Inflation PDF

Macroeconomics Inflation Dr. Chandrika Raghavendra Assistant Professor (Economics) Great Lakes Institute of Management, Chennai  Agenda 1. To understand how inflation is measured? 2. To learn how to adjust for inflation? 3. Learn to identify the type of...

Macroeconomics Inflation Dr. Chandrika Raghavendra Assistant Professor (Economics) Great Lakes Institute of Management, Chennai  Agenda 1. To understand how inflation is measured? 2. To learn how to adjust for inflation? 3. Learn to identify the type of inflation using real time data 4. What can we learn from the Quantity Theory of Money? 5. See whether Quantity Theory of Money holds up over the time and across the regions? 6. What are the Principles of Quantity Theory of Money? 7. What is the cost of Inflation? 8. How Inflation Breaks the Financial Intermediation? Have we observed this? WHY Calibri 18/20  Inflation Inflation is an increase in the average level of prices We measure the average level of prices with an index, the average price from a large and representative basket of goods and services. Thus, inflation is measured by changes in a price index. The inflation rate is the percentage change in the average level of prices (as measured by a price index) over a period of time. And it is measured as - 𝑷𝟐 − 𝑷𝟏 𝑰𝒏𝒇𝒍𝒂𝒕𝒊𝒐𝒏 𝑹𝒂𝒕𝒆 = ∗ 𝟏𝟎𝟎 𝑷𝟏 Where, - P2 is the index value in year 2 and - P1 is the index value in year 1 What could cause the price to move up and down? What is the Root cause for ‘More Demand’? ??? More Demand Inflation What is the Root cause for ‘More Demand’? More Money More Demand Inflation What is the Root cause for ‘More Money’? ??? More Money More Demand Inflation  What is the Root cause for ‘Inflation’? Cheap Loans More Money More Demand Inflation So, if RBI wants to control the inflation, what it has to control? RBI uses ‘Dear Money Policy’ to control Inflation by making lending rate of interest costly for the borrowers  Why Inflation Matters? What are its Effects? Rise in Prices Rise in Rate of Interest Decrease in the value of money Decrease in Purchasing Power  Types of Inflation Based on Speed Based on Cause Others Creeping inflation (1-4%) Demand Pull Inflation Skewflation Walking Inflation (2-10%) Cost Push Inflation Stagflation Running Inflation (10-20%) Monetary Inflation Galloping Inflation (20- Headline/Core Inflation 1000%) Profit Induced Inflation Hyperinflation (Out of Structural Inflation control – Increasing Inflation by 50% or more every month)  Types of Inflation 1. Headline Inflation: The RBI pays significant attention to headline inflation, as it represents the overall price level in the economy. It is typically measured by the Consumer Price Index (CPI). The RBI aims to keep headline inflation within a specified target range to ensure price stability and maintain public confidence in the currency. 2. Core Inflation: Core inflation, which excludes volatile items like food and fuel prices, is crucial for the RBI as it provides a clearer picture of underlying inflation trends. By focusing on core inflation, the RBI can better assess persistent inflationary pressures and make informed policy decisions. 3. Food Inflation: Given the large share of food in the Indian consumption basket, food inflation significantly impacts the overall inflation rate. The RBI monitors food inflation closely, as it affects household budgets and living standards. While food inflation is often influenced by supply-side factors, the RBI considers it in its broader inflation management strategy. 4. Fuel Inflation: Fuel inflation is another critical component, as fluctuations in fuel prices can have a cascading effect on the overall price level. Changes in global oil prices and domestic fuel policies influence fuel inflation, which the RBI takes into account when designing its policies.  Types of Inflation 5. Demand-Pull Inflation: The RBI monitors demand-pull inflation to ensure that excessive demand does not lead to overheating of the economy. By adjusting interest rates and other monetary tools, the RBI can influence aggregate demand and keep inflation within the desired range. 6. Cost-Push Inflation: The RBI is also concerned with cost-push inflation, which arises from rising production costs. While monetary policy has limited influence over supply-side factors, the RBI still considers cost-push inflation in its overall assessment of inflationary pressures. 7. Imported Inflation: As an open economy, India is susceptible to imported inflation, which can result from currency depreciation or rising global prices. The RBI monitors exchange rates and global economic conditions to anticipate and manage the impact of imported inflation on the domestic economy. Types of Inflation 8. Stagflation - Stagflation is an economic condition characterized by a combination of stagnant economic growth, high unemployment, and high inflation. In stagflation, an economy experiences slow or flat growth (stagnation) alongside inflation. Typically, inflation and unemployment have an inverse relationship, but stagflation is a scenario where both exist simultaneously. 9. Skewflation - Skewflation is a situation where there is inflation in only certain sectors or goods in the economy, while other sectors or goods have stable or even falling prices. Instead of widespread inflation, price increases are "skewed" or concentrated in specific areas. For example, there may be high inflation in food prices due to supply chain issues, but technology or apparel prices might remain stable or decline.  How is Inflation in India Calculated? The Reserve Bank of India (RBI), India’s central bank, follows a flexible inflation targeting regime with a CPI inflation target of 4% with +/-2% on either, making it a range of 2% to 6% The National Statistical Office (NSO), under the Ministry of Statistics and Program Implementation, publishes the Consumer Price Index (CPI) monthly for India, with the base year being 2012 There are six broad categories in India’s CPI: 1. Food and Beverages, 2. Pan, Tobacco and Intoxicants, 3. Clothing and Footwear, 4. Housing, 5. Fuel and Lighting and 6. Miscellaneous (which includes household goods and services, health care, transport and communication, recreation and amusement, education, personal care and effects).  How is Inflation in India Calculated? CPI and combined CPI are computed separately for rural and urban regions There are 448 commodities in the rural CPI and 460 in the urban CPI The NSO uses the modified Laspeyres Index, which bases its weights on households’ expenditure patterns To calculate expenditure-based weights, the NSO divides the expenditure under each item in the basket by the total monthly household expenditure in the base year These weights remain constant, and each month’s CPI is the weighted average of the expenditure weights multiplied by the respective category price index with the weights How to measure CPI? Does it mean we are worse off today than in past? 145.76 Average Price nearly ½X over the past 10 years 100 NO!! Bec our income has also gone up How to measure CPI? 𝑷𝟐 − 𝑷𝟏 𝑰𝒏𝒇𝒍𝒂𝒕𝒊𝒐𝒏 𝑹𝒂𝒕𝒆 = ∗ 𝟏𝟎𝟎 121.42 𝑷𝟏 𝟏𝟐𝟏. 𝟒𝟐 − 𝟏𝟏𝟐. 𝟕𝟖 𝑰𝒏𝒇𝒍𝒂𝒕𝒊𝒐𝒏 𝑹𝒂𝒕𝒆 = ∗ 𝟏𝟎𝟎 𝟏𝟏𝟐. 𝟕𝟖 112.78 = 7.66 %  Monthly Consumer Price Index – Rural India (2012=100) Overall year- Food & Pan, tobacco, Clothing and Housing Fuel and light Miscellaneous Overall CPI on-year CPI Beverages and intoxicants footwear inflation Weight 54.18 3.26 7.36 0 7.94 27.2 100 JAN-2022 164.1 190.7 172.7 - 165.8 166.6 166.4 FEB-2022 163.9 191.5 173.7 - 167.4 167.3 166.7 MAR-2022 166.6 192.3 175.1 - 168.9 168.3 168.7 APR-2022 168.6 192.8 177.1 - 173.3 170.2 170.8 MAY-2022 170.8 192.9 179.0 - 175.3 170.9 172.5 JUN-2022 172.4 192.9 180.4 - 176.7 171.0 173.6 JUL-2022 172.5 193.2 181.7 - 179.6 171.8 174.3 AUG-2022 173.9 193.7 183.0 - 179.1 172.6 175.3 SEP-2022 175.5 194.5 184.5 - 179.7 173.1 176.4 OCT-2022 177.4 194.9 185.9 - 180.8 173.9 177.9 NOV-2022 176.6 195.5 186.9 - 181.9 174.6 177.8 DEC-2022 174.4 195.9 187.8 - 182.8 175.5 177.1 JAN-2023 175.0 196.9 188.6 - 183.2 176.5 177.8 6.85 FEB-2023 174.7 197.8 189.2 - 183.0 177.3 177.9 6.72 MAR-2023 174.8 198.4 189.6 - 181.4 177.9 178.0 5.51 APR-2023 175.5 199.5 190.2 - 181.5 178.9 178.8 4.68 MAY-2023 176.8 199.9 190.8 - 182.5 179.5 179.8 4.23 JUN-2023 180.5 200.4 191.4 - 181.8 180.0 181.9 4.78 JUL-2023 190.0 201.0 191.9 - 185.5 180.7 187.6 7.63 AUG-2023 189.5 201.7 192.3 - 185.9 181.2 187.6 7.02 SEP-2023 186.7 202.2 192.7 - 181.6 181.6 185.8 5.33 OCT-2023 188.5 202.5 193.2 - 182.3 181.9 187.0 5.12  Monthly Consumer Price Index – Urban India (2012=100) Overall year- Food & Pan, tobacco, Clothing and Housing Fuel and light Miscellaneous Overall CPI on-year CPI Beverages and intoxicants footwear inflation Weight 36.29 1.36 5.57 21.67 5.58 29.53 100 JAN-2022 170.3 196.4 162.2 164.5 161.6 158.6 165 FEB-2022 170.2 196.5 163.4 165.5 163 159.4 165.5 MAR-2022 171.5 197.5 164.9 165.3 164.5 160.6 166.5 APR-2022 174.5 197.1 166.3 167 170.5 163.1 169.2 MAY-2022 177.5 197.5 167.8 167.5 173.5 163.8 170.8 JUN-2022 179.3 198.3 169.4 166.8 174.9 163.8 171.4 JUL-2022 179.4 198.6 170.6 167.8 179.5 164.7 172.3 AUG-2022 180.4 198.7 171.6 169 178.4 165.4 173.1 SEP-2022 181.8 199.7 173 169.5 179.2 166.1 174.1 OCT-2022 183.3 200.1 173.6 171.2 180 166.8 175.3 NOV-2022 181.3 200.6 174.7 171.8 180.3 167.4 175 DEC-2022 178.6 201.1 175.7 170.7 180.6 168.2 174.1 JAN-2023 179.5 201.6 176.6 172.1 180.1 168.9 174.9 6.00 FEB-2023 179.8 202.2 177.4 173.5 180.7 169.5 175.6 6.10 MAR-2023 180.8 202.7 178.2 173.5 182.6 170 176.3 5.89 APR-2023 182.1 203.5 178.9 175.2 182.1 170.9 177.4 4.85 MAY-2023 183.1 204.2 179.3 175.6 183.4 171.6 178.2 4.33 JUN-2023 187.6 204.6 179.9 174.4 184.7 172.2 179.9 4.96 JUL-2023 199.4 205.2 180.2 175.3 187.4 172.9 184.7 7.20 AUG-2023 197.6 206.7 180.8 176.4 187.4 173.4 184.5 6.59 SEP-2023 193 207.2 181.2 176.2 175.5 173.7 182.2 4.65 OCT-2023 194.9 207.8 182.1 177.7 175.7 174 183.4 4.62  Inflation Expectations of Consumer To help achieve their inflation targets, central banks strive to anchor the inflation expectations of consumers and businesses, is a critical tool for understanding the public's expectations regarding future inflation rates Inflation expectations are the rate at which people expect prices to rise If everyone expects prices to increase by a certain percentage, companies want to raise prices by the same magnitude, and workers expect a similar-sized wage increase Hence, all else being equal, if inflation expectations rise by one percentage point, actual inflation will also tend to increase by one percentage point  Inflation Expectations of Consumer The RBI conducts an inflation expectation survey once every two months in India using structured questionnaires The survey gathers qualitative and quantitative data from households across various cities to gauge their expectations of inflation over three months and one year ahead The importance of this survey lies in its ability to inform the central bank's monetary policy decisions By understanding the inflation expectations of households, the RBI can better predict inflation trends and implement policies to stabilize prices, thereby ensuring economic stability and growth Several insights have emerged- Household inflation expectations have always been higher than actual inflation since 2016 In addition, household inflation expectations have aligned closely with people’s perceptions of current inflation, especially food and housing prices  Inflation Expectations of Consumer For policymaking, it is critical to understand the origins of bias in consumers’ inflation expectations because- First, household consumption baskets diverge, and their expectations may reflect the price perceptions of their personal consumption baskets rather than the overall CPI. Depending on income levels, family structure, geographic location, gender, taste and preferences, individual consumption patterns differ from those of an average citizen. Simultaneously, the CPI is calculated using the weights assigned by an average person Second, consumers’ perceptions of retail inflation tend to be systematically biased towards the perceived inflation rates of frequently purchased items, known as frequency bias. The weights that consumers assign to price changes tend to depend on purchase frequency rather than expenditure share, and positive price changes remain in consumers’ memories more than negative price changes Third, households may experience recency bias in reporting inflation perceptions. Consumers may be unable to recall prices a year earlier and compare them with today’s prices. Households may form their inflation expectations based on the recent prices that they have experienced. Recent experiences typically affect our judgment more strongly. They are easier to access in our memories, causing us to ignore long-term trends and past information that could provide a more impartial viewpoint of inflation Adjusting for Inflation To adjust the inflation and to find the real price of Jordans in 2022- 𝐂𝐏𝐈 𝐢𝐧 𝟐𝟎𝟐𝟐 Inflation Adjusted $ in 2022 = 𝐂𝐏𝐈 𝐢𝐧 𝟏𝟗𝟖𝟓 ∗ $ 𝐢𝐧 𝟏𝟗𝟖𝟓 296 = ∗ 56.95 108 = $156.09 Adjusting for Inflation Identify the type of Inflation Hyper- Inflation Running Galloping Inflation Inflation  Quantity Theory of Money (QTM) A theory that suggests a direct relationship between the quantity of money in an economy and the level of prices of goods and services It posits that changes in the money supply have a proportional effect on the price level Introduced by classical economists such as John Locke, David Hume, and Adam Smith Popularized in the 20th century by economists like Irving Fisher and Milton Friedman The Quantity Equation MV = PY Where: M = Money Supply V = Velocity of Money P = Price Level Y = Quantity of Output (Real GDP)  Mr. Smith Jan Feb Mar Apr May Jun Nov Dec Chef  Daughter Mr. Smith Jan Feb Mar Apr May Jun Nov Dec Chef  Daughter Mr. Smith Jan Feb Mar Apr May Jun Nov Dec Ms. Lara Chef Variables of QTM 1 2 V 3 M Variables in Y the Quantity Theory of Money P  Covers the actions Covers the actions of buyers of Sellers Nominal GDP = Nominal GDP 𝑴𝑽 = 𝑷𝒀𝑹 M * V Y * P  Covers the actions Covers the actions of buyers of Sellers Purchased = Sold 𝑴𝑽 = 𝑷𝒀𝑹 M * V Y * P Let’s take up an example of an economy as a whole M → is the money supply in an Economy -Total amount of money available in an economy at a particular point in time -Includes currency in circulation and demand deposits V → is the Velocity of money in an Economy - The rate at which money circulates in the economy - Calculated as the ratio of nominal GDP to the money supply Level of Velocity  Let’s take up an example of an economy as a whole P → is the Prices of all Goods and Services in an Economy - Average level of prices for goods and services in an economy Y → is all Goods and Services Sold in an Economy - Total quantity of goods and services produced in an economy - Measured by Real GDP Assumptions of the Theory - Velocity of money (V) is constant in the short run - Real output (Y) is determined by factors of production and is also constant in the short run - Any change in the money supply (M) leads to a proportional change in the price level (P) ഥ = 𝑷𝒀 𝑴𝑽 ഥ𝑹 M must cause P How well this theory hold up?? Increase in money supply resulted in increase in prices  From the same data of PERU 6000% p.a in 1990 Inflation rate About 6000% p.a in 1990 Well, theory worked well for PERU during this time period, what about other countries during ՜=՜ different time period? 𝑴 𝑷  Relationship is perfectly linear with a 1% increase in money supply growth rate → 1% increase in inflation rate For about 110 countries between 1960 and 1990 Three important Principles of QTM 1. Money is neutral in the long run 2. Inflation is always and everywhere a monetary phenomena 3. Central Banks have significant control over a nation’s money supply and hence, inflation rate Inflation and the Breakdown of Financial Intermediation It Makes Long Term Contracts Riskier Inflation Rate is also 10% What is Bank’s Real Returns?  Real Interest Rate (R) = Nominal Interest Rate (I) – Inflation Rate (ƛ) ƛ = 7% R=I–ƛ R=I–ƛ 18% = 18% - 0 I = 18% 11% = 18% - 7% I = 18%  Inflation redistributes the wealth from the Inflation Rate lender to the borrower Real Return  Banker When expected inflation was 8% Borrower  had anticipated the inflation If rate, it would have adjusted the nominal rate  Fisher Effect For US How inflation redistributes the wealth? Wealth is redistributed if, – Actual Inflation > Expected Inflation → Bank to Borrower – Actual Inflation < Expected Inflation → Borrower to Bank  When the inflation is High and Volatile, it is difficult to predict whether inflation will go up or down!  Thinks Thinks whether to whether to lend? When the inflation is High and Volatile Borrow? The process of flowing funds from lenders to borrowers When difficult to predict inflation, it breaks down When inflation heats up, all kinds of long term lending becomes costlier and less common An Economy will fail to generate and coordinate the savings with investments As a result total wealth declines  When Peru experienced hyperinflation between 1987 and 1992, private loans virtually disappeared. When firms cannot get loans, they cannot build for future expansion and growth. The price level in Peru is approximately 10 million times higher today than it was in 1997 When the inflation is High and Volatile; difficult to predict Hence, cost of inflation is very high Learning Outcome We understood- 1. How is inflation measured? 2. What is Inflation Expectation Survey and what are the Frequency and Recency Bias? 3. How to adjust for inflation? 4. How to identify the type of inflation using real time data. 5. What can we learn from the Quantity Theory of Money? 6. Whether Quantity Theory of Money holds up over the time and across the regions? 7. What are the Principles of Quantity Theory of Money? 8. What is Fisher Effect? 9. How Inflation Breaks the Financial Intermediation?