Date: February 12, 2015

Inflation demand pull inflation cost push inflation phillips curve

Inflation and related issues

Simply, Inflation is  sustained increase in the general level of prices for goods and services. It is measured on the basis of annual percentage increase. In pure economic sense,particularly indian economic sense Inflation is the percentage change in the value of the Wholesale Price Index (WPI) on a year-to- year basis. It effectively measures the change in the prices of a basket of goods and services in a year. In India, inflation is calculated by taking the WPI as base.

Formula for calculating Inflation=

(WPI in month of current year-WPI in same month of previous year)
-------------------------------------------------------------------------------------- X 100
WPI in same month of previous year



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Causes of Inflation-

There are two major causes of inflation i.e.

1- cost push inflation

2- demand pull inflation

Cost Push Inflation-Cost-push inflation occurs when businesses respond to rising production costs, by raising prices in order to maintain their profit margins. Higher costs shift a firms supply curve upwards and lead to an increase in price. There are many reasons why costs might rise:

a- Rising imported raw materials costs

b- Rising labour costs

c-Higher indirect taxes

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Demand Pull Inflation-Demand-pull inflation is likely when there is full employment of resources and short run aggregate supply is inelastic. In these circumstances an increase in aggeregate demand will lead to a general increase in prices. Reasons for rise in demand may be-

a- Depreciation of the exchange rate- It increases the price of imports and reduces the foreign price so demand rises.
b- A reduction in direct/indirect taxation.
c-The rapid growth of the money supply
d- Rising consumer confidence

Terms associated with Inflation-

Point-to-Point Inflation: It means that the reference dates for the annual inflation is January 1 to January 1 of two consecutive years and not for January 1 to December 31 of the concerned year. Similarly, weekly inflation measurement refers to inflation measured on same week of two consecutive years. In India, this is measured on two consecutive last days of the week. (i.e. 5 PM of two Fridays in India).

Inflationary Gap: The excess of total government spending above the national income (i.e. fiscal deficit) is known as the inflationary gap.

Inflation Tax: Inflation tax is not an actual legal tax paid to a government; instead “inflation tax” refers to the penalty for holding cash at a time of high inflation. When the government prints more money or reduces interest rates, it floods the market with cash, which raises inflation in the long run. If an investor is holding securities, real estate or other assets, the effect of inflation may be negligible. If a person is holding cash, though, this cash is worth less after inflation has risen. The degree of decrease in the value of cash is termed the inflation tax for the way it punishes people who hold assets in cash, which tend to be lower- and middle-class wage earners. (Source)

Inflation Spiral: A situation when wages push prices up and prices pull wages up is known as the inflationary spiral. It is also known as wage-price spiral.

Inflation Accounting: Profits of companies get overstated due to increase in inflation. When a firm calculates its profits after adjusting the effects of current level of inflation, this process is known as inflation accounting.

Reflation: It is an act of stimulating the economy (economic growth) by higher government expenditure, tax and interest rate cuts, reducing tax rates etc. Major world economies like USA, UK went for reflationary measures to emerge from the economic recession that had set in since 2008 following the sub-prime crisis.

Stagflation: It is a combination of high inflation and low or stagnant growth (stagnant growth + inflation = stagflation). In such a situation, inflation and unemployment both are at higher levels.

Phillips Curve: It is a graphic curve depicting an inverse relationship between inflation and unemployment in an economy. The curve suggests that lower the inflation higher the unemployment and vice-versa.

Inflation Targeting: Every government aims for a stable level or comfort zone of inflation aims to target inflation rate within this range. The Reserve Bank of India (RBI) has set a inflation target of 4-5% for the Indian economy. Of course, this target is not fixed for all times but is revised as per needs of the economy.

Skewflation: Skewflation refers to skewed or lopsided inflation where there is sustained price rise in a small group of commodities even though prices of other commodities remains relatively stable. For instance, in India, food prices rose steadily during 2009 and 2010 even though prices of non-food items continued to be stable.