Inflation,deflation & stagfltion

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Text of Inflation,deflation & stagfltion

  • 1. INFLATION UNIT 12

2. INFLATION In economics, inflation is a rise in thegeneral level of prices of goods andservices in an economy over a periodof time. Inflation can also be described as adecline in the real value of moneyaloss of purchasing power. 3. INFLATION RATE A chief measure of price inflation isthe inflation rate, which is thepercentage change in a price indexover time. When the general price level rises,each unit of currency buys fewergoods and services. Economists generally agree that highrates of inflation and hyperinflationare caused by an excessive growth ofthe money supply. 4. INFLATION RATEThe rate of inflation is the percentage change in price level:Rate of inflation (year t )price level (year t ) price level (year t-1)=X 100price level (year t-1) 5. INFLATION RATE Inflation is usually measured by calculatingthe inflation rate of a price index, usuallythe Consumer Price Index. The Consumer Price Index measures pricesof a selection of goods and servicespurchased by a "typical consumer".The inflation rate is the percentage rate ofchange of a price index over time. 6. INFLATION RATE For example, in January 2007, theU.S. Consumer Price Index was202.416, and in January 2008 it was211.080. The formula for calculatingthe annual percentage rate inflationin the CPI over the course of 2007 is 7. EFFECTS OF INFLATION ON ECONOMY Inflation can cause adverse effects onthe economy. For example, uncertainty about futureinflation may discourage investmentand saving. Inflation may widen an income gapbetween those with fixed incomesand those with variable incomes. High inflation may lead to shortagesofgoodsas consumersbeginhoarding them out of concern theirprices will increase in the future. 8. EFFECTS OF INFLATION ON ECONOMY Low or moderate inflation may beattributed to fluctuations in realdemand for goods and services, orchanges in available supplies suchas during scarcities, as well as togrowth in the money supply. The consensus view is that asustained period of inflation iscaused when moneysupplyincreases faster than the growth inproductivity in the economy. 9. HOW TO MINIMIZE INFLATION RATE? The task of keeping the rate of inflationlow is usually given to monetaryauthorities who establish monetarypolicy.Generallytoday these monetaryauthorities are the central banks thatcontrol the size of the money supplythrough the setting of interest rates,through open market operations, andthrough the setting of banking reserverequirements. 10. PRICE INFLATION The relationship between the over-supplyof bank notes and a resulting depreciationin their value was noted by earlierclassical economists such as David Humeand David Ricardo.who examined and debated to whateffect a currency devaluation (latertermed monetary inflation) has on theprice of goods (later termed priceinflation). 11. DIFFERENT STRAINS OF INFLATIONLikediseases, inflationsexhibit different levels of severity, which are classified into three categories:1. Low inflation2. Galloping inflation3. Hyper inflation 12. 1. LOW INFLATION It is characterized by prices that rise slowly &predictably. It is defined as single-digit annual inflation rates. Prices are relatively stable, people trust moneybecause it retains value from month to month &year to year. People are willing to write long-term contracts inmoney terms because they are confident thatrelative prices of goods they buy or sell will notget too far out of line. 13. 2. GALLOPING INFLATION Inflation in double-digit or triple-digitrange of 20, 100 or 200 per year is calledGalloping Inflation or very high inflation. It is relatively common in countriessuffering from weak governments, war orevolution. For example, many Latin Americancountries, like Argentina, Chile & Brazil,had 50 to 700% per year in 1970s &1980s. 14. 2. GALLOPING INFLATION Once country enters in galloping inflation, seriouseconomic distortions arise. Generally, most contracts get indexed to a priceindex or a foreign currency like $. Money loses its value very quickly, People hold only the bare-minimum amount ofmoney needed for daily transactions. Financial markets wither away Capital flees abroad 15. 2. GALLOPING INFLATION Financial markets wither away Capital flees abroad People hoard goods, Buy houses, & Never lend money at low nominal interestrates. 16. 3. HYPERINFLATION A third & deadly strain takes whenHyperinflation strikes. Nothing good can be said about a marketeconomy: prices are rising a million oreven trillion percent per year (e.g. duringcivil war).It took place in Weimar Republic ofGermany in 1920s, price level rose from 1to 10,000,000,000. 17. Anticipated VS UnanticipatedInflation Anticipated Inflation (expected rate ofinflation) : inflation at low rates --- haslittle effect on economic efficiency or onthe distribution of income & wealth. People would simply be adapting theirbehaviour to changing monetaryyardstick. 18. Anticipated VS UnanticipatedInflation Unanticipated Inflation: inflation rate is morethan expected inflation rate. In more stable economies like United States, theimpact of Unanticipated inflation is less dramatic An unexpected jump in prices will impoverishsome & enrich others. This situation will make redistribution of wealth. How costly is this redistribution does not describethe problem. The effects may be more social than economic. 19. The Economic Impacts of Inflation Inflation affects the distribution ofincome & wealth because of differencesin the assets & liabilities. When people owe money, a sharp rise inprices is a windfall gain for them. Suppose, you borrow $100,000 to buy ahouse & annual fixed-interest mortgagepayments are $10,000. 20. The Economic Impacts of Inflation If a great inflation doubles all wages &incomes. Your nominal mortgage payment is still$10,000 per year, but its real cost ishalved. You need to work only half to make yourpayment. Inflation has increased your wealth. 21. The Economic Impacts of Inflation But if you are a lender and have assets infixed-interest rate mortgage or long-termbonds, The unexpected rise in prices will leave youthe poorer because the dollars repaid to youare worth much less than the dollars you lent. The major redistributive impact of inflationcomes through its effect on the real value ofpeoples wealth. Unanticipated inflation redistributes wealthfrom creditors to debtors. 22. Impacts on Economic EfficiencyRedistributionof incomes,inflation affects the real economy in two specific areas:1. It can harm economic efficiency, &2. It can affect total output. 23. CAUSES OF INFLATION Inflations occur for many reasons. Some inflations come from demand side(Demand-pull). Other, from supply side (Cost-push). 24. DEMAND-PULL INFLATION Demandpullinflation occurs whenaggregate demand (AD) rises morerapidly than the economys productivepotential, pulling prices up to equilibrateaggregate supply & demand. One important factor behind demand-pullinflation is rapid money-supply growth. Increases in the money supply increasesAD, which in turn increases price level. 25. COST-PUSH INFLATION Inflation resulting from rising costsduring periodsofhighunemployment and slack resourcesutilization is calledCost-pushinflation. 26. DEFLATION Deflation occurs "when prices aredeclining over time. This is the opposite of inflation; when theinflation rate (by some measure) isnegative, the economy is in a deflationaryperiod." Deflation makes money relatively morevaluable than the other goods in theeconomy. 27. DEFLATIONIn common usage deflation is generallyconsidered to be "falling prices".But there is much more to it than that.Often people confuse deflation withdisinflation or with Depression (as in"the Great Depression"). These threeterms are related but not synonymous. 28. DEFLATION Deflation is "a decline in general pricelevels, often caused by a reduction in thesupply of money or credit. Deflation can also be brought about bydirect contractions in spending, either inthe form of a reduction in governmentspending,personalspending orinvestment spending. 29. WHAT CAUSES DEFLATION?Deflation can occur because of acombination of four factors: The supply of money goes down. Demand for money goes up. The supply of other goods goes up. Demand for other goods goes down. 30. CAUSES Deflation generally occurs when thesupply of goods rises faster than thesupply of money. 31. INFLATION VS DEFLATION If the quantity of money increases to $200 (without increasing the quantity of goods) the price of the goods will increase to $2.00 --- that is inflation. If, the quantity of money decreases to $500 the price will fall to 5% (deflation). 32. INFLATION VS DEFLATION The money supply can also be reduced if someone on our island hoards half of it and refuses to spend it on anything no matter what. This is the second part of the definition (reduction in spending). 33. IS DEFLATION GOOD OR BAD? What happens if the quantity ofgoods available increases? What if instead of having ten itemswe build ten more? We now have twenty items and only$10. 00 so once again each item isworth 50. 34. IS DEFLATION GOOD OR BAD? This form of deflation is the good typebecause if prices go down because thegoods can be manufactured more cheaplythis ends up increasing everyones wealth. Everyone assumes that deflation is badbecause the last major deflation that wehad was during the "Great Depression" sodeflation and Depression are synonymousin many peoples minds. 35. IS DEFLATION GOOD OR BAD? Actually, deflation itself is neither goodnor bad. It depends on the cause of thedeflation whether people will suffer orrejoice. If prices go down due to increase insupply of goods because of lower cost ofproduction while supply of money remainsconstant, it is good. An example of this is in the late 1800s asthe industrial revolution dramaticallyincreased productivity. 36. IS DEFLATION GOOD OR BAD? If deflati