments
In an inflationary situation savings discourage results in scarce resources
and cost of investment will increase
With the increase in risk of investors and uncertainty long term investments
are discouraged and short term investments are encouraged.
g. Unemployment
With the inflation price of the goods will increase and producers try to
increase the supply. Therefore employment level will increase and
unemployment level will drop.
h. With an inflation the job opportunities in informal sector will abundant and
unemployment rate will drops
4. Economic growth
a. With an inflation increase the uncertainty of future profits and economic
growth will decline

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 b. Low savings, discourage of investment , capital flows to non productive
investments ( steal, real assets) from productive investments results in
decrease in economic growth
c. But it is argued that achieve low and stable inflation rate and maintain is
important to the economic growth
5. Income distribution
a. Under the inflationary situation fixed income owners( specially person who
with low bargaining power and pensions) real income will decline
b. Pensions will increase with delay but increase at low rate relatively to inflation
rate
c. But variable income owners( traders, producers) can adjust their income under
inflationary situation. They can increase their income
d. Therefore in an inflationary situation the gap between fixed income owners
and variable income owners will increase. Therefore absolute poverty will
increase.

CONCEPTS RELATED TO INFLATION

STAG INFLATION

This is a situation where an economy is experiencing twin problems of stagnation (or

sluggish growth) and rising inflation.

SUPPRESSED INFLATION

: When government prevents price rise through price controls, rationing, etc., it is known as
Suppressed Inflation. It is also referred as Repressed Inflation. However, when government
controls are removed, Suppressed inflation becomes Open Inflation. Suppressed Inflation
leads to corruption, black marketing, artificial scarcity, etc.In 1970-1977 the economy has
observed this situation

SPIRAL INFLATION

Increase in general price level as a spiral. Two reasons can be identified.

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1. Business profit will increase with the inflation. Therefore factor demand will increase and
factor price will increase. If this continuously took place inflationary situation will arise
2. In inflation consumer purchasing power will drops. Therefore they increase their salaries.
(with union actions) therefore price level again increase .This continuously took place and
inflationary situation will arise

CREEPING INFLATION

When prices are gently rising, it is referred as Creeping Inflation. It is the mildest form of
inflation and also known as a Mild Inflation or Low Inflation. According to R.P. Kent, when
prices rise by not more than (upto) 3% per annum (year), it is called Creeping Inflation

MODERATE INFLATION

Prof. Samuelson clubbed together concept of Crepping and Walking inflation into Moderate
Inflation. When prices rise by less than 10% per annum (single digit inflation rate), it is
known as Moderate Inflation. According to Prof. Samuelson, it is a stable inflation and not a
serious economic problem.

GALLOPING INFLATION

According to Prof. Samuelson, if prices rise by double or triple digit inflation rates like 30%
or 400% or 999% per annum, then the situation can be termed as Galloping Inflation. When
prices rise by more than 20% but less than 1000% per annum (i.e. between 20% to 1000%
per annum), galloping inflation occurs. It is also referred as Jumping inflation. India has
been witnessing galloping inflation since the second five year plan period.

POLIC IES FOR CONTROL LING INFLATION

1. Prepare policies for expansion of production in the economy

2. Improve productivity
3. Promote domestic and foreign investments
4. Follow appropriate fiscal policies
5. Implement better budget policies

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