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Inflation is defined as 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. The term "inflation" originally referred to increases in the amount of money in circulation, and some economists still use the word in this way.
Nowadays most economists use the term "inflation" in order to refer to a rise in the price level. An increase in the money supply may be called as a monetary inflation, so as to distinguish it from rising prices, which for the purpose of clarity be called 'price inflation'. Economists generally agree that in the long run, inflation is caused by increases in the money supply.
Price inflation is a result of "monetary inflation".
"Monetary inflation" is the cause of "price inflation".
So how will you define "monetary inflation" and where does it come from?
"Monetary inflation" is the government figuratively cranking up the printing presses and increasing the money supply.
In the old days that was how we got inflation. The government would actually print more dollars. But today the government has also developed with time and now the government has much more advanced methods of increasing the money supply. Remember, "Monetary inflation" is the "increase in the amount of currency in circulation".
And what is currency in circulation? Is it just the cash in our pockets? Or does it include the money in our checking accounts? What about our savings accounts? What about CD's, and time deposits, Money Market accounts?
"The Federal Reserve tracks and publishes the money supply and it is measured in three different ways- M1, M2, and M3.
These three money supply measures track which are slightly different in views of the money supply with M1 being the most liquid and M3 including giant deposits held by foreign banks. And M2 is somewhere in between i.e. basically Cash, Checking and Savings accounts.
Surprisingly, the FED decided to stop tracking M3 effective March 23, 2006 for some or the other mysterious reason.
But coming back to our question of the cause of inflation. Basically when the government increases the money supply faster than the increase in the quantity of goods inflation takes place. Interestingly as the supply of goods increase the money supply has to increase or else prices actually go down.
The magnitude of inflation-the inflation rate-is usually reported as the annualized percentage growth of some broad index of money prices.
Measures for calculating inflation
Inflation is 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 defined as the percentage rate of change of a price index over time.
There are many other methods of calculating the rate of inflation. Other widely employed price indices for calculating price inflation include the following:
Producer price indices (PPIs) measures average changes in prices received by domestic producers for their output. This differs from the CPI in that taxes, price subsidization, and profits, may cause the amount received by the producer to differ from what the consumer paid. There is also a delay between an increase in the PPI and any eventual increase in the CPI.
Producer price index measures the pressure being put on producers by the costs of their raw materials. This could be "passed on" to consumers, or it could be absorbed by profits, or offset by increasing productivity.
In India and the United States, an earlier version of the PPI was called the Wholesale Price Index and India uses WPI to calculate the price inflation.
Commodity price indices, which measure the price of a selection of commodities.
Core price indices: because food and oil prices can change quickly due to changes in supply and demand conditions in the food and oil markets, it can be difficult to detect the long run trend in price levels when those prices are included.
Causes of inflation
High rates of inflation and hyperinflation are caused by an excessive growth of the money supply.
Low or moderate inflation may be attributed to fluctuations in real demand for goods and services, or changes in available supplies.
There were different schools of thought as to the causes of inflation. Usually it is divided into two broad areas:
Quality theories of inflation and
Quantity theories of inflation.
The quality theory of inflation relies on the expectation of a seller accepting currency to be able to exchange that currency at a later time for goods that are desirable as a buyer.
The quantity theory of inflation rests on the quantity equation of money which relates the money supply, its velocity, and the nominal value of exchanges.
The quantity theory of money is widely accepted as an accurate model of inflation in the long run. There is an agreement among economists that in the long run, the inflation rate is dependent on the growth rate of money supply relative to the growth of the economy.
But in the short and medium term inflation may be affected by supply and demand pressures in the economy, and influenced by the relative elasticity of wages, prices and interest rates.
Keynesian economic theory proposes that changes in money supply do not directly affect prices, and inflation is the result of pressures in the economy which are being expressed in terms of prices.
There are three major types of inflation.
Demand-pull inflation is caused by increases in aggregate demand due to increased private and government spending, etc.
Cost-push inflation, also called "supply shock inflation," is caused by a drop in aggregate supply (potential output). This may be due to natural disasters, or increased prices of inputs. For example, a sudden decrease in the supply of oil, leading to increased oil prices, can cause cost-push inflation. Producers for whom oil is a part of their costs could then pass this on to consumers in the form of increased prices.
Built-in inflation is induced by adaptive expectations, and is often linked to the "price/wage spiral". It involves workers trying to keep their wages up with prices (above the rate of inflation), and firms passing these higher labor costs on to their customers as higher prices, leading to a 'vicious circle'. Built-in inflation reflects events in the past, and so might be seen as hangover inflation.
Cost Push Inflation
This type of inflation occurs when due to increase in the production costs, rising prices businesses responds in order to maintain their profit margins. In connection with the increase in price there are too many reasons. They are:
There is an increase in the costs of imported raw material due to inflation in countries which are heavily dependent on exports of these commodities or simultaneously this can also be due to a fall in the value of the pound in the foreign exchange markets which increases the UK price of imported inputs.
Rising labor costs - caused by wage increases may exceed any improvement in productivity. This cause is also important in those industries which are 'labor-intensive'.
Higher indirect taxes imposed by the government - say for example a if there occurs an increase in the the rate of excise duty on alcohol and cigarettes, if fuel duties increases or a boost in the standard rate of Value Added Tax or the range of products to which VAT is applied is broadened. Such types of taxes are raised on producers (suppliers) who, counting on the price elasticity of demand and supply for their products, have an option to pass along the burden of the tax onto consumers.
If we see an inward shift of the short run aggregate supply curve, such graph depicts us the cost push inflation as shown in the following diagram below.Cost-push inflation
Demand Pull Inflation
Demand-pull inflation is likely when there is full employment of resources. In these situations an increase in aggregate demand (AD) will lead to an increase in prices. AD might rise for a number of reasons - some of which occur together at the same moment of the economic cycle.
A depreciation of the exchange rate, which has the effect of increasing the price of imports and reduces the foreign price of UK exports
A reduction in direct or indirect taxation. If direct taxes are reduced consumers have more real disposable income causing demand to rise. .
The rapid growth of the money supply -as a consequence of increased bank and building society borrowing if interest rates are low. Rising consumer confidence and an increase in the rate of growth of house prices
Faster economic growth in other countries - providing a boost to UK exports overseas.
Output gap and consumer price inflation
Output gap = actual GDP-potential GDP.CPI inflation-annual %change in prices.
The wage price spiral - "expectations-induced inflation"
Rising expectations of inflation can often be self-fulfilling. If people expect prices to continue rising, they are unlikely to accept pay rises less than their expected inflation rate because they want to protect the real purchasing power of their incomes.
Inflation influences in the British economy
The following diagram depicts some of the key influences on inflation.( Read from left to right):
Average earnings comprises basic pay + income from overtime payments, productivity bonuses, profit-related pay and other supplements to earned income
Productivity measures output per person employed, or output per person hour. A rise in productivity helps to keep unit costs down. However, if earnings to people in work are rising faster than productivity, then unit labor costs will increase
The growth of unit labor costs is a key determinant of inflation in the medium term. Additional pressure on prices comes from higher import prices, commodity prices (e.g. oil, copper and aluminum) and also the impact of indirect taxes such as VAT and excise duties.
Prices also increase when businesses decide to increase their profit margins. They are more likely to do this during the upswing phase of the economic cycle
According to the monetarists the factor influencing inflation or deflation is how fast the money supply grows or shrinks. They consider fiscal policy, or government spending and taxation, as ineffective in controlling inflation.
Monetarists assert the empirical study of monetary history and also show that inflation has always been a monetary phenomenon. The quantity theory of money, that any change in the amount of money in a system will change the price level. This theory begins with the equation of exchange:
MV = PQ
M Is the nominal quantity of money
V is the velocity of money in final expenditures;
P Is the general price level;
Q is an index of the real value of final expenditures?
In the above formula, the general price level is related to the level of real economic activity (Q), the quantity of money (M) and the velocity of money (V). The formula is an identity because the velocity of money (V) is defined to be the ratio of final nominal expenditure ( PQ ) to the quantity of money (M).
According to the Austrian view inflation is an increase in the money supply, rising prices are merely consequences and this semantic difference is important in defining inflation.
Austrians stress that inflation affects prices in various degree, i.e. that prices rise more sharply in some sectors than in other sectors of the economy. The reason for the disparity is that excess money will be concentrated to certain sectors, such as housing, stocks or health care Austrian economists measure inflation by calculating the growth of new units of money that are available for immediate use in exchange, that have been created over time.
Expansion of the Money Supply
A third cause of inflation is an over-expansion of the money supply. The money supply is not just cash, but also credit, loans and mortgages. When loans are cheap, there will be too much money chasing too few goods, creating inflation. The prices of just about everything will increase, even though neither demand nor supply has changed.
Expansion of the money supply was another cause for inflation in housing prices in 2005-2006. Deregulation allowed banks to push mortgages onto everyone. When people could borrow for virtually nothing, and needed no money down, it made no sense to rent. With low interest rates, homeowners used their homes as ATM machines, spending their equity on TVs, cars...and more houses. However, inflation was restricted to housing prices. The price of everything else was subdued, since China kept its currency, the Yuan, pegged below the dollar. This artificially made prices of their exports to the U.S. low.
When the money supply in the market increases, it lowers the value of the dollar. When the dollar declines relative to the value of foreign currencies, the prices of imports rise, also creating cost-push inflation. That's why China pegs the Yuan to always be lower than the dollar, which has been declining since 2002.
How does the money supply expand? Through expansionary fiscal policy or expansionary monetary policy.
Expansionary fiscal policy is executed by the Federal government. It expands the money supply through either deficit spending or actually printing more cash or coins. Deficit spending pumps money into certain segments of the economy, creating demand-pull in that area, but delays the offsetting taxes in any other area until sometime in the future, adding it to the debt.
Expansionary monetary policy is executed by the Federal Reserve. It expands the money supply by creating additional credit with the use of its many tools. One tool is lowering the Federal Reserve requirement, which is the amount of reserve banks must keep on hand at the end of each day. The less they have to keep on reserve, the more they can lend. The Fed can also lower the Fed funds rate, which is the rate banks charge each other to borrow funds to maintain the Reserve requirement. This action also lowers all interest rates, allowing borrowers to take out a bigger loan for the same overall cost. Lowering the Fed funds rate has the same effect as lowering the reserve requirement, but is a lot easier, so it's done much more often.
india's current inflation rate
Inflation creeps up 7.55 per cent in August
"New Delhi, September 15, 2012: The WPI (wholesale price index)-based headline inflation has crept up to 7.55 per cent in August from 6.87 per cent in July on account of a surge in the prices of food items in addition to manufactured goods. The gross inflation for the month of august this year
However, even though the overall inflation in August this year is lower in value than the level of 9.78 per cent that prevailed in the same month of 2011, the apex bank is unlikely to compel India Inc. According to the WPI inflation data, as compared to the 10.06% food inflation in July this year, the food inflation allayed marginally to 9.4% in August. If we have a look at the manufacturing or core inflation, where there was a downfall in the previous months, has gone up to 6.14 per cent from 5.58 per cent in July due to an increase in the prices of cotton textiles, paper and paper products, cement and lime.
As per the WPI inflation data on food articles, pulses turned dearer by 34.39 per cent as compared to a gain by 12.85 per cent in wheat and 10.71 per cent in cereal prices in August on a year-on-year basis. Meanwhile, headline inflation for June was boned up to 7.58 per cent from 7.25 per cent."
Historically, from 1969 until 2012, India Inflation Rate averaged 7.8 percent reaching an all-time high of 34.7 Percent in September of 1974 and a record low of -11.3 Percent in May of 1976.
India Inflation Rate The inflation chart and table below feature an overview of the Indian inflation in 2012: CPI India 2012. The inflation rate is based upon the consumer price index (CPI). The CPI inflation rates in the table are presented both on a monthly basis (compared to the month before) as well as on a yearly basis (compared to the same month the year before). Chart - CPI inflation India 2012 (yearly basis)
Chart - inflation India 2012 (CPI)
Table - 2012 inflation India (CPI)
inflation (monthly basis)
inflation (yearly basis)
January 2012 - December 2011
January 2012 - January 2011
February 2012 - January 2012
February 2012 - February 2011
march 2012 - February 2012
march 2012 - march 2011
April 2012 - march 2012
April 2012 - April 2011
may 2012 - April 2012
may 2012 - may 2011
June 2012 - may 2012
June 2012 - June 2011
July 2012 - June 2012
July 2012 - July 2011
august 2012 - July 2012
august 2012 - august 2011
How India calculates inflation? Do we call for any changes??
Man Mohan Singh's government was recently been hit by the most delicate political issue, and that was rising inflation. . But was the reason behind an increase was because of price rise in essential commodities? Or was it because of the 'incorrect method' of calculating inflation?
Some economists assert that India's method of calculating inflation is wrong as there are serious flaws in the methodologies used by the government.
Economists V Shunmugam and D G Prasad who have been working with India's largest commodity bourse -- the Multi Commodity Exchange - have recently written a paper and according to that our government urgently needs to shift the method of calculating inflation.
The paper says that the present method of calculating inflationary has serious flaws. And India should adopt the methodologies which are being followed in developed economies.
So what's the difference between India's method of calculating inflation and other nations?
India uses the Wholesale Price Index (WPI) to calculate and then decide the inflation rate in the economy.
Most developed countries use the Consumer Price Index (CPI) to calculate inflation.
Wholesale Price Index (WPI)
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 chassed through WPI which is an blinker of movement in prices of commodities in all trade and transactions.
This price index is available on a weekly basis with the shortest possible time lag only two weeks. WPI has been adopted as an indicator of the rate of inflation in the economy in India.
Consumer Price Index (CPI)
CPI is a statistical time-series measure of a weighted average of prices of a specified set of goods and services purchased by consumers. Inflation based on consumer price index basically measures changes in retail prices facing the consumers. This is in contrast to WPI which measures changes in whole sale prices facing producers in terms of inputs. It is a price index that tracks the prices of a specified basket of consumer goods and services. And in this way it acts as a measure of inflation. Under CPI, an index is scaled so that it is equal to 100 at a chosen point in time, so that all other values of the index are a percentage relative to this one.
India is the only major country that uses a wholesale index to measure inflation. CPI is usually adopted as a measure of inflation in most countries as it assesses the rise in price which a consumer will ultimately pay
CPI is the prescribed measuring instrument of inflation in countries such as the United States, the United Kingdom, Japan, France, Canada, Singapore and China. Over there the governments brush up the commodity basket of CPI every 4-5 years to figure out changes in consumption pattern.
It pointed out that WPI does not properly measure the exact price rise an end-consumer will experience because, as the same suggests, it is at the wholesale level. The basic trouble which we face with WPI method of calculation is that more than 100 out of the 435 commodities included in the Index have ended up to be important from the consumption point of view.
But why is India sticking to WPI and not switching over to the CPI method of calculating inflation?
Finance ministry officials point out that there are many intricate difficulties that one has to face from shifting from WPI to CPI model.
As there are four different types of CPI indices i.e., CPI Industrial Workers; CPI Urban Non-Manual Employees; CPI Agricultural laborers; and CPI Rural labor; and this makes switching over to the Index from WPI fairly 'risky and unwieldy.' Secondly, the CPI cannot be used in India because there is too much of a lag in reporting CPI numbers. The WPI is published on a weekly basis and the CPI, on a monthly basis. And in India, inflation is calculated on a weekly
Effects on the economy
Inflation's effects on an economy are various and can be simultaneously positive and negative.
Negative effects of inflation include an
Increase in the opportunity cost of holding money, uncertainty over future inflation which may discourage investment and savings, and if inflation is rapid enough, shortages of goods as consumers begin hoarding out of concern that prices will increase in the future.
Positive effects include ensuring that central banks can adjust real interest rates (intended to mitigate recessions),] and encouraging investment in non-monetary capital projects.
Today, most economists favor a low, steady rate of inflation. Low (as opposed to zero or negative) inflation reduces the severity of economic recessions by enabling the labor market to adjust more quickly in a downturn, and reduces the risk that a liquidity trap prevents monetary policy from stabilizing the economy