Notesale: Turn your study into money

Document Preview

Extracts from the notes are below, to see the PDF you'll receive please use the links above

---

MEANING OF INFLATION
It is defined differently by different writers
...
e prices are rising" Crowther
" a continuing increase in the general price level"Brooman
"a persistent and appreciable rise in the general level of prices"
...

The demand for goods increases due to the increase in the supply of money without any increase in
the supply of goods
...

Types of Inflation
There are different types of inflation
...

Creeping InflationIt is themild form of inflation
...
Almost 3%
increase in price per annum is called creeping inflation
...
Here increase in prices by
3% to 6% per annum
...

Galloping or Hyper InflationPrices rise every moment and there is no limit to prices rise
...

Open InflationPrices are permitted to rise without being suppressed by government
Suppressed InflationPrice rises are controlled by the government
...
Eg
...

Sporadic InflationRise in the price level in some sectors of the economy
...
Under this situation supply cannot be increased at short notice
...
Price level rises
in all sectors of the economy
...
Prices rise due to rising costs associated with higher wages
and diminishing returns in production
...

Ratchet InflationThere is excessive aggregate demand in certain sectors and inadequate in others
...
Prices
rise in the excess demand sectors
...
The net effect
is an overall increase in the price level
...
Price rises in the capital good industry
...
Thus the aggregate price level is pushed upwards which results
in inflation
...

Mark-up is based on anticipation of future costs and prices
...
When demand is higher the mark-up tends to be
higher and less when demand is low and costs are high
...

Bottleneck Inflation Inflationary situation before full employment due to the imperfect elasticity
of supply of goods, is known as bottleneck inflation
...

Supply is limited due to a number of bottlenecks like
a
...

b
...

c
...

d
...


Reflation A type of inflation occurring during the recovery from a depression or recession in which
prices are restored to a so called desirable level by decreasing the purchasing power of money
...

Disinflation A reduction in the rate of inflation is known as disinflation
...


The Classical Theory Of Inflation

Based on quantity theory of money, which states level of prices (P) depends on the supply of
money (M)
...

P = f(M)
Inflation caused by a rise in money supply
...

V -velocity of circulation of money
...

P -general level of prices and
T -volume of transactions
...


So any increase in M must lead to a proportional rise in P
...
Remedy for inflation is a reduction in the quantity of money
...


Demand Pull Inflation

Inflation caused by an increase in aggregate demand is called demand-pull inflation
...
A shift in the
aggregate demand curve can arise as a result of an increase in private as well as government
expenditures
...

Price level

S

P2
P1
D2

P0

D1
S

0

D0
Y0

Real income

Real national income is measured on the X axis, price level on the Y axis
...

When the aggregate demand curve shifts from

DOto

D1, the price level rises form P0 to P1
...
This will cause the aggregate demand curve to shift upward again, causing the price
level to rise further
...

3
...
This additional AD is created because of the
increase in real factors
(1)increase in consumption due to increase in mps
(2) increase in investment due to increase in the MEI
(3) increase in government expenditure
...
This increase in AD while AS is
kept constant, create a demand –supply gap
...
According to Keyns
these inflationary gap is the reason for inflation
...
He defined the concept of inflationary gap as the gap between
theplanned expenditure and the real output available at full employment
...
For
Keyns expenditure at less than full employment is not inflationary, the price rise may generate
additional employment and output
...

The concept of inflationary gap can be explained by using the 'Keynesian cross'
...
At point E1 resources are
fully employed
...
Suppose the government increase its spending by
E1E2= ∆G
...

But, since there is full employment, additional resources (capital and labour) would not be
available in response to the additional demand
...
This creates an inflationary pressure in the
economy
...
Therefore, E1E2 is inflationary
gap
...


Cost-Push Inflation (Supply Side Inflation)

Inflation caused by an increase in costs is referred to as cost-push inflation
...
Here prices are pushed up by increased cost of
production
...
Wage-push inflation is caused by
rising money wage rates
...
Wage push inflation is impossible in an economy, in which wage rates are determined by
purely competitive market forces
...
Profit-Push Inflation is another variant of supply inflation
...
This will result in
an increase in price level
...


Mixed Inflation (Mixed Demand – Pull& Cost - Push Inflation)
Inflation due to a combination of demand-pull and cost-push factors called mixed inflation
...

Suppose an inflationary process begins with excess demand
...
The rise in money wages is not the
result of cost push forces
...
This will raise
prices
...

Thus both demand-pull and cost push forces are supplementary
...


Sectoral Demand-Shift Theory Of Inflation

Introduced by Charles Schultze
...
If prices and wage rates
are inflexible downwards in the sectors in which demand decreasing, and prices and wage rates
rise in the sectors to which demand increases, the overall price and wage level will rise
...

Excess demand for goods and services in the expanding sectors pushes up prices in these sectors
...
This higher prices and wages 'spill over' into
other sectors of the economy, spreading the inflation
...


One is through higher wages in the expanding sectors leading to higher demand for goods
and services in other sectors
...
Soindustries in the contracting sectors react to these higher wages by
increasing their prices
...


6
...
To explain inflation in less developed countries
...
So some sectors of
the economy are characterized by shortages of supply relative to demand whereas other sectors
are characterized by underutilization of resources and excess capacity
...
Resources GapLess developed countries are trying to industrialize their economies based
on government spending
...
So there is excessive dependence on 'deficit financing' which results in excess
increases in the supply of money which leads to inflation
...
Food Bottleneck The domestic supply of food grains in less developed countries is not
increasing sufficiently to match the increase in demand from increasing population and
urbanization
...
Thus food grain prices play a major
role in the inflation of less developed countries
...
Foreign Exchange Bottleneck less developed countriesimport increases greater than the
increase in export
...
The shortage of
foreign exchange will lead to an increase in the price level in two ways
...
The prices of such goods increase
...

Thus the shortage of foreign exchange is another cause of inflation in less developed
countries
...
Infrastructural Bottlenecks Because of the resource gap, the government is not able to
allot sufficient resources for the adequate growth of infrastructure facilities
...
The result is inflation
...

2
...

4
...

6
...

Decline purchasing power
...

The value of notes and coins falls
...

Degree of risk associated with investment in the economy increases
...


7
...
Butreal incomes remain constant
...


SACRIFICE RATIO
It is the amount of output lost when the inflation rate is reduced by one percentage
...

MEASUREMENT OF INFLATION IN INDIA
There are three indices used in the measurement of inflation
1
...
A single index is calculated for all the goods and services in the basket for the
country as a whole
...
The market basket is periodically updated
...
They are,
i
...

monthly basis
...
It is computed on a

ii
...
The CPI-AL basket covers 260 commodities
...
CPI for Urban Non-Manual Employees (CPI-UNME)
The base year is 1984-85
...

iv
...

2
...


Wholesale Price Index (WPI)

The WPI series is compiled, computed and reported on a monthly basis
...
Does not cover services and
non tradable commodities
...

i
...
The number of
primary articles is 102
...
12%
...
Fuel Power Light and Lubricants include 19 items like coal, petroleum products and
electricity
...
91%
...
Manufactured Products includes 555 items like sugar, cotton textiles, chemicals, cement,
iron and steel, machinery and tools etc
...
97%
...
The WPIat the end of a
particular month in the current year is compared with the WPI on the same day in the
previousyear
...


GDP Deflator
GDP deflator is the ratio of GDP at current prices to GDP at constant prices
...
GDP deflator is available
only annually with a long lag of over one year
...
Money Supply -The prices rise whenever the supply of money increases faster than the supply
of goods in an economy
...
Defense Expenditure
production
...
Credit Facilities Sometimes the commercial banks may grant loans easily leading to an
increase in the supply of money and the demand for goods
...


During war the supply of money increases without any increase in the supply of goods
...
Deficit Finance results in an increase in the supply of money leading to inflation
...
Hoarding result in a reduction in the supply of goods in the market and an increase in the prices
of goods
...
Increase in Wages and Cost of Production
...
An increase in the cost of production will result in an increase in
price level
...
Natural Calamities Natural calamities like failure of monsoon, floods etc reduces the supply
of goods
...

EFFECTS OF INFLATION
1
...
Though the debtors return the same amount of money,
the value of money is less than when they borrowed the money
2
...
This is due to the fact that prices
rise faster than the increase in salaries
...
Wage earners may gain or lose depending upon the speed with which their wages adjust to
rising prices
...


People like pensioners, recipients of interest income etc lose when prices are rising
...
Equity Holdersgain during inflation because of the rise in dividend payment and an increase in
share prices
...
Farmers gain during inflation because prices of the farm products increase more than the
cost of production
...
As the price level is increasing production is encouraged
...
The level of employment, output and income increase up to the
point of full employment
...
Inflation tends to increase the inequalities in the distribution of income and wealth
...

9
...
When prices rise more rapidly in the domestic economy than foreign countries it will result in
a reduction in the exports and an increase in imports, thereby making the balance of payments
unfavourable for the country
...

1
...


2
...


3
...


Strikes, lockouts and labour unrest
...


Political agitations resulting in the fall of government
...


Declining moral values
...

Monetary Measures
Measures adopted by the central bank of a country to control inflation
...
Higher Rediscount Rate (Bank Rate)
excess activity based on borrowed funds
...
Therefore regulates

2
...
A rise in reserve requirements
reduces the amount of demand deposits in the banking system
...

3
...
Sale of government securities by the central bank to the public leads
to fall in the amount of currency with people
...

4
...
to regulate and control the supply of credit among its possible users
and uses
...
Consumer Credit Regulation It is to regulate the demand for durable consumergoods
for economic stability
...

b
...


to prevent excessive use of credit to speculative

c
...


inflation and unemployment -10

d
...
It is usually adopted by the central bank by advising to the commercial
banks during inflation to regulate the supply of credit
...

1
...

2
...

3
...


4
...

5
...
It is the process of making home currency expensive relative to foreign
currencies
...
Output Adjustment Increased production is a basic solution to the problem of inflation
...
Wage Policy Trade unions demands for higher money wages should be made in accordance
with increase in labourproductivity
...
Price Control It is by establishing the legal upper limits beyond which prices of particular
goods may not rise
...
Rationing to divert consumption from those articles of consumption whose supply needs to be
restricted for some special reasons
...
Inflation
caused by excessive aggregate spending is known as demand-pull inflation
...
The central bank reduces the supply of money
by restricting the power of commercial banks to expand credit
...
Reductions in the
money supply raise the interest rate and reduce investment spending
...
The instruments of monetary policy are of two
types -quantitative instruments and qualitative instruments
...
Aggregate spending can be reduced by a
reduction in government expenditure or an increase in taxes or both
...
The result is a fall in aggregate demand and price level
...


inflation and unemployment -11

If the government is using the budget surplus for the retirement of public debt held by non-bank
public, the total expenditure in the economy will increase which will aggravate the inflationary
situation
...

Increased availability of credit at a lower rate of interest will generate greater inflationary
pressures in the economy
...
Restrictive fiscal policy can reduce the level of
aggregate demand and control demand pull inflation
...
The adoption of fiscal measures to reduce the inflation will reduce income and
rising unemployment
...
It is associated with a contraction of
bank credit and money supply
...
During deflation
levels of outputdeclines unemployment increases
UNEMPLOYMENT
Unemployment is a situation where a larger number of persons are not employed, who are
actively looking for a work or waiting to work
...

1
...

2
...
Thus a major part ofthe workforce remains
unemployed
...

3
...
To
RagnerNurkse, the marginal productivity of the disguisedly unemployed labourer is equal to zero
(MPL = 0)
...
More labourers are employed in the agricultural sector
...
Cyclical Unemployment due to fluctuations in business conditions
...
The net effect
is an increase in the unemployment rate
...
SeasonalUnemployment occurs when the demand for certain types of labour fluctuates with
the seasons of the year
...

6
...
Those who are in the process of changing jobs and are unemployed during the time
of searching for new job
...


inflation and unemployment -12

7
...
Structural unemployment results due to the emergence of
new products and techniques which requires new skills
...

8
...
Employment of persons having higher technical qualifications in ordinary
jobs
...
Technological Unemployment
methods of production
...
Natural Rate of Unemployment The rate of unemployment that prevails when output and
employment are at the full employment level
...
FU is the unemployment that exists as a result of individuals shifting
between jobs and looking for new jobs
...
It is the rate of unemployment consistent with a steady rate of
inflation
...
The idea of natural
rate of unemployment was developed by Milton Friedman and Edmund Phelps
...

1
...
When
unemployment rises, the reduction in the number of people working leads to a decline in the
quantity of goods and services produced
...

The society is also adversely affected because of the reduction in food production, availability of
medical care, education, the production of vehicles, movies and new houses
...
Another cost is the psychological cost faced by unemployed workers and their families
...
Prolonged unemployment
may also bring social and personal ills, anxiety, stress, depression, deterioration of physical and
psychological health, drug abuse, alcohol ism and suicide
...
When real GDP
rises, the unemployment rate falls and when the real GDP falls, the unemployment rate rises
...
Okun's law stated that
the unemployment rate decreased by 1 percentage point for every 3 per cent increase in real
GDP
...
The equation states that the percentage gap between potential and
actual output (output gap) equals 3 times the cyclical unemployment rate
...
If natural rate of unemployment
is 6% and actual unemployment rate is 7%, cyclical unemployment rate (u-u*) will be 1%
...

As Y* equals Rs
...
300 crores below
the full employment level
...
9708crores
...

labour rorce participation rate =

labour force
adult population

THE UNEMPLOYMENT RATE
Ratio of the number of people unemployed to the total number of people in the labour force
...


inflation and unemployment -14

1
...

2
...

3
...

STAGFLATION
The term stagflation was introduced by Paul Samuelson from two words stagnation and inflation
...

Inflation is characterised by rising prices
...
Stagflation occurs when inflation rises while output is either falling or at
least not rising
...

a deficiency in aggregate demand and
rising factor input costs
...
Rising inflation is
caused by the increase in the factor input costs
...
This relationship was first identified by the British economist A W Phillips from
the data from 1861 to 1957
...

Money wage rate

M1

M
PC

O
U1

U

Rate of unemployment

inflation and unemployment -15

The Phillips curve PC is convex to the origin
...
Money wage rate will be OM1 at the lower
unemployment rate of OU1
...
Organizedlabour can push up the wages above labour productivity
resulting in wage push inflation
...
With lower
unemployment, labour unions will demand larger wage increase
...

The second explanation relates to excess demand for labour
...
Excess demand
for labour will result in an increase in money wages and a reduction in unemployment
...

Trade Off Between Inflation and Unemployment (Modified Phillips Curve)
The original Phillips curve depicts the inverse relationship between money wage rates and
unemployment rates
...
A
...
Phillips found that a high rate of unemployment was associated with a
low rate of inflation
...
The economy cannot obtain a low rate of unemployment simultaneously with a
low rate of inflation
...
Different points on the curve identifies the combination of inflation and
unemployment
...


inflation and unemployment -16

Point B is a combination of unemployment of 4% and an inflation rate of 2%
...

Implications
1
...

and full employment are not compatible goals of fiscal and monetary policy
...
Economy can move up along the Phillips curve reducing the unemployment rate and increasing
the rate of inflation
...

Criticisms
1
...

2
...
It shifts as expectations of inflation change
...
In the long run there is no trade off between inflation and unemployment
...

4
...
This is due to the fact that wages are sticky in the
downward direction even when an economy is experiencing high rates of unemployment
...


Lack ofrigorous theoretical foundations is another limitation of the Phillips curve
...
For them there is no trade off between
inflation and unemployment in the long run
...

Friedman says that Phillips curve holds only in the short-run
...
This rate of unemployment is "natural rate of
unemployment"
...

The expansionary policies will accelerate the rate of inflation and cause an upward shift in the
Phillips curve showing a higher level of unemployment and inflation rate
...
This is the essence of Friedman's theory of the expectation augmented
Phillips curve
...
Now, suppose that at some point of time the economy is at
point A with unemployment rate of Un and inflation rate of R and that these rates are consistent
with the potential level of output
...
As the economy is at
the full employment, any expansionary policy will only push up the price
...

As long as the workers are confused by the situation or do not realize the decline in the real
wages, real wages continue to decline
...
So employment increases and unemployment decreases
...

This shows a decline in the unemployment rate from Un to U
...
Because workers eventually feel the decline in their
real wages and begin to anticipate a further fall in their real income
...
They negotiate for a higher money wage rate at the time of the renewal of
the labour contract
...
The rise in the real wage rate causes a decline in the
demand for labour
...
The movement from point B to C indicates an increase in the rates of both
inflation and unemployment
...
As a
result, the rate of unemployment rises back to its natural level, Un, the rate of inflation rises
from R to R'
...


inflation and unemployment -18

At point C, if the policy-makers decide to reduce the unemployment rate to a lower target level,
they will have to increase the money supply
...
The expansion of money supply will make the system move
from point C towards point D and then from D to point E
...

When we take a long-run view of the Phillips curve and its upward shift, we find the equilibrium points shifts upward from point A to C and then from C to E, all conforming to the shortrun Phillips curves
...
The long-run Phillips curve means
that there is no trade-off between the unemployment and inflation rates in the long run, and
that the natural rate of unemployment can be compatible with any rate of inflation
...
So they adopt an anti-inflationary policy and reduce the money
supply
...
As a result,
employers cut down the demand for labour
...
This situation is depicted by the movement from the equilibrium
point C to point F along the SPC2
...

Validity of the Phillips Curve
Historically there has been a negative correlation between the rate of unemployment and the rate
of inflation
...
The Phillips curve indicates that the rate of
wage increase is inversely related to the unemployment rate
...
For Milton Friedman and Edmund
Phelps there is no tradeoff between inflation and unemployment in the long run
...
According to Friedman in long run a different Phillips curve exists for
each level of inflation expectations
...

Inflation and Interest Rates
Interest rates are the most important macroeconomic variables
...

Two Interest rate: Real and Nominal
...
Next
year, he withdraw his savings and the interest
...

But if prices have risen, each dollar buys less, and his purchasing power has not risen by 8
percent
...

And if the inflation rate was 10 percent, then his purchasing power has fallen by 2 percent
...

If i denotes the nominal interest rate, r the real interest rate, and + the rate of inflation, then the
relationship among these three variables can be written as
, =-−+
The real interest rate is the difference between the nominal interest rate and the rate of inflation
...

It shows that the nominal interest rate can change for two reasons: (1) the real interest rate
changes or (2) the inflation rate changes
...

The quantity theory of money shows that the rate of money growth determines the rate of
inflation
...

The quantity theory and the Fisher equation together tell us how money growth affects the
nominal interest rate
...

According to the Fisher equation, a 1 percent increase in the rate of inflation in turn causes a 1
percent increase in the nominal interest rate
...

Demonetization
Removal of a currency note or coin from circulation, by eliminating its status as legal tender
...

No much impact, because that currencies was not accessible to the common people
...

Rs 500 and Rs 1000 and 10000 notes were introduce in 1938
...
Aim of the ban was to curb black money
...

It is to curtail the shadow economy and stop the use of illicit and counterfeit cash to fund illegal
activity and terrorism
Great Depression
1
...

in most countries it started in 1929 and lasted until 1941
...

2
...

The scale and timing of the recession varied from country to country
...

Gresham's Law
'Bad money drives out good money from circulation'
...

when two forms of coins with the same face value exist in the metal coinage system,
coins of lower intrinsic value (bad money) will become the chief circulating medium
and the coins of higher intrinsic value (good money) will disappear from circulation
because people hoard it
...




---