INFLATION - CAUSES AND CONSEQUENCES
Inflation
What is inflation?
Inflation is the persistent rise/Sustained rise in the general price level / average price level of a basket of goods and services in an economy over a period of time usually in one year.
Inflation does not mean that the price of all the goods has increased. During inflation the price of some goods may increase, some may decrease and some may remain constant but the overall Average/general price level increases.
During inflation when the general price level increases and the purchasing power of money decreases, therefore the value of money decreases. It means during inflation the same money will buy less amount of goods.
Causes of Inflation(Types of Inflation)
There are mainly 2 causes of inflation :
Demand-pull inflation
When the general price level increases due to an increase in aggregate demand and aggregate supply is insufficient to meet the aggregate demand. Demand-pull inflation occurs when there is 'too much money chasing too few goods' because the AD for current output exceeds AS. It happens when an economy is in full employment, and it is not possible to get more output out of the existing factors of production.
The aggregate demand for goods increases due to :
Increase in income, population, advertisement etc. (Increases C & I component of AD)
Rise in the amount of public expenditure (government investment) in the country. (Increases G component of AD)
Reduction in the tax rate, which leaves more disposable income in the hands of the people. (Increases C & I component of AD)
Increase in exports, which gives more money in the hands of people. (Increases X-M component of AD)
In the diagram due to an increase in AD, the curve shifts to the right to AD1 (due to changes in C/I/G/(X-M) causing the general price level to rise from Pl to Pl1 which is known as demand-pull inflation.
Cost push inflation
Cost-push inflation is when the general price level increases due to an increase in the cost of production. When the cost of production increases the profitability of the business decreases, therefore to maintain the same level of profit the business increases the price which ultimately leads to cost push inflation. (assume AD constant)
It (Cost Push Inflation) is generally caused by the following factors :
an increase in the cost of production, which can be due to increase in the cost of raw material, transport cost, Interest rate,
Increase in indirect taxes,
Increase in the import prices due to high tariffs etc.
Increase in the price of crude oil.
Although increase in wages due to trade union negotiations is the most important factor (a wage-price spiral, which occurs when price increases spark off a series of wage demands which lead to further price increases and so on)
An increase in the profit margin of the entrepreneurs.
In the diagram due to an increase in the cost of production the SRAS shift to the left to SRAS 1 causing the general price level to rise from Pl to Pl1 which is known as cost-push inflation.
Cost-push inflation is considered to be bad inflation compared to demand-pull inflation because it leads to an increase in GPL and unemployment. Cost-push inflation causes Stagflation.
Stagflation- it is when GPL and unemployment increase together at the same time. It is only possible during cost-push inflation
Demand-pull inflation is comparatively better than cost-push because in demand-pull inflation even though the general price level increases, economic growth and employment increase.
Monetary inflation: Many economists believe that excessive issues of currency by the central bank as a part of monetary policy may create inflation. According to them, when there is too much money supply by the central bank, there will be too much money in circulation which eventually leads to an increase in AD leading to demand pull inflation. This is caused by to excessive money supply; it is called monetary inflation.
Imported inflation: Occurs when the cost of imported raw materials increases. If the country from which it is imported is experiencing higher inflation, it will increase the cost of production as raw material becomes expensive, leading eventually to cost-push inflation. For example, an increase in the price of crude oil always accelerates cost-push inflation for most countries who import oil.
Consequences or effect of inflation
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Savers: inflation leads to a rise in the general price level so that money loses its value. When inflation is high, people may lose confidence in money as the real value of savings is severely reduced. Savers will lose out if nominal interest rates are lower than inflation - leading to negative real interest rates.
Lenders: Inflation lowers the real interest earned on loans, so the money paid back by borrowers is worth less than the money lent. During inflation, the borrower returns the same amount of money but with less value so lenders lose out the real value. On the other hand, if the interest rate is lower than the rate of inflation, then lenders' real earning reduces.
Exporters: Domestic inflation increases product prices relative to foreign prices hence their exported products are less attractive to foreign buyers. During inflation when domestic goods become expensive, export decreases and therefore the exporting firm loses out on sales and revenue.
Wage demands: inflation can get out of control because price increase leads to higher wage demands as people try to maintain their real living standards. Businesses then increase prices to maintain profits and higher prices then put further pressure on wages. This process is known as a wage price spiral''. Rising inflation leads to a build up of inflation expectations that can worsen the trade-off between unemployment and inflation.
Redistribution of income: inflation tends to hurt those employees in jobs with poor bargaining power in the labour market - for example, people in low-paid jobs with little or no trade union protection may see the real value of their pay fall. Inflation can also favour borrowers at the expense of savers as inflation erodes the real value of existing debts. And, the rate of interest on loans may not cover the rate of inflation. When the real rate of interest is negative, savers lose out at the expense of borrowers.
Investment: budgeting becomes very difficult because of the uncertainty created by rising inflation of both prices and costs - and this may reduce planned capital investment spending. Lower investment then has a detrimental effect on the economy's long run growth potential.
Balance of payments: inflation is a possible cause of higher unemployment in the medium term if one country experiences a much higher rate of inflation than another, leading to a loss of international competitiveness and a subsequent worsening of their trade performance. If inflation in the UK is persistently above our major trading partners, British exporters may struggle to maintain their share in overseas markets and import penetration into the UK domestic market will grow. Both trends could lead to a worsening balance of payments. On the other hand, during high inflation, domestic consumers prefer to import cheaper goods from other countries which will have an adverse effect on net exports and therefore it will worsen the BOP deficit.
Unemployment: as firms' costs of production rise production becomes less profitable and firms reduce their output as a consequence and therefore less labour is required to produce lower levels of output. During inflation when exports decrease and consumers prefer cheaper imports net exports (X-M) will decrease, which will cause real GDP to fall and therefore there will be less demand for labour and eventually unemployment will increase.
Menu costs: costs associated with firms having to change price lists, reprogramme computers, change vending machines etc to deal with the higher prices. During inflation when producers have to change their packaging to match the price, it will increase their costs.
Shoe leather costs: during times of rising inflation consumers find it difficult to know what price to pay for certain goods and services and therefore spend much more time 'shopping around' to check whether the prices they have been quoted are appropriate. Producers also put a lot of effort and time into finding cheaper alternative raw materials from domestic and foreign markets, which adds up to the cost of production.
Q. How inflation is calculated ?
Ans :
Inflation is calculated using CPI (Consumer Price Index). CPI is the statistical index used by the government to calculate the changes in general Price level(Inflation).
Following are the steps used for calculating CPI:
Selection of Base year: Base year is the year to compare the changes in general price level/inflation. Base year index is always 100, because inflation is calculated in %. [Base year should be a normal year without any economic unrest like there should be not be any hyperinflation, recession in economy, drought, tsunami, pandemic or any other disaster]
Selection of Current Year: Current year is the year for which inflation is calculated.
Selection of Baskets of goods: Baskets of goods are those selected goods which are used by most of the common families in an economy and changes in the prices of those goods will have an impact more or less on everyone in the economy.
Weights : Each and every good in the basket is given a weight which represents the proportion of spending on a particular good by a consumer.
Weighted index: Weights are multiplied by Price to construct a weighted index.[For example if a consumer spends $52 on traveling and weight for traveling is 32% then weighted index for traveling would be equal to: $52X 32% = 52X.32=$16.64].
Calculation of CPI: CPI is calculated using the following formula - The C.P.I for a particular year is the price of a basket of goods in that year divided by the price of the same basket in a base year.
CPI =Price of the basket of Current year Price of the basket of Base year X100
Calculation of Inflation: Following formula is used for inflation calculation :
Inflation rate =CPI of current year - CPI of base year CPI of base year x 100
Limitations of Using the Consumer Price Index (CPI) to Measure Inflation
Limitations of Using the Consumer Price Index (CPI) to Measure Inflation
1. Prices of different products rise at different rates. Consumers tend to shift their consumption away from the more expensive products and substitute cheaper products. Because the CPI uses a fixed basket of goods, it will assume people are still buying the same amount of the relatively expensive products. In reality, however, they are buying less of the expensive products. So their overall expenses are not as large as the CPI suggests.
2. Price indexes have difficulty measuring changes in quality. Consumers benefit from higher quality products. When inflation calculations use a fixed basket of goods, however, the implicit assumption is the quality does not change. A product could be more expensive because it has improved in quality. The CPI would attribute the price rise to inflation.
3. Price indexes have difficulty including new technology. Consumers benefit from new technology, but the fixed basket of goods used in the CPI will not include the newest products and technology. Thus, the CPI is an inaccurate measure of the true cost of living of a typical urban consumer.
The CPI is the primary index used to calculate the inflation rate in the United States. Because of its shortcomings, most economists think the CPI overestimates the inflation rate by 1-2%. This is why the macroeconomic policy goal is low inflation, not no inflation. When the inflation rate is reported around 1.5%, economists feel there is very little real inflation.
Calculation of CPI using weight:-
Weighted index for 2011:
Pizza = 25% of $2 = $0.5
Haircut = 30% of $11 = $3.3
Wine = 45% of $8 = $3.6
Total spending on basket of goods in 2011:
$0.5 + $3.3 + $3.6 = $7.4
CPI 2011 =Price of the basket of Current year Price of the basket of Base year X100 = 7.4/7.4 x 100 = $100
Weighted index for 2012:
Pizza = 25% of $1.5 = $0.375
Haircut = 30% of $10 = $3
Wine = 45% of $12 = $5.4
Total spending on basket of goods in 2012:
$0.375 + $3 + $5.4 = $8.7750
CPI 2012 =Price of the basket of Current year Price of the basket of Base year X100 = 8.775/7.4 x 100=$118.58
Inflation rate =CPI of current year - CPI of base year CPI of base year x 100
Inflation rate = [(118.58 - 100)/100] x 100 = 18.58%
2 : This method is used when the weights of different goods are given.
Weighted indexes for 2009:
Cost of basket in 2009 = ($100*0.3)+($80*.20)+($75*.15)+($150*.2)+($60*.05)+($200*.1)= $110.25
CPI 2009 =Price of the basket of Current year Price of the basket of Base year X100 = 110.25*100/110.25 = $100
Weighted index for 2011:
Cost of basket in 2011 = ($120*0.3)+($90*.20)+($95*.15)+($190*.2)+($80*.05)+($250*.1)= 135.25
CPI 2010 =Price of the basket of Current year Price of the basket of Base year X100 = 135.25/110.25 x 100=$122.68
Inflation rate =CPI of current year - CPI of base year CPI of base year x 100
Inflation rate = [(122.68 - 100)/100] x 100 = 22.68%
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