MB0042-Managerial Economics Unit-14 Inflation and Deflation

Program Semester

: MBA :I

Subject Code
Subject Name Book Id Unit Number Unit Title

: MB0042
: Managerial Economics : B1131 : 14 : Inflation and Deflation

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MB0042-Managerial Economics Unit-14 Inflation and Deflation

Inflation and Deflation

Objectives:
To define inflation and distinguish between different kinds of inflation. Describing the causes of inflation and its effects on different sections of society. To explain different measures that can be adopted to control inflation. Analyzing the concept of inflationary gap. To adopt suitable measures to tackle the situation of stagnation.

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MB0042-Managerial Economics Unit-14 Inflation and Deflation

Lecture Outline

Introduction Meaning and Types of inflation

Inflationary Gap
Stagflation Philips Curve Deflation Summary Check Your Learning Activity

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MB0042-Managerial Economics Unit-14 Inflation and Deflation

Introduction

Inflation is a period of steady rise in price level. Monetary, fiscal & direct measures are adopted to control inflation. Inflationary gap means excess of anticipated expenditure over available output at a base price.

Phillips curve explains the relationship between inflation and unemployment. Stagflation explains the situation of stagnant conditions in economic activity when there is inflation in the economy.

Deflation is a period of falling prices and rise in the value of money.

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MB0042-Managerial Economics Unit-14 Inflation and Deflation

Meaning and Types of Inflation

Inflation is a state in which the value of money is falling i.e. Prices are rising. Inflation is statistically measured in terms of percentage increase in the price

index, as a rate percent per unit of time- usually a year or a month.

Percentage rate of inflation, P[t] =

Change in Pr ice [ t] 100 Pr ice [ t 1]

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MB0042-Managerial Economics Unit-14 Inflation and Deflation

Meaning and Types of Inflation

Types of Inflation :
Creeping inflation: the rise in prices is very slow (less than 3 %). Walking inflation: the price rise is moderate ( 3 to 7 %) and the annual inflation rate is of a single digit. Running inflation: the prices rise rapidly (10 to 20 % ) per annum. Hyper Inflation: prices rise very fast, ( more than 20 to 100 % )per annum or more and becomes absolutely uncontrollable.

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MB0042-Managerial Economics Unit-14 Inflation and Deflation

Meaning and Types of Inflation

Demand pull Inflation: is a result of an excessive aggregate effective demand over aggregate supply of goods and services in a slowly growing economy. F=equilibrium position where aggregate demand =aggregate supply

OP=price level and OY=supply

As demand increases, supply being constant, price level rises from OP to OP1 & OP2.
Y S

Price Level

P2 P1 P F D S 0 Y X D1 D2

Output

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MB0042-Managerial Economics Unit-14 Inflation and Deflation

Meaning and Types of Inflation

Cost-Push Inflation: prices rise on account of increasing cost of production. F=original equilibrium position where demand =supply OP=original price level and OY=supply.

A =new equilibrium point when supply curve shifts upwards on account of cost
push factors.

OP1=new price level, which is higher than original one and OY1=new supply.
Y S

Price Level

P 4
P3
P2

D2 D1

P1 P

S3
S1 S

A
F D

Y2 Y1

Real Output
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MB0042-Managerial Economics Unit-14 Inflation and Deflation

Meaning and Types of Inflation

Causes of Inflation :
Demand side: Aggregate demand exceeds aggregate supply. Increase in money supply and Increase in disposable income Increase in private consumption expenditure and investment expenditure High rates of indirect taxes and Reduction in the rates of direct taxes Increase in Foreign Exchange Reserves Reduction in the level of savings Existence of Black Money Increase in Exports Population Increase

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MB0042-Managerial Economics Unit-14 Inflation and Deflation

Meaning and Types of Inflation

Supply side : Supply falls short of demand. Shortage in the supply of factors of production Increase in prices of inputs with in the country Operation of law of diminishing returns Hoardings by Traders and speculators Role of natural Calamities Hoarding by Consumers Role of Trade unions International factors

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MB0042-Managerial Economics Unit-14 Inflation and Deflation

Meaning and Types of Inflation

Expectations : If people expect further rise in price, current aggregate demand increases which in turn causes a raise in prices. Expectations about higher wages and salaries. Effects of Inflation : Positive side of effects of inflation: Leads to increase in the demand for money It is a necessary cost of development

Leads to rise in investment

Creates better opportunities Encourage entrepreneurship Full utilization of resources

Inflation tax

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MB0042-Managerial Economics Unit-14 Inflation and Deflation

Meaning and Types of Inflation

Effects on production: A low inflation rate stimulates economic growth Disturbs the working of price- mechanism Adverse effects on investment and production Adverse effects on savings and capital formation Leads to hoardings and black marketing Encourages speculative activities Distortion in resource allocation Creates business uncertainty Reduces production

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MB0042-Managerial Economics Unit-14 Inflation and Deflation

Meaning and Types of Inflation

Effects on distribution Leads to unequal distribution of income and wealth Inflation creates hardships for fixed income earners Adverse effects on wage-earners and salaried class Entrepreneurs and business community gain Debtors gain and creditors lose Affects investors and farmers

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MB0042-Managerial Economics Unit-14 Inflation and Deflation

Meaning and Types of Inflation

Social and political effects of inflation : Social effects: It leads to social conflicts between the rich and poor. Moral and ethical effects: It gives a serious blow to business morality and ethics. Political effects: Due to discontentment among people and deterioration in social and ethical standards people loose faith in administrative ability of Govt. Impact of demonstration effect: It encourages consumerism and a country may have to suffer on account of demonstration effects.

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MB0042-Managerial Economics Unit-14 Inflation and Deflation

Meaning and Types of Inflation

External effects of Inflation : Decline in international competitiveness Discourage the inflow of foreign capital Reduces the volume of exports

Measures to Control Inflation :

Monetary Measures Credit control by using quantitative and qualitative methods. Ceasing a friction of currency

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MB0042-Managerial Economics Unit-14 Inflation and Deflation

Meaning and Types of Inflation

Fiscal Measures Increase in taxes and imposing new taxes Minimum use of deficit financing Economy in public expenditure Raise public debt Direct measures

Direct control of prices and introduction of rationing.

Control of speculative and gambling activities. Adopting appropriate wage-profit policy. Adopting an appropriate income policy.

Overvaluation of currency
Control of population

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MB0042-Managerial Economics Unit-14 Inflation and Deflation

Inflationary Gap

The Inflationary Gap : shows a situation in the economy when anticipated expenditure exceeds the available output at pre-inflationary prices. AD intersects AS at E, where OY1 >YF. Amount by which aggregate demand (YF A) exceeds aggregate supply (YF B) at full Expenditure employment level of income (YF) is inflationary gap(AB).
Y AS

AD E A B

YF

Y1

Income

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MB0042-Managerial Economics Unit-14 Inflation and Deflation

Inflationary Gap

Measures to wipe out inflationary gap :

Increase in savings to reduce aggregate demand.

Raise the out put to match the disposable income.

Raise the taxes to mop up the excess purchasing power.

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MB0042-Managerial Economics Unit-14 Inflation and Deflation

Stagflation

Stagflation : period with a high rate of inflation combined with unemployment and economic recession. Deflationary gap occurs when aggregate demand is less than aggregate supply. It is the most difficult type of inflation that the world is facing today. Keynesian remedial measures have not succeeded in containing inflation but actually have aggravated un-employment.

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MB0042-Managerial Economics Unit-14 Inflation and Deflation

Philips Curve

Phillips

Curve

identifies

the

inverse

relationship

between

the

rate

of

unemployment and the rate of increase in money wages. Paul Samuelson and Robert Solow extended the Phillips curve analysis and

concluded that there is a trade-off between the level of unemployment in a country

and the rate of inflation.
Growth of Money wages (%)
Y Y

Rate of inflation

P1 P2 P3

Unemployment

X PC

U1

U2

U3

Unemployment

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MB0042-Managerial Economics Unit-14 Inflation and Deflation

Deflation

Deflation is just opposite to inflation. Deflation is that state of the economy where the value of money is rising or the prices are falling.

Effects of Deflation :
On Production Deflation has an adverse effect on the level of production, business & employment. Fall in demand and prices force many firms to quit industry or operate partially. Wages are reduced or workers are retrenched.

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MB0042-Managerial Economics Unit-14 Inflation and Deflation

Deflation

On Distribution : The salaried persons and wage earners will benefit by deflation. Producers, merchants and speculators lose badly. Debtors lose while the creditors gain.

Methods to Control Deflation :

Monetary policy: Monetisation, Credit creation, Reducing rate of interest.

Fiscal Policy: Deficit financing, reduction in tax rates, tax concessions, increase
public expenditure, pay back public debt.

Other measures: Price support programs, rationing of essential commodities, import of essential goods, grant of subsidies, development of infrastructure, etc.

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MB0042-Managerial Economics Unit-14 Inflation and Deflation

Summary

Inflation refers to a period of general rise in price level. A number of measures like monetary, fiscal and physical controls are adopted to control inflation.

Inflationary gap is a Keynesian concept; it arises when expenditure is in excess of

the goods available in the economy.

Phillips curve explains the inverse relationship that exists between the rate of unemployment and the rate of increase in money wages.

Deflation is a state of falling prices, incomes, output and employment.

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MB0042-Managerial Economics Unit-14 Inflation and Deflation

Check Your Learning

1. The value of money and price level is ___ related. Ans. Inversely 2.The state of steady rise in price level is called ____. Ans. Inflation 3. The trade-off between inflation and unemployment is called the ____ Curve. Ans. Philips 4. A situation where inflation is accompanied by stagnation is called _____. Ans. Stagflation 5. A state of steady fall in price is called ________________. Ans. Deflation

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MB0042-Managerial Economics Unit-14 Inflation and Deflation

Activity

Discuss the business policy measures that you would like to recommend to the government of India.

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