Chapter 5 Anatomy of Inflation PDF

Chapter 5: Anatomy of Inflation 11/3/23 3:32 PM Anatomy of Inflation What is inflation? What is inflation? Inflation rate is calculated as the weighted average of the increase in prices o...

Chapter 5: Anatomy of Inflation 11/3/23 3:32 PM Anatomy of Inflation What is inflation? What is inflation? Inflation rate is calculated as the weighted average of the increase in prices of different commodity groups in the consumption basket. After this is calculated Govt. come up with the general price level in the economy which is referred to as the index number. The value of index number in its reference year is set as 100. Index Number Year 2009 100 2010 120 2011 132 Above implies inflation rate was 20% from 09-10 and 10% from 10-11 (note it is 12/120*100 = 10 %) and 32% from 2009 -> 2011. Teienne Laspeyres Formula to construct index numbers Laspeyres Price Index: A price index representing a weighted average of the prices of different goods or group of goods, where weights are decided based on share of good(s) in the total expenditure in the base year. Why does inflation occur? Demand for goods exceeds the supply over a sustained period of time Most of the prices start to rise due to relative shortage of those goods. Inflation is triggered by general increase in demand or general fall in supply of goods. Causes: ○ Supply shock/ Cost-push inflation What is stagflation? § OPEC controls oil production. Can reduce production which can result in stagflation. § OPEC/Embargo resulted in price of crude rising steeply, cost of dependent goods increased, smaller qties of such goods purchased -> reduction in output. Such an inflation that leads to a lowering of output and employment is Stagflation. § India - drought/famine can impact produce and prices can shoot up. ○ Demand Pull Inflation § When demand exceeds existing output levels Ex. Real estate prices in Bengaluru, Pune (IT salaries gone up, demand by them for goods has increased) Govt schemes rural employment and mid day meals, increase demand in rural areas and contribute to inflation Small amount of demand pull is good. Incentive for producers. What is hyper Increase in prices also indicates that production has not kept up with consumption inflation? □ Ex. Dal, edible oil What is deficit Hyperinflation occurs when govt and central bank engage in reckless printing of money tomake financing by additional payments to various stakeholders. monetization of sequence of events: debt? Govt owns large amounts to various stakeholders Not allowed in Govt issues new securities and forces central bank to buy them to generate income India by law! Central bank can only buy it by printing new currency This new supply of money in the hands of people creates additional demand in the market No output exists for this burst of demand... Prices go up due to increased demand Example: Germany after WW I and Argentina Indian Govt and RBI regulates ad-hoc monetization Described by Quantity Theory of Money What is quantity MV=PY M = Money Supply V= velocity of money P = price level Y = level of output theory of Money? RHS = current or nominal GDP Velocity of money represents - how many times money is used over a period of time. If V and Y are constant, then money supply drives price level. MV = 1000 if Rs 100 has a velocity of 10x As technology improves - less money bills are used so same amount of money moves around. Velocity is increased. Real vs Nominal GDP Difference between The real GDP is the Nominal GDP divided by the inflation factor real and nominal To calculate real growth in GDP, it needs to exclude inflation. This will give you true increase in output. GDP? Is inflation bad? Not necessarily if income grows proportionate to inflation For Socio economic group where income doesnt rise, inflation is a problem. Getting the Inflation Rate right Definitions Consumer Price Index (CPI) It represents the index of average price of all goods and services traded at the retail level. Different CPIs are calculated for urban employees, industrial n agricultural workers Wholesale price index (WPI) Represents the index of the average price of all commodities at the wholesale level, which includes the price of raw material, semi finished products and imported commodities traded at wholesale level - BUT excludes the prices of services Headline Inflation Inflation in the economy measured on the basis of Wholesale price index (WPI) Core Inflation Inflation in the economy, measured on the basis of WPI without considering food and fuel prices Inflation: A sustained, general rise in the price level. Policies for Controlling Inflation Easing Supply Constraints Restricting the demand pull Repo Rate: The rate at which commercial banks borrow short term funds from RBI Repurchase Order: RBI buys Govt bonds from commercial banks. The rate at which the commercial bank buys back. Repo Rate and If repo rate is increased - ability to borrow by commercial banks goes down. Inflation control Rate at which banks lend to institutions and indviduals also increases, projects become less viable, demand for investment goods falls and stalls inflation Reverse Repo rate: Excess cash is parked with RBI for an interest rate paid by RBI Interbank lending rate: Difference between Repo rate and reverse repo rate. Base year: In the context of price indices, this refers to the year for which the price level is assumed to be 100. Laspeyres Price Index: A price index representing a weighted average of the prices of different goods or group of goods, where the weights are decided on the basis of the share of the good or the group of goods in the total expenditure in the base year. Open Market Operations (OMO): The selling (or buying) of government securities by the central bank of a country to (and from) commercial banks, financial institutions, and/or others in the financial market. Price index: Represents a weighted average of the prices of different goods and services or group of goods and services. The weights are determined on the basis of the share of the good or a group of goods in the total expenditure. Real GDP: The Nominal GDP divided by the inflation factor.