INFLATION

Definition
A sustained, rapid increase in prices, as measured by some broad index (such as Consumer Price Index) over months or years, and mirrored in the correspondingly decreasing purchasing power of the currency.

How Inflation Is Measured?

To measure inflation, a number of goods that are representative of the economy are put together into market basket. It is then compared over time. This results in a price index. Price index shows the changes in the cost of the present market basket as a percentage of the cost of that identical basket in the previous year.

Price Indexes
There are two main price indexes that measure inflation: Consumer Price Index (CPI) A measure of price changes in the retail market of consumer goods and services such as petrol, food, clothing and automobiles. The CPI measures price change from the perspective of the retail buyer. It is the real index for the common people. It reflects the actual inflation that is borne by the individual. This is not taken into consideration in India.

Price Indexes
Wholesale Price Index (WPI): It is used in India. It takes into account the rise in prices of goods and services in a select range of goods and services at the wholesale level. Since the general public does not buy at the wholesale level, it does not give the actual feeling of the amount of pressure borne by the general buyer.

Measuring Inflation
The CPI can be thought of as an imaginary basket of selected goods and services bought by a typical capital city household. The CPI is merely a measure of the changes in the price of this basket of goods and services.

Measuring Inflation
The price of the CPI basket in the base (first) period is given a value of 100 and the prices of subsequent periods are compared against the base year.

Measuring Inflation
For example, if the price of the basket had increased 15% since the base year, the CPI would read 115, if the price had fallen by 15% since the base year the CPI would be 85.

Measuring Inflation

It is important to remember that the CPI measures price movements and not actual price levels.

Measuring Inflation
For example, if the index for beer is 108 and the corresponding index for wine during the same period is 104 it doesnt mean that the price of beer Is more expensive than wine.

10

Measuring Inflation

It means that the price of beer has increased twice as much as that of wine since the base year.
11

Measuring Inflation
Compilation of the CPI involves a quarterly survey of a basket of goods and services representing a high proportion of household expenditure.

12

Measuring Inflation
The basket of goods and services upon which the CPI is based is divided into 8 groups. Which are further divided into a number of sub-groups and then into specific expenditure classes.

13

Measuring Inflation
The eight groups of the CPI are as follows: Food Clothing Housing Education and Recreation Transportation Health and Personal Care Household Equipment and Operation

14

Measuring Inflation
To reflect the importance of each expenditure class in relation to total household expenditure, weight or measure of relative importance to each expenditure class in the CPI, are attached to each item in the index.

Measuring Inflation
Weights are compiled as a result of extensive surveys of patterns of consumption and are revised every 5 years to take account of changes in expenditure patterns.

Measuring Inflation
The usefulness of an index number in statistics is to allow comparisons of data between one period and another, using a common unit of measurement.

Constructing the CPI Index

Commodity Food Clothing Housing Recreation Total Price Index
Period 1 Period 2 Weight Price WXP Price WXP 40 0.65 26 0.80 32 30 0.70 21 0.80 24 20 1.15 23 1.15 23 10 1.00 10 1.10 11 100 80 90 100 112.50

Inflation
Measured by:
CPI =
price of the most recent market basket in a particular year price estimate of same market basket in 1982-1984

Inflation
Percent increase in CPI = [(CPI in current year CPI in previous year)] [CPI in previous year] all*100

Inflation
From 1972 to 1982, the consumer price index rose from 125.3 to 289.1 By what percentage did the cost of living rise?

Inflation
Percent increase in CPI = [(289.1 125.3] [125.3] *100 =130.7%

Inflation
The CPI rose from 114.3 in 2013 to 126.1 in 2020. By what percent did the CPI rise?

Inflation
Percent increase in CPI = [(126.1 114.3] [114.3] *100 =10.3%

Inflation
The CPI rose from 200 in 1991 to 240 in 1997. By what percent did the CPI rise?

Inflation
The CPI rose from 129.6 in 2029 to 158.3 in 2045. By what percent did the CPI rise?

Inflation
Percent increase in CPI = [(240 200] [200] *100 =20%

Inflation
Percent increase in CPI = [(158.3 129.6] [129.6] *100 =22.1%

Calculating Inflation
Year 2 cost Year 1 cost x 100

= Therefore
1

90 80

100

= 112.5
1

Calculating Inflation
112.5 100 (Base Year) = 12.5 % From this we can say over the year, average prices increased by 12.5 %.

Inflation
Inflation is a steady and upward movement in the level of prices, decreasing purchasing power, over a given period of time, usually one year.

32

Demand Pull Inflation

Demand Pull Inflation occurs when Aggregate demand (C+I+G+(X-M)) increases at a rate faster than the capacity of the economy to produce goods and services ie: AD>AS. This increase competition for goods and services drives up their prices.
33

Demand Pull Inflation

Price Aggregate Supply

P2
Aggregate Demand 2

P1 Aggregate Demand 1

Q1

Q2

Real GDP

Demand Pull Inflation

An increase in demand shifts the aggregate demand curve to the right, from AD1 to AD2 pushing up the price level from P1 to P2.

Sources of Demand Pull Inflation

Any increase in Aggregate Demand (C + I + G + ( X M ) ) as the economy approaches full employment.

Sources of Demand Pull Inflation

Full employment causes labour shortages, employers thus bid up wages to attract labour. The increased income, transpires into increased consumption causing Aggregate Demand to rise.

Sources of Demand Pull Inflation

High levels of foreign investment increases employment, income, consumptions and ultimately Aggregate Demand.

Sources of Demand Pull Inflation

Growth in foreign economies can lead to higher incomes for our exporters, thus allowing increases in Aggregate Demand.

Sources of Demand Pull Inflation

Inflationary expectations If members of an economy expect prices to rise, it brings forward expenditure decisions leading to demand pull inflation eg: Pre GST in Australia.

Sources of Demand Pull Inflation

Increasing consumption due to changes in consumption patterns (less savings at any level of income).

Sources of Demand Pull Inflation

Monetary consideration too much credit in the economy. A relaxed monetary policy leads to a reduction in interest rates leading to an increase in Aggregate Demand and thus prices.

Cost Push Inflation

Cost Push Inflation occurs when prices are pushed up by rising costs to producers who compete with each other for increasingly scarce resources. The increased costs are passed onto consumers.

Cost Push Inflation

Price Aggregate Supply 2

Aggregate Supply 1

P2

P1

Aggregate Demand

Q2

Q1

Real GDP

Cost Push Inflation

An increase in the prices of inputs shifts the aggregate Supply Curve to the left, from AS1 to AS2 pushing up the price level from P1 to P2.

Sources of Cost Push Inflation

Any input may become a major cost to business eg: wage increases lead to higher production costs.

Sources of Cost Push Inflation

Labour shortages in some sectors necessitate wage increases in that sector, however it has a domino effect leading to wage rises in other sectors.

Sources of Cost Push Inflation

NB: Wage rises in excess of productivity increase leads to inflationary pressure. The extend to which a producer can pass on price rises depends on the level of competition in the industry. The more competitive the industry, the more the producer has to absorb costs rather than pass them onto consumers.

Sources of Cost Push Inflation

Inflation imported from abroad, eg: the rise in the cost of intermediate goods and resources imported from other countries flows through in the form of higher prices domestically eg: oil prices.

Sources of Cost Push Inflation

Government budgetary problems an increase in the cost of public utilities eg: electricity, water etc, leads to higher costs to business and households.

Inflation
Who is hurt by inflation?

Who is Hurt by Inflation

PEOPLE ON FIXED INCOMES LENDERS/CREDITORS

Who is Hurt by Inflation: People on Fixed Incomes

Nominal Income Real Income

Who is Hurt by Inflation: Nominal vs. Real Income

NOMINAL INCOME = face value of your income

REAL INCOME = nominal income adjusted for inflation with price indexes

Who is Hurt by Inflation: Nominal vs. Real Income

% CHANGE IN REAL INCOME = % Change Nominal Income - % Change Price Level

Who is Hurt by Inflation: Nominal vs. Real Income

Fixed income receivers

Anyone who income is fixed over time finds that their real income falls at the same rate that inflation rises.

Who is Hurt by Inflation: Lenders/creditors

Lenders, such as banks and credit card companies, lend money to earn a profit. To earn a profit, the interest they charge must cover all costs, and be higher than the rate of inflation.

Who is Hurt by Inflation: Lenders/creditors

When lenders lend money, they have an expected rate of inflation at the time of the loan. This expected rate of inflation is based on current rate of inflation, plus a guess about the future.

Who is Hurt by Inflation: Lenders/creditors

If lenders guess right about inflation, they earn a profit. If lenders guess wrong, they lose money.

Who is Hurt by Inflation: Lenders/creditors

Nominal interest rate = the observed interest rate
Real interest rate = nominal interest rate rate of inflation

Who is Hurt by Inflation: Lenders/creditors

If inflation is less than the nominal interest rate, lenders earn a profit.
If inflation is greater than the nominal interest rate, lenders suffer a loss.

Inflation: Any Winners?

Not everyone loses with low and moderate rates of inflation. - People whose income is flexible. - Borrowers (debtors).

Inflation: Any Winners?

Borrowers win because the real value of their loan repayments decreases at the same rate as inflation rises. If their incomes rise as well, they are double winners.