Wednesday 29 December 2010

Economics : Inflation

It’s the persistent increase in general price level, while deflation is the persistent decrease in general price level. The followings are not included as inflation:
1)       Temporary rise in price level (e.g. during Festival, weather)
2)       Once-and-for-all (only one time) rise in general price level (e.g. imposes of tax)
3)       Persistent rise in the price of a single good
Inflation or deflation rate = %ΔPI = (PI2-PI1)/PI1 * 100%
Nominal value (money value) is the value (in terms of money) in the period. Larger general price level implies smaller purchasing power per unit of nominal value.
Real value implies the value in terms on money in the base period. It implies purchasing power directly. Real and nominal values are related by:
Real value = Nominal value in a specified period/PI in that period * 100
Nominal interest rate (n) is the rate of change in nominal value of an asset over a specified period of time. Real interest rate (r) is the rate of change in real value of an asset over a specified period of time. The inflation rate (i) is given by: i = n – r.
Usually the inflation rate in future is unknown at present, so there will be a n expected real interest rate (re) : re = n – ie, where ie is the expected inflation rate.
Also, the actual real interest rate ra can be given by ra = n - ia where ia is the actual inflation rate.
When the actual change in price level differs from expected, there will be a redistributive effect between providers and recipients of fixed future payments.
-          Anticipated change in price level is expected (correctly).
-           Unanticipated change in price level is unexpected or expected incorrectly.
-           Under inflation, providers of fixed future payments (borrower) gain while the recipients (lender) lose. It’s because the interest rate of fixed future payment is bonded by expected inflation rate. When unanticipated inflation exist, the value of returning sum is less than expected in real terms (ia > ie, ra = n - ia < n - ie = re).
-           Oppositely, under deflation, providers of fixed future payments (borrower) lose while the recipients (lender) gain.

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