Inflation Topics All in One

What is sectoral inflation?

This is the fourth major type of inflation. The sectoral inflation takes place when there is an increase in the price of the goods and services produced by a certain sector of industries. For instance, an increase in the cost of crude oil would directly affect all the other sectors, which are directly related to the oil industry. Thus, the ever-increasing price of fuel has become an important issue related to the economy all over the world. Take the example of aviation industry. When the price of oil increases, the ticket fares would also go up. This would lead to a widespread inflation throughout the economy, even though it had originated in one basic sector. If this situation occurs when there is a recession in the economy, there would be layoffs and it would adversely affect the work force and the economy in turn.

What is pricing power inflation?

Pricing power inflation is more often called administered price inflation. This type of inflation occurs when the business houses and industries decide to increase the prices of their respective goods and services to increase their profit margins. Pricing power inflation does not occur at the time of financial crises and economic depression or when there is a downturn in the economy. This type of inflation is also called oligopolistic inflation because oligopolies have the power of pricing their goods and services at whatever levels they want.

Definition of 'Hyperinflation'

Extremely rapid or out of control inflation. There is no precise numerical definition to hyperinflation. Hyperinflation is a situation where the price increases are so out of control that the concept of inflation is meaningless.

Explanation 'Hyperinflation'

When associated with depressions, hyperinflation often occurs when there is a large increase in the money supply not supported by gross domestic product (GDP) growth, resulting in an imbalance in the supply and demand for the money. Left unchecked this causes prices to increase, as the currency loses its value.
When associated with wars, hyperinflation often occurs when there is a loss of confidence in a currency's ability to maintain its value in the aftermath. Because of this, sellers demand a risk premium to accept the currency, and they do this by raising their prices.
One of the most famous examples of hyperinflation occurred in Germany between January 1922 and November 1923. By some estimates, the average price level increased by a factor of 20 billion, doubling every 28 hours.

Explain Fiscal Inflation

Fiscal Inflation occurs when there is excess government spending. This occurs when there is a deficit budget. For instance, Fiscal inflation originated in the US in 1960s at the time President Lydon Baines Johnson. America is also facing fiscal type of inflation under the presidentship of George W. Bush due to excess spending in the defense sector.

Definition of 'Stagflation'

A condition of slow economic growth and relatively high unemployment - a time of stagnation - accompanied by a rise in prices, or inflation.

Explanation 'Stagflation'

Stagflation occurs when the economy isn't growing but prices are, which is not a good situation for a country to be in. This happened to a great extent during the 1970s, when world oil prices rose dramatically, fueling sharp inflation in developed countries. For these countries, including the U.S., stagnation increased the inflationary effects.

Definition of 'Deflation'

A general decline in prices, often caused by a reduction in the supply of money or credit. Deflation can be caused also by a decrease in government, personal or investment spending. The opposite of inflation, 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. Central banks attempt to stop severe deflation, along with severe inflation, in an attempt to keep the excessive drop in prices to a minimum.
The decline in prices of assets, is often known as Asset Deflation.

Explanation 'Deflation'

Declining prices, if they persist, generally create a vicious spiral of negatives such as falling profits, closing factories, shrinking employment and incomes, and increasing defaults on loans by companies and individuals. To counter deflation, the Federal Reserve (the Fed) can use monetary policy to increase the money supply and deliberately induce rising prices, causing inflation. Rising prices provide an essential lubricant for any sustained recovery because businesses increase profits and take some of the depressive pressures off wages and debtors of every kind.
Deflationary periods can be both short or long, relatively speaking. Japan, for example, had a period of deflation lasting decades starting in the early 1990's. The Japanese government lowered interest rates to try and stimulate inflation, to no avail. Zero interest rate policy was ended in July of 2006.

Definition of 'Disinflation'

A slowing in the rate of price inflation. Disinflation is used to describe instances when the inflation rate has reduced marginally over the short term. Although it is used to describe periods of slowing inflation, disinflation should not be confused with deflation.

Explanation 'Disinflation'

Disinflation is commonly used by the Federal Reserve to describe situations of slowing inflation. Instances of disinflation are not uncommon and are viewed as normal during healthy economic times. Although sometimes confused with deflation, disinflation is not considered to be as problematic because prices do not actually drop and disinflation does not usually signal the onset of a slowing economy.

Definition of 'Reflation'

A fiscal or monetary policy, designed to expand a country's output and curb the effects of deflation. Reflation policies can include reducing taxes, changing the money supply and lowering interest rates.
The term "reflation" is also used to describe the first phase of economic recovery after a period of contraction.

Explanation 'Reflation'

Reflation policy has been used by American governments, to try and restart failed business expansions since the early 1600s. Although almost every government tries in some form or another to avoid the collapse of an economy after a recent boom, none have ever succeeded in being able to avoid the contraction phase of the business cycle. Many academics actually believe government agitation only delays the recovery and worsens the effects.

Definition of 'Depression'

A severe and prolonged downturn in economic activity. In economics, a depression is commonly defined as an extreme recession that lasts two or more years. A depression is characterized by economic factors such as substantial increases in unemployment, a drop in available credit, diminishing output, bankruptcies and sovereign debt defaults, reduced trade and commerce, and sustained volatility in currency values. In times of depression, consumer confidence and investments decrease, causing the economy to shut down

Explanation 'Depression'

A depression is a sustained and severe recession. Where a recession is a normal part of the business cycle, lasting for a period of months, a depression is an extreme fall in economic activity lasting for a number of years. Economists disagree on the duration of depressions; some economists believe a depression encompasses only the period plagued by declining economic activity. Other economists, however, argue that the depression continues up until the point that most economic activity has returned to normal.

Definition of 'GDP Price Deflator'

An economic metric that accounts for inflation by converting output measured at current prices into constant-dollar GDP. The GDP deflator shows how much a change in the base year's GDP relies upon changes in the price level. Also known as the "GDP implicit price deflator.

Explanation 'GDP Price Deflator'

Because it isn't based on a fixed basket of goods and services, the GDP deflator has an advantage over the Consumer Price Index. Changes in consumption patterns or the introduction of new goods and services are automatically reflected in the deflator.

In most systems of national accounts the GDP deflator measures the ratio of nominal (or current-price) GDP to the real (or chain volume) measure of GDP. The formula used to calculate the deflator is:

The nominal GDP of a given year is computed using that year's prices, while the real GDP of that year is computed using the base year's prices.

Definition of 'Consumer Price Index - CPI'

A measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care. The CPI is calculated by taking price changes for each item in the predetermined basket of goods and averaging them; the goods are weighted according to their importance. Changes in CPI are used to assess price changes associated with the cost of living.
Sometimes referred to as "headline inflation."

How to Calculate CPI

The consumer price index (CPI) is the government's key inflation indicator. The Bureau of Labor Statistics calculates the CPI each month. This index is based on data related to consumer spending habits and the prices paid for a variety of goods, including food, clothing, medications, energy, homes and furnishings. You don't have to be a labor economist to calculate the inflation rate on goods you regularly buy.

 

1.Instructions

1. Determine the goods and the time frame for which you are interested in measuring the inflation rate. People often want to know how prices have increased over a year. Suppose, for simplicity's sake, that you are interested in the inflation rate for a basket of goods that includes a gallon of milk, a loaf of bread and a paperback novel.
2. Calculate the number of units you purchase of these goods and the prices you paid one year ago. For example, suppose you buy four gallons of milk, three loaves of bread and a paperback per month and that one year ago, you paid the following prices: $2.75 per gallon; $2 per loaf; and $7 per novel. This means you spent a total of $24 a month one year ago for these goods.
3. Repeat Step 2, but consider the prices you pay now. Suppose the current prices are $3.50 for a gallon of milk and $2.50 for a loaf of bread, while the price of a paperback is the same $7. This means you now spend $28.50 a month for the same basket of items.
4. Subtract the amount you spent per month one year ago ($24) from the amount you spend now ($28.50), then take the difference ($4.50) and divide by last year's amount ($24). This gives you a result of 0.188 (with rounding).
5. Multiply the result you obtained in Step 4 (0.188) by 100 to obtain the percentage rate increase for the selection of goods you're interested in studying. For this example, the results show that the consumer price index for a gallon of milk, a loaf of bread and a paperback novel increased 18.8 percent in the past year.

Calculating the CPI for a single item

Current item price ($) = (base year price) * (Current CPI) / (Base year CPI)

or

Where 1 is usually the comparison year and CPI₁ is usually an index of 100.

Alternatively, the CPI can be performed as . The "updated cost" (i.e. the price of an item at a given year, e.g.: the price of bread in 2010) is divided by the initial year (the price of bread in 1970), then multiplied by one hundred.

Calculating the CPI for multiple items

Many but not all price indices are weighted averages using weights that sum to 1 or 100.

Example: The prices of 95,000 items from 22,000 stores, and 35,000 rental units are added together and averaged. They are weighted this way: Housing: 41.4%, Food and Beverage: 17.4%, Transport: 17.0%, Medical Care: 6.9%, Other: 6.9%, Apparel: 6.0%, Entertainment: 4.4%. Taxes (43%) are not included in CPI computation.

where the 's sum to 1 or 100.

What are the positive and negative effects of inflation?

Inflation is defined as a persistent increase in the general price level. It can take the form of creeping inflation of several percent per year. This is viewed as healthy for the economy because it means that some level of economic growth is occurring in the economy. On the other hand, hyperinflation can take place in an economy. There is no figure at which inflation can be deemed hyperinflation but a figure of annual inflation as high as 100% could be regarded as such. The economic effects of each of these are different so it will be important to note that I will be looking at creeping inflation. Inflation affects a large number of economic factors within the economy such as unemployment, growth, the balance of payments, distribution of wealth and taxation revenues.

Inflation is viewed as being undesirable because of some serious economic and social effects. Inflation impacts on income distribution making an random redistribution of real income. Those receiving fixed money incomes (e.g., pensioners, beneficiaries etc.) are usually disadvantaged because often their incomes are not adjusted upwards fast enough to compensate for the effects of continually rising prices. Their real incomes (i.e., the goods and services their incomes will buy) will fall. Individuals whose incomes rise more rapidly than the inflation rate will experience increasing real incomes. Generally, the pattern of income distribution tends to become more unequal than it was before inflation. If the rate of inflation is high, individuals with money tend to buy real assets such as property, gold and antiques, which often increase in value faster than the rate of inflation. This group will gain by increasing the size of their share of the nation's wealth.

Inflation tends to increase spending and encourage borrowing at the expense of savings. If prices are rising quicker than incomes, individuals will tend to buy at current prices before goods and services become more expensive and less affordable. Some consumers may buy using higher levels of debt (i.e., borrowing) than otherwise might the case. Savings may be discouraged because with high inflation when the money saved is repaid, it can be worth much less than when it was lent and the real rate of interest may be low. The real rate of interest rates fail to keep pace with inflation the saver loses purchasing power, i.e., their ability to buy things falls. Rising prices are a boon to borrowers because the repayment of interest and the sum borrowed (i.e., the principal) is with lower valued money. Inflation reduces the real value of the amount they owe, as the sum repaid has less purchasing power. Of course, any gain by borrowers must be weighed against the interest they must pay.

Investment, in economics, means the creation of new capital goods. Investment can only take place if there is saving. Inflation encourages spending and discourages saving, so funds that might otherwise have been available for investment tend to dry up. With lower levels of investment there is likely to be a slowing of the rate of growth of national output (GDP). This in turn leads to a reduction in new jobs and so can increase the level of unemployment. Inflation can distort market price signals and the market may fail to allocate resources efficiently. Planning and investment decisions become more difficult to predict as firms are unsure what will happen to prices and costs during times of inflation. If firms are unable to pass on the increase in costs to consumers this will impact on profits possibly causing some firms to close or cut back production and subsequent employment.

PAKISTAN INFLATION RATE The inflation rate in Pakistan was recorded at 5.80 percent in April of 2013. Inflation Rate in Pakistan is reported by the Pakistan Bureau of Statistics. Historically, from 1957 until 2013, Pakistan Inflation Rate averaged 8.03 Percent reaching an all time high of 37.81 Percent in December of 1973 and a record low of -10.32 Percent in February of 1959. In Pakistan, most important categories in the consumer price index are food and non-alcoholic beverages (35 percent of total weight); housing, water, electricity, gas and fuels (29 percent); clothing and footwear (8 percent) and transport (7 percent). The index also includes furnishings and household equipment (4 percent), education (4 percent), communication (3 percent) and health (2 percent). The remaining 8 percent is composed by: recreation and culture, restaurants and hotels, alcoholic beverages and tobacco and other goods and services. This page includes a chart with historical data for Pakistan Inflation Rate.

Price Levels and Inflation

Monetary policy

The price level is the overall measure of prices in a given country or region at a particular point in time.

Inflation is an increase in the price level over a specified period of time.

• The inflation rate is the percentage change in the price level from one period of time to the next. The rate of inflation varies from country to country

Deflation is a decrease in the price level over a specified period of time.

• A negative inflation rate would mean there is deflation.

How is the price level measured? The Consumer Price Index (CPI).

• There is a “basket” of goods and services commonly bought by the average consumer. This “basket” is actually a very specific list of what you might buy: apples, chicken, gas, a dishwasher, dry cleaning services, a shirt, a movie ticket, an iPod, a car repair, etc.
• A group of government workers goes out and writes down the prices of everything on that list. They then come back and calculate how much their list, or basket, would have cost.
  • The cost of this basket is the price level, also called the price index, for that time period. Because the basket is specific to what consumers would buy, it is called the consumer price index (CP

How is inflation measured?

• Every few months these workers go back out to measure the price of their basket and record the price index for each new time period.
• Because the basket of goods is not changing, if the price of the basket changes from one period of time to the next you know the general price level has changed. If the price of the basket increases, the country has experienced inflation.
• To calculate the inflation rate, say from period 1 to period 2, you just calculate the percentage change.
  Inflation>_1,2 = 100% * (CPI₁ - CPI₂) / CPI₁

What determines the price level and inflation rate?

• In the long run the price level is determined by the amount of money available in the economy.
  • The relationship between the supply of money, the price level, and inflation is captured in the quantity theory of money:
    M*V = P*Y
    Where (M) is the supply of money, (V) is the velocity of money, (P) is the price level, and (Y) is output.
  • If you look at the percentage change of this relationship and assume that money velocity (V) and output (Y) are fixed, you get:
    % change in the money supply (M) = % change in the price level (P)
  • If the money supply increases 10 percent, prices will increase 10 percent. There is too much money chasing too few goods (remember we assumed the amount produced (Y) stayed the same).
• The supply of money is most often controlled by a country’s central bank.
  • There are episodes in history (and today) when the amount of money available was controlled more so by politicians than an independent central bank. In times of crisis, some of these countries started printing mass amounts of money, leading to extreme episodes of inflation called hyperinflation.
• In the short run the price level and inflation are determined by fluctuations in aggregate demand and short-run aggregate supply. This can result from either shocks or fiscal and monetary policy. 
  • When price fluctuations are minimal and inflation is fairly constant at a low rate (say around 2%), price stability has been obtained.

What are the costs of inflation?

• If your income does not rise at the same rate as inflation, you will not be able to purchase as many things as prices rise.
  • This is a real problem for those on fixed incomes such as retirees living off of their fixed pensions.
• The value of your savings is eroded.
  • The $100 you save today will not buy as much in the future once you take it out of savings.
• It causes uncertainty about future prices and thus complicates today’s economic decisions.

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