INFLATION pdf for BCom uni students okay

Eco

1. INFLATION

2. ►Inflation is a sustained increase in the general price level leading to a fall in the purchasing power
of money.
►Inflationary pressures can come from domestic and external sources and from both the supply and
demand side of the economy
►Two Main Types of Inflation:
►1) Cost Push Inflation
►2) Demand Pull Inflation

►Cost-push inflation occurs when businesses respond to rising costs, by
increasing their prices to protect profit margins
►Cost-push inflation is an inflation that results from an initial increase in
costs. 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.

3. ►Increase in costs cause producers to raise the prices of products.
►This in turn leads to cause the workers to demand higher wages. Increase in wages in one sector
leads to the other sector workers demanding higher wages.
►This ultimately leads to a cost push inflation
►There are many reasons why costs might rise:
► 1. Component costs: e.g. an increase in the prices of raw materials and components. This might
be because of a rise in global commodity prices such as oil, gas copper and agricultural products
used in food processing – a good recent example is the surge in the world price of wheat.

►2. Rising labour costs - caused by wage increases that exceed improvements in productivity.
Wage and salary costs often rise when unemployment is low (creating labour shortages) and
when people expect inflation so they bid for higher pay in order to protect their real incomes..

4. ►3. Higher indirect taxes imposed by the government – for example a rise in the duty on alcohol,
cigarettes and petrol/diesel or a rise in the standard rate of Value Added Tax.
► 4. A fall in the exchange rate – this can cause cost push inflation because it normally leads to an
increase in the prices of imported products. For example during 2007-08 the pound fell heavily
against the Euro leading to a jump in the prices of imported materials from Euro Zone countries

9. ►2) Demand pull inflation
►Demand pull inflation occurs when aggregate demand and output is growing at an unsustainable rate
leading to increased pressure on scarce resources and a positive output gap.
►When there is excess demand in the economy, producers are able to raise prices and achieve bigger
profit margins because they know that demand is running ahead of supply.
►Typically, demand-pull inflation becomes a threat when an economy has experienced a strong boom
with GDP rising faster than the long run trend growth of potential GDP.

10. ►POSSIBLE CAUSES OF DEMAND PULL INFLATION
►1)Higher demand from a government (fiscal) stimulus e.g. via a reduction in direct or indirect
taxation or higher government spending and borrowing. If direct taxes are reduced, consumers will
have more disposable income causing demand to rise.
►Higher government spending and increased borrowing feeds through directly into extra demand in the
circular flow.
►2)Monetary stimulus to the economy
► A fall in interest rates may stimulate too much demand – for example in raising demand for loans or
in causing rise in house price inflation
►3) Faster economic growth in other countries – providing a boost to exports overseas.
►4) Improved business confidence which prompts firms to raise prices and achieve better profit
margins
►5) Increase in Exports

14. ►Demand Pull inflation is also known as a situation where “too many dollars chasing too few
goods”.
►Demand Pull Inflation is a Keynesian Economics Concept.
►Output Gap is defined as the difference between actual GDP and Potential Gdp.
►Potential GDP or Potential Output is that output when all the factors of production of the
economy work at the rates consistent with stable inflation
►There are two types of Output Gaps. One is the Inflationary gap and the other is
Deflationary gap or Recessionary Gap

17. ►INFLATIONARY GAP
►An inflationary gap is a macroeconomic concept that describes the difference between the current
level of real gross domestic product (GDP) and the anticipated GDP that would be experienced if an
economy is at full employment (potential gdp)
►Inflationary gap exists when REAL GDP > POTENTIAL GDP
►Inflationary gap represents the point in business cycle when economy is expanding
►The inflationary gap exists when the demand for goods and services exceeds production due to
factors such as higher levels of overall employment, increased trade activities or increased
government expenditure
►This can lead to the real GDP exceeding the potential GDP, resulting in an inflationary gap.
► The inflationary gap is so named because the relative increase in real GDP causes an economy to
increase its consumption, which causes prices to rise in the long run

18. ►Fiscal Policy to Manage the Inflationary Gap
►A government may choose to use fiscal policy to help reduce an inflationary gap, often through
decreasing the number of funds circulating within the economy.
►This can be accomplished through reductions in government spending, tax increases, bond and
securities issues, interest rate increases and transfer payment reductions.
►By shifting overall demand for goods, the adjustments control the amount of funds available to
consumers. As the amount of money within an economy decreases, the overall demand for goods
and services also declines.
►Monetary Policy to Manage IG
►The central bank can raise the interest rate. This will result in borrowings becoming more
expensive.
►This increase in expense leads to a fall in Aggregate Demand and this will reduce the inflationary
gap.

20. ►A recessionary gap is a macroeconomic term which describes an economy operating at a level
below its full-employment equilibrium. Under a recessionary gap condition, the level of
real gross domestic product (GDP) is lower than the level of full employment
►Puts downward pressure on prices in the long run.
►These gaps are evident during times of economic downturn and associated with higher
unemployment numbers
►A more important outcome of a recessionary gap is increased unemployment. During an
economic downturn, the demand for goods and services lowers as unemployment rises.
►If prices and wages remain unchanged, this can further elevate unemployment levels. In a cycle
which feeds upon itself, higher unemployment levels reduce overall consumer demand, which
reduces production, and lowers the realized GDP
►As the amount of output continues to fall, fewer employees are required to meet production
demand resulting in additional job losses and further reducing the need for goods and services.
►As a company's profits stagnate or decline, the company cannot offer higher wages.

22. Monetary Theory of Inflation

23. ►Initially, the economy is at point 1, with output at the natural rate level and the price level at P1
(the intersection of the aggregate demandcurve AD1 and the aggregate supply curve AS1) .
►If the money supply increases steadily over the course of the year, the aggregate demand curve
shifts rightward to AD2. At first, for a very brief time, the economy may move to point 1 and
output may increase above the natural rate level to Y, but the resulting decline in unemployment
►below the natural rate level will cause wages to rise, and the aggregate supply curve will quickly
begin to shift leftward.
►It will stop shifting only when it reaches AS2, at which time the economy has returned to the
natural rate level of output on the longrun aggregate supply curve.1 At the new equilibrium, point
2, the price level has increased from P1 to P2.

24. ►If the money supply increases the next year, the aggregate demand curve will shift to the right again
to AD3, and the aggregate supply curve will shift from AS2 to AS3;
►The economy will then move to point 2 and then 3, where the price level has risen to P3. If the
money supply continues to grow in subsequent years, the economy will continue to move to higher
and higher price levels.
►As long as the money supply grows, this process will continue, and inflation will occur.

►In monetarist analysis, the money supply is viewed as the sole source of shifts in the aggregate
demand curve, so there is nothing else that can move the economy from point 1 to 2 to 3 and
beyond.
►Monetarist analysis indicates that rapid inflation must be driven by high money supply growth.

25. ►Sectoral Demand-Shift Theory of Inflation
►Prof Schultze could not find any excess demand in the economy in U.S.A, in the early fifties
though the prices were found to be rising. He did not accept the cost-push theory of inflation
►So, in his efforts to reconcile the demand-pull theory with the fact of the rising price level
without any general apparent excess demand, he developed this theory
►He showed that in a dynamic economy, demand is shrinking in some sectors and shifting to
other sectors
►The sector or the industry in whose favour, demand has shifted will register a rise in the price
of that commodity produced in that sector
►This will also enable the employers to grant the rise in money wages to the employees working
in that sector,

26. ►Sectors in which, demand has fallen, will fail to register a fall in prices and money-wages, on
account of the downward rigidity of money wages and hence the general price level will rise
►Thus the rising price-level is not explained "by an overall excessive demand, but rather by the
sectoral rise in demand in conjunction with the refusal by the declining demand sectors to
register a price-fall and the wage-fall.
►Demand factor is responsible for increasing the prices and wages in only those sectors where
demand has gone; up, but the cost factor becomes relevant when prices and wages refuse to fall in
the declining sectors.
►This cost factor which is of strategic importance, is an institutional factor which is responsible for
turning the relative price and wage-change into a general price-wage level change

27. ►In the industries where demand is fallings output may be fallings but the wages and prices may not
fall on account of two main reasons –
► (1) the trade union pressure and the full-employment policy of the Government
►(2) is the high percentage of overhead cost in total cost of production which makes it difficult to
reduce cost when output declines,


►MARK-UP INFLATION
►Concept developed by Prof Gardner Ackley.
►Mark-up is the excess of selling price of a product over the cost of making or buying it. The
mark-up on any product has to cover the overhead costs of the firm as well as provide a profit
margin.
►Overhead costs is the fixed costs a business must incur for production to be possible.

28. ►If all firms add up a certain mark up (by way of overhead costs and profits) to the costs of direct
material and direct labour, in order to fix up the prices of their respective commodities and
► if the labourers also price their services by adding a certain definite mark up to their cost of living
and if these two do not tally, then inflation may result.
►The mark up pattern followed by firms may he such that the wage rate of 2 leads to a price-index
of 104 and the mark up pattern pursued by the labourers may he such that the price-index of 104
leads them to demand and succeed in getting the wage-rate of >2 which again, from the point of
view of the firms, requires the price-index >104 which necessitates the wage-rate to increase
further and so on.
►When the total demand in the economy is rising, firms increase their
markups and when a high level of employment is reached, the labourers
enhance their markups and vice versa.

29. ►PHILLIPS CURVE
►The Phillips curve is an economic concept developed by A. W. Phillips
►It is the curve which shows negative relationship between unemployment and inflation rates.
►Phillips curve is a negative relationship between unemployment rate and inflation rate.
►Higher rates of growth in aggregate demand stimulate output and hence lower the unemployment
rate.
►High rates of growth in aggregate demand cause the inflation to rise. (refer to monetary theory of
inflation)
►There exists a trade-off between inflation and unemployment in the short run

31. ►NATURAL RATE OF UNEMPLOYMENT AND OUTPUT
►There exists an equilibrium level of output and accompanying rate of unemployment
determined by the capital stock, technology etc.
►Changes in aggregate demand causes temporary movements of the economy away from
natural rate.
►For eg. Expansionary monetary policy move the output above the natural rate and reduces the
unemployment for a short period of time. The increased aggregate demand causes prices to
rise.
►Natural rate of output (shown by the vertical Long run aggregate supply curve) changes only
if there is an improvement in technology or capital stock.

32. ►Friedman’s view of Long run Philips curve
►Suppose initial level of unemployment is 6% and the inflation rate =0.
►6% is the natural level of unemployment.
►Suppose the money supply rises the economy moves to short run equilibrium due to rise in
aggregate demand.
►The unemployment is reduced to 5% and inflation rate is 2%. Therefore the unemployment is
reduced below the natural rate of unemployment.
►In the short run prices increases faster than wages. Thus the real wage falls.
►Since the real wages have fallen, firms hire more labour and this leads to a rise in output.
►According to Friedman, In the short run the labour does not recognize that their real wages
have fallen because they tend to evaluate their wages at earlier prices.

33. ►This situation is temporary and the labourers will eventually recognize the higher price level and
demand higher wages.
►Since the real wages have fallen below the equilibrium (W/P*) the firms demand more labour.
►This increased demand for labour by the firms coupled with demand for higher wages by labourers will
lead the prices to go back to the equilibrium level or natural level.

35. ►The Short Run Philips Curve 1 (SRPC1) at 8% unemployment rate is the equilibrium. Here the
inflation rate is zero.
►Now suppose the money supply increases=> leads to increase in aggregate demand=>AD curve
shifts to right=> the unemployment reduces below natural rate(Point B 3%)=> The inflation rate
becomes 2%=> reduction in real wages (W/P) => the labourers demand an increase in wages to
keep up with inflation rate => this reduces the profit margin of the firms and therefore reduces the
supply by laying-off labour=> this leads to a decrease in output and an increase in unemployment
=> the unemployment reaches the natural level of unemployment i.e 8%.
►The new phillips curve is SRPC2.
►The conclusion is that as a result of increase in money supply the economy was able to reduce
unemployment at the cost of increase in inflation in the short run.
►But in the long run, the unemployment return to the normal level of 8% along with an increased
inflation rate(2%).
►In SRPC2 the people develop an expectation that the inflation rate will equal 2% in the future.

36. ►DISINFLATION VS DEFLATION
►Deflation is the economic term used to describe the drop in prices for goods and services.
Deflation slows down economic growth. It normally takes place during times of economic
uncertainty when there is demand for goods and services is lower, along with higher levels of
unemployment. When prices fall, the inflation rate drops below 0 percent.
►Deflation, which is harmful to an economy, can be caused by a drop in the money supply,
government spending, consumer spending, and corporate investment.
►Disinflation occurs when price inflation slows down temporarily. This term is commonly to
describe a period of slowing inflation. Unlike deflation, this is not harmful to the economy
because the inflation rate is reduced marginally over a short-term period.
►Unlike inflation and deflation, disinflation is the change in the rate of inflation. Prices do not drop
during periods of disinflation and it does not signal an economic slowdown.
►So disinflation would be measured as the change of 4 percent from one year to 2.5 percent in the
next.