Price StabilityDr. Shylajan, C.S

Topics of DiscussionMacroeconomic objectivesInflation and its MeasurementThe Economic Impacts of InflationModern Inflation Theory: Prices in the AD-AS FrameworkDemand-Pull & Cost-Push InflationManagement of Inflation The Philips CurveThe Problem of Inflation in India

Macroeconomic Policy Objectives

Macroeconomic Policy ObjectivesSustained Economic GrowthPrice Stability

Price Stability

Stability in the general price level is captured by the rate of inflation in the economy

Movements in Wholesale Price Indices or Consumer Price Indices

Each provides a measure of inflation in the economy

Calculation of rate of inflation Rate of inflation is the rate of growth or decline of the price level from one year to the next year

Rate of inflation = CPI (this year) CPI (last year) * 100CPI (last year)

InflationContinuous rise of general price levelCalculated using price indexesPercentage change in the price level is called rate of inflationDifferent types: low inflation, galloping, hyperinflation etc

Inflation Theory: What Causes Inflation?Due to Demand factors :Demand pull: Real vs monetary factors

Due to Cost factors :Cost push: Wage push & Supply shock inflation

Graphical approach

Demand pull inflationCaused by increase in any of the components of aggregate demand That is, in C, I, G or net foreign demandUsually due to increase in G (fiscal deficit and inflation)If there is more supply of goods to meet excess demand, then price will not rise

Demand pull inflationBut, if the economy is operating at its full capacity, then supply can not be increased to meet excess demand. So price may go up .inflation

In real life, as demand increases, prices and output both increases.

Cost-push inflationDue to increase in costs

Cost push inflation results in a rise in prices and a fall in output

Higher costs of production due to higher labor cost, material costs, import costs, increase in oil prices, strong bargaining power of producers etcOil shock and inflationWage push: increase in labour costs without increasing productivity

Inflation and Money SupplyGrowth of money supply leads to inflation (monetarist view)

The Central Bank may increase the money supply to meet the growing demand for government spending (for example by deficit financing)

Costs of Inflation or Economic Impacts of InflationThere can be anticipated and unanticipated inflation

Unanticipated inflation will be costly

Who will be affected badly by inflation? Fixed income groups ?

Other impactsMay slow down external sector demand for our domestic productsThen what happens to our export competitiveness? What happens to the trade balance, current account of the economy?

Adverse implications for growth:

A 10 % point permanent increase in the inflation rate is estimated to bring down the level of the real GDP by 4 7 % (Robert Barro)

Management of InflationKeynesians argue that some acceptable level of inflation is good for the economy. Why?What is an acceptable rate of inflation?No consensusIn India, between 5 % to 6 % (Rangarajan)How can we manage inflation?Depends on what caused inflation (Demand factors or Cost factors)

Management of InflationIf inflation is caused by Demand factors, then what measures can be taken?In Demand pull inflation, with price rise, output also rises.So follow a contractionary fiscal and monetary policy (lower G, higher T, higher r)?What is the cost of reducing inflation?

The Philips CurveA trade- off between wage rate and unemployment (at higher wage rate (wage push inflation), there will be lower unemployment rate).In inverse relationshipAt higher inflation, unemployment will be low It means unemployment can be reduced at the cost of higher inflation

StagflationThe combination of recession with high inflation Stagflation is not a state that occurs often because recession reduces demand for goods because people have less money to spend Low demand during recessionm usually leads to low inflation.

StagflationPossible causes of stagflation include short supplies of essential commodities (such as oil, oil shock) and too fast a rise in money supply (which in turn usually reflects government policy). Oil shocks, loose monetary policy, out-of-control government spending etc This happened to a great extent during the 1970s, when world oil prices rose dramatically, fueling sharp inflation in developed countries.

How to deal with Stagflation?Once stagflation occurs it is difficult to deal with (why?)

Can we use Keynesian policies to combat stagflation?

Suppose government takes measures to revive the economy using fiscal and monetary policies. (AD-AS framework and C+I+G+NX framework to explain), then what happens?

How to deal with Stagflation?The measures a government would usually take to revive an economy in recession (for example by cutting interest rate or increasing government spending (G) will also increase inflation.

How to deal with Stagflation?Government policies may fail. One school of thought is that the best policy mix is one in which government stimulates growth through increased spending or reduced taxes (fiscal policy) while the central bank fights inflation through higher interest rates (monetary policy).

How to deal with Stagflation?Stagflation in the USA was defeated by then Federal Reserve chairman, Paul Volkar, who sharply increased interest rates to reduce money supply from 1979-1983. Investors are more worried about stagflation (why?)

How to deal with Stagflation?Coordinating fiscal and monetary policy is not an easy task during stagflation!What about Supply-side policies? (large tax cuts, deregulation, incentives and subsidies to increase supply etc (use AD-AS framework)US slowdown and stagflation in 2007-08US recession 2008

How to deal with Stagflation?Fed chief Bernanke observed on Nov 27th:

In the case of inflation, the risks to the forecast seem primarily to the upside. A failure of inflation to moderate as expected would be especially troublesome.

Problem of Inflation in India

Magnitude

Causes Correction

Wholesale Price Index in India- Annual Average (Source: RBI)1993-941001994-95112.51995-96121.61996-97127.21997-98132.81998-99140.71999-00145.32000-01155.72001-02161.32002-03166.92003-04175.92004-05187.2

Rate of Inflation in India1993-94-1994-9512.51995-968.081996-974.601997-984.401998-995.951999-003.262000-017.15 (due to high energy price) 2001-023.592002-033.472003-045.392004-056.4220073-4200812

Thanks