Inflation Inflation

Chapter 3Macro Economics

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Chapter #3

• Overview• Inflation 1. Meaning and concept of Inflation2. Kinds of Inflation3. Causes of Inflation4. Inflation rates5. Control over Inflation

6. Effects of Inflation7. Future Forecasting on the basis of inflation.

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Inflation A process of rising prices OR

persistent rise in the general price level in a country over a period of time is called inflation.

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Kinds of Inflation

• Cost push

• demand pull inflation

• Suppressed inflation

• Stagflation

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Cost push InflationCost push inflation: It is a situation where a rise in the

general price level is initiated and sustained by rising cost due to which prices go up.

For example: when the cost of raw material goes up the price of goods also go up which leads to inflation. That’s call cost push inflation. Simply we can say when the price of factor of production increase it increase the prices of goods and services. Factor of production (land, Labor, Capital and Enterprise).

When C and P is called Cost Push Inflation.

Demand pull Inflation• Demand pull inflation: It is a situation where

the aggregate demand persistently exceeds the available supply of output at a current prices which once again causes the general price level to go up.

• For example: The demand is high in the market but supply is less so due to which the sellers increase the price of products.

• When D and S it lead inflation.

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Suppressed Inflation This is a temporary measure of preventing inflation but

eventually leads to inflation. the government fixes the prices of basic essentials like agriculture products very much below the equilibrium price. This is suppressed inflation i.e suppressed through price control.

it means gov. don't let the sellers to sell goods with high prices and

gov. fixes the price

what the sellers do they stock the goods and sell it in black market

and when this policy of gov. finishes the price goes very high

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Stagflation

This is a combination of two words i.e. stagnation (unemployment) of the economy and inflation in the economy.

Stagflation is a situation where both unemployment and the rate of inflation are higher as compared to the accepted standard. Which lead inflation.

Accepted standard every country has there own standard for employment and inflation.

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Causes of Inflation

• Policy of deficit financing: some time the Govt implement new taxes on commodities or borrow loans from other countries to cover their losses due to which inflation occur in a country.

• Backwardness of agricultural and industrial sector of the economy:

• Devaluation of currency: when a country currency start devaluation due to which it loss purchasing power. So the prices of commodities increase.

• Political instability: Private sector does not get involved in the production.

• Undesirable activities: like black marketing, smuggling etc. (the shortage of supply leads to inflation)

• Growth of population: when population of a country start increase it also lead inflation.

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Inflation rates • It is a particular rate at which the level of inflation in

the economy is measured or evaluated in a specific time period.

• Such rate is found by the given following formula…

Inflation rate = current price level – previous price level X 100

previous price level

Calculation of inflation• The basket contains 20 pizzas and 10

compact discs.

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Prices

Year Pizza CDs

2001 $10 $15

2002 $11 $15

2003 $12 $16

2004 $13 $15

Continue• For each year, compute

• the cost of the basket. Total Cost of production

• the CPI (use 2001 as the base year)

• the inflation rate from the preceding year.CPI= Cost of basket in current year X 100

Cost of basket in base year

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Continue

Prices

year Pizza

CDs Cost of basket CPI Inflation Rate

2001

10 15 (20×10)+(10×15)= 350

350/350×100= 100

-----

2002

11 15 (20×11)+(10×15)= 370

370/350×100= 105.7

{(105.7-100)/100}×100= 5.7%

2003

12 16 (20×12)+(10×16)= 400

400/350×100= 114.3

{(114.3-105.7)/105.7}×100= 8.13%

2004

13 15 (20×13)+(10×15)= 410

410/350×100= 117.1

{(117.1-114.3)/114.3}×100= 2.5%

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Inflation Based on Rates

• Creeping inflation. A situation in which the rise In

general price level is at a very slow rate up to 2%.

• Walking inflation. A situation in which the rise in

price level in around 5%

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Cont`d

• Running inflation. In this type of inflation the price

rises from 8 to 10%.

• Hyper inflation. This is known as final stage of

inflation where the prices go up very high from 10 % to onward

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Control over Inflation

• Inflation can be controlled by three sorts of Policies…

• Fiscal Policy.

• Monetary policy.

• Direct measure.

Fiscal Policy:

Fiscal Policy: which refers to the government policy of public expenditure and taxes, can be used an anti-inflationary measure. The government reduces its expenditure on unproductive activities. It raises direct taxes which decrease disposable income of the consumers and due to direct taxes aggregate demand of goods falls down.

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Monetary Policy:• Monetary Policy:Raising bank rates: bank increase interest rate on

deposit due to which people deposit their money in banks and purchasing power of the people decrease due to which inflation control.

Varying reserve ratio: the central bank change the reserve ratio. Mean central bank increase reserve ratio to all commercial banks due to which major portion of money goes to central bank and commercial banks can not issues

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3) Direct Measures

Direct Measures: The government regulatory authority play an important role. For example ministry of labor fix wages and salaries for employees. Same the government fix the prices of different commodities to control inflation in the country.

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Effects of Inflation

Inflation has both positive and negative effects for the economy. But mostly harmful effects are greater than positive effects.

Harmful Effects of Inflation:

1) Increase in cost of living: The working classes are hard hit. Wages and salaries do not rise at that rate as prices are rising. Those section of society who have fixed incomes, find difficulty in buying their daily needs.

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Conti

2) Income inequalities increase: when prices are rising and businessmen and big landlords make huge money. The distribution of income among various classes of society becomes more unequal. Due to which the position of wage earners become weaker. They get a smaller share of national income and the rich-poor gape increase.

3) Decrease in Saving: during rising prices the saving of common people are adversely affected. Greater part of their incomes is used to buy consumer goods.

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4) Less export and more import: due to inflation local goods become costly for the foreigners means for other country people. They start buying from other countries. It effect our export and the graph of import increase.

5) Productive investment falls: due to inflation cost of production increase. Which affect the sale of the product. And local producer face greater lose. 22

Conti Good effects: healthy effects of inflation on the

economy are felt only when the inflation rate is up to 2 % per year.

1)Increase in production: when prices are rising slowly, the profits of the industrialist and businessmen rise. They try to produce more good for more profit.

2) Increase in Employment: Because of high prices of products, firms try to increase

production and employ more workers.

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3) Increase in Investment: when prices increase the investor increase their investment in business to earn more profit.

4) Increase in Economic Development: low inflation is helpful for economic development. The government increase resources by increasing money supply. When government print more money they use it for more development in the country.

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Future forecasting on the basis of inflation rate.

To find out the cost of a product for future on the basis of inflation rate we use the following formula.

Fv= pv (1+i)

Fv= future value

Pv= Present value

i= rate of inflation

n= number of year

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n

ContiSuppose the cost of a house is 20000, if we

purchase it today. If there is 5% inflation , how much we will pay after 4 years for the same house.

Fv= 20000(1+.05)

= 20000(1.21551)

=24310

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End of chapter