INFLATION

Inflation

The inflation rate is used to measure the rate of change in the overall price level of goods and services that we typically consume. It only becomes a policy concern when reaching unacceptably high levels. Small doses of annual inflation seem normal and uneventful.

Measures of Inflation

Consumers Price Index Wholesale Price Index GDP Deflator Inflation rate (2002) = CPI (2002) - CPI (2001) CPI (2001)

The CPI May Overestimate Inflation

The CPI fails to adjust for improvements in quality. The weights used to add together the prices of different goods and services that go into the index are often out-of-date. Consumers often substitute away from goods that are increasing in price.

Effects on output and wealth

Short Term: tonic effect as long as wage increases are less than inflation Long Term: Growth in the economy as long as wage increase does not keep pace with price rise. Fixed income earners will suffer

The Effects of Unanticipated Inflation

A redistribution of income and wealth within the economy

bank profits fall during periods of rising interest rates (caused by increased inflation); unanticipated jumps in inflation hurt lenders while helping borrowers who pay off their debts with money, the value of which has been eroded by inflation; and if inflation is properly anticipated lenders can raise the interest rates that they charge borrowers in order to maintain a positive rate of return.

Other Consequences of Inflation

Inflation distorts the price mechanism by making it difficult to distinguish changes in relative prices from changes in the general price level. Inflation creates uncertainty. There may be a redistribution of resources and production into areas less affected by high inflation rates. Inflationary uncertainty pushes up real interest rates, as lenders demand a bigger risk premium on their money. Overall redistribution of productive and financial resources may lead to a loss in efficiency.

There are three main types of inflation: Demand-pull inflation Cost-push inflation Hyperinflation

Types of Inflation

Demand pull inflation

Cost push inflation

Hyperinflation

The best definition of hyperinflation is price increases that are so out of control as to make the concept of inflation meaningless. For example, in Germany between January 1922 and November 1923 (less than two years!) the average price level increased by a factor of about 20 billion.

Inflation in India
Demand pull factors

Cost push factors

Government expenditure & deficits Population Corruption

Vagaries of nature Rising administered rates Rising cost of Raw materials and Imports High taxation