Business Environment.2. Week 6. Inflation

Transcription

1 Business Environment.2 Week 6 Inflation 1

2 Definition "In simple words, inflation is a persistent and appreciable rise in the general price level". 2

3 Classification Inflation has been classified in many ways. The most important classification has been demandpull and cost-push inflation. A new term 'stagflation' has also assumed importance in recent years. 3

4 Demand-pull inflation Demand-pull inflation is that type of inflation, which arises because aggregate demand for goods exceeds their supply. When demand persistently exceeds total supply of real goods and services at current prices, prices tend to rise. This results in inflation. 4

5 Demand-pull inflation The demand for goods may rise as a result of an expansion in the supply of money or from other influences such as changed attitude towards the spending of money or not holding it in the form of idle balances. 5

6 Demand-pull inflation The concept of demand-pull inflation is generally associated with a situation of full employment. 6

7 Demand-pull inflation Example: Suppose the Government starts a new project costing RO. 100 millions, which will yield results only after 5 years. But since Government employs people for the project, it will pay money wages. Thus, the money income of people will rise but the volume of consumption goods produced will not increase correspondingly because of the time gap involved in production. This will result in demand-pull inflation, as disposable income with people with people will be more than the actual value of the available output of goods and services. Thus there will be too much money chasing 7

8 Aggregate demand curve The rise in aggregate demand is illustrated by a rightward shift in the aggregate demand curve, from AD1 to AD2. Prices rise from P1 to P2, and output rises from Q1 to Q2. The steeper the aggregate supply curve, the more prices will rise and less output will rise 8

9 Aggregate demand curve Fig.6.1 9

10 Cost-push inflation When prices rise due to increase in the cost of production of goods, (their demand and supply remaining steady) cost push inflation results. Thus, cost-push inflation occurs when prices persistently rise because of growing factor costs. 10

11 Cost-push inflation Cost-push inflation occurs when prices persistently rise because of growing factor costs. Such a rise may be caused by a rise in wages through trade union action or in the costs of any other input entering into production. In the latter case the initial increases in price may be just the result of administrative action such as the exercise of monopoly power by suppliers or joint decision of a group of producers to raise the price of an input, leading ultimately to cost-push for final product, and etc., 11

12 Cost-push inflation Example, Trade union in the steel industry may force the management to increase the wages of workers. As a result, the price of steel will rise and this will raise the costs of those industries, which use steel as input such as vehicles, machines etc. The rise in prices of vehicles may in turn push up the cost of transportation and manufactured products. The costs of food products may also go up due to high prices of tractors. Ultimately, food and raw material prices will also go up leading to higher cost of living. Higher cost of living will further push wage rates. Thus a type of chain reaction will develop. 12

13 Cost-push inflation (Supply-side inflation) There is a leftward shift in the aggregate supply curve from AS1 to AS2. This causes the price level to rise to P3 and the level of output to fall to Q3 How much firms raise prices and cut back on production depends on the shape of the aggregate demand curve. The less elastic the AD curve, the less will sales fall as a result of any price rise, and hence the more will firms be able to pass on the rise in their costs to consumers as higher prices. 13

14 Cost-push inflation (in diagrammatic form) Fig

15 Stagflation This type of inflation was named 'Stagflation' indicating co-existence of stagnation and inflation in the economy. There is thus inflationary rises in prices and wages, at the same time people are unable to find jobs and firms are unable to find customers for their products. 15

16 Consequences of inflation Inflation affects different groups of people differently. In the following paragraphs, we will study its effect on different groups: 1) Producers and traders 2) Debtors and Creditors 3) Fixed income groups 4) Investors 5) Effects on balance of payment 16

17 Measures to Check Inflation 1) Monetary Measures 2) Fiscal Measures 3) Control over Investment 4) Increases in Output 5) Increased imports 17