Inflation & deflation
impact on economy
Inflation & Deflation
impact on economy
Major outlines
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Introduction
Definition
Types of Inflation/deflation
Causes of Inflation/deflation
Effects of Inflation/deflation
Inflation Vs Deflation
Introduction
Prices 2008
commodity
Prices 1956
Rs.15/kg
rice
0.30/kg
Rs.12/kg
wheat
0.25/kg
300/kg
almond
3/kg
8/kg
potato
0.20/kg
Inflation
Defined as:
 A SUSTAINED RISE IN THE AVERAGE LEVEL OF
PRICES
Intro……………
 Situation of rapid
general increase in
price level.
 Decline in the value
of money.
Definition
 Inflation is defined as : The general
increase in the price level.
 An inflationary shock is anything that
tends to increase the price level.
 A deflationary shock is anything that
tends to decrease the price level.
Definitions:
 AccordIng to crowthers “ InflAtIon
means a state in which the value of
money Is fAllIng I.e.… prIces Are
rIsIng”.
 AccordIng to pIgou “ InflAtIon ArIses
when money income is expanding more
than proportionate to income
eArnIng ActIvIty”.
 AccordIng to prof. sAmuelson “
Inflation occurs when general level
of prIces & cost Are rIsIng”.
Types of inflation
 Creeping inflation
 Walking inflation
 Running inflation
 Galloping inflation
 Hyper inflation
Cont…
Demand – pull inflation:
 Due to high GDP and low unemployment.
Supply shock inflation:
 due to adverse change in price of
raw materials ( like oil).
Built in inflation:
 induced by expectations based on
previous inflation levels.
Causes of Inflation

First, we have to make three important distinctions
concerning these shocks:
1. (1) Inflations or deflations that are caused by shifts in
aggregate demand must be distinguished from
inflations or deflations caused by shifts in aggregate
supply.
2. (2) Isolated, once-and-for-all shocks, must be
distinguished from repeated shocks.
3. (3) Increases in the price level that occur even though
the money supply is constant must be distinguished
from those that take place when the money supply
increases.
Causes of
Inflation
 1. Shifts in AD curve to the right. This is called
“demand shock inflation “ or demand-side
inflation.
 2. Shifts in SRAS curve upward to the left. This is
called “ Supply Shock Inflation “ or Supply- Side
Inflation or Cost- Push Inflation.
Why Wages Change

Two of the main forces that cause wages and other
factor prices to change are:
1. Demand for labor: when output exceeds potential,
an inflationary gap occurs that is characterized by
excess demand for labor which will increase wages
and unit costs, the opposite is also true.
2. Expected inflation: the expectation of specific
inflation rate creates pressure for wages to rise by
that rate. These expectation could be backward or
forward (rational) expectations.
From Wages to the SRAS
Curve
 The overall change in money wages is a result of two differe
basic forces:
Change in
money wages = demand effect + expectation
effect
 The net effect of these two forces acting on unit costs
determines what happened to the SRAS curve.
Demand Inflation
 Isolated Demand Shocks: A rightward Shift in AD
curve, that causes equilibrium income to exceed Y*
will result in different effects depending on whether
there is monetary validation (i.e., with money
supply held constant) or not. Figure 30-1.
Demand Inflation
1. A shift in AD curve to the right with no monetary
validation will cause the price to rise and then
stabilizes, and the actual output to fall back to Y* .
2. A shift in AD curve to the right accompanied by
monetary validation (the central bank will start to
increase the money supply whenever output starts
to fall because of the upward shift in the SRAS
curve) will lead to sustained inflation and the
actual output will remain above Y*.
The Effects of Inflationary Shocks
Supply Inflation
 1. Isolated Supply Shock: Once and for all
increase in the cost of production (oil price
increase in 1973). This adverse supply shock is
due to some factors other than an excess
demand on inputs such as: an increase in
wages because of expectations of future
inflation or because of a rise in the costs of
imported raw materials.
 2. Repeated Supply Shock
Both the isolated and repeated supply shocks
lead to an upward shift in the SRAS curve.
 In addition, negative technological shocks lead
to a left shift in the vertical LRAS.
Isolated Supply Shock
 A. No Monetary Validation:
An Isolated supply shock without monetary
validation will have a period of inflation followed by
a period of deflation.
 This deflation takes place since an upward left shift
in SRAS curve causes a recessionary gap that causes
factor prices to fall slowly and thus, it takes a long
time to go back to the potential output.
 B. Supply Shock inflation with monetary
Validation: the central bank validates the
adverse supply shock by increasing the money
supply because it believes that factor prices
fall only slowly. This will shift AD curve to the
right and causes both the price level and
output to rise.
 This means that the initial increase in the price
level will be followed by a further rise.
 Examples: in 1974, the Canadian central bank
validated the supply shock with large
increases in the money supply whereas the
U.S. Federal Reserve Bank did not. This
resulted in a large increase in the price level in
Canada with almost no recession, while the
U.S. experienced a much smaller increase in
the price level but a severe recession.
Repeated Supply Shock
 This means continuous shift in SRAS curve to
the left resulting from continuous rise in wage
or price of raw materials . Here also we need
to distinguish between two cases :
 A. IF no monetary validation: the results here
are identical to those of a single isolated
supply shock.
 B. If there is a monetary validation.
Sustained Inflation
 Accelerating Inflation:
 In figure 30-2, we saw how the central bank engaged in money
validation that results in shifting both AD and SRAS upward
allowing the price level to rise continuously.
 This could be explained by the acceleration hypothesis:
“when the central bank engage in a monetary expansion policy
to hold the inflationary gap constant, the actual rate of
inflation accelerates”.
 Example: the central bank may start validating 3% inflation,
but soon the 3% will become 4% and so on without limit until
the central bank stops its validation.
 Expectational Effects:
 According to the acceleration hypothesis, as long as
an inflationary gap persists, expectations of inflation
will be rising, and this rise will lead to increases in the
actual rate of inflation:
Actual Inflation = Demand Inflation + Expected Inflation
 Correct expectations mean that expected inflation
equals actual inflation, which in turn implies that
demand inflation must be zero.
Ending a Sustained Inflation
 Costs of reducing inflation:
 In order to reduce the rate inflation, the central
bank has to stop validating the inflation (stop
increasing the money supply).
 This process involves many costs because the
economy will suffer from a recessionary gap which
will hurt both unemployed workers and the owners
of firms who lose profits.
Reducing sustained inflation can be
divided into three phases
 Phase 1: Removing Monetary Validation:
 the elimination of a sustained inflation begins with a
demand contraction to remove the inflationary gap.
The central bank stops expanding the monetary
supply, thus stabilizing AD at AD1.
 Wages continue to rise, taking SRAS curve leftward to
SRAS2, at which the inflationary gap is removed.
Causes of inflation
 Increases in money supply.
 Expansion of bank credit.
 Deficit financing.
 Black money.
 Scarcity.
 Taxes.
 Population growth.
Effect of Inflation
 Debtors and creditors.
 People with fixed income.
 Consumers .
 Producers and businessman.
 Farmers.
 Tax payers and government.
Deflation
 A general decline in price often
caused by a reduction in the supply
of money or credit.
 Deflation can be caused also by
decrease In government , personal
or investment spending.
 Deflation has the side effect of
increased unemployment.
Causes of deflation
 Decreasing money supply.
 Increasing supply of goods.
 Decreasing demand of goods.
 Increasing demand for money.
Problems with Inflation
A. UNEVENESS
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Inflation produces uneven increases in the prices
of products.
In periods of inflation it is possible of have some
products decrease in price, others increase
slowly, while others increase quickly.
Problems with Inflation
A. UNEVENESS


This means that some consumers are hurt worse
than others.
Buyers of gasoline are hit worse than buyers of
DVD’s and computers
Problems with Inflation
A. UNEVENESS

People with fixed incomes will see their income
fall at the same rate as inflation rises.

Some savers will see their savings fall almost as
fast as the rate that inflation
Problems with Inflation
B. UNCERTAINTY
Who else is hurt by the uncertainty and
unevenness of inflation?
Lenders – banks, etc.
Problems with Inflation
B. UNCERTAINTY
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Lenders lend money to earn a profit.
To earn a profit, the interest they charge must
cover all costs, and be higher than the rate of
inflation.
Problems with Inflation
B. UNCERTAINTY
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When lenders lend money, they have an
expected rate of inflation at the time of the loan.
This expected rate of inflation is based on
current rate of inflation, plus a guess about the
future.
Problems with Inflation
B. UNCERTAINTY
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If lenders guess right about inflation, they earn a
profit.
If lenders guess wrong, they lose money.
Problems with Inflation
B. UNCERTAINTY
Nominal interest rate = the observed interest
rate
Real interest rate = nominal interest rate –
rate of inflation
Problems with Inflation
B. UNCERTAINTY
Lenders try to set the nominal interest rate to:
1) cover costs
2) match expected rate of inflation
3) yield a profit
Inflation: Any Winners?
Not everyone loses with low and moderate rates
of inflation.
- People whose income is flexible.
- Borrowers (debtors).
Inflation: Any Winners?
Borrowers win because the real value of their
loan repayments decreases at the same rate
as inflation rises.
If their incomes rise as well, they are double
winners.
Problems with Inflation
Much of the United States Federal
government’s monetary policy, and the
focus of most introductory econ textbooks,
is on the evils of inflation.
In the dispute between lenders and
borrowers, which side are they on?
Effect on economy as well as
our self
 Inflation affects you directly when you go to
the grocery store but find that a hundred
dollars doesn't get you the same amount as it
did last year.
 Many people hang on to their money & stop
spending on many non-essential items
because of fear.
 Houses & Cars begin to depreciate.
Cont…
 Business starts to dry up & employers find
themselves cutting down on staff.
 Our fixed income gets depleted & we find
ourselves having to survive on even less.
 The quality or standard of life that many have
grown, downgrades as a direct result of
inflation.
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