Knowledge Series : Inflation

February 2009

Price Shocks?

Fiscal measures?

Declining output?

Excess money
supply?

Monetary
tightening?
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Inflation

<<What is inflation>>

Introduction to Inflation
- Inflation is defined as the increase in the general level of prices of goods and services
from one period to another (generally one year).
- It is measured in terms of percent change in the value of price index consisting of a basket of
goods or services.
- An inflation rate of 10% means that the general level of prices of goods and services has
increased by 10% over the previous period.
- In other words purchasing the same amount of goods and services will cost you 10% more
than what it would have cost you in the previous period.
- Hence Inflation can also be described as a decline in the real value of money- a loss of
purchasing power in the medium of exchange which is also the monetary unit of account

Why do prices rise and fall

- Prices of goods and services in a free market are determined by the forces of demand and
supply. Thus you cannot have constant prices unless and until you have a constant demand
for these good as and services along with a constant rate of supply
- In general it is observed that demand increases faster than the supply which leads to an
increases in prices over a period
- However in unusual times, when demand falls you may actually see a fall in the general level
of prices, which in technical terms is called Deflation

An increase in the general level of prices implies a decrease in the purchasing power of the currency. That
is, when the general level of prices rises, each monetary unit buys fewer goods and services.
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Is deflation healthy?
- Both, a high level of inflation and deflation impact the economy adversely
- It is believed that moderate inflation over a period of time is good for the economy because
it encourages producers to increase output
- However, a high level of inflation or deflation has the opposite effect.
- If inflation rises to very high levels then..
- It reduces the purchasing power of the money in the hands of the people..
- Resulting in a slowing down of demand for the goods and services produced
- Which in turn compels providers of these goods and services to reduce output

- On the other hand, a deflationary scenario makes the production of these goods or services
less lucrative and so encourages producers to reduce output

Types of Inflation
- Demand Pull Inflation is caused by the presence of excess money in the system which leads to
increase in aggregate demand in the system. Its a classic case of Too much Money chasing Too
Few Goods
- This kind of inflation can be controlled by monetary measures such as high interest rates and by asking
banks to maintain high cash reserves. These measures act as breaks on money supply

- Cost Push Inflation on the other hand has been caused by supply side constraints. The high cost of
labor or raw materials may force producers to increase the prices of their goods and services. High
crude oil and food prices are examples of supply shocks leading to unexpected increases in prices
of their goods and services
- This kind of inflation requires a more careful use of monetary and fiscal measures

- Built-in inflation is a type of inflation that resulted from past events and persists in the present. It
thus might be called hangover inflation.
- Often linked to the "price/wage spiral, as it involves workers trying to keep their wages up with prices
and then employers passing higher costs on to consumers as higher prices as part of a "vicious circle."
- In this case, inflation encourages inflation to persist, which means that the standard methods of
fighting inflation using either monetary policy or fiscal policy to induce a recession are extremely
expensive, i.e., meaning increase in unemployment and fall in real GDP. Hence, alternative methods
such as wage and price controls may be needed as complementary to recessions in the fight against
inflation.
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Difference between Core Inflation and Headline Inflation.

We hear economist use the terms Core Inflation and Headline Inflation. What are these?
- Headline Inflation is most commonly represented by a price index consisting of a basket of
different goods and services
- Core Inflation is what we get after removing volatile elements such as oil and food from
the basket of goods and services.
- Headline inflation is generally higher then core inflation

How does inflation affect us?

- Inflation will affect you depending upon where you are placed financially
- People living on fixed sources of income such as retirees will feel the pinch more, as
inflation eats away the value of their income day by day
- In an inflationary scenario, a person living on borrowed money is better off as the rate of
interest that he would have paid for his borrowed money would be less than the rate of
inflation. Therefore inflation decreases the real value of debt
- But when you pay back your loan in an inflationary environment your lender realizes that
now he can buy a little less than what he could have bought earlier with the he lent to you

Thank You

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