B.A. LL.B. (Hons.

SEMESTER: II

SECTION: B

FINAL PROJECT OF

INFLATION: CAUSES AND EFFECTS

A BRIEF OVERVIEW OF STAGFLATION, DEFLATION, REFLATION AND DISINFLATION
SUBJECT: ECONOMICS SUBMITTED TO: Dr. MADHURI SRIVASTAVA (PROFESSOR)
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SUBMITTED BY: VEDANG MISHRA Roll no: 153

ACKNOWLEDGEMENT
A major research project like this is never the work of anyone alone. Firstly, I would like to thank respected Professor MADHURI SRIVASTAVA, for giving me such a golden opportunity to show my skills and capability through this project.

This project is the result of the extensive ultrapure study, hard work and labour, put into to make it worth reading. This project has been completed through the generous co-operation of various persons, especially my seniors, who, in their different potentials helped me a lot in giving the finishing touch to the project.

This project couldnt be completed without the help of my universitys library Dr. Madhu Limaye Library and its internet facility.

I am glad to have made it

Thanking You........

Table of Contents
1. CHAPTER 1. Introduction

Page No.
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2. CHAPTER 2. 05 Objective and Research Methodology 3. CHAPTER 2. Causes of Inflation 4. CHAPTER 3. Effects of Inflation 5. CHAPTER 4. Types of Inflation 6. CHAPTER 5. Inflationary Gap 7. CHAPTER 6 Measures for Calculating Inflation 8. CHAPTER 7. Stagflation, Reflation, Deflation and Disinflation 9. CHAPTER 8. Summary 19 16 15 13 10 08 06

CHAPTER 1 INTRODUCTION
Inflation is commonly understood as a situation of substantial and rapid general increase in the level of prices and consequent deterioration in the value of money over a period of time. It refers to the average rise in the general level of prices and fall in the value of money. Inflation is a global phenomenon. It is linked with the money supply. By inflation we mean a process of rising prices. Prof. Crowther has defined inflation as a state in which the value of money is falling i.e. prices are rising. Prof. Goldenweiser says Inflation occurs when the volume of money actively bidding for goods and services increases faster than the available supply of goods Webster's 1983 Definition of Inflation: "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 of gold mined, or a relative increase in expenditures as when the supply of goods fails to meet the demand. 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. Consequently, inflation also reflects erosion in the purchasing power of money a loss of real value in the internal medium of exchange and unit of account in the economy. A chief measure of price inflation is the inflation rate, the annualized percentage change in a general price index (normally the Consumer Price Index) over time. When inflation goes up, there is a decline in the purchasing power of money. For example, if the inflation rate is 2% annually, then theoretically a $1 pack of gum will cost $1.02 in a year. After inflation, your dollar can't buy the same goods it could beforehand. A movie ticket was for a few paise in my dads time. Now it is worth Rs.50. My dads first salary for the month was Rs.400 and over he years it has now become Rs.75,000. This is what inflation is, the price of everything goes up. Because the price goes up, the salaries go up.

CHAPTER 2 OBJECTIVE AND RESEARCH METHODOLOGY

OBJECTIVE OF PROJECT:
During World War II, you could buy a loaf of bread for $0.15, a new car for less than $1,000 and an average house for around $5,000. In the twenty-first century, bread, cars, houses and just about everything else cost more. A lot more clearly, we've experienced a significant amount of inflation over the last 60 years. When inflation surged to double-digit levels in the mid- to late-1970s, Americans declared it public enemy No.1. Since then, public anxiety has abated along with inflation, but people remain fearful of inflation, even at the minimal levels we've seen over the past few years. Although it's common knowledge that prices go up over time, the general population doesn't understand the forces behind inflation. So we have many questions regarding inflation like, What causes inflation? How does it affect your standard of living? What are the consequences of inflation? What are the remedies of inflation? The aim of my project is to shed light on these questions as well as consider other aspects of inflation i.e. deflation, reflation, disinflation and stagflation that play as much important role in trade or business cycle and affect the income of people as inflation do.

RESEARCH METHODOLOGY:
To complete my project I will follow Doctrinal Research Methodology. By which I will collect the material from documentary sources both paper document and electronic document. Paper contains all the writings available from the books, articles, journals, and newspapers. Whereas the electronic documents in this aspect means the documents available in the World Wide Web. In my research the role of my universitys library Dr. Madhu Limaye Library and its Internet facility will be very important.

CHAPTER 3 CAUSES OF INFLATION

There are a few different reasons that can account for the inflation in our goods and services; let's review a few of them. Demand-pull inflation refers to the idea that the economy actual demands more goods and services than available. This shortage of supply enables sellers to raise prices until equilibrium is put in place between supply and demand. The cost-push theory , also known as "supply shock inflation", suggests that shortages or shocks to the available supply of a certain good or product will cause a ripple effect through the economy by raising prices through the supply chain from the producer to the consumer. You can readily see this in oil markets. When OPEC reduces oil supply, prices are artificially driven up and result in higher prices at the pump On the DEMAND side y Increase in public expenditure: An increase in the public expenditure consequent upon the outbreak of war or development planning invariably causing an increase in the demand for goods and services in the economy. Increase in exports: It is evident that when more and more of commodities are exported to foreign countries, less and less of them are available for domestic consumption. Reduction in taxation: When the government reduces taxes, it result in an increase in the purchasing power in the hands of the public. Repayment of past internal debt: When government repays its past debts to the public it results in an increase of purchasing power of the public. Rapid growth of population: A rapidly growing population has the effect of rising up the level of aggregate effective demand for goods and services in the country. Black Money: It is widely condemned that black money in the hands of tax evaders and black marketers as an important source of inflation in a country. Black money encourages lavish spending, which causes excess demand and a rise in prices. Deficit Financing: Deficit financing means spending more than revenue. In this case government of India accepts more amount of money from the Reserve Bank India (RBI) to spend for undertaking public projects and only the government of India can practice deficit financing in India. The high doses of deficit financing which may cause reckless spending, may also contribute to the growth of the inflationary spiral in a country. Cheap money policy: Cheap money policy or the Rapid expansion of bank credit is also responsible for the inflationary trend in a country.

y y y y y

ON THE SUPPLY SIDE y Shortage of supplies of factor of production: The shortage of productive factors such as labour, capital equipment, raw material etc. is a serious obstacle to any effort to increase production in the country. Industrial disputes: In countries where trade unions are strong strikes, lock-outs causes industrial production falls, thereby reducing supply of goods. Natural calamities: Natural calamities like floods, draughts etc. adversely affect the supply of agricultural product and raw material thereby helping inflationary pressures. Lop-sided production: If the stress is placed on the production of comfort and luxury goods, thereby neglecting essential and consumers goods, it creates shortage of goods in the market. Hoarding by traders and consumers as well: At the time of shortage and rising prices there is a tendency of traders to hoard essential commodities for profiteering purposes and on the part of individual consumers to hoard them to avoid payment of higher prices in future causing further scarcity of these commodities. Operation of law of diminishing returns: When the law of diminishing returns operate, increase in production is possible only at a higher cost which de motivates the producers to invest in large amounts. Thus production will not increase proportionately to meet the increase in demand. Hence, supply falls short of demand.

CHAPTER 4 EFFECTS OF INFLATION

Effects on production: y Increased risk - Higher uncertainties in business always exist, but with inflation risks are very high, because of the instability of prices. Lowers national saving: When there is a high inflation, saving money would mean watching your cash decrease in value day after day, so people tend to spend the cash on something else. Causes mal-investment: In inflation times, the data given about an investment is often deceptive and unreliable, therefore causing losses in investment. Causes an increase in tax bracket: People will be taxed a higher percentage if their income increases following an inflation increase. Currency debasement: This lowers the value of a currency, and sometimes causes a new currency to be born. Hoarding: Inflation also leads to hoarding of essential goods both by traders as well as consumers. People will try to get rid of cash before it is devalued, by hoarding food and other commodities creating shortage of the hoarded object.

Effects on distribution: y Effects of Inflation on Business Community: Inflation is welcomed by entrepreneurs and businessmen because they stand to profit by rising prices. They find that the value of their inventories and stock of goods is rising in money terms. They also find that prices are rising faster than the costs of production, so that their profit is greatly enhanced. y Fixed Income Groups: Inflation hits wage-earners and salaried people very hard. Although wage- earners, by the grace of trade unions, can chase galloping prices, they 8

seldom win the race. Since wages do not rise at the same rate and at the same time as the general price level, the cost of living index rises, and the real income of the wage earner decreases. y Farmers: Farmers usually gain during inflation, because they can get better prices for their harvest during inflation. y Investors: Those who invest in debentures and fixed-interest bearing securities, bonds, etc, lose during inflation. However, investors in equities benefit because more dividend is yielded on account of high profit made by joint-stock companies during inflation. y Debtors and Creditors: During inflation, debtors are generally the gainers while the creditors are the losers. y Inflation will lead to deterioration of gross domestic savings and less capital formation in the economy and less long term economic growth rate of the economy.

CHAPTER 5 TYPES OF INFLATION

Depending upon the rate of rise in prices and the prevailing situation inflation has been classified under different heads: y Creeping inflation: When the rise in prices is very slow like that of a snail or creeper, (less than 3 %) it is called creeping inflation. y Walking inflation: When the price rise is moderate (is in the range of 3 to 7 %) and the annual inflation rate is of a single digit, it is called walking inflation. It is a warning signal for the government to control it before it turns into running inflation. Running inflation: When the prices rise rapidly, at a rate of speed of 10 to 20 percent per annum, it is called running inflation. Such inflation affects the poor and middle classes adversely. Its control requires strong monetary and fiscal measures; otherwise it leads to hyper inflation. Hyper Inflation: Hyper inflation is also called by various names like jumping, runaway, or galloping inflation. During this period prices rise very fast, at double or triple digit rates from more than 20 to 100 percent per annum or more and becomes absolutely uncontrollable. Such a situation brings a total collapse of the monetary system because of the continuous fall in the purchasing power of money.

Demand pull Inflation: It may be defined as a situation where the total monetary demand persistently exceeds total supply of goods and services at current prices, so that prices are pulled upwards by the continuous upward shift of the aggregate demand function. It arises as a result of an excessive aggregate effective demand over aggregate supply of goods and services in a slowly growing economy. Supply of goods and services will not match with rising demand. The productive ability of the economy is so poor that it is difficult to increase the supply at a quicker rate to match the increase in demand for goods and services. When exports increase the money income of the people rises. With excess money income, purchasing power, demand, prices move in the upward direction. It is essential to note that demand pull inflation is the result of increase in money supply. This leads to fall in the interest raterise in investment increase in production increase in the incomes of factors of production increase in the demand for goods and services and finally, in the level of prices. Thus, excess supply of money results in escalation of prices. Again, when there is a diversion of productive 10

resources from the production of consumer goods to either capital or defense goods or nonessential goods, prices start rising in view of scarcity of consumer goods and excess income in the hands of people. It is clear from the following diagram

Cost Push Inflation: It refers to a situation where in prices rise on account of increasing cost of production. Thus, in this case, rise in price is initiated by growing factor costs. Hence, such a price rise is termed as cost push inflation as prices are being pushed up by the rising factor costs. A number of factors contribute for the increase in cost of production. 1. Demand for higher wages by the labour class. 2. Fixing up of higher profit margins by the manufacturers. 3. Introduction of new taxes and raising the level of old taxes. 4. Increase in the prices of different inputs in the market. 5. Rise in administrative prices by the government etc., These factors in turn cause prices to rise in the market. Out of many causes, rise in wages is the most important one. It is estimated and believed that wages constitute nearly 70% of the total cost of production. A rise in wages leads to a rise in the total cost of production and a consequent rise in the price level. Thus costpush inflation occurs due to wage push or profitpush. We can explain the costpush inflation with the help of the following diagram.

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CHAPTER 6 INFLATIOARY GAP

J.M.Keynes invented the term inflationary gap to describe a situation when there is excess of anticipated expenditure over the available output at base prices. It is a gap between /money incomes of the community and the available supply of output of goods and services. According to Lipsey The inflationary gap is the amount by which aggregate expenditure would exceed aggregate output at the full employment level of income. The larger the aggregate expenditure, the larger is the gap and more rapid the inflation. During a war period, the volume of money expenditure by the government increases, resulting in increased income with the community leading to increased consumption expenditure and investment. Given a constant average propensity to save, rising money incomes at full employment level lead to an excess of demand over supply and result in the development of inflationary gap. We can explain this with an illustration: (Rs.Crores) 1. Gross National Income at current prices 20,000 2. Less Taxes 5,000 3. Personal Income (gross disposable income) 15,000 4. Less Savings of the community 3,000 5. Disposable Income 12,000 6. Gross National Product at pre inflation prices 15,000 7. Government expenditure (to meet the war requirements) 6,000 8. Output available for consumption at pre inflation prices 9,000 9. Inflationary gap (12, 000 9,000) 3,000

Now the net disposable income with the community is 12,000, but the available output for civilian consumption is only 9,000. There is excess of demand over available supply to the extent of Rs.3000 crores. This is referred to as the inflationary gap. Though Keynes associated an inflationary gap with war, such a gap can arise even during the period of economic development. We can show the inflationary gap diagrammatically using the Keynesian concepts of aggregate supply and aggregate demand:

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Measures to wipe out inflationary gap 1. Increase in savings to reduce aggregate demand. 2. Raise the output to match the disposable income. 3. Raise the taxes to mop up the excess purchasing power. The first two measures have a limited scope, monetary policy also cannot be very effective so the government will have to rely more on fiscal measures like taxation to wipe out the inflationary gap.

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CHAPTER 7 MEASURES FOR CALCULATING INFLATION

Inflation is usually estimated by calculating the inflation rate of a price index, usually the Consumer Price Index. The Consumer Price Index measures prices of a selection of goods and services purchased by a "typical consumer". The inflation rate is the percentage rate of change of a price index over time. Prof, Rowan suggests the following formula Change in Price [t] Price [t-1]

Percentage rate of inflation, P[t] =

X 100

Change in price [t] = P [t] P [t1]. Here, P = price level and [t], [t1] are the periods of calendar time to which the observations are made. For instance, in January 2007, the U.S. Consumer Price Index was 202.416, and in January 2008 it was 211.080. The formula for calculating the annual percentage rate inflation in the CPI over the course of 2007 is

The resulting inflation rate for the CPI in this one year period is 4.28%, meaning the general level of prices for typical U.S. consumers rose by approximately four percent in 2007 How India calculates Inflation ? India uses the Wholesale Price Index (WPI) to calculate and then decide the inflation rate in the economy. So next question that would arise is What is Wholesale Price Index? WPI is the index that is used to measure the change in the average price level of goods traded in wholesale market. In India, a total of 435 commodities data on price level is tracked through WPI which is an indicator of movement in prices of commodities in all trade and transactions. The data for this is available weekly and this helps the Indian government to calculate the inflation weekly. For instance in 2007-08 WPI was 255 and in 2008-09 it was 280 than The formula for calculating the annual percentage rate inflation in the WPI over the course of 2008-09 will be 9.8% according to above mentioned formula. 15

CHAPTER 8 STAGFLATION, REFLATION, DEFLATION AND DISINFLATION

STAGFLATION:
The present day inflation is the best explanation for stagflation in the whole world. It is inflation accompanied by stagnation on the development front in an economy. Instead of leading to full employment, inflation has resulted in unemployment in most of the countries of the world. It is a global phenomenon today. Both developed and developing countries are not free from its clutches. Stagflation is a portmanteau term in macro economics used to describe a period with a high rate of inflation combined with unemployment and economic recession. Inflationary gap occurs when aggregate demand exceeds the available supply and deflationary gap occurs when aggregate demand is less than the aggregate supply. These are two opposite situations. For instance, when inflation goes unchecked for some time, and prices reach very high level, aggregate demand contracts and a slump follows. Private investment is discouraged. Inflationary and deflationary pressures exist simultaneously. The existence of an economic recession at the height of inflation is called stagflation. The effects of rising inflation and unemployment are especially hard to counteract for the government and the central bank. If monetary and fiscal measures are adopted to redress one problem, the other gets aggravated. Say, if a cheap money policy and public works programme are adopted to remedy unemployment inflation gets aggravated. On the other hand, if a dear money policy and stringent fiscal measures are followed unemployment will get aggravated. It is the most difficult type of inflation that the world is facing today. Keynesian remedial measures have not succeeded in containing inflation but actually have aggravated unemployment. Thus, the world stands today between the devil (inflation) and deep sea (unemployment). FACTORS RESPONSIBLE FOR STAGFLATION: y During 1970s rise in oil price and related commodities caused stagflation as oil price affected the cost of production which put the price up. Rigidity in wage structure due to string trade unions which did not allow fall in wages. Any step taken to ease the unemployment situation through increased expenditure adds in inflation fire. Prices adopted to check inflation through cut in expenditure adds to inflation fire. 16

y y

DEFLATION :
Deflation is just opposite to inflation. It is essentially a period of falling prices, fall in incomes and rise in the value of money. According to Prof. Crowther Deflation is that state of the economy where the value of money is rising or the prices are falling. But every fall in price level is not deflation. In the words of Prof. Pigou Deflation is that state of falling prices which occurs at the time when output of goods and services increases more rapidly than the value of money income in the economy. Prof. Paul Einzig gives a better and convincing definition. In his view deflation is a state of disequilibrium in which a contraction of purchasing power tends to cause, or is the effect of a decline of price level. Thus, fall in price level is both the result as well as the cause of fall in money supply. Effects of Deflation Deflation like inflation will have both dampening and encouraging effects on different sections of the society. On Production Deflation has an adverse effect on the level of production, business and employment. Fall in demand and fall in prices force many firms to quit the industry or operate partially. Wages are reduced or workers are retrenched. It creates a hopeless situation in the field of production. On Distribution Deflation affects adversely distribution of income too. In the first place, producers, merchants and speculators lose badly during this period because prices of the goods fall at a much greater rate and faster than their costs. Being unable to manage with the situation many are compelled to quit the industry. Failure of business and inability to repay the loans incurred with the banks worsens the position of the merchants and the producers. Debtors lose while the creditors gain. Fixed income groups enjoy a better standard of living as the money income is fixed, there will be a rise in their real incomes. The salaried persons and wage earners will benefit by deflation. However, the beneficial effects of deflation are far less compared to its adverse effects. During this period because of unemployment, falling incomes, falling output, a kind of pessimistic atmosphere is established in the entire economy. Inflation is unjust; deflation is inexpedient, Of the two deflation is worse - Prof. J.M. Keynes

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REFLATION:
Reflation is the act of stimulating the economy by increasing the money supply or by reducing taxes. It is the opposite of disinflation. It can refer to an economic policy whereby a government uses fiscal or monetary stimulus in order to expand a country's output. This can possibly be achieved by methods that include reducing tax, changing the money supply, or even adjusting interest rates. Just as disinflation is considered an acceptable antidote to high inflation, reflation is considered to be an antidote to deflation (which, unlike inflation, is considered bad regardless how high it is). Originally it was used to describe a recovery of price to a previous desirable level after a fall caused by a recession. Today it also (in addition to the above) describes the first phase in the recovery of an economy which is beginning to experience increasing prices at the end of a slump. With rising prices, employment, output and income also increase till the economy reaches the level of full employment. Reflation is necessarily deliberated and is good for economy.

DISINFLATION:
Disinflation is an attempt to counter a highly inflationary situation in the same manner as reinflation is an attempt to cure a highly deflationary situation. Whenever there is an exessive expansion in the supply of money and the prices start rising to higher and higher levels, then the government may resort to a policy of disinflation to bring the normal level. DISINFLATION DISTINGUISED FROM DEFLATION: y Disinflation is lower inflation. Prices are still rising during disinflation, but at a lower rate. The general price level still rises, but, at a slower rate resulting in a continued, but, lower rate of real value destruction in money and other monetary items. A lowering of inflation is not deflation but disinflation, while Deflation means the general price level is not increasing at all, but, actually decreasing continuously and the internal functional currency money - and other monetary items are worth more all the time. Deflation causes an increase in the real value of money and other monetary items. In disinflation prices does not fall below the price level. While in deflation prices may fall below the price level. Disinflation is necessarily deliberated. While in deflation fall in prices may be deliberate or may be natural. Disinflation is not bad for the economy. While deflation is not good for the economys health.

y y y

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CHAPTER 9 SUMMARY
Inflation refers to a period of general rise in price level. There are different types of Inflation, like demand pull inflation, cost push inflation etc. Inflation is caused by a number of factors like rise in the supply of money, increase in exports, black money, rise in the coast of production, hoarding, war etc. It affects different sections of the population differently. Producers, merchants, debtors gain while the consumers, laborers, fixed income groups suffer. A number of measures like monetary, fiscal and physical controls are adopted to control inflation. Inflationary gap is a Keynesian concept; It arises when the expenditure is in excess of the goods available in the economy. Variations on inflation include deflation, disflation, reinflation and stagflation. Deflation is a state of falling prices, incomes, output and employment. As deflation has the danger of creating conditions of depression it must be cured adopting various monetary and fiscal measures. Disinflation is an attempt to counter a highly inflationary situation in the same manner as reinflation is an attempt to cure a highly deflationary situation. Reflation is the act of stimulating the economy by increasing the money supply or by reducing taxes. Inflation is measured with a wholesale price index. Lack of inflation (or deflation) is not necessarily a good thing. To avoid irreparable damage, the budget must be balanced at the earliest possible moment, and not in some sweet by-and-by. Balance must be brought about by slashing reckless spending, and not by increasing the tax burden that is already undermining incentives and production.

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Bibliography: Books :
K. K. Dewett. Modern Economic Theory S. Chand and Company Paul A. Samuelson And William D. Nordhaus Economics Tata McGraw-Hill Publishing Company Limited Eighteenth Edition. Dominick Salvatore Microeconomic Theory McGraw-Hill Publishing Company Limited, Third Edition. Dr. S.R. Myneni Principal Of Economics Allahabad Law Agency

WEBSITES:
maeconomics.webs.com business.business2k.com economywatch.com tutor2u.net

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