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This 100% to 25% drop is our disinflation. Inflation is positive but rate is slow.
Deflation is not good. It means prices are sinking. When price sink, remuneration to producers or FoP decrease.
Widespread unemployment. Demand almost disappears.
But at same time in deflation, money value increase. What you were getting in more price during inflation, can be
available for less during deflation.
It is similar to deflation, as money supply decrease in both, but disinflation is not bad. Rather government goes for
disinflation to tackle inflation. Disinflation saves our poor people from too much inflation. Disinflation also brings back
glory of the currency, as it start looking piece of paper, when there is too much inflation.
Disinflation is till inflation rate remains positive, that means still there is remuneration for producers. In deflation
prices can fall, even below the base year price, there is no limit.
Inflationary Gap
Imagine a situation in which 10 year old kid is given so many tonics & supplements, so that he start working like a
25 year old guy.
This is same method used by government to make economy more mature and responsible. Government introduce
more and more money in economy to increase the production level. This intended production level is to satisfy
future demand of economy.
Definition: The gap between the actual output & potential output is known as inflationary gap.
Before explaining the actual output and potential output, imagine 10 year old output as potential output & after
supplements, the grown up boy output as actual output.
That is in a certain period, an economy output (or income) increase from potential output to actual output.
Of course this actual output exceeds the potential output, that is why when we subtract 2nd from 1st our answer is
in negative.
Let us name potential output, the output at full employment (Not everyone is working, as some quit job, some are in
process of getting a new job, some lost their seasonal job) as Output (fe).
The output after increased expenditure (giving supplements) as Output (a).
Output (fe) Output (a) = (or negative). This is known as inflationary gap.
This is half part of story, meaning govt. increased expenditure to raise the production level has a result. Result of
inflation in products price in economy.
Note: Some author do a blunder by naming the extra expenditure of govt as inflationary gap. This is wrong. As you
read above, it is the effect or the result of extra expenditure. The result is inflation.
Question ) At some date, the output (Potential GDP) is going to match with the level of expenditure in economy. How
can inflationary gap exist then ?
Answer ) The expenditure by govt. is not one time but continuous, with aim of increasing economic activities. When
it will start coming to match, there will be more expenditure again. **Until this expenditure turn into no growth and
only inflation scenario which is stagflation**
Deflationary Gap
Deflationary gap is situation when economy is producing less than its potential. It means that actual output sink
below the potential output. Whereas in Inflationary gap we saw, the actual output above potential output.
Why this situation can take place ?
When savings are more than the investment, the purchasing capacity is reduced. To buy the goods and services,
there is need of more investment, which acts as remuneration for the economic activity. Hence lower investment
with more saving and less expenditure by government is reason for this situation to take place.
In deflationary gap, resources are under utilized as the equilibrium take place below the equilibrium at full level
employment. There is widespread unemployment, less demand and more supply.
Whereas in inflationary gap, we saw aggregate demand more than aggregate supply.
Components of CPI:
Food, Beverages & Tobacco (Highest weight)
Fuel & Light
Clothing, bedding & Footwear
Housing (0% weight in rural CPI)
Miscellaneous (Education, transport etc)
Old CPIs:
A) BY Labor bureau, Ministry of Labor
So according to this logic, Unemployment should never be issue to worry about. RBI can print any amount of money,
introduce it in economy through cheapest loan and there would never be situation of people remaining unemployed.
Actually this was the mindset of govt till 1970, they focused on price rise but always thought more expenditure as
solution to start new economic activities and people getting employed in it.
This impression challenged itself in 1970, when govt were spending money like crazy, so that they can see new
economic activities. But this money wasnt contributing to any economic activity rather it was increasing products
price. As new products were not being manufactured and existing product price were going high due to this extra
money.
This was situation of stagflation. Stagnant growth + High inflation.
Summarizing:
Phillips curve tells about inverse relationship between rate of inflation and level of unemployment in economy.
Higher the inflation, lower the level of unemployment and lower the inflation rate, higher level of unemployment.
Keeping unemployment below its natural rate is not possible for long term. As there are many factor like labor
unions, worker demanding more wage when there is high inflation going on in market.
Stagflation is a trap, in which expansionary monetary policy, fiscal policy stop working. These policies keep on
pushing price level & have no positive effect on growth.
Source; proudpoor.com