1. Inflation & deflation impact on economy

2. Inflation & Deflation impact on economy

3. Major outlines Introduction Definition Types of Inflation/deflation
Causes of Inflation/deflation
Effects of Inflation/deflation
Inflation Vs Deflation

4. Introduction Prices 2008 commodity Prices 1956 Rs.15/kg rice 0.30/kg
wheat
0.25/kg
300/kg
almond
3/kg
8/kg
potato
0.20/kg

5. Inflation
Defined as:
A SUSTAINED RISE IN THE AVERAGE LEVEL OF PRICES

6. Intro…………… Situation of rapid general increase in price level.
Decline in the value of money.

7. 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.

8. 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”.

9. Types of inflation Creeping inflation Walking inflation
Running inflation
Galloping inflation
Hyper inflation

10. Cont… Supply shock inflation: Built in inflation:
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.

11. Causes of Inflation
First, we have to make three important distinctions concerning these shocks:
(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) Isolated, once-and-for-all shocks, must be distinguished from repeated shocks.
(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.

12. 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.

13. Why Wages Change
Two of the main forces that cause wages and other factor prices to change are:
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.
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.

14. From Wages to the SRAS Curve
The overall change in money wages is a result of two different 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.

15. 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.

16. Demand Inflation
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* .
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*.

17. The Effects of Inflationary Shocks

18. 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

19. 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.

20. 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.

21. 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.

22. 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.

23. 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.

24. 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.

25. 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.

26. 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.

27. 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.

28. Causes of inflation Increases in money supply.
Expansion of bank credit.
Deficit financing.
Black money.
Scarcity.
Taxes.
Population growth.

29. Effect of Inflation Debtors and creditors. People with fixed income.
Consumers .
Producers and businessman.
Farmers.
Tax payers and government.

30. 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.

31. Causes of deflation Decreasing money supply.
Increasing supply of goods.
Decreasing demand of goods.
Increasing demand for money.

32. Problems with Inflation
A. UNEVENESS
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.

33. 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

34. 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

35. Problems with Inflation
UNCERTAINTY
Who else is hurt by the uncertainty and unevenness of inflation?
Lenders – banks, etc.

36. Problems with Inflation
B. UNCERTAINTY
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.

37. Problems with Inflation
B. UNCERTAINTY
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.

38. Problems with Inflation
B. UNCERTAINTY
If lenders guess right about inflation, they earn a profit.
If lenders guess wrong, they lose money.

39. Problems with Inflation
UNCERTAINTY
Nominal interest rate = the observed interest rate
Real interest rate = nominal interest rate –
rate of inflation

40. Problems with Inflation
UNCERTAINTY
Lenders try to set the nominal interest rate to:
1) cover costs
2) match expected rate of inflation
3) yield a profit

41. Inflation: Any Winners?
Not everyone loses with low and moderate rates of inflation.
- People whose income is flexible.
- Borrowers (debtors).

42. 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.

43. 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?

44. 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.

45. 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.

46. Thank you