INFLATION AND DEFLATION

INTRODUCTION

Inflation and deflation are both far-reaching titanic forces that spread out and greatly influence returns across all major financial markets.

The usefulness of money to an economy depends on its stability.

Inflation and deflation hurt an economy because people can’t count on the value of their money.

CONCEPT OF INFLATION AND DEFLATION

Inflation

A consistent increase in the prices of goods and services over time is known as inflation. 

• During inflationary times, money loses its "buying" or "purchasing" power, and it takes more units of currency to purchase the same units of goods or services.

• The basic cause of inflation is the creation of too much money by the government.

• This situation occurs when there is a more rapid increase in the quantity of money than in the output of goods and services.

• Inflation's effects on an economy are various and can be simultaneously positive and negative.

Deflation 

• A consistent decrease in the prices of goods and services over time is known as deflation. 

• During deflationary times, money increases in its "buying" or "purchasing" power, and it takes less units of currency to purchase the same units of goods or services. 

• It occurs when the annual inflation rate falls below zero percent (a negative inflation rate), resulting in an increase in the real value of money.

BASIC AND RELATED DEFINITIONS

• Various Definitions for Inflation:

According to the Crowthers : “Inflation means a state in which the value of money is falling i.e., prices are rising”

According to Pigou: “ Inflation arises when money income is expanding more than in proportionate to income earning activity”

According to Prof. Samuelson : “ Inflation occurs when the general level of prices and cost are rising”

• Disinflation– a decrease in the rate of inflation.

• Hyperinflation – an out-of-control inflationary spiral.

• Stagflation – a combination of inflation, slow economic growth and high unemployment.

• Reflation– an attempt to raise the general level of prices to counteract deflationary pressure.

INFLATION VS DEFLATION

• Today, most economists favor a low, steady rate of inflation. 

• Deflation causes a burden on borrowers and holders of various illiquid assets and is favorable for savers and holders of liquid assets and currency.

• On the other hand, inflation favors short-term consumption and borrowers and is a burden on currency holders and savers.

• Both inflation and deflation can negatively impact the economy. However, most economists consider the effects of moderate long-term inflation to be less damaging than deflation.

CAUSES OF INFLATION

CAUSE 1: DEMAND RELATED  Rate of inflation accelerates:

aggregate demand > goods and services available

This shortage of supply enables sellers to raise prices till equilibrium between supply and demand.

Constructive to a faster rate of economic growth -

EXCESS DEMAND FAVORABLE MARKET CONDITIONS

INVESTMENT & EXPANSION

CAUSE 2: COST RELATED

“SUPPLY SHOCK INFLATION”

Causes: Natural disasters Increased prices of inputsHoarding (recession)

Shortage of products causes ripple effect through economy by raising prices through supply chain

Example:

Decrease in oil supply increased oil prices Producers (who use oil) passes this to consumers as increased prices.

CAUSE 3: BUILT-IN INFLATION

A GDP level where economy is at optimal level of production

GDP > potential level Inflation accelerates suppliers increase prices

GDP < potential level inflation decelerates suppliers cut prices

Workers demand higher wages to stay above the rate of inflation

Firms pass higher labor costs onto customers as higher prices

CAUSE 4: MONEY SUPPLY

Central banks influence money supply: makes money cheaper / expensive by varying interest rates

If money supply not controlled, it may grow at rate faster than GDP. This will drive up prices and hence, inflation.

Low interest rates

High level of money supply

Allows more investment in big business

Unsustainable levels of inflation as cheap money is available

CAUSES OF DEFLATION

CAUSE 1: DEMAND-SIDE CAUSES

Consumption supply and demand curve is in a downswing

Meaning people in the country are not buying products and services (most notably durable goods).

Two primary reasons for non-consumption:

1. GROWTH DEFLATION:

People do not have money due to unemployment.

Scenario:

Money supply not increased at rate of positive population ` growth and economic growth

Available amt of hard currency per person falls

Money scarce

Purchasing power of unit of currency increases

Two primary reasons for non-consumption:

2. CASH BUILDING (HOARDING) DEFLATION:

Low consumer spending index, people pessimistic about financial future

Deflation is related to risk (scenario):

Risk-adjusted return on assets drops to negative

Investors and buyers hoard currency than invest it, even in the most solid of securities

Produces a liquidity trap

CAUSE 2: SUPPLY-SIDE CAUSES

BANK CREDIT DEFLATION:

Central bank initiates higher interest rates (to 'control' inflation), thereby popping an asset bubble

TYPES OF INFLATION

There are basically 4 different classifications for inflation.Based on Rate of InflationBased on CauseBased on the Government ReactionBased on the Nature of Time Period of Occurrence

BASED ON THE RATE OF INFLATION

Sneaking Inflation

•Small or sneaky

•Annual rise less than 3 percent per annum

•Safe and essential

Walking or jogging Inflation•Moderately•Annual rise between 3-7%•Warning signal for the government Consecutive Inflation•Fast•Annual rise of 10-20% per annum•Affects deprived and middle class•Requires strong monetary measures

Twitchy Inflation

•Also called hyper inflation

•Immeasurable and completely uncontrollable.

•Prices increase many times every day.

Hurtling inflation

•Very rapid

•Annual rise of more than 20-100%

•Also called runaway inflation.

GRAPHICAL REPRESENTATION

BASED ON THE CAUSE OF INFLATION

Demand-pull inflation

- caused by increase in aggregate demand

Cost-push inflation (supply shock inflation)

- caused by a drop in aggregate supply (potential

output)

Built-in inflation (Hangover inflation)

-caused by adaptive expectations

BASED ON GOVERNMENT REACTION

Open Inflation

Govt. does not attempt to prevent price rise

Free market mechanism

Repressed Inflation

Govt. interrupts Price rise

Price control and rationing

BASED ON TIME PERIOD OF OCCURENCE

War Time Inflation

Post War Inflation

Peace Time Inflation

TYPES OF DEFLATION

Cash Building Deflation

Growth Deflation

Bank Credit Deflation

Confiscatory Deflation

POSITIVE EFFECTS OF INFLATION

Decreasing unemployment rates Drop in real interest rates Increasing value of assets Room to manoeuvre

NEGATIVE EFFECTS OF INFLATION

Loss of purchasing power Effect on saving Effect on interest rates Effect on international competition Uncertainty Hoarding Labour unrest

COSTS OF DEFLATION Effect on investment Cost to debtors Unemployment

MEASUREMENT METHODS

Consumer price index

List of the typical goods and services consumed by the average household. grouped into a number of different Categories.

The prices of these items are measured each month to calculate the change in the price of the “basket”.

The change in the price of the basket is reflected in the measure called the consumer price index.

Gross Domestic Product

measures the value of a nation's output of goods and services for some period of time, usually a year.

not the only measure of output--the Federal Reserve, for example, publishes an index of industrial production

but the GDP has become a favorite among economists because it is the most comprehensive of output measures.

Other widely used price indices for calculating price inflation include the following:

Producer price index

Commodity price index

Core price index

PROBLEMS IN MEASUREMENT

As we have seen, there are a number of methods to measure inflation . Some of them are

•Consumer Price Index (CPI)•Producer Price Index (PPI)•Employment Cost Index (ECI)•Gross Domestic Product Deflator (GDP Deflator)•BIS International price program

All these measuredifferent aspects of inflation

Since CPI is a convenient way to compute the cost of living and the relative price level across time , and as it is based on a fixed basket of goods, it does not provide a completely accurate estimate of the cost of living.

The limitations with the CPI are either

limitations in applications or limitations in measurement

LIMITATIONS IN APPLICATION

1) Introduction of New Items -

As time goes on, new items enter into the basket of goods and services purchased by the typical consumer.

Since the CPI uses only a fixed basket of goods, the introduction of a new product cannot be reflected. Items are removed or added to be more representative of the typical household’s demand. However, this takes a good deal of time.

Moreover, if the items in the basket are changed, then this limits the ability of analysts to make comparisons from one time period to another.

2) Substitution Bias –

As the prices of goods and services change from one year to the next, they all do not change by the same amount.

The number of specific items that consumers purchase changes depending upon the relative prices of items in the fixed basket.

The intuitive phenomenon of consumers

substituting purchase of low priced items for higher priced items is not accounted for by the CPI.

3) Differences in purchasing habits.

The basket used in any country represents the purchasing habits of a “typical” household, but this will not be applicable to all people.

The purchasing habits of different people will vary greatly.

For example, the “basket” of a family with children will be very different from that of an elderly couple. Similarly, the “basket” of a rich family will be different from that of a poor family.

4) Change in quality-

When an item in the fixed basket of goods used to compute the CPI increases or decreases in quality, the value and desirability of the item changes.

For example, if some good X becomes much more satisfying than in earlier time , but the price of X does not change, then the cost of living would remain the same

5) Seasonal changes of prices- Prices may change for a variety of reasons that are

not sustained. 

LIMITATIONS IN MEASUREMENT

 1. There may be errors in the collection of data that

limit the accuracy of the final results. The larger the sample, the more accurate will be the results, but this is time-consuming and very costly.

 2. Countries measure their rate of inflation in

different ways, and include different components. This can make it problematic to make international comparisons.

LIMITATIONS IN MEASUREMENT (Contd....)

3) There may be variations in regional rates of inflation within a country. This will be harmful if the group has a higher cost of living and beneficial for those whose spending costs are less than the average.

4) The CPI only measures changes in consumer prices. The changes in producer prices and commodity prices are not given due importance in the measurement of inflation.

CONTROL MEASURES FOR DEFLATION

Reduction in Taxation Reduce the number and burden of taxes levied on

commodities This will increase the purchasing power of the

people

Redistribution of Income Redistribution of income and wealth from the rich

to the poor

Repayment of Public Debt The government can repay the old public debts This will increase the purchasing power of the

people and push up effective demand.

Subsidies The government should give subsidies to induce

the businessmen to increase investment

Reduction in Interest Rate The monetary authority of a country reduced the

interest rate This stimulates investment and thereby expands

economic activity in the economy

Credit Expansion The central bank and the commercial banks

adopt a credit expansion to promote business and industry in the country

Bank credit should be made easily available to the entrepreneurs for productive purposes

VIVEK S NAIR?????

Foreign Trade Policy The government should adopt such a foreign

trade policy to increase exports, and, on the other hand, reduce imports

This will solve the problem of overproduction, and help overcoming deflation

Regulation of Production Production in the economy should be regulated in

so that the problem of over-production does not arise

Attempts should be made to adjust production with the existing demand to avoid over-production.

CONTROL MEASURES FOR INFLATION

1. Monetary measures bank rate policy Increased cost of borrowing which reduces

commercial banks borrowing from the central bank.

The flow of money from the commercial banks to the public gets reduced 

Open Market Operations Central bank sells the government securities to the

public through the banks

Credit Control Central bank raises the bank rates, sells securities

in the open market, raises the reserve ratio etc.

Issue of New Currency The most extreme monetary measure is the

issue of new currency in place of the old currency

Under this system, one new note is exchanged for a number of notes of the old currency

2. Fiscal Measures Reduction in Unnecessary Expenditure Government should reduce unnecessary expenditure

on non-development activities in order to curb inflation

Increase in Taxes The rates of personal, corporate and commodity taxes

should be raised and even new taxes should be levied The government should reduce import duties and

increase export duties

Increase in Savings This will tend to reduce disposable income with the

people, and hence personal consumption expenditure The government should float public loans carrying

high rates of interest, start saving schemes with prize money, or lottery for long periods etc

Surplus Budgets Government should give up deficit financing and

instead have surplus budgets It means collecting more in revenues and

spending less

Public Debt Stop repayment of public debt and postpone it to

some future date till inflationary pressures are controlled within the economy

Instead, the government should borrow more to reduce money supply with the public

3. Other Measures To Increase Production Increase the production of essential consumer

goods like food, clothing, kerosene oil, sugar, vegetable oils, etc

If there is need, raw materials for such products may be imported on preferential basis to increase the production of essential commodities

All possible help in the form of latest technology, raw materials, financial help ,subsidies, etc. should be provided to different consumer goods sectors to increase production

Rational Wage Policy Increase in wages to increase in productivity This will control wage and at the same time

increase productivity, and hence production of goods in the economy

Price Control Price control means fixing an upper limit for the

prices of essential consumer goods They are the maximum prices fixed by law and

anybody charging more than these prices is punished by law

RationingIt aims at distributing consumption of scarce

goods to make them available to a large number of consumers

Applied to essential consumer goods like wheat, rice, sugar, kerosene oil, etc. meant to stabilise the prices of necessaries and assure distributive justice

CASE STUDY:INFLATIONPAKISTAN

•concentrated on the food and energy

•40% increase in wheat price in Pakistan would cause 2 percentage

point increase in national poverty.

•lower income groups in Pakistan tended to experience higher inflation

rates than higher income groups

•the low income group having income up to Rs5,000 suffered an

inflation rate, on average, of 15.17% during 2008/10

• 13.95% for income group earning above Rs12,000, during 2008/10

CAUSES

•floods and sporadic rains

• weak currency

• flattening yield growth of major crops

• low productivity gains

•increasing costs of agriculture inputs

• population syndrome

• energy shortage

•stocking of essential items

REMEDIES

• making Pakistan Agriculture Research Council more vibrant and

result oriented

• broad-based productivity gains

•timely import of essential food items to soften prices

• effective support price mechanism and encouraging corporate-

framing concept

•strong checks on food cartels and hoardings

•building water reservoirs

• improving farm-to-market road networks

• scientifically maintaining storage capacity of agri-produce

• regional trade liberalisation

• broadening of the safety nets for the poor

•Deflation started in the early 1990’s.

•The Bank of Japan and the government have tried to eliminate

it by reducing interest rates,.

•but did not create a sustained increase in broad

money and deflation persisted.

• In July 2006, the zero-rate policy was ended.

JAPAN

•Fallen asset prices. When assets decrease in value, the money supply

shrinks, which is deflationary.

•Insolvent Companies

•Insolvent banks

•Fear of insolvent banks: Japanese people are afraid that banks will

collapse so they prefer to buy gold or Treasury bonds instead of saving

their money in a bank account.

•Imported deflation: Japan imports Chinese and other countries'

inexpensive consumable goods, raw materials.

CAUSES

MEASUREMENT OF INFLATION IN INDIA

WPI (Wholesale Price Index) •Gives the price of a representative basket of wholesale goods. •To measure change in average price level• WPI index released weekly on every Thursday•Focus on price of goods traded between corporations•Helps in analyzing microeconomic and macroeconomic conditions

CALCULATION OF WPI IN INDIA

•No of items used

435 items (Base year -1993-94)676items (Base year 2004-05)

This consists of

•Primary Articles (weight of 22.0253) – 22% Index•Fuel, Power, Light, and Lubricants (weight of 14.2262) - 14% Index•Manufactured Products (weight of 63.7485) – 64% Index

REASONS FOR HIGHER INFLATION RATE IN INDIA

Uncertainty of the monsoons• Agricultural product supply decreases• Increase in priceHike in fuel prices Increases manufacturing cost

MEASURES TAKEN TO CURB INFLATION

During 2006-07 RBI announced the following measures Increasing repo ratesIncreasing Cash Reserve RatioReducing rate of interest on cash deposited by banks

PERSPECTIVES

Traditional anti-inflationary measures

Changing interest rates slows down economic growth

Showed economic mismanagement