Disinflation & Deflation
Deflation is negative inflation rate whereas Disinflation is positive inflation rate but slow compared to previous period.
Let’s assume your cycle wheel rotation rate is inflation rate. Wheel is moving at 10 rotation per minute, in 1st minute. In 2nd minute it is moving at 20 rotation per minute.
Inflation rate = 20 rpm – 10 rpm / 10 rpm * 100 = 100% inflation.
Now in 3rd minute wheel rotation is 25 rotation per minute.
Inflation rate = 25 rpm – 20 rpm / 20 rpm * 100 = 25% inflation.
This 100% to 25% drop is our disinflation. Inflation is positive but rate is slow.
In 4th minute wheel rotation is 20 rotation per minute.
Inflation rate = 20 rpm – 25 rpm / 25 rpm * 100 = -20% inflation.
This negative rate of inflation is our Deflation.
What is Deflation and Disinflation in real economy ?
First we pick up any govt. index say CPI or WPI.
We compare point-to-point two value of index. Say index value of june 15 and june 14.
Then we calculate the inflation rate: june 15 – june 14 / june 14 * 100
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.
Let us see how inflation occurs.
Consider situation 0, in which demand and supply matched (Full employment equilibrium)
Now extra money enters or more expenditure by govt starts.
This extra money create more demand.
Till the time, Factor of Production do not multiply or increase, the existing factor of production have to work more and more to fulfill this demand. Resources are now being utilized more and over capacity, labor are working more, to fulfill this new demand, more operational cost for businesses etc.
Let’s say this extra supply meet this increased demand at situation 1(Above full employment equilibrium).
At situation 0 = Demand (0) and supply (0) Full employment equilibrium.
At situation 1 = Demand (1) and supply (1) Above full employment equilibrium.
If demand and supply already matched, why the hell, is inflation going to appear ?
Inflation will appear as this increased short-term supply by over utilized resources won’t continue for long. Consider this, labor earlier working for 8 hours, now have to work overtime. This will create demand for more wage & bring down our short-term increased supply. Thus demand remain high and supply can’t keep up with it. The result is inflation.
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 it’s 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.
When will this situation cease to exist ?
These condition will stop, when there will be more aggregate demand. Or, by reducing the aggregate supply. But lowering supply would settle the economy at low production level, hence is not suitable. Whereas decreased savings and increasing investment will provide a chance to take economy back to full employment production level, given deflation spiral is broken.
Consumer Price Index
CPI or Consumer Price index is a general price level index prepared by taking price of commodities paid by consumers in retail market. This Price index tells inflation effect direct on consumers. Whereas WPI price quotations are taken from wholesale market, one level before CPI’s retail market quotations.
Why different CPI are released by authority ?
As stated above, CPI objective is to fathom inflation effect on consumer, but different consumer consume different set of commodities. Example: An agricultural laborer will spend almost 70% of his wage on his food necessity. Whereas it is not same for urban non manual laborer.
Due to these different consumption pattern, & to assess effect of inflation in realistic manner, Govt release different CPI numbers.
Different type of CPI:
CPI numbers are released for all states, UT and all India, with CPI (Rural) & CPI (Urban) for each.
The consumption pattern of consumer is taken from National Sample Survey 68th round of consumer expenditure survey. NSS employee move from home to home, shop to shop and ask people about their consumption choice. The broad pattern becomes part of consumer expenditure survey.
Components of CPI:
Food, Beverages & Tobacco (Highest weight)
Fuel & Light
Clothing, bedding & Footwear
Housing (0% weight in rural CPI)
Miscellaneous (Education, transport etc)
Base year: 2012 for both rural and urban.
Old CPI’s:
A) BY Labor bureau, Ministry of Labor
- CPI IW (Industrial Worker):
-This CPI mainly focus on 78 centres across India, and an overall CPI for all India
-Mainly focus on workers of Mines, plantation, factories etc worker and not bankers and vodafone employee which fall under different CPI
– Help looking at inflation consequences to these workers and decide new wage by increasing the dearness allowance
– Base year = 2001 = 100
- CPI AL (Agricultural laborer)
– Help assess inflation consequence on Agricultural laborer, & decide minimum wage
– Base year = 1986-87 = 100
- CPI Rural laborer:
– Mostly same as Rural laborer
B) By Central Statistical Organisation:
- CPI UNME (Urban Non manual employee)
Inflation consequence on Vodafone employee, bankers
Base year = 1984-85 = 100
For 59 urban centres and all India
Phillips curve and Stagflation
Alban William Phillips, professor at London School of Economics, observed and mentioned in his paper “The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957”, that various economies between this period followed a pattern.
He observed that whenever government expenditure increased, which means higher inflation, turned unemployment number short.
Writing it in simple terms, whenever more and more money entered economy, this new money (Being source of Inflation) helped decreasing unemployment (i.e more and more people got employed in economic activities thus generated)
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 wasn’t 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
