Author: Rojan Mehta

Definition

• Inflation means increase in the money supply or sustained increase in the general price level of goods and services in an economy normally owing to increase in money supply.• When money supply increase, price level of products increase and

each unit of currency buys lower quantity of products.• As a result, inflation results in reduction in purchasing power per

unit of currency.• In a more technical way, it is rise in general price level caused by

an imbalance between the quantity of money and trade needs.

Variations of Inflation• Deflation : This is the opposite of inflation i.e. the fall in general price level of products. Many people have heard about the deflation in Chinese Economy in 2014 to current timeline. Their economy is currently in painful transition from Investment based economy to Consumer Spending. The prices of Chinese products have further decreased and Yuan Has devaluated. The markets are rapidly decreasing and they are more vulnerable. The gigantic Chinese economy will in fact effect the other economy which is based on it. American Dreams are made in China. I mean to say about the product manufacturing outsourcing to china. So, as a result, American Economy too will face the outcome.

Hyperinflation : It is unusually rapid inflation. It can lead to breakdown of national economy. Most recent example is Zimbabwe in 2008 Prices doubled here every 24.7 hours in November 2008 and inflation reached levels of 79 billion-odd %. They eventually stopped using the official currency and switched to the South African Rand or the $US. A loaf of bread ended up costing $35 million. This is the most recent case. It was Mugabe’s land-redistribution program that caused this. Other unofficial case is my own country, Nepal in 2015 where due to months long strike, the prices of products nearly doubled and that of gases nearly tripled.

Stagflation: It is the result of the combination of high unemployment and economic stagnation with inflation. Most recent case is of Argentina in 2012 where industrial production slumped to all time high and as result majority of population was unemployed. Stagflation was visible in the market of properties in the country. Home sales and construction declined very much and as a result even these remained out of clutches of middle class people

Calculation of inflation• Most countries(USA and India included) calculate the movement in price index

usually called the Consumer Price Index(CPI). In US, it is calculated by Department of Labor Statistics.

• In UK Retail Prices Index is used, which is more broader than CPI as it contains broader basket of goods and services.

• Other widely used price indices are Producer price indices, Commodity price indices, Core Price Indices, etc.

• CPI uses the data collected by surveying households to quantify the rational consumer’s spending on specific products and weigh in the average prices of those items accordingly.

• To better relate over time, a base year is chosen and index of 100 is assigned.• When looking at inflation rate, Economic institution (Central Banks) only look at

certain indices of specific goods to formulate the monetary policy.• Formulae: Current Index Less Base Index 100• Base Index

Keynesian VIEW or Causes of Inflation: It is one of the most popular view by Keynesian economists. They propose that changes in money supply do not directly affect prices of products and apparent inflation is the result of the expression of economy itself in prices. As per this view, there are three major types of inflation:1. Demand Pull Inflation2. Cost Push Inflation3. Built-in inflation

This view is also popularly called Triangle Model

Income Redistribution:

Regressive effect of

inflation hits the lower income

families. In a nutshell, rich

becomes richer and

poor becomes poorer

Negative Real Interest Rates: Inflation eats up savings . If rate of savings

is less than rate of

inflation, the people who depends on their saving deposits will

be hit severely.

Cost of Borrowing:

Inflation is well reflected in

higher cost of borrowing also

as the financial

institution will also tend to reduce the impact of

inflation on them through

these measures

Risky Environment:

Business environment will be very

much volatile if inflation is not stable.

Stable inflation can be

complied to but it takes a

lot of resources to cope to risky

business environment

Other effects: 1. Reduction in production 2. Hoarding and Black Marketing 3. Encourages Speculation

4. Hinders Foreign Capital

EFFECTS OF INFLATION

Monetory Policy: The

central bank can increase

interest rate of borrowings and make savings attractive. A

higher interest rate increases exchange rate which helps to

reduce inflationary position by

making imports cheap and reducing

demand for exports

Fiscal Policy: The

government could increase taxes and cut its spending . This improves

the budget situation and

helps to reduce demand

situation in the economy. Fiscal

Policy is nothing but

annual budget policy generally

introduced 2 months before

start of new fiscal year.

Wage Control: Powerful labor unions demand

for higher wages which can increase

inflation. Limiting wage

growth can moderate inflation.

However it is extremely difficult to

control wages especially in developed

countries due to prevalence

of strong unions.

Money Supply: It would take

detailed study of economy to

understand whether

increasing money supply

will control inflation or not. Recent pasts

show that controlling

money supply can control

inflation while there has also

been unsuccessful

cases.

Other Methods:1.Supply side economic policies.2. Prices Control3. Gold and Silver Reserves

METHODS TO CONTROL INFLATION

Inflation Good or Bad

• Inflation is a highly debated subject. The term has has to be understood in different economic conditions separately.• However, acceptable rate of inflation is good for economy as it stabilizes

economy by increasing economic output and productivity while creating opportunities for employment.• Neither low inflation nor high inflation is good for the economy. The crux

would be steady rate of inflation is good as it introduces certainty perspective.• However the rate of inflation is to be seen from macroeconomic variables

of economy• From above you must have got confused. So, it is really a open debate as

inflation requires various angles. Every economists have opinion on inflation. It’s a myth really.

Both GDP and inflation are considered important economic indicators.

GDP stands for Gross domestic product which is used to determine the standard of living and economic health of country as well as nation’s productivity.

The relationship between these two is open to debate on any given day.

If an economy is not growing fast enough or is slow, the central bank may have to lower interest rates to make borrowings more attractive. The reason behind such decision is that it will encourage spending which will in fact increase GDP.

Inflation and GDP

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Rojan Mehta