BBA (2021-24)

Macroeconomics
(ME)

Lecture 33-35
Inflation

Types and measures

Definition
• Inflation is a state of persistent rise in prices
• Note:
 This does not mean that all prices must be rising during a
period of inflation –some prices may even be falling; but
the general trend must be upward.

 It is a process of rising prices & not a state of high prices.

• Inflation Reduces the purchasing power of
money.
Too much money chases few goods
Measuring Inflation
• Inflation is the rate of change in the price level
• If the price level in the current year is ‘P1’ & in
the previous year is ‘Po’, then inflation for the
current year is

(P1 – Po)/ Po x 100

Suppressed & Open Inflation
• Inflation is a state of disequilibrium at which aggregate
demand exceeds aggregate supply at the existing prices,
causing a rise in general price level.

• But sometimes an inflationary situation does not exhibit

increases in the price level, if price controls & rationing
are introduced by the government. Such a situation is
called suppressed inflation

• As soon as these controls are withdrawn, prices start

rising & inflation becomes an open inflation
Types of Inflation
• A. On the Basis of Causes:
(i) Currency inflation:
This type of infla­tion is caused by the printing of
currency notes.
(ii) Credit inflation:
Being profit-making institutions, commercial banks
sanction more loans and advances to the public
than what the economy needs. Such credit
expansion leads to a rise in price level.
(iii) Deficit-induced inflation:
The budget of the government reflects a deficit when
expenditure exceeds revenue. To meet this gap, the
government may ask the central bank to print additional
money. Since pumping of additional money is required to
meet the budget deficit, any price rise may the be called the
deficit-induced inflation.
(iv) Demand-pull inflation:
An increase in aggregate demand over the available output
leads to a rise in the price level. Such inflation is called
demand-pull in­flation (henceforth DPI). But why does
aggregate demand rise? Classical economists attribute this
rise in aggre­gate demand to money supply. If the supply of
money in an economy ex­ceeds the available goods and
services, DPI appears. It has been described by Coulborn as a
situation of “too much money chasing too few goods.”
• (v) Cost-push inflation:
Inflation in an economy may arise from the
overall increase in the cost of production.
This type of inflation is known as cost-push
inflation (henceforth CPI). Cost of production
may rise due to an increase in the prices of
raw materials, wages, etc. Often trade
unions are blamed for wage rise since wage
rate is not completely market-determinded.
Higher wage means high cost of production.
Prices of commodities are thereby increased.
• B. On the Basis of Speed or Intensity:
(i) Creeping or Mild Inflation:
If the speed of upward thrust in prices is slow but small then we
have creeping inflation. What speed of annual price rise is a
creeping one has not been stated by the economists. To some, a
creeping or mild inflation is one when annual price rise varies
between 2 p.c. and 3 p.c.
(ii) Walking Inflation:
If the rate of annual price increase lies between 3 p.c. and 4 p.c.,
then we have a situation of walking inflation. When mild inflation
is allowed to fan out, walking inflation appears. These two types
of inflation may be described as ‘moderate inflation’.
• (iii) Galloping and Hyperinflation :
Walking inflation may be converted into running
inflation. Running inflation is danger­ous. If it is
not controlled, it may ultimately be converted
to galloping or hyperinflation. It is an extreme
form of inflation when an economy gets
shatter­ed.”Inflation in the double or triple
digit range of 20, 100 or 200 p.c. a year is
labelled “galloping inflation”.
(iv) Government’s Reaction to Inflation:
In­flationary situation may be open or suppressed. Because of
anti-infla­tionary policies pursued by the govern­ment, inflation
may not be an embar­rassing one. For instance, increase in
income leads to an increase in con­sumption spending which
pulls the price level up.

If the consumption spending is countered by the govern­ment via

price control and rationing device, the inflationary situation
may be called a suppressed one. Once the government curbs
are lifted, the sup­pressed inflation becomes open inflation.
Open inflation may then result in hyperinflation.
Theories of Inflation

Basically there are two theories of Inflation:

• 1. Demand Pull Inflation (demand side theory
of Inflation)
• 2. Cost Push Inflation (Supply side theory of
Inflation)
1.Demand Pull Inflation
• Demand pull inflation occurs when aggregate
demand is growing at an unsustainable rate
leading to increased pressure on scarce
resources and a positive output gap
• When there is excess demand, producers can
raise their prices and achieve bigger profit
margins.
Causes of Demand-Pull Inflation
• A depreciation of the exchange rate increases the price of imports and
reduces the foreign price of a country's exports. If consumers buy fewer
imports, while exports grow, AD in will rise – and there may be a multiplier
effect on the level of demand and output
• Higher demand from a fiscal stimulus e.g. lower direct or indirect taxes or
higher government spending. If direct taxes are reduced, consumers have
more disposable income causing demand to rise. Higher government
spending and increased borrowing creates extra demand in the circular flow
• Monetary stimulus to the economy: A fall in interest rates may stimulate
too much demand – for example in raising demand for loans or in leading to
house price inflation. Monetarist economists believe that inflation is caused
by “too much money chasing too few goods" and that governments can lose
control of inflation if they allow the financial system to expand the money
supply too quickly.
Keynes’ inflationary gap
• An inflationary gap as an excess of planned
expenditure over the available output at pre-
inflation or base prices.
• It is so called because this gap causes price to
rise.
Figure to explain inflationary gap
AS (C+I+G)’
A
Real Expenditure

C+I+G

(C+I + G)’’
C

Yf Ym Y
Explanation of the figure
• Let Yf be the full employment level of output at current prices
• If AD curve in the economy is given by (C+ I + G) then equilibrium
occurs at full employment level
• If AD curve shifts to (C+ I + G)’ for some reason AD > AS & there is an
inflationary gap in the product market. The size of this gap is AB (in fig)
which is equal to AD – AS at full employment
• If AD curve shifts to (C+ I + G)’’ for some reason AD < AS & there is an
deflationary gap of the magnitude BC in the product market.
Explanation of inflationary gap
• In the figure AD = C + I + G = total expenditure on the
aggregate output of the nation. An upward shift in any
one of these components or a combination of these
three in a situation of full employment can produce
inflationary gap
• If foreign trade is added to (C + I + G) then an increase in
net exports (X – M) can also produce such a gap.
2. Cost-push inflation

• Cost-push inflation occurs when firms respond to rising

costs by increasing prices in order to protect their
profit margins.

Causes of Cost Push Inflation:

• Component costs: e.g. an increase in the prices of raw
materials and other components. This might be because
of a rise in commodity prices such as oil, copper and
agricultural products used in food processing. A recent
example has been a surge in the world price of wheat.
Causes of Cost Push Inflation..
• Rising labour costs - caused by wage increases, which are greater
than improvements in productivity. Wage costs often rise when
unemployment is low because skilled workers become scarce and
this can drive pay levels higher. Wages might increase when
people expect higher inflation so they ask for more pay in order
to protect their real incomes. Trade unions may use their
bargaining power to bid for and achieve increasing wages, this
could be a cause of cost-push inflation
• Higher indirect taxes – for example a rise in the duty on alcohol,
fuels and cigarettes, or a rise in Value Added Tax or GST.
Depending on the price elasticity of demand and supply for their
products, suppliers may choose to pass on the burden of the tax
onto consumers.
Causes of Cost Push Inflation..
• Monopoly employers/profit-push inflation –
where dominants firms in a market use their
market power (at whatever level of demand)
to increase prices well above costs.
Wage-Price Spiral
• When W ↑ → P ↑ → cost of living of the workers ↑
• Again when W ↑ → P ↑ → real wage rate ↓
 Both the consequences lead the trade unions to claim a
higher money wage
 If this claim is granted by employers, there is a second
round price inflation caused by the cost factor
 Thus, there is a wage-price spiral

W↑→P↑→W↑→P↑
Wage Price Spiral

“Wages chase price and prices chase wages” and

create a wage price spiral.
•Workers attempt to protect their real wages by pushing for
higher money (or nominal) wages.

Prices Rise

Cost of
production rises
Cost of living rises

Wages rise
Control of Inflation
• Inflation erodes the value of money
and discourages savings
• But zero inflation is
undesirable as it discourages investment in
productive activities.
• There is a need to control inflation
• Two broad categories of inflation control
– monetary policy measures (proposed by those who
believed money supply is the major culprit)
– fiscal policy measures (proposed by Keynes and his
followers).
Monetary Policy Measures

• Excessive money supply may bring about inflation,

therefore to control inflation it is necessary that a
curb is put on money supply.
• The central bank of the country uses various
methods of credit control to keep a check on
inflation.
– Increasing the discount rate
– Higher reserve ratios
– Open market operations
– Selective credit control
Monetary Policy Measures
• Increasing the discount rate: The central bank
rediscounts the eligible papers offered by
commercial banks. This is also called bank
rate.
– Increase in discount rate will leave
less money with the banks
– High cost of money the banks; hence
to interest rates will
increase
• Loans will be discouraged
• Savings will increase
Monetary Policy Measures
• Higher reserve ratios:
– Cash Reserve Ratio (CRR)
– Statutory Liquidity Ratio (SLR)
• Open market operations:
– Central bank may directly sell government
securities to general public and thus restrain
their disposable income
• Selective credit control:
– discourages consumption but not investment
Fiscal Policy Measures
• The government may reduce public
expenditure or increase public revenue to
keep a check on inflation

– Increasing public revenue

• Major source of government revenue is various types
of taxes
• Increase in income tax leaves less disposable income
in the hands of consumers and reduces effective
demand
Fiscal Policy Measures
– Reducing public expenditure
• When government spends on activities like health,
transport, communication, etc., income of individuals
increases; this in turn increases the aggregate
demand.
• Therefore the reverse will also be true.

• Monetary and Fiscal measures hit the

demand side and ignore the supply side of
prices.
Other Measures
Increasing Supply
–Effective public distribution system,
–administered pricing of essential commodity groups
–increase imports and decrease exports of the items which are short in
supply.
–Economic Survey 2007-08 states that government has decided to maintain
price stability of food grains, reduction in import duties and custom duties on
edible oils and other oils and ban on export of wheat and pulses.

The government has to adopt an appropriate combination of all

of these measures after thorough examination of the causes of
inflation.
Measuring Inflation

• A price index is a numerical measure designed to help to

compare how the prices of some class of goods and/or
services, taken as a whole, differ between time periods or
geographical locations.
Prices of that base year are assumed to be equal to 100.

Price Index = Current Year's Price  1 0 0

Base Year's Price
Measuring Inflation
• Wholesale Price Index (WPI): measures on the
basis of wholesale prices of a wide variety of
goods (including consumer and capital goods). In
India, WPI is available on a weekly basis, and is the
most popular measure.
• Producer Price Index (PPI): measures
average changes in prices received by
domestic producers for their output.
measures Itthe pressure being put
producers
on by the costs of their raw materials.
– USA has replaced WPI with PPI
Measuring Inflation
• Consumer Price Index (CPI): measures the price of a selection of goods
purchased by a "typical consumer.“
– CPI differs from PPI in that price subsidization, profits, and taxes may cause the
amount received by the producer to differ from what the consumer paid.

• In India four types of Consumer Price Indices (CPls) are issued that are
specific to different groups of consumers
– CPI-IW for industrial workers;
– CPI-UNME for urban non manual employees; CPI--AL for agricultural
– labourers; and,
– CPI-RL for rural labourers
• CPI-IW is the most well known of these indices as it is used for wage
indexation in Government and in the organized sectors
• Central Statistical Organization has initiated steps to compile CPI under
two broad categories
– CPI (Rural) and
– CPI (Urban).
Measuring Inflation
• Cost of Living Indices (COLI): provides a baseline for
understanding how regional costs of living compare to the
nation and to each other. The index is comprised of six major
categories: grocery items, housing, utilities, transportation,
health care, and miscellaneous goods and services.
• Service Price Index (SPI): is a business-cycle indicator which
measures the gross change in the trading price of services
including : passenger transport, postal services, accomodation
and food services, information and communciation services,
computer programming.

Inflation Rate Last year's Index - Current Year's Index

 100

Current Year's Index

Wholesale Price Index (WPI) in India: A Brief History

• 1942 Beginning of the process of compilation of prices and converting

them into comparative indices
– published for the first time an index number of wholesale prices from the
week commencing January 10, 1942, with base week ended August 19, 1939 =
100.
– The WPI was calculated as the geometric mean of the price relatives of 23
commodities.
• 1947, the series included as many as 78 commodities, covering 215
individual quotations classified into five groups: food articles; industrial
raw materials; semi-manufactures; manufactures; and miscellaneous.
1952-53 a new series was issued with 1952-53 as base price and 1948-49
• as weight base consisting of 112 commodities and 555 quotations.

– The commodities were reclassified into new set of five groups: food article;
liquor & tobacco; fuel, power, light & lubricants; industrial raw materials; and
manufactures.
– The weighted arithmetic average replaced the weighted geometric mean.
Wholesale Price Index (WPI) in India:
A Brief History
• Since then the base year has changed four times and number
of articles/commodities increased substantially.
• July 1969: A new series of WPI with base 1961-62 = 100
covering 139 commodities and 774 quotations.
• January 1977 a new series with wider coverage of items (360
commodities) and 1295 quotations and a new base year
1970-71.
– the commodities were divided into three major groups: i. primary
articles; ii. fuel, power, light & lubricants; and iii. manufactured
products.
– Weights were assigned on the basis of the entire wholesale
transactions in the economy and the values of transactions of the
non-selected commodities were assigned to selected commodities
whose nature and price trends were similar.
Wholesale Price Index (WPI) in India:
A Brief History
• 1989:The WPI series underwent another restructuring with
1981-82 as the base year, 447 distinct commodities and
2,371 price quotations.
– The method of compilation and assigning of weights, as well as the
classification into three major groups continued.
• The latest WPI series with the new base year 1993-94 follows
the same methodology as earlier however now there are
altogether 435 articles/items in the new series, comprising
of 98 'primary articles', 19 items of 'fuel, power, light and
lubricants'; and 318 'manufactured products'.
The new series is constructed with 2004-05 as the base year.
•
Stagflation
Meaning
• Stagflation is a period of rising inflation but
falling output and rising unemployment.
• Stagflation is often caused by a rise in the
price of commodities, such as oil. Stagflation
occurred in the 1970s following the tripling in
the price of oil.
• A degree of stagflation occurred in 2008,
following the rise in the price of oil and the
start of the global recession.
Higher oil prices increase costs of firms causing SRAS to shift to the left.
AD/AS diagram showing stagflation (higher price level P1 to P2 and lower real
GDP Y1 to Y2)
Causes of stagflation
• Oil price rise Stagflation is often caused by a supply-side shock. For
example, rising commodity prices, such as oil prices, will cause a
rise in business costs (transport more expensive) and short-run
aggregate supply will shift to the left. This causes a higher inflation
rate and lower GDP.
• Powerful trade unions. If trade unions have strong bargaining
power – they may be able to bargain for higher wages, even in
periods of lower economic growth. Higher wages are a significant
cause of inflation.
• Falling productivity. If an economy experiences falling productivity
– workers becoming more inefficient; costs will rise and output fall.
• Rise in structural unemployment. If there is a decline in traditional
industries, we may get more structural unemployment and lower
output. Thus we can get higher unemployment – even if inflation is
also increasing.
Solutions to stagflation

• Monetary policy can generally try to reduce inflation

or increase economic growth (cut interest rates).
Monetary policy cannot solve both inflation and
recession at the same time.
• One solution to make the economy less vulnerable to
stagflation is to reduce the economies dependency on
oil. Rising oil prices are the major cause of stagflation.
• The only real solution is supply-side policies to
increase productivity, this enables higher growth
without inflation.