LESSON – 32

Measures of Prices, Inflation,

Expected Inflation, and Interest Rates

Learning outcomes

After studying this unit, you should be able to:

Identify the expected inflation and interest rates

Define consumer price index
Know real rate of return
Know Inflationary rate

Measures of Prices, Inflation,

Expected Inflation, and Interest Rates

Inflation (or Deflation) is a macroeconomic concept referring to an increase (decrease)

in the absolute price level over some defined time period. An increase in the price of all
goods has the effect of reducing the purchasing power of money and money incomes and
thus must be taken into account when planning future economic activity.

Inflation is difficult to measure because it represents the percentage change over time of a
nonexistent economic variable--the price level 'Pt'.

%∆Pt= (Pt - Pt-1)/Pt-1

Unlike GDP or other national income measures, no single observable measure exists to
represent the aggregate price level. Thus economists rely on a price index based on some
well-defined market-basket of goods as a proxy to measure the level of prices and
changes in prices over time.

The most common measure of inflation is that of the Consumer Price Index or 'CPI' as
calculated by the Bureau of Labor Statistics (the BLS). This particular index is based on
the prices of a basket of goods which represents the purchasing behavior of some average
urban consumer. The CPI, also known as the Laspeyres Index, is calculated using a
weighted average of current to past price ratios for this basket of goods:

CPIt = Σwi,t[Pi,t / Pi,o] (1)

These weights 'wi,t' are based on the expenditure patterns of the consumer in a base period
(currently 1982-84) reflecting the importance of each item relative to the overall level of
consumer expenditure in that base period or:
 Pi,oQi,o
wi = --------------- (2)
Σ [Pi,oQi,o]

thus

Σ[Pi,tQi,o]
CPIt = --------------- (3)
Σ[Pi,oQi,o]

where 'Qi,o' represents the quantity of the ith good consumed in the base time period (t =
0), 'Pi,o' represents the price of the ith good in the base time period, and 'Pi,t' represents the
price of the same good in the current time period 't'.

A measure of inflation is then developed by computing the percentage change in CPI

from one time period to the next:

CPIt - CPIt-1
πt = %∆.(CPI) = -------------- (4)
CPIt-1

It is important to note that the CPI is not a perfect measure of the price level or changes
in the price level. Because this index is computed using base-period quantities (reflecting
buying behavior and preferences in the base year), it does not allow for substitution
among goods as relative prices change. For example, it might be that the overall rate of
inflation is 5%. However, within that value some goods might be rising by 3-4% and
other goods by 6-7%. Consumers will attempt to soften the effects of increasing prices on
household budgets by substituting away from the relatively more expensive goods and
towards the relatively cheaper good. This behavior is not captured in the CPI.

A second problem with the CPI is that it does not allow for changes in product quality
over time. It may be that prices are rising due to improved quality of the good being
purchased such that this good does not have to be replaced as often. Quality changes can
also show up in the size of the good in question. Over the past generation, housing prices
have been rising. But during this same period of time, the average size of a housing unit
(in terms of square footage, number of bedrooms and baths, size of the garage and lot)
has also increased.

Finally, the CPI does not allow for the inclusion of new goods and services as they
emerge into the market place. A fixed basket of goods based on 1982/84 preferences
ignores DVD players, PDA's, cell phones, audio CD's and many other goods that perhaps
lead to improvements in living standards or life style.
A common use of this measure of inflation is to add an inflation premium to interest rates
to allow for expectations about future inflation. As stated above inflation erodes the
purchasing power of money over time. An individual lending money in an inflationary
environment will be repaid in dollars which possess less purchasing power upon maturity
of the debt contract. An inflation premium is often built in to nominal interest rates
protect against this loss of purchasing power. However, at the time the debt contract is
developed the inflation premium is based on expected rates of future inflation. If these
expectations differ from actual inflation rates during the life of the debt contract either the
lender or borrower can be adversely affected.

The inflation premium represents the difference between nominal interest market rates
'imarket' (i.e., those interest rates published in the paper or posted on the wall at a bank) and
the desired real rate of interest 'r*' which usually reflects the rate of real economic
growth (the amount of reward that should accrue to the lender for lending to a productive
economy). Thus the nominal rate of interest (holding risk constant) on a short-term debt
contract (one year or less) is developed as follows:

imarket = r* + E[πt] (5)

where 'E[πt]' represents the expected rate of inflation. At the termination of the debt
contract an ex-post real rate of interest 'r' can be developed as follows:

r = imarket - π (6)

Thus the Real Interest Rate represents the real return to lenders measured in terms of the
purchasing power of interest paid. For example suppose we have the following:
A one year loan (N = 1) with the following terms:

• Principal 'P' = $1000, and

• nominal rate of interest 'i' = 5%.

At the time the loan is made, the price of a common commodity 'Gasoline' (Pgas) is equal
to $1.00/gal. In real terms the lender is providing the borrower with the purchasing
power equivalent to 1000 gallons of gasoline.
At the termination of the loan the borrower repays the principal 'P' of $1000 plus an
interest payment 'I' of $50 ($1000 x 0.05). If when the loan is repaid one year later, the
price of gasoline Pgas' has risen to $1.03/gal. (a 3% rate of inflation); the purchasing
power of the principal plus interest ($1050) will be equal to 1019 gallons of gasoline. In
real terms, the purchasing power of the lender has increased by roughly 2%.

If the price of gasoline had risen to $1.07 (a 7% rate of inflation) then the purchasing
power of the repayment would have been equal to 981 ($1050/$1.07) gallons of gasoline.
In this case the lender provided the opportunity for the borrower to acquire 1000 gallons
of gasoline and at the termination of the loan the borrower repaid to the lender the ability
to acquire only 981 gallons. An unexpectedly high rate of inflation had had an adverse
impact on the lender -- a negative real rate of return.

If E[π(t)] is greater than πt then 'r' will exceed 'r*' to the benefit of lenders (real returns to
lending greater than desired and perhaps greater than the rate of real economic growth) as
shown by the following operation -- substituting (5) into (6) we have:

r = r* + E[π ] - π

If the opposite is true, then benefits will accrue to the borrower.

During the 1980's, many economists have felt that the real rate of interest was abnormally
high (i.e., in excess of 2.5-3%). This may be explained in part due to the inflationary
expectations that built up in the late 1970's and early 1980's. Nominal interest rates have
taken these expectations into account.

Over time, changes in market interest rates may be attributed to changes either in the real
desired rate 'r* or due to changes in inflationary expectations. Changes in the desired real
rate reflects the behavior in the market for loanable funds. If the supply of these funds
(public and private savings) exceeds the demand for these funds (public and private
borrowing) then the desired rate should fall in reaction to a surplus of these funds. In
periods of economic growth the opposite is true. The growing economy is sustained in
part by increased borrowing activity for inventory investment and investment in new
capital stock to allow for increased production to meet growth in aggregate demand.

Changes in inflationary expectations tends to be a more complicated matter. One may

hypothesize that current inflationary expectations are based on the history of past actual
rates of inflation. A formal model that may help in understanding the development of
these expectations is that of the Adaptive Expectations model. This model is based on
the notion that economic agents slowly adapt to a changing inflationary environment.
This may have been the case in the late 1960's and early 1970's. During the 1960's, the
inflation rate was relatively low in the 2-4% range. Basically, during this period time
inflation was not considered to be a major economic problem. Thus in the next decade
when actual inflation began to creep up towards the double-digits, many individuals and
institutions were surprised. Forecasts of future inflation (based on recent historical
experience) consistently lagged behind an accelerating actual rate of inflation.

In the early to mid-1980's the actual rate of inflation was de-accelerating, a phenomenon
known as disinflation. During this period, economic agent's expected rates of inflation
were greater than what actually occurred. These agents were slow to adapt thus putting
upward pressure on ex-post real interest rates.
A different price index, known as the GDP Deflator or the Paasche Index, is constructed
using current expenditure shares [to represent the spending habits as reflected in current
GDP via Q(i,t)] and is defined by the following equation:

Pt = Σ [Pi,tQi,t] / Σ[Pi,oQi,t]

where 'Qi,t' represents the quantities produced and sold of the i-th good in the current time
period 'Pi,t' represents the current price of that i-th good and 'Pi,o' represents the base
(1996) price of that same good. This measure can be interpreted as the ratio of actual
spending in the current year (NGDP) and the level of expenditure on that same quantity
of goods if prices had not changed (RGDP) -- spending in base-year prices.

Meaning of Deflation
Deflation is the inverse of inflation. Deflation may be defined as a situation of falling

prices, or what is the same thing as saying, the rising value of money.

Deflation and Disinflation. However, everyfall in prices is not to be defined as

deflation. Deflation is a persistent downward movement in the price level at a
substantial rate that typically continue for a number of years. A period in which
the price level rose by 3 per cent in one, fell by 2 per cent in a second year, rose
by 4 per cent in a third, and fell by 3 per cent in a fourth would hardly deserve to
be described as a period characterized by alternating year of deflation.

We can distinguish between two types of fall in prices:

(i) fall in prices not accompanied by any decrease in the level of output; and
(ii) fall in prices accompanied by decrees in the level of output.

When the price level falls and it does not adversely affect the level of employment,
output and income in the economy, we will not call such a price fall as deflationary.
Rather, we can use the term disinflation for such a situation. On the contrary, if fall in the
price level is accompanied by a fall in the level of output also, we will call this type of
fall as deflation. In short, as shown in Fig. 13.1 (page 1.202) if with a fall in prices the
economy moves towards the full employment level, this fall in prices will be defined as
disinflation, as shown between points C and D. If the price level continues to fall below
the full employment level, it will be defined as deflation as disinflation, as shown
between points C. d. if the price level continues to fall below the full employment level, it
will be defined as deflation as shown between the points D and E. This fall in prices will
be accompanied by a fall in the level of output.

Causes of Deflation
Deflation will occur in either of the following two situation:
(a) when the aggregate demand falls, and / or
(b) when the supply rises.

Deflation arises due to deficiency of demand; there are ‘ too many goods chasing too
little income’. A few important factors that may cause deflation can be grouped in
two parts as : (a) factors on the demand side, and (b) factors on the supply side.
(a) On the Demand side. On the demand side the major factors that work to cause
deflation are as follows:
(i) Money Shortage. Money shortage in the economy may not be the
result of two factors. First, the note-issuing authority may decide the
cut the supply of currency in pursuit of its own defined objective.
Secondly, the commercial banks may choose to contract their deposits
and credit.
(ii) Fall in Disposable Income. Disposable income in the economy may
fall either through a fall in national income itself or due to higher rates
of taxation. Either of the situations will lead to a contraction in
consumer expenditure and hence in aggregate demand, resulting in a
deficiency of demand to lift the available supplies.
(iii) Fall in Business outlays. Fall in investment may be the result of a
number of factors like accumulating stocks of goods with the
producers, falling profit margins, etc. Any cut in investment and
production programme will have an adverse effect on the level of
income and employment in the country, and will breed deflationary
forces.

(b) On the supply side. On the supply side, deflation may be caused by a glut of
commodities which may result from over-investment and over-production. If the
level of demand is adequate enough to absorb the existing level of production, this
situation, sooner or later, is going to lead to this type of glut, and breed
deflationary forces in the economy.

Deflationary Gap
Corresponding to the inflationary gap is the deflationary gap which appear when total
expenditures at the full employment level are insufficient to maintain that level of
income. In other words, the excess of aggregate supply over the aggregate demand at
the full employment level is called the deflationary gap. The reason for deflationary
gap is that the excess supply brings the price level down at the full employment level.
This can be explained by means of a diagram.
DIAGRAM SHOWING THE DEFLATIONARY GAP:

In the above diagram the total expenditure of the economy is shown by C + I + G

Function. This function intersects the 450 line at point D which gives at the
equilibrium income OYF, which may be assumed as full employment income at
current prices. Let us suppose that the government expenditure for some reasons
decreases, which gives the economy new expenditure function C + I + G.
Consequently, there will be no change in the money income because the economy is
assumed to the at full employment level. At the full employment level of income, the
aggregate supply (money income) is OYF (=DYF) which is more than the aggregate
demand (total expenditure) CYF. The deflationary gap is CD. The gap CD, between
expenditures and the full employment level of the equilibrium level of OY0, the gap
will disappear. The deflationary gap is, therefore, defined as the amount by which
total spending falls short of the full employment level of income, will require a drop
in national income. When income is decreased to the equilibrium level of OY0, the
gap will disappear. The deflationary gap is, therefore, defined as the amount by which
total spending falls short of the full employment level of income at existing prices.
Effects of Deflation
We, in the developing world, have become much accustomed to the rising price that
we hardly think of the impact falling prices—deflationary forces—may have on an
economy. If a little serious thinking was to be given to this aspect of phenomenon,
one would shudder to think of the adverse effect that deflation may have on an
economy. We can study these effects under two headings, viz.:
(a) Effect on economic activity and
(b) Effect on distribution of income

(a) Effect on economic activity. Deflation has an adverse effect on the level of
activity in an economy. Deflation leads to depression. Depression is a phase of
economic activity characterized by shrinking investment, shrinking production,
shrinking employment of factor service and shrinking income. Once started, the
deflationary process is self-generation in character. What harm a worst type of
depression can do to an economy can be well-illustrated by the experience of the
United States during the thirties of the present century : It was hit by server
depression. A few statistics will help to explain the impact of this depression.
During 1930-32 about, 5,000 banks in the United States failed, meaning a whole
 or partial loss of their accumulated savings by about million people. Business
profits sank to zero and the failure rate for business went up by one-half, and
construction activity fell to only 5 percent of its 1929 level. For workers, the
depression was catastrophic. For those who stayed employed, the average weekly
wage was down by about a third but the problem was more seem incredible.
Formerly prosperous businessmen could be seen on street corners selling apples
and at night they would go “home” to tar paper shacks, or old car bodies, or
discarded packing cases near the railroad yards or the town dump, which they,
with not little venom, named “Homervilles” (Grand Place).

Such could be the horrors of depression set by deflationary movement of prices.

(b) Effect on Distribution of Income. Ordinarily, all those economic groups who gain
during inflation tend to lose during deflation. Conversely, those groups who lose
during inflation tend to gain during deflation. Consumers, creditors small
investors, wage and salary earners, and groups with fixed incomes will gain
during deflation, because their incomes will fetch more goods and services.
Businessmen, debtors, farmers, investors in equities and similar economic groups
will be hit most during deflation. But a careful thought will reveal that
particularly all economic grou8ps are adversely affected by deflation. As already
portrayed above, deflation is accompanied by a depression in economic activity.
In a worst sort of depression, employment is the major casualty. Laborers and
similar factors may find it hard to retain their old jobs; retrenchment may leave
them unemployed on roads. Moreover, the wages would has to be cut drastically
if at the all they can be allowed to continue in their old jobs. In this type of
situation, where everyone is clamouring for some paid job, wage falls lead the
price declines rather than following them. At low prices, there is hardly any
incentive for the producers and investors to expand the size of output, or even to
continue the production activities. Firms after firms start crashing, factors are
rendered unemployed, and the whole economy is trapped in the quagmire of
depression.

Measures to Check Deflation

Measures to check deflation take the same form as are used to check inflation, viz.,

monetary measures, fiscal measures and non-monetary measures; only that this

measures have to operate in the reverse direction.

Money Measures. Various monetary instruments can be used to expand the supply of
credit in an economy. For example, a fall in the bank rate will lower the cost of credit and
increase its availability. Similarly, the purchase of securities by the central bank will lead
to an increase in the cash balances with the commercial banks; such an increase will
enable them to create more credit. Likewise, lowering of cash reserve requirements will
also facilitate the creation of credit by banks. Various qualitative measures can also be so
operated as to increase the flow of credit in desired channels.
However, the monetary measures are plagued by various limitations. Besides the
limitations already mentioned earlier in the form of the absence of central bank’s
effective control over the money market and its inability to direct the various constitutes
of the money market to follow the path chalked down by it, there is another inherent
limitation in the use of monetary measures as anti-deflationary tools. While the controls
imposed on the expansion of credit may have some deterrent effect in ordinary market
conditions, they hardly help when it is desired that the volume of credit in the economy
should increase. In this type of situation, it is lack of demand that plays havoc with the
economic system. Easy availability of credit may not be sufficient to induce the investors
to borrow and undertake economic activities. What is required is that initial pull of
demand should be provided so as to set in a sequential chain of higher demand, higher
production and higher income. A suitable fiscal policy, rather than a monetary policy,
may more easily perform the trick.
Fiscal Measures. Anti-inflationary fiscal policy consists of increased public spending. Keynes
and later economists have put much emphasis on public spending to push up employment and
the level of income in an economy. To make up for the decline of private spending and push up
employment and income, public spending on public works programmes has been advocated.
These programmes include such schemes as construction of roads, dams, parks, etc. These
programmes should be financed through borrowings from banks. This will provide employment to
the unemployed increse the incomes of the people, raise the aggregate demand and thus lead to
increased employment. In short, public spending increases employment directly and indirectly. It
increases employment directly by giving work to the unemployed; it increases employment
indirectly by raising the income and aggregate demand for goods and services. When once
employment has started rising, multiplier effect will come into play and push up production and
employment still further.
Non-Monetary Measures. Provision of subsides and arrangement of easy availability of
consumer goods on schemes like hire-purchase may help to stimulate demand, and thus
be instrumental in fighting deflation.
To sum up, deflation results from lack of aggregate demand and hence it need be fought
with all command. The strategy is to raise the level of demand in the economy. In this
strategy, major role is to be played by fiscal authorities.

Comparison between Inflation and Deflation

Inflation is a state of rising prices; deflation is a state of falling prices. Both of these
situations have adverse effects on an economy. First, we take inflation. Inflation leads
to an unjust distribution o income by penalizing those who save and rewarding those
who spend. There is a classic example of the two youngmen who inherited fabulous
wealth. One of them sat quietly on it by investing it in fixed income earning bonds
and fixed deposits. The other, more liberal in his approach, made good of it by filling
up his garage with empty soda and whisky bottles. When Germany was hit by hyper-
inflation, the former found his assets reduced to naught, whereas the latter could ear
handsome income from his garbage. This type of effect on saving may adversely
affect capital formation and investment if hyper-inflation continues for a fairly long
perod of time. Inflation, if not controlled by suitable monetary and fiscal measures,
may end up by adversely affecting the level of economic activity. It will happen, if
inflation creates uncertainties and instabilities of worst order.
 Similarly, deflation also adversely affects an economy hit by it. In a sate of falling
prices, the entrepreneur are generally prone to cut down on their investment expenditure.
With their unsold, but consumers are going without them since they do not have
ade1quate purchasing power?
There is hardly anything to choose between inflation and deflation. Both create
instabilities of worst kind. But, if the choice is limited to these two phenomena, one will
prefer inflation to deflation, as Keynes pointed out “Inflation is unjust and deflation is
inexpedient, of the two deflation is worse.”
Deflation hits at the very existence of the individuals, and breeds squalor and
misery all around. Inflation creates inequalities, perpetuates and sustains them, but at
least it offers expanding work opportunities as long as ‘boom’ lasts. Deflation will lead to
an equal distribution of poverty, in which all the economic groups will suffer. Inflation
will create income which all the economic distributed among all the sections of the
society. But as long as inflation creates income it is to be preferred to deflation during
which all activities come to standstill.

Concepts for Review:

• Adaptive Expectations
• Consumer Price Index (CPI)
• Deflation
• Desired Real Rate of Return
• Disinflation
• Inflation
• Inflationary Expectations
• Inflation Premium
• Laspeyres Index
• Nominal Interest Rate
• Paasche Index
• Real Interest Rate
• T-bill Rate