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 cant count on the value of their money. 2

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.
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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
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INVESTMENT & EXPANSION

CAUSE 2: COST RELATED

SUPPLY SHOCK INFLATION Causes: Natural disasters Increased prices of inputs Hoarding (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.

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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
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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
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CAUSES OF DEFLATION

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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).

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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
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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
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CAUSE 2: SUPPLY-SIDE CAUSES

BANK CREDIT DEFLATION:

Central

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

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TYPES OF INFLATION There are basically 4 different classifications for inflation. Based on Rate of Inflation Based on Cause Based on the Government Reaction Based on the Nature of Time Period of 19 Occurrence

BASED ON THE RATE OF INFLATION

Sneaking
Small

Inflation

or sneaky rise less than 3 percent per annum

Annual Safe 20

and essential

Walking
Moderately Annual

or jogging Inflation

rise between 3-7% Warning signal for the government

Consecutive
Fast
Annual

Inflation

rise of 10-20% per annum Affects deprived and middle class 21 Requires strong monetary measures

Twitchy
Also

Inflation

called hyper inflation

Immeasurable Prices

and completely uncontrollable.

increase many times every day.

Hurtling
Very

inflation

rapid

Annual
Also

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rise of more than 20-100%

called runaway inflation.

GRAPHICAL REPRESENTATION

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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 24

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

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BASED ON TIME PERIOD OF OCCURENCE

War Time Inflation Post War Inflation Peace Time Inflation

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TYPES OF DEFLATION

Cash Building Deflation Growth Deflation Bank Credit Deflation Confiscatory Deflation

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POSITIVE EFFECTS OF INFLATION

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

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NEGATIVE EFFECTS OF INFLATION

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

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COSTS OF DEFLATION
Effect on investment Cost to debtors Unemployment

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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.

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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.

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

price index price index

Commodity

Core

price index

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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
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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 limitations in measurement or

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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 households demand. However, this takes a good deal of time. Moreover, if the items in the basket are changed, then this 36 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.
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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.
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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 pricesPrices may change for a variety of reasons that are not sustained.
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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 timeconsuming 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.

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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.

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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.

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

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.
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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.

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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

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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 47 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

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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

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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

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Rationing It 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

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CASE STUDY:INFLATION
PAKISTAN

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 52 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 costs of agriculture inputs

increasing

population syndrome
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energy shortage of essential items

stocking

REMEDIES
making Pakistan Agriculture Research Council more vibrant and strong checks on food cartels and hoardings result oriented building water reservoirs

broad-based productivity gains improving farm-to-market road networks

timely scientifically import ofmaintaining essential food storage items capacity to soften of

agri-produce prices
corporate-

regional trade liberalisation effective support price mechanism and encouraging

broadening of the safety nets for the poor framing concept 54

JAPAN
Deflation started in the early 1990s. 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.

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CAUSES
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'
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inexpensive consumable goods, raw materials.

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

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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

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REASONS FOR HIGHER INFLATION RATE IN INDIA

Uncertainty of the monsoons Agricultural product supply decreases Increase in price Hike in fuel prices Increases manufacturing cost

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MEASURES TAKEN TO CURB INFLATION

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

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PERSPECTIVES
Traditional anti-inflationary measures Changing interest rates slows down economic growth Showed economic mismanagement

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