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SEMESTER: II
SECTION: B
FINAL PROJECT OF
ACKNOWLEDGEMENT
A major research project like this is never the work of anyone alone. Firstly, I would like to thank respected Professor MADHURI SRIVASTAVA, for giving me such a golden opportunity to show my skills and capability through this project.
This project is the result of the extensive ultrapure study, hard work and labour, put into to make it worth reading. This project has been completed through the generous co-operation of various persons, especially my seniors, who, in their different potentials helped me a lot in giving the finishing touch to the project.
This project couldnt be completed without the help of my universitys library Dr. Madhu Limaye Library and its internet facility.
Thanking You........
Table of Contents
1. CHAPTER 1. Introduction
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2. CHAPTER 2. 05 Objective and Research Methodology 3. CHAPTER 2. Causes of Inflation 4. CHAPTER 3. Effects of Inflation 5. CHAPTER 4. Types of Inflation 6. CHAPTER 5. Inflationary Gap 7. CHAPTER 6 Measures for Calculating Inflation 8. CHAPTER 7. Stagflation, Reflation, Deflation and Disinflation 9. CHAPTER 8. Summary 19 16 15 13 10 08 06
CHAPTER 1 INTRODUCTION
Inflation is commonly understood as a situation of substantial and rapid general increase in the level of prices and consequent deterioration in the value of money over a period of time. It refers to the average rise in the general level of prices and fall in the value of money. Inflation is a global phenomenon. It is linked with the money supply. By inflation we mean a process of rising prices. Prof. Crowther has defined inflation as a state in which the value of money is falling i.e. prices are rising. Prof. Goldenweiser says Inflation occurs when the volume of money actively bidding for goods and services increases faster than the available supply of goods Webster's 1983 Definition of Inflation: "An increase in the amount of currency in circulation, resulting in a relatively sharp and sudden fall in its value and rise in prices: it may be caused by an increase in the volume of paper money issued or of gold mined, or a relative increase in expenditures as when the supply of goods fails to meet the demand. Inflation is 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. A chief measure of price inflation is the inflation rate, the annualized percentage change in a general price index (normally the Consumer Price Index) over time. When inflation goes up, there is a decline in the purchasing power of money. For example, if the inflation rate is 2% annually, then theoretically a $1 pack of gum will cost $1.02 in a year. After inflation, your dollar can't buy the same goods it could beforehand. A movie ticket was for a few paise in my dads time. Now it is worth Rs.50. My dads first salary for the month was Rs.400 and over he years it has now become Rs.75,000. This is what inflation is, the price of everything goes up. Because the price goes up, the salaries go up.
RESEARCH METHODOLOGY:
To complete my project I will follow Doctrinal Research Methodology. By which I will collect the material from documentary sources both paper document and electronic document. Paper contains all the writings available from the books, articles, journals, and newspapers. Whereas the electronic documents in this aspect means the documents available in the World Wide Web. In my research the role of my universitys library Dr. Madhu Limaye Library and its Internet facility will be very important.
y y y y y
ON THE SUPPLY SIDE y Shortage of supplies of factor of production: The shortage of productive factors such as labour, capital equipment, raw material etc. is a serious obstacle to any effort to increase production in the country. Industrial disputes: In countries where trade unions are strong strikes, lock-outs causes industrial production falls, thereby reducing supply of goods. Natural calamities: Natural calamities like floods, draughts etc. adversely affect the supply of agricultural product and raw material thereby helping inflationary pressures. Lop-sided production: If the stress is placed on the production of comfort and luxury goods, thereby neglecting essential and consumers goods, it creates shortage of goods in the market. Hoarding by traders and consumers as well: At the time of shortage and rising prices there is a tendency of traders to hoard essential commodities for profiteering purposes and on the part of individual consumers to hoard them to avoid payment of higher prices in future causing further scarcity of these commodities. Operation of law of diminishing returns: When the law of diminishing returns operate, increase in production is possible only at a higher cost which de motivates the producers to invest in large amounts. Thus production will not increase proportionately to meet the increase in demand. Hence, supply falls short of demand.
Effects on distribution: y Effects of Inflation on Business Community: Inflation is welcomed by entrepreneurs and businessmen because they stand to profit by rising prices. They find that the value of their inventories and stock of goods is rising in money terms. They also find that prices are rising faster than the costs of production, so that their profit is greatly enhanced. y Fixed Income Groups: Inflation hits wage-earners and salaried people very hard. Although wage- earners, by the grace of trade unions, can chase galloping prices, they 8
seldom win the race. Since wages do not rise at the same rate and at the same time as the general price level, the cost of living index rises, and the real income of the wage earner decreases. y Farmers: Farmers usually gain during inflation, because they can get better prices for their harvest during inflation. y Investors: Those who invest in debentures and fixed-interest bearing securities, bonds, etc, lose during inflation. However, investors in equities benefit because more dividend is yielded on account of high profit made by joint-stock companies during inflation. y Debtors and Creditors: During inflation, debtors are generally the gainers while the creditors are the losers. y Inflation will lead to deterioration of gross domestic savings and less capital formation in the economy and less long term economic growth rate of the economy.
Demand pull Inflation: It may be defined as a situation where the total monetary demand persistently exceeds total supply of goods and services at current prices, so that prices are pulled upwards by the continuous upward shift of the aggregate demand function. It arises as a result of an excessive aggregate effective demand over aggregate supply of goods and services in a slowly growing economy. Supply of goods and services will not match with rising demand. The productive ability of the economy is so poor that it is difficult to increase the supply at a quicker rate to match the increase in demand for goods and services. When exports increase the money income of the people rises. With excess money income, purchasing power, demand, prices move in the upward direction. It is essential to note that demand pull inflation is the result of increase in money supply. This leads to fall in the interest raterise in investment increase in production increase in the incomes of factors of production increase in the demand for goods and services and finally, in the level of prices. Thus, excess supply of money results in escalation of prices. Again, when there is a diversion of productive 10
resources from the production of consumer goods to either capital or defense goods or nonessential goods, prices start rising in view of scarcity of consumer goods and excess income in the hands of people. It is clear from the following diagram
Cost Push Inflation: It refers to a situation where in prices rise on account of increasing cost of production. Thus, in this case, rise in price is initiated by growing factor costs. Hence, such a price rise is termed as cost push inflation as prices are being pushed up by the rising factor costs. A number of factors contribute for the increase in cost of production. 1. Demand for higher wages by the labour class. 2. Fixing up of higher profit margins by the manufacturers. 3. Introduction of new taxes and raising the level of old taxes. 4. Increase in the prices of different inputs in the market. 5. Rise in administrative prices by the government etc., These factors in turn cause prices to rise in the market. Out of many causes, rise in wages is the most important one. It is estimated and believed that wages constitute nearly 70% of the total cost of production. A rise in wages leads to a rise in the total cost of production and a consequent rise in the price level. Thus costpush inflation occurs due to wage push or profitpush. We can explain the costpush inflation with the help of the following diagram.
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Now the net disposable income with the community is 12,000, but the available output for civilian consumption is only 9,000. There is excess of demand over available supply to the extent of Rs.3000 crores. This is referred to as the inflationary gap. Though Keynes associated an inflationary gap with war, such a gap can arise even during the period of economic development. We can show the inflationary gap diagrammatically using the Keynesian concepts of aggregate supply and aggregate demand:
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Measures to wipe out inflationary gap 1. Increase in savings to reduce aggregate demand. 2. Raise the output to match the disposable income. 3. Raise the taxes to mop up the excess purchasing power. The first two measures have a limited scope, monetary policy also cannot be very effective so the government will have to rely more on fiscal measures like taxation to wipe out the inflationary gap.
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X 100
Change in price [t] = P [t] P [t1]. Here, P = price level and [t], [t1] are the periods of calendar time to which the observations are made. For instance, in January 2007, the U.S. Consumer Price Index was 202.416, and in January 2008 it was 211.080. The formula for calculating the annual percentage rate inflation in the CPI over the course of 2007 is
The resulting inflation rate for the CPI in this one year period is 4.28%, meaning the general level of prices for typical U.S. consumers rose by approximately four percent in 2007 How India calculates Inflation ? India uses the Wholesale Price Index (WPI) to calculate and then decide the inflation rate in the economy. So next question that would arise is What is Wholesale Price Index? 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 tracked through WPI which is an indicator of movement in prices of commodities in all trade and transactions. The data for this is available weekly and this helps the Indian government to calculate the inflation weekly. For instance in 2007-08 WPI was 255 and in 2008-09 it was 280 than The formula for calculating the annual percentage rate inflation in the WPI over the course of 2008-09 will be 9.8% according to above mentioned formula. 15
y y
DEFLATION :
Deflation is just opposite to inflation. It is essentially a period of falling prices, fall in incomes and rise in the value of money. According to Prof. Crowther Deflation is that state of the economy where the value of money is rising or the prices are falling. But every fall in price level is not deflation. In the words of Prof. Pigou Deflation is that state of falling prices which occurs at the time when output of goods and services increases more rapidly than the value of money income in the economy. Prof. Paul Einzig gives a better and convincing definition. In his view deflation is a state of disequilibrium in which a contraction of purchasing power tends to cause, or is the effect of a decline of price level. Thus, fall in price level is both the result as well as the cause of fall in money supply. Effects of Deflation Deflation like inflation will have both dampening and encouraging effects on different sections of the society. On Production Deflation has an adverse effect on the level of production, business and employment. Fall in demand and fall in prices force many firms to quit the industry or operate partially. Wages are reduced or workers are retrenched. It creates a hopeless situation in the field of production. On Distribution Deflation affects adversely distribution of income too. In the first place, producers, merchants and speculators lose badly during this period because prices of the goods fall at a much greater rate and faster than their costs. Being unable to manage with the situation many are compelled to quit the industry. Failure of business and inability to repay the loans incurred with the banks worsens the position of the merchants and the producers. Debtors lose while the creditors gain. Fixed income groups enjoy a better standard of living as the money income is fixed, there will be a rise in their real incomes. The salaried persons and wage earners will benefit by deflation. However, the beneficial effects of deflation are far less compared to its adverse effects. During this period because of unemployment, falling incomes, falling output, a kind of pessimistic atmosphere is established in the entire economy. Inflation is unjust; deflation is inexpedient, Of the two deflation is worse - Prof. J.M. Keynes
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REFLATION:
Reflation is the act of stimulating the economy by increasing the money supply or by reducing taxes. It is the opposite of disinflation. It can refer to an economic policy whereby a government uses fiscal or monetary stimulus in order to expand a country's output. This can possibly be achieved by methods that include reducing tax, changing the money supply, or even adjusting interest rates. Just as disinflation is considered an acceptable antidote to high inflation, reflation is considered to be an antidote to deflation (which, unlike inflation, is considered bad regardless how high it is). Originally it was used to describe a recovery of price to a previous desirable level after a fall caused by a recession. Today it also (in addition to the above) describes the first phase in the recovery of an economy which is beginning to experience increasing prices at the end of a slump. With rising prices, employment, output and income also increase till the economy reaches the level of full employment. Reflation is necessarily deliberated and is good for economy.
DISINFLATION:
Disinflation is an attempt to counter a highly inflationary situation in the same manner as reinflation is an attempt to cure a highly deflationary situation. Whenever there is an exessive expansion in the supply of money and the prices start rising to higher and higher levels, then the government may resort to a policy of disinflation to bring the normal level. DISINFLATION DISTINGUISED FROM DEFLATION: y Disinflation is lower inflation. Prices are still rising during disinflation, but at a lower rate. The general price level still rises, but, at a slower rate resulting in a continued, but, lower rate of real value destruction in money and other monetary items. A lowering of inflation is not deflation but disinflation, while Deflation means the general price level is not increasing at all, but, actually decreasing continuously and the internal functional currency money - and other monetary items are worth more all the time. Deflation causes an increase in the real value of money and other monetary items. In disinflation prices does not fall below the price level. While in deflation prices may fall below the price level. Disinflation is necessarily deliberated. While in deflation fall in prices may be deliberate or may be natural. Disinflation is not bad for the economy. While deflation is not good for the economys health.
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CHAPTER 9 SUMMARY
Inflation refers to a period of general rise in price level. There are different types of Inflation, like demand pull inflation, cost push inflation etc. Inflation is caused by a number of factors like rise in the supply of money, increase in exports, black money, rise in the coast of production, hoarding, war etc. It affects different sections of the population differently. Producers, merchants, debtors gain while the consumers, laborers, fixed income groups suffer. A number of measures like monetary, fiscal and physical controls are adopted to control inflation. Inflationary gap is a Keynesian concept; It arises when the expenditure is in excess of the goods available in the economy. Variations on inflation include deflation, disflation, reinflation and stagflation. Deflation is a state of falling prices, incomes, output and employment. As deflation has the danger of creating conditions of depression it must be cured adopting various monetary and fiscal measures. Disinflation is an attempt to counter a highly inflationary situation in the same manner as reinflation is an attempt to cure a highly deflationary situation. Reflation is the act of stimulating the economy by increasing the money supply or by reducing taxes. Inflation is measured with a wholesale price index. Lack of inflation (or deflation) is not necessarily a good thing. To avoid irreparable damage, the budget must be balanced at the earliest possible moment, and not in some sweet by-and-by. Balance must be brought about by slashing reckless spending, and not by increasing the tax burden that is already undermining incentives and production.
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Bibliography: Books :
K. K. Dewett. Modern Economic Theory S. Chand and Company Paul A. Samuelson And William D. Nordhaus Economics Tata McGraw-Hill Publishing Company Limited Eighteenth Edition. Dominick Salvatore Microeconomic Theory McGraw-Hill Publishing Company Limited, Third Edition. Dr. S.R. Myneni Principal Of Economics Allahabad Law Agency
WEBSITES:
maeconomics.webs.com business.business2k.com economywatch.com tutor2u.net
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