ECO401 Short Notes

For More Short Notes Freely Visit · ECO401 · SHORT NOTES FROM LECTURE NO 34 TO 38 · INFLATION AND DEFLATION:

Inflation is a situation in which there is a continuous rise in the general price level. Deflation is the opposite of inflation and occurs when the general level of prices falls. The rate of inflation is the percentage annual increase in average price level.

Pure inflation:

Pure inflation is a special case of inflation in which the prices of all the goods and services in the economy are rising at the same rate. So if an economy produces three goods: apples, shirts and cars, and they cost Rs. 5, Rs. 100 and Rs. 400,000 respectively in 1992, while the prices in 1993 are Rs. 6, Rs. 120 and Rs. 480,000, and the prices in 1994 are Rs. 9, Rs. 180 and Rs. 720,000, respectively, then we can say that there was pure inflation of 20% in 1993 (over 1992) and pure inflation of 50% in 1994 (over 1993).

MEASUREMENT OF INFLATION:

More generally, inflation (in % p.a.) is measured as [(Pt - Pt-1)/Pt-1]*100 Where Pt refers to the average price level prevailing in year t, and Pt-1 is the average price level prevailing in period t-1. The term average price level usually refers to the value of an index, like consumer price index or producer price index etc., which weights the prices of goods according to their share in the total nominal GDP.

Dates · Price level · Inflation (%)

30 th June 2000 30 th June2001 5% 30 th June2002 1.9% 30 th June2003 12.1%

THEORIES ABOUT THE CAUSES OF INFLATION: THREE VIEWS ABOUT INFLATION:

There are three views here:

•  The Traditional Keynesian Views,

Keynes sees inflation and unemployment as opposite sides of the same coin, so is merely a result of excessive aggregate demand (demand-pull inflation). Assuming that increases in aggregate demand in a Keynesian world do have some output and employment impact, one can think of plotting the relationship between inflation and unemployment as trade-off: a downward sloping curve in inflation unemployment space. This curve

is called the Phillips curve names after the economist who first quantitatively

documented this trade-off in the context of the UK economy in the 1950s and 60s. The Phillips curve tradeoff can be summarized as follows: Lower unemployment can be achieved only at the cost of higher inflation. The policy prescription flowing from this particular diagnosis of inflation was simple: reduce aggregate demand by contractionary fiscal and/or monetary policies. Keynes looked inflation and unemployment as the opposite side of the same coin. If inflation increases, unemployment decreases and vice versa.

Philips Curve

W.A.Philips gave the idea of Keynes a formalized shape and draws the Philips curve stating inverse relationship between unemployment and inflation rate. Philips’s views were consistent with the Keynesian views. The cost of reducing inflation is unemployment and the cost of reducing unemployment is inflation.

•  The cost push inflation,

This view came to fore in the 1970s when the world was confronted with a situation of rising prices but high unemployment (stagflation), something that demand-pull theories could not explain. It was observed that the two oil price shocks in the 1970s, which were essentially supply side shocks (because they increased the cost of production), were capable of producing such a situation. In AD-AS space, such a supply shock would be shown by shifting the AS curve to the left (and up) causing prices to rise and output (and employment) to fall. In the context of the Phillips curve, the supply shock would be shown by shifting the Phillips curve out to the right, reflecting a structural shift in the inflation unemployment trade-off. The name given to the resulting higher inflation (at any level of unemployment) was cost-push inflation. The policy prescription appropriate for dealing with it, included supply-side measures such as developing alternative energy sources, fuel efficient technologies, production cost reduction methods, and reducing tax distortions (that reduce the incentive to produce), increasing competition (in search of productivity gains), removing price floors etc. Keynesian demand management policies were obviously not seen as relevant in this context. It is important to note that sometimes what appears as costpush inflation is actually driven by higher demand. For e.g., let’s say demand for property increases in an economy; this causes housing prices to rise, causing rents to rise, Real Output Price AS AD1 AD2 P0 AD3 P1 Y* AD4 Unemployment Inflation (%) causing workers to demand higher wages. Higher wages causes firms’ production costs to increase prompting them to raise goods prices which in turn cause retail prices to rise. At every point of the whole chain, it is the costs that are rising (rental costs, production costs, purchase costs of retailers), but the cause of these rising costs is higher demand for property. This situation is often branded cost-push illusion.

Summing up in the words of Hazrat Ali (AS), “high inflation together with a deteriorating law and order position are hallmarks of the worst possible government.”

 THE MONETARISTS VIEW

In economics, the quantity theory of money is a theory emphasizing the positive relationship of overall prices or the nominal value of expenditures to the quantity of money. Monetarists located the causes of inflation in the Quantity Theory of Money (QTM), which provided an explanation for inflation totally independent from that for unemployment. QTM states: MV = PQ, where M is the real money supply, V is the velocity of money (the no. of times money is circulated in the economy in a year), P is the price level and Q is the real output. Assuming a constant V and a stable (natural rate) output Q*, changes in P could be explained totally by changes in M. A stable M would imply a stable P. Thus the Monetarist key to solving the inflation problem was a stable money supply set to grow at the rate of growth of natural rate output (Q*). For Monetarists, the concern was not the government’s expansionary fiscal policy per se, but the manner in which the fiscal deficit was financed. If the government financed its deficit by borrowing from the central bank (i.e. printing money,

and thus expanding money supply), this would be tantamount to inflationary

finance of the budget. If, however the government financed the deficit by borrowing from banks or the retail savers, then there would be little inflationary consequences.

Monetarism and Philips curve:

It is also instructive to see how Monetarist’s viewed the Phillips curve, and the inflation-unemployment tradeoff. Monetarists believed that the economy generally gravitated around a full-employment or natural rate level, and any positive output or employment impact of inflationary demand policies would have be limited. The duration and extent of this limited impact would depend on how much money illusion private agents suffered from.

Money illusion:

Money illusion is when agents base their decisions on their expectations about inflation (set in period t-1), so that when government driven actual inflation (increase in prices and wages) in period t exceeds expected inflation, agents view the increase as real rather than nominal, and therefore erroneously spend more than they should.