Macroeconomics
Lecture : Inflation &
Money
10/01/2024 Inflation & Money 1
• Inflation rate in India is measured by the changes in wholesale price
index (WPI)
• The WPI is based on the wholesale prices of 697 items ranging from
How is agricultural commodities to manufactured products.
• Note here that the WPI does not track the price of services,
inflation which is increasingly the major part of India’s value added in
GDP. However, since services constitute an important input for
manufacturing and agricultural products, it is arguable that the
measured in price of services gets indirectly reflected in the WPI.
India • Monthly inflation rate is calculated by comparing the index number
of a certain month with the index number of the same month of a
year ago.
• WPI is available weekly and that’s why it is more commonly used.
Consumer Price Index (CPI) can also be used for calculating inflation.
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Composition of WPI
Major Group/ Group Weights No. of Items
2004-05 2011-12 2004-05 2011-12
ALL COMMODITIES 100 100 676 697
PRIMARY ARTICLES 20.118 22.62 102 117
FUEL&POWER 14.910 13.15 19 16
MANUFACTURED
64.972 64.23 555 564
PRODUCTS
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Consumer Price Index
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CPI
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All India year-on-year inflation rates (%) based on CPI (General) and CFPI: July 2024
over July 2023
July 2024 (Prov.) June 2024 (Final) July 2023
Rural Urban Combd. Rural Urban Combd. Rural Urban Comb
d.
Inflation CPI 4.10 2.98 3.54 5.66 4.39 5.08 7.63 7.20 7.44
(General)
CFPI 5.89 4.63 5.42 9.15 9.6 9.36 11.04 12.37 11.51
Index CPI 195.3 190.2 192.9 192.2 187.8 190.2 187.6 184.7 186.3
(General)
CFPI 201.3 210 204.3 195.6 204.3 198.7 190.1 200.7 193.8
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Monthly changes (%) in All India CPI (General) and CFPI: July 2024 over June 2024
Indices July 2024 (Prov.) June 2024 (Final) Monthly change (%)
Rural Urban Combd. Rural Urban Combd. Rural Urban Comb
d.
CPI 195.3 190.2 192.9 192.2 187.8 190.2 1.6 1.3 1.4
(General)
CFPI 201.3 210 204.3 195.6 204.3 198.7 2.9 2.8 2.8
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How do the inflation
measures using CPI
and WPI compare?
• CPI and WPI may not be directly
comparable as the base year,
weightage of the products and the
commodity tracked are different
• Inflation based on CPI used to show
some upward bias, but this seems to
have changed in recent times
• In some periods the CPI and WPI
based inflation do not converge
• Salaries are indexed to the CPI(IW)s
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In India, there is also State level Variation
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Problems Substitution bias:
The CPI uses fixed weights, so it cannot reflect
consumers’ ability to substitute toward goods whose
with the relative prices have fallen.
calculation Introduction of new goods:
The introduction of new goods makes consumers better
off and, in effect, increases the real value of the rupee
of inflation But it does not reduce the CPI because the CPI uses fixed
weights.
using Unmeasured changes in quality:
indices Quality improvements increase the value of the
rupee but are often not fully measured.
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Contrasting the CPI and GDP Deflator
Imported consumer goods:
• included in CPI
• excluded from GDP deflator
Capital goods:
excluded from CPI
included in GDP deflator
The basket:
(if produced domestically)
CPI uses fixed basket
GDP deflator uses basket of
currently produced goods & services
This matters if different prices are
changing by different amounts.
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India
CPI, WPI and GDP Deflator (Base year 2011-12)
200
180
160
140
120
100
80
60
40
CPI WPI GDP Deflator
Source: World Bank (World Development Indicators-https://databank.worldbank.org/source/world-
development-indicators#)
Inflation using WPI, CPI and GDP deflator
Inflation Rate
15
10
5
0
-5
2011
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2012
2013
2014
2015
2016
2017
2018
2019
2020
2021
2022
2023
Year
Inflation Rate based on CPI Inflation Rate based on WPI
Inflation rate based on GDP Deflator
10/01/2024 Inflation & Money 16
Headline Inflation
and Core Inflation
• Now headline is based on CPI©
• Core inflation is calculated using CPI-C but
excluding food and energy products.
• “… food and energy prices tend to be quite
volatile, so that, looking forward core inflation
(which excludes food and energy prices) may
be a better gauge than overall (headline)
inflation of underlying inflation trends”.
• Core inflation is more easily managed by
monetary and fiscal policies
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Demand Pull Inflation: increases in the price level caused by an excess of
total spending beyond the economy’s capacity to produce
Cost Push inflation: increases in the price level resulting from an increase in
resource costs and hence per unit cost.
For example, if petroleum prices increase and if people think that the increase
Types of is permanent, then everybody will incorporate that increased price in their
cost of production/wage expectations. This is lead to a price rise lead by cost
push.
Inflation
Structural Inflation: If there are capacity mismatch between sectors. More
typical in a developing country. Structural inflation is less likely in an open
trade regime.
Inflation can happen because of one or many of these factors. Important for
policymakers to understand the dynamics of inflation.
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Demand-Pull Inflation
• Demand-pull inflation occurs when aggregate demand for goods
and services in an economy rises more rapidly than an economy's
productive capacity.
• One potential shock to aggregate demand might come from a
central bank that rapidly increases the supply of money. This
leads to a situation when “too much money is chasing too few
goods”
• Possible Sources of Demand-Pull Inflation
• High fiscal deficit by a government can also lead to high demand • High economic growth when demand
and if the output/supply does not adjust quickly, there can be a growth can outpace supply growth
possibility of a demand pull inflation in such cases. • Surge in Exports
• High Government Spending
• Expectation of high inflation
• Exorbitant supply of money
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10/01/2024 Inflation & Money
Cost-Push Inflation
• Cost-push inflation means prices have been "pushed up" by increases
in the costs of any of the factors of production—labor, capital, land,
etc.
• The price of raw materials may also cause an increase in costs. This
may occur because of a scarcity of raw materials, an increase in the
cost of labor to produce the raw materials, or an increase in the cost of
importing raw materials.
• The government may also increase taxes to cover higher fuel and
energy costs, forcing companies to allocate more resources to paying
taxes.
• In order to compensate, the increase in costs is passed on to
consumers, causing a rise in the general price level causing inflation.
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Expectations and Inflation
• Expectations also play a key role in determining inflation.
• If people or firms anticipate higher prices, they build these expectations into wage
negotiations and contractual price adjustments (such as automatic rent increases).
• This behavior partly determines the next period’s inflation; once the contracts are
exercised and wages or prices rise as agreed, expectations become self-fulfilling.
• And to the extent that people base their expectations on the recent past, inflation would
follow similar patterns over time, resulting in inflation inertia.
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Policies to Manage Inflation
• In textbooks, inflation generally is assumed to driven by
demand and expectations
• Managing inflation and price stability is largely the role of the
Monetary Policy authority in a country
• The government of a country provides guidelines/parameters
within which the central bank of the country operates.
• The central bank will deploy various monetary policy tools to
control inflation
• Managing inflation expectations through guidance is an
important monetary policy tool
• However, monetary policy authority is not equipped to handle
a pure cost-push inflation. Other policies are needed to
deployed to manage such inflations.
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• Generally, the policy response to a demand-pull inflation
should be very different from a cost-push inflation
• While a demand-pull inflation will warrant contractionary
policies by the government, such policies may be counter-
productive for a cost-push inflation
• But Central Banks still raise interest rates to counter any type
Policy Response to demand pull of inflation, as a cost-push inflation may also include demand
side repercussions
and cost push inflation… • Workers have indexed wages. So, a demand-pull or a cost-push inflation
increases the wage bill and therefore leads to further inflationary pressures
• A supply shock may create major demand supply imbalance and this may
further add to the inflationary pressures unless the demand side is
controlled.
• In many cases both demand pull and cost push types of inflation work in
tandem.
• Central Bank policies also can be seen as signals for managing
inflation expectations
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•US central bank kicks off easing cycle
•Fed's policy rate lowered to 4.75%-5.00% range
•Policymakers see another 50 basis points of cuts in 2024
•Fed Governor Bowman dissents; preferred smaller cut
https://www.reuters.com/markets/rates-bonds/with-feds-rate-
cut-hand-debate-swirls-over-how-big-move-2024-09-18/
US inflation has tumbled from a peak of 9.1 per cent in
mid-2022 to a three-year low of 2.5 per cent in August, not
far above the US Fed’s two per cent target. With inflation
barely above their target level, US Fed officials have been
shifting their focus toward supporting a weakening job
market and achieving a rare “soft landing," which curbs
inflation without causing a sharp recession.
US Fed Meet Live: Expect RBI to cut repo rate in
policy meeting next month: Wallfort Financial
Services
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Inflation Expectations and Forward Guidance by the Central Bank (RBI in India)
RBI announces launch of 'inflation expectations' and 'consumer
confidence' surveys for monetary policy inputs
The RBI has launched two new surveys, the 'Inflation Expectations Survey of
Households' and the 'Consumer Confidence Survey,' ahead of its June monetary
policy review. These surveys will gather insights crucial for monetary policy
decisions. The 'Inflation Expectations Survey' will collect data on price changes and
inflation expectations from households in 19 cities. Meanwhile, the 'Consumer
Confidence Survey' will gather views on the general economic situation,
employment, prices, income, and s ..
Read more at: Last Updated: Apr 29, 2024, 07:07:00 PM IST
https://economictimes.indiatimes.com/news/economy/policy/rbi-announces-launch-
of-inflation-expectations-and-consumer-confidence-surveys-for-monetary-policy-
inputs/articleshow/109698758.cms?utm_source=contentofinterest&utm_medium=te
xt&utm_campaign=cppst
10/01/2024 INFLATION & MONEY 25
Inflation expectation
• The Reserve Bank's survey indicated Indian households' growing
concerns about inflation, predicting higher rates across all measured
periods. The survey noted an increase in the number of respondents
who expect price rises, particularly in food and services. Persistently
high food inflation since November 2023 has influenced these
expectations.
Read more at:
https://economictimes.indiatimes.com/news/economy/indicators/ho
useholds-expect-inflation-to-edge-up-rbi-
survey/articleshow/112381747.cms?utm_source=contentofinterest&
utm_medium=text&utm_campaign=cppst
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What does RBI target?
• In India, the amended RBI Act defines the metric for the inflation
target as the year-on-year change in the monthly consumer price
index (CPI).
• The numerical inflation target has been set by the government at
four per cent, with an upper tolerance level of 6 per cent and a
lower tolerance level of 2 per cent, internalising flexibility.
• The amended RBI Act has also specified accountability norms for
dealing with failure to achieve the inflation target while building in
recognition of the lags inherent in the conduct of monetary policy.
• It defines failure as average inflation breaching the tolerance band
for three consecutive quarters, not instantly. Although concerns
about inflation had dominated monetary policy over the past
decades in deference to a societal intolerance threshold, such an
explicit commitment to a numerical inflation target as the centre-
piece of policy had never been made.
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Why it makes sense for food prices to be cut out of
RBI's inflation target
Monetary policy cannot fix supply-side problems. It is
meant to address short-term problems with aggregate
demand. But food prices in India respond to various
rigidities in the economy that are all about the supply side
problems.
The argument against change is equally simple: As long
as food prices affect Indians’ expectations of future
inflation, they can’t be excluded from the RBI’s calculus.
This is essentially what the central bank governor insisted
last week. He worries that the RBI’s credibility depends on
responding to the overall price level, not just to core
inflation.
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Readings : Moving towards monetary
policy
• Chapter 2 and Chapter 5 of your textbook
• Suggested readings on inflation will beuploaded
• Inflation Targeting – by Sarwat Jahan
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Some Basics of Money
Chp: 4.1
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Money: Definition
• Money is the stock of assets that can be readily used to make
transactions.
What are the roles of ‘Money’?
• Medium of Exchange- something that people can use to buy and sell
from one another.
• As a medium of exchange, money is what people use to buy goods
and services.
• When you walk into stores, you are confident that the shopkeepers
will accept your money in exchange for the items they are selling.
• The ease with which an asset can be converted into the medium of
exchange and used to buy other things (goods, services, or capital
assets) is called the asset’s liquidity.
• Because money is the medium of exchange, it is the economy’s most
liquid asset.
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What are the roles of ‘Money’?
10/01/2024 Inflation & Money
What are
the roles of
‘Money’?
10/01/2024 Inflation & Money
To Summarize…
• To put it a different way, money is something
that holds its value over time, can be easily
translated into prices, and is widely accepted.
• Many different things have been used as money
over the years—among them, cowry shells,
barley, peppercorns, gold, and silver.
10/01/2024 Inflation & Money
What are these things salt, cheese
and cocoa have in common?
• First, they are edible. Second, they have been used as currencies over hundreds
of years, high valued.
• Salt was a medium for trade throughout East Africa in the Middle Ages. The
Aztecs used cocoa beans (which were thought to be more precious than gold).
In Italy, bank Credito Emiliano has allowed parmigiana cheese (one wheel is
worth roughly US$350) to be used as collateral since 1953.
• In China, Tibet and Mongolia, people used tea bricks, which continued to
function as a currency in parts of Siberia up until WW2. Some would choose tea
over coins!
• The same goes for cheese, coffee beans, and even gold. These objects used as
currencies are unchanged, but we change the value attached to them.
https://www.forbes.com/sites/peterpham/2017/11/20/what-is-money/#e6d5b1516ea5
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NOW YOU TRY Discussion question
• Which of these are money?
a. Currency
b. Checks
c. Deposits in checking accounts (“demand deposits”)
d. Credit cards
e. Fixed deposits (“time deposits”)
Money: Examples, part 1
• Deposits in checking accounts (“demand deposits”)
• Yes, the funds in a checking account serve the three purposes
• Checks
• The check itself is not money, but the funds in the checking account are
money
• Currency
• Yes; U.S. dollar bills, Mexican pesos, INR and other currencies are all
money
Money: Examples, part 2
• Fixed deposits (“time deposits”),
• Depends on the length of time; they are a store of value and are measured
in money units (dollars, for example) but are not easily spent (medium of
exchange)
• Credit cards
• No, they are a means of deferred payment
• For credit card purchases, you agree to pay back your credit card
company in the future
Types of Money
• Although money can take an extraordinary variety of forms, there
are really only two types of money:
• money that has intrinsic value and
• money that does not have intrinsic value.
• Commodity money is money that has value apart from its use
as money. Gold and silver are the most widely used forms of
commodity money. Gold and silver can be used as jewelry and for
some industrial and medicinal purposes, so they have value apart
from their use as money.
• Fiat money is money that some authority, generally a
government, has ordered to be accepted as a medium of exchange.
The currency—paper money and coins—used in India today is fiat
money; it has no value other than its use as money. You will notice
that statement printed on each bill: “I promise to pay the bearer a
sum of …rupees.”
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https://en.wikipedia.org/wiki/Fiat_money#China
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Pre-gold standard
• Gold, silver and copper coins were used for national and long-distance commerce and the value of the coins varied based
on the weight of the coins.
• Prices of goods and services were expressed in terms of weights of these metals and these precious metals were
accepted across nations as a mode of payment, therefore, explicit exchange rates were not required.
• This is called specie commodity standard, in which metals-predominantly –gold, silver and copper- made up for the bulk
of the circulating media of the economy.
• Various types of currency systems were prevalent. USA was on bimetallic (silver-gold) standard. India was on silver-
copper standard etc.
• There were two types of coins:
• Full bodied coins: monetary value of which equaled the value of coins
• Debased coins- Sovereigns sometimes reduced the gold (or silver) content of the coins they minted. Coin
debasement is predecessor of the modern devaluation
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Pre-gold standard
• There were two types of coins:
• Full bodied coins: monetary value of which equalled
the value of coins
• Debased coins: Sovereigns sometimes reduced the gold
(or silver) content of the coins they minted. Coin
debasement is predecessor of the modern devaluation
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The notion that overvalued money
drives undervalue money out of
circulation when they bear the same
face value is popularly expressed as
“bad money drives out good”
This is known as the Gresham’s law.
What happens if the same
nominal value is assigned to
debased and full-bodied coins?
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The ‘Gold Standard’
• Chemically, gold is of all major metals the one most
resistant to corrosion
• For centuries, currencies were tethered to the ‘gold
standard’, meaning the value of banknotes depended on
government gold reserves, and each can be swapped for
the other. For example, if you have $1,000, you can bring
that to the U.S. Federal Reserve and receive an ounce of
gold in exchange.
• However, countries began abandoning the use of gold
standard to value their currencies. Britain had done so in
1931, and U.S. followed shortly after. That’s because gold is
scarce, and as demand of rapidly growing economies
swells, supply couldn’t catch up.
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• Under the gold standard system, countries fixed the value of their
currencies in terms of a specific amount of gold.
Introduction
of Gold • The government or the central bank ensured complete two-way
convertibility between money and gold. That means that the
Standard central bank would freely exchange money to gold at the specified
rate and vice versa.
(1870–1914) • To ensure this convertibility, the amount of money issued by the
central bank was tied to the amount of gold in its reserve.
• Given that each currency was tied to a specific amount of gold,
bilateral exchange rates were automatically fixed.
• For example, if Britain fixes the value of pound to £10 per ounce of
gold and USA fixes the value of dollar to $20 per ounce of gold,
them the bilateral dollar to pound exchange rate is fixed as $2/£.
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Gold Standard…contd.
• The gold standard was a promise. If you had a
dollar, you could take it to the government any
time you want, and trade it in for a fixed amount of
gold. In the U.S. year after year, $20.67 got you an
ounce of gold. 1 ounce of gold would give you 4.24
GBP
• In the early part of the 20th century, all the world's
key economies were on the gold standard.
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• The biggest shortcoming of gold standard turned out to be the
requirement that money created by the central bank must be
backed by gold reserves.
• As the gold supply did not grow adequately in the global economy,
this restriction prevented the central banks to use monetary policy
Breakdown of
effectively when the situation demanded.
the Gold • Eventually this constraint led to the demise of the gold standard.
Standard • During the onset of the World War 1, as demand to finance war
expenditures grew, countries suspended the two-way
convertibility between money and gold and went off gold
standard.
• Only USA continued with gold standard, but as other important
currencies moved away from a gold peg, dollar in effect was
floating against these countries.
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Demise of the Gold
Standard
• With the eruption of WWI in 1914, the gold standard was suspended.
• The interwar years were marked by severe economic instability.
• Governments started to finance war expenditure by printing money
• Same was done with the reconstruction process
• Along with other factors, this led to episodes of hyperinflation in
Europe.
• There was a brief return to Gold Standards, but it was abandoned again
just around the great depression.
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Features of the Bretton Woods System…1
Exchange Rates as a tool of global governance
The essential characteristic of what may be called the Bretton Woods order was that exchange rate relationships, rather than
being within the domain of domestic economic policy, were to be governed by a set of internationally agreed rules.
• A system of adjustable peg was established
• This was a gold exchange standard where most currencies were
pegged into dollar and the dollar was pegged into gold
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• The Bretton Woods system collapsed in 1973 because
central banks were unwilling to continue to buy over-
valued dollar denominated assets and to sell
undervalued foreign currency denominated assets.
Collapse of the • In 1973, central banks thought they would
temporarily stop trading in the foreign exchange
Bretton Woods market, and would let exchange rates adjust to
supply and demand, and then would reimpose fixed
exchange rates soon.
• But no new global system of fixed rates was started
again.
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Crypto Assets as an alternative to fiat money?
• “Bitcoin is an open-source, peer-to-peer digital currency” that relies
on “the world’s first completely decentralized digital-payments
system. Until Bitcoin’s invention in 2008 by the unidentified
programmer known as Satoshi Nakamoto, online transactions always
required a trusted third-party intermediary,” like Visa/MasterCard or
PayPal.
• Rather than relying on that third party, “every transaction that occurs
in the Bitcoin economy is registered in a public, distributed ledger,
which is called the block chain.
• New transactions are checked against the block chain to ensure that
the same Bitcoins haven’t been previously spent, thus eliminating the In Bitcoin, we now seem to have a new form of currency
double-spending problem.
that rivals fiat money as we move full speed into the age
of technology. Unlike its predecessor currencies, it is not
backed by a physical commodity (gold) or any government
• The global peer-to-peer network, composed of thousands of users,
or bank. It transcends borders and allows for complete
takes the place of an intermediary.” So, the term Bitcoin is used to
refer to both the virtual currency as well as the decentralized anonymity. Transactions are cheap to execute and it is
payments network, and “the dollar value of a Bitcoin is determined on quickly and easily transferred around the world.
an open market, just as is the exchange rate between different world
currencies.”
https://www.huffingtonpost.com/entry/bitcoin-future-global-currency_us_5936ea49e4b0c670a3ce68d9
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http://www.imf.org/external/pubs/ft/fandd/2018/06/central-bank-monetary-policy-and-cryptocurrencies/he.htm
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