Dr.

Kalpana Tokas
Why Care About Inflation?
Inflation is a gradual rise in the price level of an economy. A high level of inflation erodes the
purchasing power of money.

High inflation causes our wealth, income, savings, money balances in the economy and wages to fall
in real or purchasing power terms.

Shoe Leather Cost

As inflation causes money to lose value and purchasing power , one has to frequently visit the bank/
ATM to take out money for transactions creating costs in form of time, hassle etc. called ‘ shoe-leather
cost’( Causing the leather of your shoes to wear out!)

Menu Costs
The higher transactions costs associated with frequently changing prices requiring firms to alter
their cost calculations, inventories as well as contracts. These are referred to as menu costs as it is
like a restaurant changing the prices on its menu due to volatility in prices.
Inflation leads to redistribution of real income. This helps some people, hurts other people and leaves yet
others largely unaffected.

Real Income = Nominal Income/ Price index

% change in real income = % change in nominal income – % change in price level (inflation)
 Who are hurt by inflation?
• Fixed income receivers
• Savers
• Creditors

 Who is unaffected/ helped by inflation?

• Flexible income receivers ( Cost of living adjustments)
• Debtors

This is particularly hurtful to people who live on a fixed income like pensioners.

Inflation benefits debtors/borrowers ( as the real value of amount to be repaid by

them is lower than the value of the sum they borrowed) while it hurts savers/ lenders.
Since Governments are one of the biggest borrowers, inflation often benefits them
by eroding the value of their debts.
The redistributive effects of inflation are less severe if people expect inflation and can adjust their
future nominal incomes to reflect expected changes in inflation rates. Thus, cost of living adjustments
in labour contracts and charging of inflation premium by lenders can help mitigate the effects of
inflation.

Inflation Expectations can be :

1. Adaptive : adaptive expectations is a hypothesized process by which people form their

expectations about what will happen in the future based on what has happened in the past.

2. Rational: Economic agents should use all the information they have about how the economy
operates to make predictions about economic variables in the future. The predictions may not always
be right, but people should learn over time and improve their predictions.
Some amount of Inflation is Desirable! Why?

Modest inflation gives a momentum to an economy. Expectation of inflation incentivizes the

consumers and investors to spend and purchase today as tomorrow the prices may rise. In
moderation, inflation creates a virtuous economic cycle in which consumers have an incentive to
purchase, businesses to invest, firms to hire, wages to rise and employment to expand.
Disinflation : It is a decrease in magnitude of inflation over time. For example, “The wholesale price index
(WPI) based inflation fell to 4.64 per cent in November 2018 from a level of 5.28 per cent in October”

Deflation : This refers to a fall in overall level of prices over time.

Malign( Bad deflation)

Deflation occurs when prices are falling. When people notice that prices are going down, they start to hold
off buying things because the price could keep going down in the future. People begin holding onto their
money rather than spending it, which brings down consumer demand. Since companies are unable to sell
their products, they slash prices and lay off employees . As more people lose their jobs, demand falls even
more, setting a deflationary spiral into motion.

Deflation also causes the borrowers to suffer as the value of their debt rises, making them pay off more.
 Increases in AD – Demand Pull Inflation
 Decreases in AD – Recession and Cyclical Unemployment
 Decreases in AS : Cost Push Inflation
 Increases in AS
Types Of Inflation
(i) Demand Pull Inflation
Inflation resulting from an increase in Aggregate Demand is called demand- pull inflation. A rise in
Aggregate demand can occur through an expansionary fiscal policy ( rise in G , reduction in taxes) or an
expansionary Monetary policy that causes the money supply to increase. It causes a rise in the price level
as well as output level ( temporary)

Price Level
AS

AD’

AD
Output/ GDP
Y*
A fall in AD( shifting AD leftwards due to deficient demand in the economy,) would cause a drop in
price level as well as output level. This is a sort of bad/ malign deflation.
Recession And Cyclical Unemployment as AD Falls
(ii) Cost- Push Inflation
Inflation resulting from an upward shift of the Aggregate Supply curve is called cost push inflation. This may
occur due to supply shocks resulting from higher commodity prices ( oil, metals etc.) , structural constraints,
higher costs of doing business etc. A negative supply shock shifts the AS curve upwards and brings about a
dual problem of fall in output and rise in price level. This phenomenon is known as stagflation.

AS’
Price Level AS

AD

Y* Output/ GDP

There can be positive supply shocks too such as fall in major commodity prices or increased
productivity or technological innovation etc. that shifts AS curve downwards. This causes a decrease in
prices and increase in output. This is also called benign/ good deflation.
• Price indices are used to measure price movements in the economy.

• Price Index converts prices of many goods and services into a single index
measuring the overall level of prices

• How ?

• They help us compare the average prices of a representative consumer basket of

goods and services over two different time periods.

• Three important price indices – Consumer Price Index (CPI), Wholesale Price
Index (WPI) and GDP deflator.
• CPI is a weighted average of prices for a basket of goods and services
commonly purchased by households, at the retail level, and expressed in relation
to a base year with an index value of 100.

• It does not include exports, but includes imports.

• It is used as a representative measure to measure changes in overall level of

retail prices. These changes affect the purchasing power and welfare of
consumers.

• It is used to adjust wages and pensions, to make cost of living adjustments for
contractual payments and to measure changes in purchasing power of
currencies/ exchange rates. Over the years, CPI has been widely used as a
macroeconomic indicator of inflation, and also as a tool by Government and
Central Bank for targeting inflation and monitoring price stability.
• The Central Statistics Office (CSO), Ministry of Statistics and Programme
Implementation started releasing Consumer Price Indices (CPI) on base
2012=100 for all-India and States/UTs separately for rural, urban and combined
with effect from January, 2015.
• Steps in construction of CPI involve :

 Surveys are used to determine a representative basket of goods and

services and the importance of each commodity represented by its share in
total expenditure.

 Each item is assigned weight according to its relative importance in the

representative basket.

 These surveys are usually conducted at an interval of 10 years, price surveys

are however conducted every year.

CPI ={𝛴 𝑃𝑖Current * 𝑄𝑖 Base / 𝛴𝑃𝑖 Base* 𝑄𝑖 Base } * 100

 CPI compares the cost of buying a certain bundle of goods and services in
current year with the cost of buying the same bundle in the base year.
Example
Good 2012 2019
Quantity Price (Rs.) Quantity Price (Rs.)
A 20 10 30 11
B 1 600 2 640
C 1 100 4 120
D 1 50 0.5 40

Year 2012 is base year.

The cost of consumption basket in base year 2012 : 𝛴 𝑃𝑖Current * 𝑄𝑖 Base

= 20 * 10 + 1 * 600 + 1 * 100 + 1 * 50 = Rs. 950

Next, multiply the base year quantities and prices of current year ( 2019) and add
them up i.e. 20 * 11 + 1 * 640 + 1 * 120 + 1* 40 = Rs. 1020
• The CPI for an year is given by the formula:

Cost of BASE YEAR consumption basket in the given year

-------------------------------------------------- * 100
Cost of BASE YEAR consumption basket in the BASE year

Applying this formula to the second year, we get

• CPI = Rs.1020 / Rs. 950 = 1.0737 * 100 = 107. 37

• The base year index is 100, then it means that the cost of buying the same basket
of goods has risen by 7 per cent between 2012 and 2019.

• The inflation rate is the percentage change in CPI i.e. 7. 37 % here.

 Source : MOSPI, CSO, 2015, CES is consumer expenditure survey.

• In India, there have been multiple CPIs – Industrial Worker CPI, Urban Non Manual
Employees CPI, Agricultural Labour CPI, Rural Consumer CPI, which were
subjected to numerous problems of coverage as well as base years.

• In 2011, a new CPI was introduced which provides information at all India, rural and
urban levels and the base year was changed to 2011-12 in 2015. The number of
items increased from 437 to 448 in the rural basket and from 450 to 460 in the urban
1. Comparisons between years that are far apart can be erroneous and misleading
since the weights assigned to goods as well as the representative basket are fixed.
However, there are changes in the availability of goods and services as well as
consumer spending patterns as well as preferences over time. A narrow basket
makes CPI less representative.

2. It does not account for changes in quality of goods and services produced. A
change in price may often be due to change in quality of a product and hence CPI
may overstate price increases by not accounting for quality improvements.

3. With rise in prices, consumers tend to substitute expensive products with

cheaper products, reducing the weights of expensive products in consumer
basket. But because of fixed weights in the consumer basket, CPI tends to
overestimate the price rise. This is known as SUBSTITUTION BIAS.
Calculate CPI for each year with 2007 as base year.

Basket : 4 Pizzas, 10 Burgers

• WPI is a weighted average of the prices for a basket of goods that are commonly
purchased by a firm in a given period.

• The WPI representative basket consists of important inputs in the production

process including raw materials and semi-finished goods.

• Construction of WPI is similar to CPI and the composition of a representative

input basket is determined through a producer survey. Price surveys are carried
out more frequently.

• As WPI is measured at early stages of production and distribution, it signals

inflationary pressures earlier than CPI.

• In April 2014, the RBI adopted the CPI as its key measure of inflation. Prior to this,
the central bank had given more weightage to the WPI as the key measure of
inflation for all policy purposes.
Source : Ministry of Commerce and Industry, GOI
• The base year for the current WPI series for India is 2011-12.

• So, wholesale inflation, measured by WPI, tracks year-on-year inflation at the

producer or factory gate level, and is a marker for price movements in the
purchase of bulk inputs by traders. CPI, on the other hand, captures changes
in prices levels at the shop end, and is, thereby, reflective of the inflation
experienced at the level of consumers.
• The problems are similar to the ones with CPI, however, the preferences for
inputs as well as their availability is less likely to change relative to final
products.

• Also, WPI excludes services altogether and given their rising importance in the
Indian economy , makes the WPI basket less representative.
• Differencein weights assigned to goods in the representative baskets. Food has a
much higher share in CPI (45%)as compared to WPI (22%). This factor plays an
important role, whenever the primary trigger of inflation is food inflation.

•Second, the fuel group has a much higher weight in the WPI (13 %)than the CPIs (6.7
%). As a result, movement in international crude prices has a greater bearing on WPI
than on the CPIs.
• There
are certain items which figure in CPI but do not figure in WPI. These may
be broadly treated as ‘services’ such as medical care, education, travel,
communication etc. They have a total weight 28.3 per cent in CPI.
Headline Inflation : In general, it refers to a measure of change in the overall price
level in an economy over a period of time. Since 2014, RBI targets inflation based
on CPI since it reflects the prices of essential consumption goods faced by
consumers.

Core Inflation : An inflation measure which excludes transitory or temporary price

volatility as in the case of some commodities such as food items, energy products
etc. Core inflation is calculated using the Consumer Price Index (CPI) by
excluding such commodities. The main argument here is that the central bank
should be responding to the movements in permanent components of the price
level rather than temporary deviations.
• It measures changes in economy’s price level by measuring the changes in
prices between the base and current year for all output in an economy.
Nominal GDP
GDP deflator = 100 
Real GDP

NGDPt P1t Q1t  P2t Q2t  P3t Q3t

GDP deflatort  
RGDPt RGDPt
• The index is called implicit as there are no pre-determined weights such as for
the case of CPI and WPI.

If, Nominal GDP for 2017 = 1918

Real GDP for 2017 ( i.e. 2017 GDP valued at base year 2011-12 prices ) = 1185.9

GDP deflator for 2017 = (1918/ 1185.9) * 100 = 161.7

• This means that given a GDP deflator of 100 for the base year 2011-12, the
general price level for all goods and services produced in the economy has
increased by 61.7 Per cent between 2011-12 and 2017-18.
• GDP Deflator is a broader index than the CPI or WPI. The former covers all
goods and services produced in the economy while the latter includes only a
representative goods basket.

• Deflator includes only domestically produced goods and does not account for
the impact of import prices.

• The CPI/WPI gives fixed weights to the prices of different goods while the
deflator has changing weights since it allows the market basket to change with
the composition of GDP.
 Two primary targets of Fiscal policy & monetary policy :
 Low inflation
 Low unemployment

 Are these two goals conflicting or compatible?

What Is Unemployment?
 InIndia, employment-unemployment surveys are conducted by the National Sample Survey
Organization(NSSO).
 National Sample Survey Organization (NSSO) defines employment and unemployment on the following
activity statuses of an individual:
 Employed :Working

 Unemployed : Seeking or available for work

 Not in the Labour force : Neither seeking nor available for work ( full-time students, retirees, discouraged
workers etc.)

 Labour force = No. of employed + No. of unemployed

 Unemp Rate = No. of unemployed/ Labor Force * 100

 Labor force Participation Rate = L Force/ Adult population * 100

• Labour Force : The number of people in adult population (15-64 years) holding
or seeking a job or the sum of those employed or unemployed. It excludes
discouraged workers i.e. unemployed workers who give up looking for work
and are no longer part of the labour force.

• Unemployment Rate : The percentage of labour force that is without a job but
seeking a job.
= ( No. of unemployed / No. in labour force) * 100

• Labour Force Participation Rate : The percentage of adult population that is in

the labour force ( holding or seeking a job)
= ( Labour force/ Adult population) * 100
Types of unemployment :

1. Structural Unemployment : This unemployment refers to the workers who have

lost their jobs due to their skills no longer being in demand, e.g. job
displacement due to automation. Changes over time in consumer demand and
technology cause ‘structure’ of labor demand to change occupationally and
geographically. (Offshoring?)

2. Frictional Unemployment : This unemployment is due to normal workings of

the labour market. A It includes people who have been temporarily between
jobs because they are moving or changing occupations or for similar reasons.
Some are voluntarily moving b/w jobs, others laid off and looking for
reemployment, young workers looking for first job etc.
Cyclical Unemployment : The portion of unemployment that is due to a decline in
the economy’s total output and total spending. It results from insufficient demand of
goods and services. It rises during recessions and falls during recovery periods.
 Full Employment represents the situation in which every person who is
willing to work at the prevailing rate of wages is, infact, employed. The
output produced when all the available resources are employed is called
full employment level of output.

 The rate of unemployment associated with full employment is known as

Natural rate of unemployment. At this rate, there is no cyclical
unemployment and the economy is achieving its potential output. The
unemployment numbers that are seen represent structural and frictional
unemployment.

 Natural rate of unemployment is the unemployment rate that occurs when

cyclical unemployment is zero. It is the full employment rate or the rate of
unemployment achieved by the economy when economy is achieving its
potential output.
 The basic economic cost of unemployment is foregone output. When the economy fails
to create enough jobs for all who are able and willing to work, potential production is
lost. (GDP Gap)

 An increase in unemployment rate might be tolerable to society if every worker’s hours

and income were reduced proportionately but this is not the case. The burden of
unemployment is unequally distributed on the basis of occupation, race, gender etc
 Difficult to distinguish between an unemployed person and person out of labor
force.
 Movements into and out of L force are common. Recent entrants into workforce?
 Some of the unemployed may not be trying hard enough to find a job. Qualify for
Government aid?
 Some of those who are out of labour force may want to work. Discouraged workers
tried finding jobs and may have given up after an unsuccessful search.
• In an ideal labor market, wages should adjust to balance the quantity of labor supplied and quantity of
labour demanded. This will ensure full employment.

• However, reality is not same. Some employment always exists even with good growth numbers.Why?

Frictional Unemployment

• It takes times for workers to search a job suiting their tastes and skills the best.
• Job Search requires matching workers with appropriate jobs
• It can result due to changes in labor demands across firms in an industry. Different regions of a country
produce different goods and can have different trends. Sectoral shifts in demand can alter employment
patterns.
• Job search – internet?
• Government programs can impact job search in many ways : Training programs, unemployment insurance (
eases the hardship or increases unemp?),
 Minimum wage laws
 Forces the wages to remain above equilibrium , raising the quantity of labor supplied and reducing
the quantity of labour demanded. This leads to a surplus of labor.
 Unions and collective bargaining
 Union allows the workers to bargain with their employers over wages, benefits and working
conditions collectively. The unions exert their joint market power over employers and engage in
collective bargaining. Above equilibrium wages creates unemployment.
The Phillips Curve
 Demonstrates short term tradeoff between inflation and
unemployment rate.
 Named after A.W Phillips who developed this idea in Great
Britain.
 Lower unemployment rates are associated with higher rates
of inflation.
 Rightward Shift in AD…
 FP/MP move the economy along the AS curve
This idea is apparent here as we look at the short-run aggregate supply curve illustrated in this graph.
Here you can see that as aggregate demand expands, in the short run the price level increases. As the
price level increases, firms will increase production, which in turn will lead to higher employment. We will
end up with the downward sloping Phillips Curve. MP an FP move the economy along the Phillips Curve.
AS Shocks & the Phillips Curve
 During the 1970s and 1980s, the Phillips Curve was put to the test.
This period saw both higher inflation and higher unemployment
rates, leading economists to develop the term “stagflation,” a
combination of stagnation and inflation.
 It led to the development of a second generalization: aggregate
supply shocks can cause both higher rates of inflation and higher
rates of unemployment.
 Adverse aggregate supply shocks are sudden, large increases in
resource costs that can jolt an economy’s short-run aggregate supply
curve leftward.
Phillips Curve and Stagflation (Cost Push Inflation)
Inflation and unemployment both increase, shifting the curve outwards
Long Run Phillips Curve
 there is no long-run tradeoff between inflation and unemployment,
meaning you can control inflation without causing an increase in the
unemployment rate. In the short-run analysis, if the actual inflation
rate is higher than expected, profits temporarily rise, and the
unemployment rate temporarily falls.
 But this is not a permanent situation. In the long run, workers will
demand an increase in nominal wages to reflect the increased
demand for workers and the higher prices they must pay. This will
reduce the temporary profits, and output will decrease, returning
unemployment to its natural level.
The Long Run Phillips Curve
This graphs helps to illustrate the movement in prices as aggregate demand increases beyond the full-
employment output level. Profits may temporarily increase, but nominal wages will also eventually
increase, moving output back to the full-employment level. There is no apparent long-run tradeoff
between inflation rate and unemployment rate. When decades are considered, any rate of inflation is
consistent with the natural rate of unemployment.

The long-run Phillips curve shows the relationship between

unemployment and inflation after expectations of inflation have
had time to adjust to experience
In the short-run analysis,
• If the actual inflation rate is higher than expected, profits temporarily rise, and the unemployment
rate temporarily falls.

• But this is not a permanent situation. In the long run, workers will demand an increase in nominal
wages to reflect the increased demand for workers and the higher prices they must pay. This will
reduce the temporary profits, and output will decrease, returning unemployment to its natural level.
 Takeaways
 Under normal circumstances, there is a short run tradeoff between inflation rate
and the unemployment rate.
 Aggregate supply shocks can cause both higher inflation and higher unemp rates.
 There is no significant trade off bw inflation and unemployment in the long run.