Price

Stability
Dr. Shylajan, C.S

Topics of Discussion

Macroeconomic objectives
Inflation and its Measurement
The Economic Impacts of Inflation
Modern Inflation Theory:
Prices in the AD-AS Framework
Demand-Pull & Cost-Push Inflation
Management of Inflation
The Philips Curve
The Problem of Inflation in India

Macroeconomic Policy
Objectives
Macroeconomic Policy
Objectives

Sustained Economic Growth

Price Stability

Price
Stability
Stability in the general price level

is captured by the rate of inflation

in the economy

Movements in Wholesale Price

Indices or Consumer Price Indices

Each provides a measure of

inflation in the economy

Calculation of rate of
inflation

Rate of inflation is the rate of growth or

decline of the price level from one year to
the next year
Rate of inflation = CPI (this year) CPI (last year)
100
CPI (last year)

Inflation
Continuous rise of general price level
Calculated using price indexes
Percentage change in the price level
is called rate of inflation
Different types: low inflation,
galloping, hyperinflation etc

Inflation Theory: What

Causes Inflation?

Due to Demand factors :

Demand pull: Real vs monetary factors

Due to Cost factors :

Cost push: Wage push & Supply
shock inflation

Graphical approach

Demand pull inflation

Caused by increase in any of the

components of aggregate demand
That is, in C, I, G or net foreign demand
Usually due to increase in G (fiscal
deficit and inflation)
If there is more supply of goods to meet
excess demand, then price will not rise

Demand pull inflation

But, if the economy is operating at

its full capacity, then supply can
not be increased to meet excess
demand. So price may go up
.inflation

In real life, as demand increases,

prices and output both increases.

Cost-push inflation

Due to increase in costs

Cost push inflation results in a rise in prices

and a fall in output

Higher costs of production due to higher labor

cost, material costs, import costs, increase in
oil prices, strong bargaining power of
producers etc
Oil shock and inflation
Wage push: increase in labour costs without
increasing productivity

Inflation and Money

Supply

Growth of money supply leads to

inflation (monetarist view)

The Central Bank may increase the

money supply to meet the growing
demand for government spending
(for example by deficit financing)

Costs of Inflation or
Economic Impacts of
Inflation

There can be anticipated and

unanticipated inflation

Unanticipated inflation will be costly

Who will be affected badly by

inflation? Fixed income groups ?

Other impacts

May slow down external sector demand for

our domestic products
Then what happens to our export
competitiveness?
What happens to the trade balance, current
account of the economy?

Adverse implications for growth:

A 10 % point permanent increase in the

inflation rate is estimated to bring down the
level of the real GDP by 4 7 % (Robert Barro)

Management of
Inflation

Keynesians argue that some

acceptable level of inflation is good for
the economy. Why?
What is an acceptable rate of inflation?
No consensus
In India, between 5 % to 6 %
(Rangarajan)
How can we manage inflation?
Depends on what caused inflation
(Demand factors or Cost factors)

Management of
Inflation

If inflation is caused by Demand

factors, then what measures can be
taken?
In Demand pull inflation, with price
rise, output also rises.
So follow a contractionary fiscal and
monetary policy (lower G, higher T,
higher r)?
What is the cost of reducing inflation?

The Philips Curve

A trade- off between wage rate and

unemployment (at higher wage rate
(wage push inflation), there will be
lower unemployment rate).
In inverse relationship
At higher inflation, unemployment will
be low
It means unemployment can be
reduced at the cost of higher inflation

Stagflation

The combination of recession with

high inflation
Stagflation is not a state that
occurs often because recession
reduces demand for goods
because people have less money
to spend
Low demand during recessionm
usually leads to low inflation.

Stagflation

Possible causes of stagflation include

short supplies of essential commodities
(such as oil, oil shock) and too fast a
rise in money supply (which in turn
usually reflects government policy).
Oil shocks, loose monetary policy, outof-control government spending etc
This happened to a great extent during
the 1970s, when world oil prices rose
dramatically, fueling sharp inflation in
developed countries.

How to deal with

Stagflation?

Once stagflation occurs it is difficult to

deal with (why?)

Can we use Keynesian policies to

combat stagflation?

Suppose government takes measures

to revive the economy using fiscal and
monetary policies. (AD-AS framework
and C+I+G+NX framework to explain),
then what happens?

How to deal with

Stagflation?

The measures a government

would usually take to revive an
economy in recession (for
example by cutting interest rate
or increasing government
spending (G) will also increase
inflation.

How to deal with

Stagflation?

Government policies may fail.

One school of thought is that the
best policy mix is one in which
government stimulates growth
through increased spending or
reduced taxes (fiscal policy) while
the central bank fights inflation
through higher interest rates
(monetary policy).

How to deal with

Stagflation?

Stagflation in the USA was

defeated by then Federal Reserve
chairman, Paul Volkar, who
sharply increased interest rates to
reduce money supply from 19791983.
Investors are more worried about
stagflation (why?)

How to deal with

Stagflation?

Coordinating fiscal and monetary policy

is not an easy task during stagflation!
What about Supply-side policies? (large
tax cuts, deregulation, incentives and
subsidies to increase supply etc (use ADAS framework)
US slowdown and stagflation in 2007-08
US recession 2008

How to deal with

Stagflation?

Fed chief Bernanke observed on

Nov 27th:

In the case of inflation, the risks

to the forecast seem primarily to
the upside. A failure of inflation to
moderate as expected would be
especially troublesome.

Problem of Inflation
in India
Magnitude
Causes
Correction

Wholesale Price Index

in India- Annual
Average
(Source:
RBI)
1993-94
100

1994-95
1995-96
1996-97
1997-98
1998-99
1999-00
2000-01
2001-02
2002-03
2003-04
2004-05

112.5
121.6
127.2
132.8
140.7
145.3
155.7
161.3
166.9
175.9
187.2

Rate of Inflation in
India

1993-94
1994-95
1995-96
1996-97
1997-98
1998-99
1999-00
2000-01
2001-02
2002-03
2003-04
2004-05
2007
2008

12.5
8.08
4.60
4.40
5.95
3.26
7.15 (due to high energy price)
3.59
3.47
5.39
6.42
3-4
12

Thanks