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MB0042-Managerial Economics

Unit-14 Inflation and Deflation

Program : MBA

Semester : I

Subject Code : MB0042

Subject Name : Managerial Economics

Book Id : B1131

Unit Number : 14

Unit Title : Inflation and Deflation

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MB0042-Managerial Economics

Unit-14 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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Inflation and Deflation

C o n f i d e n t i a l

MB0042-Managerial Economics

Unit-14 Inflation and Deflation

• Introduction

• Meaning and Types of inflation

• Inflationary Gap

• Stagflation

• Philips Curve

• Deflation

• Summary

• Check Your Learning

• Activity

Lecture Outline

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C o n f i d e n t i a l

MB0042-Managerial Economics

Unit-14 Inflation and Deflation

• 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.

Introduction

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MB0042-Managerial Economics

Unit-14 Inflation and Deflation

• 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] =

100]1t[icePr

]t[icePrinChange

Meaning and Types of Inflation

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MB0042-Managerial Economics

Unit-14 Inflation and Deflation

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.

Meaning and Types of Inflation

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MB0042-Managerial Economics

Unit-14 Inflation and Deflation

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.

D

D1

D2

S Y

X Y

0

P

P1

P2

F

S

Pri

ce L

evel

Output

Meaning and Types of Inflation

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MB0042-Managerial Economics

Unit-14 Inflation and Deflation

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.

X Y Y1 Y2

D

D1

D2

H S

F

G

S S1

S3 B

A

P P1

P2 P3

P

4

0

Y

Real Output

Pri

ce L

evel

Meaning and Types of Inflation

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MB0042-Managerial Economics

Unit-14 Inflation and Deflation

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

Meaning and Types of Inflation

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MB0042-Managerial Economics

Unit-14 Inflation and Deflation

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

Meaning and Types of Inflation

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MB0042-Managerial Economics

Unit-14 Inflation and Deflation

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

Meaning and Types of Inflation

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MB0042-Managerial Economics

Unit-14 Inflation and Deflation

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

Meaning and Types of Inflation

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MB0042-Managerial Economics

Unit-14 Inflation and Deflation

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

Meaning and Types of Inflation

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MB0042-Managerial Economics

Unit-14 Inflation and Deflation

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.

Meaning and Types of Inflation

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MB0042-Managerial Economics

Unit-14 Inflation and Deflation

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

Meaning and Types of Inflation

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MB0042-Managerial Economics

Unit-14 Inflation and Deflation

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

Meaning and Types of Inflation

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MB0042-Managerial Economics

Unit-14 Inflation and Deflation

The Inflationary Gap : shows a situation in the economy when anticipated

expenditure exceeds the available output at pre-inflationary prices.

Y

A

E

B

AS

AD

O YF Y1 X

Income Exp

en

dit

ure

AD intersects AS at E, where OY1 >YF.

Amount by which aggregate demand (YF A)

exceeds aggregate supply (YF B) at full

employment level of income (YF) is

inflationary gap(AB).

Inflationary Gap

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C o n f i d e n t i a l

MB0042-Managerial Economics

Unit-14 Inflation and Deflation

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.

Inflationary Gap

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MB0042-Managerial Economics

Unit-14 Inflation and Deflation

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.

Stagflation

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MB0042-Managerial Economics

Unit-14 Inflation and Deflation

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.

X

Y

0

PC Unemployment Gro

wth

of

Mo

ne

y w

ag

es

(%

)

X

Y

0

Unemployment

Ra

te o

f in

fla

tio

n

U1 U2 U3

P1

P2

P3

Philips Curve

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C o n f i d e n t i a l

MB0042-Managerial Economics

Unit-14 Inflation and 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.

Deflation

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MB0042-Managerial Economics

Unit-14 Inflation and 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.

Deflation

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C o n f i d e n t i a l

MB0042-Managerial Economics

Unit-14 Inflation and Deflation

• 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.

Summary

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C o n f i d e n t i a l

MB0042-Managerial Economics

Unit-14 Inflation and Deflation

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

Check Your Learning

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C o n f i d e n t i a l

MB0042-Managerial Economics

Unit-14 Inflation and Deflation

Discuss the business policy measures that you would like to

recommend to the government of India.

Activity

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