Inflation a strategy to check it

Content
             Introduction Important characteristics Features of Aggregate Demand Vs Aggregate Supply Factors causing demand pull / cost push Types of Inflation Measurement of Inflation  WPI & CPI Inflation levels across developed & developing economy Phillips curve Effect & Impact on Economy Strategic control mechanism Life cycle of inflation Summary References

Introduction
Inflation refers to a rise in price level after full employment level has been achieved
John Maynard Keynes

It is a phenomenon of continuous increase in general price levels in a given period. It is measured by taking the percentage change in the price index.

Important characteristics
 Continuous: rather than one off process  Increases in general price levels: rather than prices of specific goods Demand pull
Aggregate demand higher than aggregate supply Major factors  Increase in money supply,  Government budget deficit,  Increase in export earnings,  Unemployment level remains minimum

Cost push
Cost of factors of production increases supply reduces aggregate demand remains same Major impact  Unemployment level increases to maximum

Features of Aggregate demand & supply

 Aggregate Demand refers to the collective behavior of all buyers in marketplace.  Aggregate Supply is the real value of output producers are willing & able to bring to market at alternative price levels.
Aggregate Supply
Price level (Average price)
1st Qtr 2nd Qtr 3rd Qtr 4th Qtr

Aggregate Demand
Price level (Average price) 100 80 60 40 20 0 Real Output (Qty per year)

100 80 60 40 20 0 1st Qtr 2nd Qtr 3rd Qtr 4th Qtr Real Output (Qty per year)

Effects Real Balance Effect Foreign trade Interest rate effect

Effects Profit Effect Cost effect

Factors causing demand / cost push

Inflation Factors
Real: Increase in Government expenditure with no change in tax receipts or vice a versa Monetary: Decrease in demand for money or Increase in supply

Impact
Increase in consumption, export, investment
100 80 60 40 20 0

Explained

Demand Pull

B A

X
1st Q tr 2nd Q tr 3rd Q tr 4th Q tr

R eal O utput (Q ty per year)

Cost Push

Originating from supply side, increase in wage levels not matched by productivity increase in profit margins who exercise market power Monopolists / oligopolists Supply shock inflation increase in cost of raw material or shortage due to natural calamities

Price level (Average price)

Increase in labor cost per unit higher cost of living fall in real wages

100 90 80 70 60 50 40 30 20 10 0 1st Qtr 2nd Qtr

P Q Y
3rd Qtr 4th Qtr

Real Output (Qty per year)

Types of inflation
Types Modest Creeping Running Defined
Very low level of inflation (2% - 3%) Increase in price levels are small & gradual (5% - 10%) Continuous creeping inflation without adequate monetary or fiscal control will lead to running inflation (8% to 10%) When monetary authorities completely lose control on running inflation it will lead to galloping inflation Price decrease in some goods / services overweigh increase in price of other goods / services

Impact
Slow but steady growth Induces investments in economy Reduce savings, Hindrance to future economic growth Increase in velocity of circulation of money

Hyper of galloping Deflation

Inflation becomes negative & asset price tumbled (Eg Japan in 1995)

Inflation how measured

 Wholesale Price Index WPI indicator designed to measure changes in price level of commodities in wholesale trade intermediaries  Consumer Price Index CPI is measured on the basis of changes in retail prices of selected goods & services (essential goods)  Producers Price Index PPI is a family of indexes that measures the average change over time in the selling prices received by domestic producers of goods and services

As of now inflation is measured through WPI, The consumer price index is the most commonly cited measurement of inflation. With undue changes in inflation rate, the Indian Government is giving a thought to switch over to a more realistic way of measuring inflation through PPI that would replace WPI

Measurement of Inflation
Wholesale Price Index (WPI)
Measures the different prices of a basket of commodities in the wholesale markets. Made up of 98 - Primary products; 19 - Fuel, Power, Lubricant products;318 manufactured products. The office of economic adviser (OEA) in the Ministry of Industry compiles the WPI. Started in 1942 with base year as 1939. Frequent revision in the base, Present base year 1993-94. As of now the inflation is measured through wholesale price index

Consumer Price Index (CPI)

The CPI reflects the cost of living of a particular group in the population Based on changes in retail prices of selected goods and services (essential goods) on which a particular group of consumers spend their money Several consumer price indices For Industrial Workers : CPI-IW (Basket of 260 products) For Urban non-manual employees : CPI-UNME (Basket of 180 commodities) For Agricultural Labours : CPI-AL (Basket of 60 commodities) Data is collected through family budget surveys Base year is changed every few years to take care of tastes / appearance of consumption basket.

Producers Price Index (PPI)

PPI is a family of indexes that measures the average change over time in the selling prices received by domestic producers of goods and services The target set of goods and services included in the PPIs is the entire marketed output of producers. The set includes both goods and services (imports excluded) The price collected for an item included in the PPIs is the revenue received by its producer

WPI/CPI/PPI critical analysis

Wholesale Price Index (WPI)
WPI measures the prices of both inputs and outputs with the inclusion of taxes paid by producers Available at frequent levels continuous monitoring of price levels are possible Duration is usually 1 or 2 weeks Services & non-tradable commodities excluded

Consumer Price Index (CPI)

The price collected for an item included in the CPI is the out-ofpocket expenditure by a consumer for the item. Sales and excise taxes are included in the price The target set of items included in the CPI is the set of goods and services purchased for consumption purposes by urban households (including imports).

Producers Price Index (PPI)

PPI requires only prices of outputs excluding intermediate costs and taxes The PPI methodology provides easily understood data & transparent methodology as a whole process. The PPI methodology automatically factors in the effects of inflation as well as the effects of changes in wages and/or prices. drawback in PPI is its huge dependence on the quality of data voluntarily provided by the respondents

Weighting diagram of WPI & CPI

WPI All commodities Primary Products Food Articles Paan, Supari, Tobacco Fuel Group Coal Mining Housing Manufactured products Food Products Miscellaneous Basic Metals Weight 100.00 22.02 15.04 3.15 14.23 1.75 8.67 63.75 11.54 16.36 8.34 CPI All commodities Food Non-Food articles Minerals Fuel & Light Mineral oils Electricity Clothing, Bedding Textiles Chemicals Others Weight 100.00 57.00 6.14 0.48 6.28 6.99 5.48 8.54 9.80 11.93 21.62

CPI status of India

Consumer Price Index across Globe

Inflation Level across developed countries

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Rate/Bank Re er e Target

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Inflation Level across developing countries

Phillips curve
 British Economist A W Philips pioneered the relationship between the rate of employment and rate of wage increases  Important findings:  Inverse relationship : when wage rate rises low unemployment & vice a versa  Wages increase not matched by increase in labour productivity converted into increase in price level  Organized labor can cause autonomous increase in wage rates in excess of increase in productivity  The link between price changes and employment goes beyond the dynamics of the labour markets.

Effect & Impact on Economy

 Interest rate inflation leads to increase in interest rates which reduces purchasing power of every rupee earned  Exchange rate depends on inflationary trend, as per PPP principle change in value of currency vis--vis another approximately equals to inflation differential  Overall economy inflation & economic growth inversely related  Distribution of Income and Wealth  Production  Unemployment

Economic Impact of Inflation

 Effect of Inflation on the distribution of Income & Wealth
 Different income groups of society negative effect more on fixed income groups  Debtors & creditors debtors gain / creditors loose  Producers - gain  Investors equity investors gain / fixed income security investors loose, Reduction in the real value of investment  Erosion of purchasing power

Effect of inflation -------- contd..

Positive effects
 Mild inflation
 stimulates production &
lead to near full employment  encourages capital investments

Adverse effects


Hyperinflation
    Adversely affect production Decreasing purchasing power Discourages people from saving Hoarding of stock reducing supply & lead to black marketing Production shifts from consumer to luxury goods.

How can we control Inflation

This graph is terrible! Dont worry. I think I can fix it

Strategies by Government / RBI /FM to control inflation

 Monetary Measures
 Monetary Policy (money supply, credit control and bank rate)

 Fiscal Measures
 Public expenditure (increase / reduction)  Taxation (higher taxes & duties on luxurious goods)  Public borrowing and debt (introduce special savings program to divert consumption into savings)

 Other Measures
 Price control and rationing  Wage policy

The Life cycle of Inflation

 Overheating inflation growth
Output Inflation Inflation Inflation Inflation

 Recession-Stagflation
Output

 Recession-Deflation
Output Output

 Recovery-Non inflationary growth

Summary
 Inflation is one important economic variable which is playing an ever-expanding role in the decision making process of business, industry and government  Inflation affects real income tax liabilities in two ways.  It erodes the real values of fixed deductions.  It moves a tax payer in a high tax bracket. Low income groups suffers more than high income groups during inflation  "Containing inflationary expectations would continue to pose a challenge to monetary management," RBI annual report 2005-06.  Is there a trade-off between inflation and employment?  Can policy-makers generate more employment through a deliberate policy of inflation  CPI or PPI  Does it have any effect in controlling the current trend in inflation??  Inflation measured in terms of variation in wholesale prices was 4.92 percent, as compared with 3.7 per cent a year ago

References
 Web sites Reserve Bank of India Government of India : Labour Bureau IMF working paper Sources of Inflation in Developing countries IIMA India Policy Forum Meeting paper How applicable is Inflation Targeting Framework (ITF) for India ICICI Bank e-business site http://ebusiness.icicibank.com/research/  Managerial Economics - Trivedi  Economics for Managers ICFAI  Economics Subject Notes

Thanks for your patience

- Discussion -