Understanding Inflation: Types and Impacts

• Inflation is the persistent increase in the prices of goods and services over time
• It reduces the purchasing power of currency
• Inflation rate is the percentage increase in the overall price level from one period to the next

Types of Inflation

• Creeping/Mild Inflation: Low, consistently increasing (2-3% annually)
• Federal Reserve considers increases of 2% or less beneficial for economic growth, boosting demand as consumers expect prices to rise
• Walking/Moderate Inflation: 3-10% annually, considered destructive due to rapidly heating up the economy
• People buy more than needed to avoid higher prices, increasing demand beyond suppliers' capacity, and wages can't keep pace
• Galloping Inflation: 10% or more, disrupts the economy
• Money loses value rapidly, impacting business and employee income; it deters foreign investors and destabilizes the economy
• Hyperinflation: Prices skyrocketing by more than 50% monthly, with examples including Germany (1920s), Zimbabwe (2000s), and Venezuela (2010s)
• Stagflation: Economic growth is stagnant with price inflation
• Occurred in 1970s when the U.S. abandoned the gold standard
• Core Inflation: Measures rising prices, excluding food and energy
• Reflects that gas price increases during vacation months drive up transportation and food costs
• Deflation: A decrease in general price levels over time, opposite of inflation; happens when the inflation rate is negative
• Disinflation: A temporary slowdown in the rate of inflation

Causes of Inflation

• Demand-Pull Factors: Aggregate Demand exceeds Aggregate Supply at Full employment
• Cost-Push Factors: Aggregate supply decreases due to increased production costs while Aggregate demand remains the same
• Structural Bottlenecks: Relate to agriculture, infrastructure, etc
• Monetary Policy Intervention: Actions by central banks
• Expansionary Fiscal Policy: Government policies

Demand Pull Inflation

• Results from an increase in aggregate demand due to increased Government Expenditure or household and firm expenditure
• The root cause is that Aggregate demand exceeds Aggregate Supply
• Firms cannot produce enough goods to meet demand, leading to shortages that fuel price increases

Cost-Push Inflation

• Happens when production costs increase, raising the price of products
• If factor of production costs increase so does the product price
• Imported Inflation: Outside suppliers raise prices, forcing importing countries to pay more

Built-in Inflation

• Arises from expectations of future inflation
• Higher prices lead to demands for higher wages to maintain living standards, further raising production costs and prices, creating a cycle
• Double-edged sword as higher labor costs can raise the cost of living

Triangle Model of Inflation

• New Keynesian economics model by Robert J. Gordon (1988), which is based on the Phillips Curve
• Posits three root causes of inflation: built-in, demand-pull, and cost-push inflation
• Built-in Inflation: Inflation resulting from past cost-push or demand-pull factors
• Cost-Push Inflation: Referred to as supply-shock inflation
• Stagflation: Rising prices coupled with falling growth and employment is more dangerous than demand-pull inflation because output levels fall
• Stuctural inflation: Due to agricultural, foreign exchange, and infrastructural bottlenecks

Structuralist Inflation

• More common in developing and low-income countries
• Attributes inflation to the weak structure of developing economies with unstable institutions and imperfect markets
• Argues that increased money supply and government spending can only partially explain inflation

Reaganomics

• Economic policies of President Ronald Reagan (1981–1989)
• Policies included large tax cuts, decreased social spending, increased military spending, and deregulation
• Introduced in response to stagflation that began under President Gerald Ford in 1976

Headline versus Core Inflation

• Headline Inflation: Measures overall inflation in the economy
• Core Inflation: Excludes volatile food and fuel prices

Important Points About Inflation

• Inflation benefits debtors but hurts creditors
• Creditors lose as repayments have less value, while debtors gain by repaying debts with devalued currency
• Inflation leads to domestic currency depreciation, reducing the cost of exports and increasing import costs
• Fisher Equation: i = r + inflation rate where i = nominal interest rate, r = real interest rate
• Inflation lowers the real cost of borrowing; bond holders are hurt if declared interest rate on bond is fixed as inflation rises, since the real interest rate decreases

Consumer Price Index (CPI)

• Measures retail inflation by tracking changes in prices of common goods and services
• Called market basket, CPI is calculated for a fixed list of items including food, housing, apparel, transportation, electronics, medical care, education etc. Calculated periodically to determine inflation levels
• Used to compute cost of living and how much consumers need to spend to keep up with price changes
• India uses multiple CPI numbers:
  • CPI for Industrial Workers (IW)
  • CPI for Agricultural Labourers (AL)
  • CPI for Rural Labourers (RL)
  • CPI for Urban Non-Manual Employees (UNME)
• CPI for Urban Non-Manual Employees data is collected and compiled by the Ministry of Statistics and Program Implementation
• The remaining three are collected by the Labour Bureau in the Ministry of Labour

Wholesale Price Index (WPI)

• Measures changes in prices of goods sold in bulk by wholesale businesses
• It tracks prices at the factory gate before retail
• Used to track supply and demand dynamics; released by the Economic Advisor in the Ministry of Commerce and Industry
• Rise in WPI indicates inflationary pressure, while a fall indicates the opposite
• CPI measures average household prices for goods and services
• The RBI now uses CPI as the key measure for monetary policy
• The base year was updated to 2011-12, effective April 2017
• Major WPI components include:
  • Primary Articles : broken down into food and non-food items
• Food Articles are cereals, pulses, vegetables, eggs etc
• Non-Food such as oil seeds, minerals and petroleum
• Fuel & Power: Which tracks price movements in Petrol, Diesel and LPG
• Manufactured Goods such as textiles, paper, chemicals, plastic, and metals.
• The WPI Food Index is a sub-index combining food articles from the Primary Articles basket and food products from the Manufactured Products basket.

Basis For Comparison Between WPI and CPI

• CPI indicates the average change in the prices of commodities, at the retail level.
• WPI amounts to the average change in prices of commodities at the wholesale level
• WPI published by Office of Economic Advisor, Ministry of Commerce & Industry
• CPI published by Central Statistics Office, Ministry of Statistics and Programme Implementation
• Goods only are measured by the WPI
• Goods and Services Both are measured by CPI
• Measurement of Inflation occurs at the first stage of the transaction for WPI
• Measurement of Inflation occurs at the final stage of the transaction for CPI
• Prices are paid by manufacturers and whole salers for WPI
• Prices are paid by consumers for CPI
• The items covered are 697 and base year 2011-2012 for WPI
• The items covered are 448-460 based on rural/urban and base year 2012 for CPI

Optimal Inflation Rate

• No general consensus on optimal rates
• Economists debate whether it should be 1-3% like in industrialized economies or 6-7% as in less developed countries

Bent Hansen's Dynamic Model of Demand Inflation [1951]

• The analysis distinguished between cost push and demand pull inflation
• Argued that inflation can be linked to the increase in factor inputs
• It incorporates two separate price levels, one for the goods market and other for the factor (labour) market.
• Assumed perfect competition in goods and factor markets
• Only one commodity is produced with the help of labour services
• The quantity of labour services per unit of time is a given magnitude
• There is a fixed actual level of employment which is full employment