38 Inflation

  1. Learning Outcome
  • know the meaning and measurement of inflation.
  • understand the important theoretical explanations of inflation.
  1. Meaning and Measurement of Inflation

Inflation is a commonly observed phenomenon, and most people have a fair understanding of its meaning (though not precise). People often talk about rising prices in the economy. Sometimes they say that the value of rupee has declined over the years. Both of these statements have the same meaning. In market, people exchange money for a commodity. The above two statements explain the same phenomenon from two different prospective. Rising prices means that people have to pay more for the same good. Declined value of money means that more money is required to buy the same amount of a commodity.Though the meaning of inflation is clear in above discussion, it does not provide a precise definition. For example, it is quite common that prices of some commodities in the economy may have increased when prices of some other commodities may have either declined or remained the same. In such a situation, the general understanding of inflation neither help us to claim that prices are increasing nor enable us to measure the extent of change.

 

Therefore, a formal definition must help us to measure the change in prices. To overcome the problem of measurement, an average measure of prices is required. Let us suppose that an average measure of prices can be calculated which represented price level in the economy at any point in time.

 

Given that price level can be measured, the inflation can be formally defined as the rate of change inprice level in the economy. In symbols, the rate of inflation (or just inflation), p, can be written as:
= −  −1 (1)−1

 

Here, and  −1 are price level at time t and t-1, respectively.The percentage change in price level or percentage rate of inflation can be calculated by multiplying inflation, p, with 100. Since the definition of inflation is based on change in price level, one needs an unambiguous definition of price level. The price level is defined as weighted average ofexisting prices of a set of goods and servicesproduced in the economy.Here, the price of each commodity may be given same or different weight (higher weight means more importance and vice-versa).If each price is given equal weight, the price level will be simple arithmetic mean of prices. For empirical estimation of price level, the quantity of a good or service produced isused as weight. The choice of quantity as a weight is based on the logic that change in prices can be called inflation only if more money is required to buy same quantity of goods and services. Assume that the production of goods and services in the economy remains same. If the money required to buythewhole output is also the same, then there is no overall change in price level. It is because when some prices may have increased, others must have declined to negate the effect of increase. In other words, it is possible to have relative change in prices without any change in price level. Therefore, the estimation of change in price level uses quantity of goods and services as weight, so that, itsmeasurement is based on the money required to purchase the same quantity of goods and services.

 

In empirical estimation, a price indexis used to represent the price level. Price index is oftenbased oncurrentperiod or base period quantities of goods and services as weight.When the quantity of base period is used as weight, the weight remains same for all years. Laspeyres Index uses base period quantity as weight. Using current period quantity as weight means a different weight in each year, as the change in quantity of different commodities over the years is likely to be disproportionate.PaascheIndex takes current period quantity as weight. Since the weight used in two types of indices is different, they provide different estimates of price level. Some indicesuse both base period and current quantities. In such indices, theactual weight is a weighted average of present and base period quantities.Fisher Index is one such index, which is the geometric mean of Laspeyresand PaascheIndex. Despite the difference in estimates provided by different indices, they provide good estimates of price level for measuring inflation. Further, the change in relative quantities of goods and services is often small in the short run. Therefore, the short run estimates of different indices donot vary much.

 

Let us take Laspeyres Indexas an example. Laspeyres Indexuses the base period quantities as weight. One can calculate Laspeyresprice index using the formula:

= =1 0 × 100 (2) =10  0

 

Here, is the value of Laspeyresprice index at time ‘t’, and represent price level in time period ‘t’ (that is, ). and 0 are the price of ‘i th’ commodity at time ‘t’ and in base period (base year is written as ‘0’), respectively. 0is the quantity of ‘i th’ commodity produced in the base year, and used as a weight.Now take the case of two commodities, wheat and cloth, for an example of estimation. Suppose that prices of wheat in the first period were Rs. 1500 per quintal, and clothwas sold at Rs. 200 per meter, respectively. In the second period, the prices of wheat increased to Rs. 1600 per quintal, and the price of cloth changes to Rs. 190 per meter. Now, we need to take one of these periods as the base. Let us takethe first period asbase. Suppose, in the first year, the production of wheat and cloth was 10000 quintal and 1000 meter, respectively. The value ofprice index is always 100 for the base period. For second year price index, multiply the prices of wheat and cloth in second period with their respective base period quantities to get the numerator of Laspeyresprice index.The multiplication will give us Rs. 16 million for wheat and Rs. 190 thousand for cloth. Thus, the numerator in formula will be Rs. 16.19 million. To calculate denominator, multiply the prices of wheat and cloth ofthe base period with their base period quantities. This multiplication will give us values Rs. 15 million and Rs. 200 thousand for wheat and cloth, respectively. The denominator in the formula will be Rs. 15.2 million. Taking the ratio of Rs. 16.19 million and Rs. 15.2 million and multiplying it with 100 will give106.5, whichis the value of price index in second period.A similar calculation can be done for third period prices. However, the denominator, Rs. 15.2 million, will remain same for all years. To calculate inflation, subtract the previous period price index from the present year price index and divide it with previous period price index, that is, = −  −1. In the above example, inflation is 0.065 (or 6.5 percent). It should also be remembered that the number of commodities included in a price index and weight used may be different depending on the type of inflation that a person wishes to measure. For instance, the number of commodities included in measurement of consumer price index (CPI) and whole sale price index (WPI) are different. It is because both indices are meant to estimate different types of inflation.

 

The value of the price index may increase or decrease depending on the change in price level in economy. The price index can be interpreted as the money required to buy a comparable bundle of good at different points of time. For example, if the price index in the second period is 106.5, then it means a bundle of goods and services, which used to cost Rs. 100 in the base period, now costs Rs. 106.5. If the price index in the third period is 108, then it means the same bundle now costs Rs. 108.The definition of inflation covers both positive and negative changes. However, a negative inflation is often termed as deflation. Similarly, a rate of inflation more than 1000 percent (that is, more than 10 times increase in prices) is called hyperinflation.

 

3. Money and Inflation

 

After understanding the meaning of inflation, we can now move to understanding the reasons for price change. Money is directly associated with price changes. Many pre-classical economists observed that increase in supply of precious metals, such as, gold and silver (which were used as money in that period) is associated with price increase. David Hume, a famous pre-classical economist, provided an earlier version of quantity theory of money,and is often knows as price-specie flow mechanism.Classical economists considered increase in money supply as the sole reason for price increase. The empirical evidence also showed a positive relation with increase in money supply and prices. The modern understanding of relation between money supply and prices is based on quantity theory of money. Quantity theory of money specify the relationship among stock of money (M), velocity of money (V), average price level (P) and aggregate quantity of goods and services purchased (Q). Velocity of money is the number of times total money stock is used within a time interval for purchasing goods and services.For example, V is four if the total money stock, M, is used four times in a time interval. P and Q can be though as price index and quantity index. Price index is equal to the average price level within a time interval (similar to the one discussed in previous section). However, quantity index measures aggregate quantity of goods and services purchased within a time interval. Multiplication of P and Q (that is, PQ) represents the nominal income in the economy. The relationship between these four variables is given as:= (3)

 

The above equation is true for any time interval. However, for convinces, we may consider the time interval as one year. So, M is average stock of money in a year. V is the number of times the money stock is used in a year. P is the average price level in a year. And Q is aggregate of quantities purchased within a year.

 

Let us take an example to understand the meaning of the above relationship. Suppose that Rs. 10 billion worth of currency is issued by the central bank (or a government department having the power to do so).

 

People use this currency to purchase goods and services. Now assume that people buy Rs. 10 billion worth of commodities first three months of the year.In other words, the whole money stock is used once in first three months. Next time, people purchased Rs. 10 billion worth of goods in two months. It means that the whole money stock is used twice within five months. Suppose that it takesanother four months and three months for the whole money stock to be used for third and fourth time,respectively. In this example, the money stock is used for four times in a year, that is, the whole money stock, on an average, is used each three months.Since the money stock used is equal to the total value of commodities purchased, the total purchases in the economyin a year (that is, = . 40 billion) are equal to total money stock multiplied (that is, = . 10 billion) by number of times the money stock is used (that is, = 4). Therelationship in (3) can be rewritten as: = (4)

 

The relationship in (4) shows that the price of a commodity depends on money stock, velocity of money and production level in the economy. The classical economists considered V and Q as constant, in which case the price level depends on money stock. Though long run trend had shown association betweenmoney stock and price level, the studies have pointed out a much complex relation, where all the three factors contributes to change in price level.The relation between these four factors can also be represented as percentages change as given bellow:

+ = + Or = + − (5)

 

In above formula, , , and represent percentage change in price level (that is, inflation), quantity of goods and services purchased, money stock and velocity of money.

 

4. Demand and Supply Explanation of Inflation

 

The previous section provides the general form of relationship among price level, money stock, velocity of money and quantity of commodities purchased. The present section discusses the process that leads to inflation. Inflation can be understood as the change in aggregate demand (AD) and aggregate supply (AS).

 

a) Aggregate Supply (AS)

 

Aggregate supply is the quantity of goods and services that producers are willing to supply at a given price level in the economy. The shape of AS curve depends on the flexibility of prices and the wage rate in an economy. If prices and wage rate are flexible, the excess production will disappear as argued by classical economists. Therefore, the total production (Q) in an economy depends on amount of capital (K) and labour (L), and on existing technology, and AS curve will be vertical. In long run, prices and wage rate adjust themselves to their demand. Hence, the long run AS curve is vertical as shown in Figure 1 (a). The vertical AS curve represents no effect of prices on supply of goods. Long run AS curve shifts to the left (as shown in Figure 1 (a)) with improvement in technology, increase in labour or increase in capital.The prices and wage rates tend to be stickyin the short run. Therefore, AS curve is horizontalup to a point as shown in Figure 1 (b). It means producers respond to the price change by changing their levels of production, where lower prices mean lower production.However, the production cannot exceed the point where all resources are full employed.

 

  1. b) Aggregate Demand (AD)

 

Aggregate demand is the quantity of goods and services that people are willing to buy at a given price level. AD depends on the money stock (M) and velocity of money (V). The quantity theory relation in equation (3) can be rewritten as:

 

Here, = 1/ , and / represents the real money balance. Remember that the purchasing power in an economy depends on the availability of money and prices. If there is an increase in price level without change in money supply, then it means that aggregate purchasing power of the people has declined, which is same as decline in aggregate demand. One can also explain the relationship from production point of view. A larger output requires higher real money balance to purchase all the production. If M and V remains same, the price must be inversely related to the output level. In other words, prices level must be low to purchase higher level of output and vice-versa. Thus, for a fixed M and V, AD is negatively related to the price level. An increase in M increases the aggregate demand and shifts AD curve to the right, and any decrease in M shifts the curve to the left as shown in Figure 2 (a) and 2 (b).

 

c) Supply Push and Demand Pull Inflation

 

Inflation may be the result of change in aggregate demand or aggregate supply or both.The effect of this change on price level can be understood with the help of shift in AD curve and AS curve. The inflation due to demand side factors is called demand pull inflation. Figure 3a shows the effect of shift in AD curve in short run. AD curve may shift due to change in money supply or increase in total spending in the economy. The increase in total spending in the economy may be the result of increase in government expenditure, lowering of taxes or rise in investment.In short run, AS curve is horizontal up to a point. In this situation, the effect of AD curve shift on price level depends on the shape of AS curve at their interaction point. There will be no rise in price level if old and new AD curves meet AS curve, where it is horizontal. At this portion of AS curve, the shift in AD curve only affects the output level in the economy. In Figure 3a, the shift in AD curve from AD1 to AD2 does not lead to price rise. On the other hand, a shift of AD curve at the vertical portion of AS curve, which shows full employment of resources, leads only to price rise. In long run, AS curve is verticalas shown in Figure 3b, therefore, any shift in AD curve leads to price increase. The long run effect is similar to the short run effect at vertical portion. It is because the resources are fully employed in the long run.

 

A shift in AS to the right may also lead to increase in price level. The shift in AS curve may be the result of increase in cost of production due to rise in wage rates or supply shock. These factors shift the AS curve upwards and towards left. The inflation due to supply side factors is referred to as supply push inflation.

 

These factors may shift AS curve with no change in vertical portion of the curve as shown in Figure 4a. This shift increases the price level in the economy. In Figure 4a, the price level rises from P1 to P2 as a result of shift in AS curve. Therise in price level due to this shift is also associated with decline in output in the short run. However, the long run output level may remain same if the vertical portion of the curve remains unaffected.Supply shock may also shift the long run AS curve to the left as shown in Figure 4b. This shift not only increases the price level but also lowers the long run output in the economy. Nonetheless, the improvement in technology and increase in labour productivity shift AS curve towards rightin long run. Therefore, the long run shift in AS curve often tends to lower prices and increase output.

 

The price level in an economy is the result of interaction of AD curve and AS curve. The change in price level is also the result of shift in AD curve and AS curve. In the long run, AS curve generally shifts towards right and prices are flexible, therefore, the rising price is likely to be the result of upward shift in AD curve.In long run, the shift in AD curve is mainly attributed to change in money supply. Therefore, long run price increase is often argued as a monetary phenomenon. However, a number of factorsmay be responsible for increasing price level in the short run. It must be remembered that the price level is not same as inflation. The price level represents the aggregate price level in the economy at any point of time, whereas, the inflation is rate of change in price level from one point to another. For example,the increase in price level between two time pointsmeans inflation. No further increase in price level means zero inflation in the next period, even though the price level has not moved back to the old level. In fact, going back to old price level will mean negative inflation (or deflation) in the economy.

  1. Summary

 

Inflation is one of the most talked about topics in today’s world. Inflation can simply be understood as therate of increase in price level in an economy.The empirical estimation of inflation uses price index to measure price level in the economy at different points of time. Money is at the heart of the cause of inflation. Keeping other things constant, the quantity theory of money predicts inflation as solely a monetary phenomenon. Another way to analyse inflation is through change in AD curve and AS curve. It provides a more general explanation of inflation.Inflation may be the result of shift in AD curve or AS curve. AD curve shifts due to increase in money supply or increase in aggregate spending in the economy. The shift in AS curve may be the result of increase in cost of production due to wage rate increase or supply shock. Accordingly, inflation may be called demand pull or supply push inflation.

 

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