Macro Economics

Inflation, Deflation, Stagflation and Price Stability

BBA Programme Course Code: ECO221

Inflation

Definition: The rate at which the general level of prices for goods and services is rising, and, subsequently, purchasing power is falling. (www.investopedia.com) Central banks attempt to stop severe inflation, along with severe deflation, in an attempt to keep the excessive growth of prices to a minimum. As inflation rises, every Pak rupee will buy a smaller percentage of a good. For example: if the inflation rate is 2%, then Rs.10 pack of gum will cost Rs.10.2 in a year.

Hyperinflation

Definition: Hyperinflation is a situation where the price increases are so out of control that the concept of inflation is meaningless.

Formula for Inflation Rate

Inflation Rate

F I x 100% I

Where; F = Final Value and I = Initial Value.

Calculation for Inflation Rate

The most common way to calculate the inflation rate is by recording the prices of goods and services over the years (which is called a Price Index). How you can do this ??? By taking a base year and then determine the percentage rate changes of those prices over the years. Keeping in mind that The price index on its own does not give the inflation rate but it can be used to calculate the inflation rate.

Some Popular Price Indices

Consumer Price Index (CPI) measure the price of a selection of goods and services for a typical consumer. Commodity Price Index measure the price of a selection of commodities with. It is a weighted index (in other words, some commodities are more important than others in determining price changes). Cost of Living Index (COLI) measure the cost to maintain a constant standard of living. In other words, what would it cost you from year to year to live exactly the same.

Some Popular Price Indices cont

Producer Price Index (PPI) measures the prices for all goods and services at the wholesale level. It is like the consumer price index but it is measuring the prices the producers have to pay. GDP Deflator measures the prices of all goods and services (GDP). (www.rateinflation.com)

Calculation for Inflation Rate cont

Lets use the CPI as an example as it is the most commonly used index to calculate the inflation rate. Consider the following data.

Year 2006 2007 2008 2009 2010

CPI (Rs.) 100 115 121 127 135

Calculation for Inflation Rate cont

Now, calculate the inflation rate from 2006 2007. Inflation Rate = F I x 100 % I = 115 100 x 100 % 100 Inflation Rate = 15% Now, calculate the inflation rate from 2007 2008, 2008 2009 and 2009 2010.

Inflation Rate in Pakistan

Year Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 2011 14.19 12.91

2010

13.68

13.04

12.91

13.26

13.07

12.69

12.34

12.79

13.77

14.17

15.48

15.46

2009

20.52

21.07

19.07

17.19

14.39

13.14

11.17

10.69

10.12

8.87

10.51

10.52

2008

11.86

11.25

14.12

17.21

19.27

21.53

24.33

25.33

23.91

25.00

24.68

23.34

(www.tradingeconomics.com)

Inflation Rate in Pakistan cont

From Jan 2007 Feb 2011

Deflation

Definition: A general decline in prices, often caused by a reduction in the supply of money or credit. (www.investopedia.com) Deflation can also be caused by a decrease in government, personal or investment spending.

Side Effect of Deflation

Deflation has the side effect of increased unemployment since there is a lower level of demand in the economy, which can lead to an economic depression. For example: Unemployment in the farming industry during great depression due to increased supply within the market from the farmers. Central banks attempt to stop severe deflation, along with severe inflation, in an attempt to keep the excessive drop in prices to a minimum or excessive rise in prices to a maximum.

Occurrence of Deflation

Deflation can occur because of a combination of four factors: 1. The supply of money goes down. 2. The supply of other goods goes up. 3. Demand for money goes up. 4. Demand for other goods goes down. Deflation generally occurs when the supply of goods rises faster than the supply of money, which is consistent with these four factors. For example: prices of personal computers.

Stagflation

Definition: A condition of slow economic growth and relatively high unemployment is called stagflation. (www.investopedia.com) When high inflation and high unemployment (stagnation) occurring simultaneously is called stagflation. (www.investorwords.com)

Stagflation

cont

Stagflation occurs when the economy is not growing but prices are growing (inflation) which is not a good situation for a country to be in. For example: The world has faced the stagflation to a great extent during 1970s.

Stagflation in Pakistan

Pakistans current economy is badly affected by stagflation. It is a double-edged sword for the poor and deprived. Following are some consequences due to stagflation. Rise in crime and suicides. Higher prices of essential foods, e.g., sugar prices are 300% more as it was 3 years before. Higher credit prices due to inflation discourage private sector credit. Lack of purchasing power due to stagnation. Higher interest rates due to fewer saving results in negative economic growth. Closure of industries due to loans scarcity.

Price Stability

The condition in which average price level in the economy does not change or changes very slowly. (glossary.econguru.com) It is a situation in which an economy would not experience inflation or deflation. However, it is not common for an economy to have price stability. (www.investorwords.com)

Effects of Price Stability

When prices are stable, it is easier for consumers to understand relative values of products. For example: If a price of a commodity is Rs.10, which customers will assume as a fair price. In a stable price system, if a supermarket decides to start selling the same commodity for Rs.20, then customers will likely notice the change and stop buying that commodity because it is being sold far above the regular value.

Price Stability in Pakistan

Unfortunately there is no such price stability in Pakistan for different commodities. Following are some reasons for price instability in Pakistan. Personal interests of the elite and bureaucratic class are the main hurdles in ensuring price stability across the country. Sugar mills owners who are present in the parliament always prioritising their business interests over national interest. Ignoring the governments recommended price lists for daily useable items. Lack of consensus over ensuring price stability in the country from mills owners belong to different political parties (especially sugar mills owners).

Suggestions to Reduce Price Instability in Pakistan cont

Following are some suggestions to reduce price instability in Pakistan. Business class has to be separated from politics in order to keep national interest on top. Warranting a prompt action by the government to enforce price control mechanism. Ensuring proper implementation of the government orders i.e., enforcement of price lists. Ensuring steady supplies of items that are most used during the holy month of Ramadan.