In economics, inflation is a rise in the general
level of prices of goods and services in an
economy over a period of time. When the
general price level rises, each unit of currency
buys fewer goods and services.
According to Webster's “An increase in the
amount of currency in circulation, resulting in
a relatively sharp and sudden fall in its value
and rise in prices: it may be caused by an
increase in the volume of paper money issued,
or a relative increase in expenditures as when
the supply of goods fails to meet the demand”.
According to Prof. Samuelson “inflation occurs
when general level of prices & cost are rising”.
Demand-pull inflation
Cost-push inflation
Any inflation that results from an increase in
demand is called demand-pull inflation
Caused by
Increased Incomes
Decreased income taxes
Decreased tendency to save
Consumers expect prices to rise in the future
More money in the economy
Any inflation that results from a decrease in
supply is called cost-push inflation.
Caused by
Increased costs of raw materials
Increased Wages
Failure to replace capital goods as they age, reducing
its productivity, or increasing its maintenance costs
Falling Productivity of workers
Producer Price Index
The PPI measures the average change in the sale prices
for the entire domestic market of raw goods and
services.
These goods and services are bought by consumers
from their primary producers, bought indirectly from
retail sellers and purchased by producers themselves.
The PPI comprises prices of both capital equipment
and consumer goods.
The industries that compile the PPI include mining,
manufacturing, agriculture, fishing, forestry, natural
gas, electricity, construction, waste and scrap materials.
Sales and excise taxes are not taken into account while
determining PPI.
Economists have developed a measure called the
consumer price index (CPI),
Which is based on a typical market basket of goods
and services required by the average consumer.
This market basket usually consists of items from
eight major group
1. Food and beverages
2. Housing
3. Apparel
4. Transportation
5. Medical care
6. Entertainment
7. Personal care
8. Other goods and services
Constructing the CPI
Constructing the CPI involves three stages:
Selecting the CPI basket
Conducting a monthly price survey
Using the prices and the basket to calculate the CPI
For a simple economy that consumes only
oranges and haircuts, we can calculate the CPI.
The CPI basket is 10 oranges and 5 haircuts.
Item Quantity Price Cost of CPI
basket
Oranges 10 $1.00 $10
Haircuts 5 $8.00 $40
Cost of CPI basket at base period prices $50
This table shows the prices in the base period.
The cost of the CPI basket in the base period was
$50.
Item Quantity Price Cost of CPI
basket
Oranges 10 $1.00 $10
Haircuts 5 $8.00 $40
Cost of CPI basket at base period prices $50
This table shows the prices in the current period.
The cost of the CPI basket in the current period is
$70.
Item Quantity Price Cost of CPI
basket
Oranges 10 $2.00 $20
Haircuts 5 $10.00 $50
Cost of CPI basket at current period prices $70
The CPI is calculated using the formula:
CPI = (Cost of basket in current period/Cost of
basket in base period) 100.
Using the numbers for the simple example, the CPI
is
CPI = ($70/$50) 100 = 140.
The CPI is 40 percent higher in the current period
than in the base period.
Measuring Inflation
The main purpose of the CPI is to measure inflation.
The inflation rate is the percentage change in the
price level from one year to the next.
The inflation formula is:
Inflation rate = [(CPI this year – CPI last year)/CPI
last year] 100.
The first difference between the indexes is the targeted goods
and services. The producer price index focuses on the whole
output of producers. This index is very broad, including not
only the goods and services purchased by producers as inputs in
their own operations or as investment, but also includes goods
and services bought by consumers from retail sellers and
directly from the producer.
In contrast, the consumer price index targets goods and services
that are bought for consumption by urban residents. The CPI
includes imports; the PPI does not.
The second fundamental difference between the indexes
includes the prices. In the producer price index, taxes are not
included for the producer's returns.
Conversely, the consumer price index includes taxes because
these factors do directly impact the consumer by having to pay
more for the goods and services.
There are broadly two ways of controlling inflation in
an economy:
1). Monetary measures
2). Fiscal measures
Monetary Measures
The most important and commonly used method to
control inflation is monetary policy of the Central
Bank. Most central banks use high interest rates as the
traditional way to fight or prevent inflation.
(i) Bank rate policy
(ii) CRR
(iii) Open market operations
(i)Increase in Taxes
(ii) Increase in savings
(iii) surplus budgets
