Inflation


Inflation is the rate of increase in prices for goods and services.

It is an indication of the rise in the general level of prices over time.

The rate of inflation is measured on the basis two indices—

[1] Wholesale Price Index (WPI) and [2] Consumer Price Index (CPI).

 

Formula for calculating Inflation=

         = Price level (current year) –Price level (previous year) / Price level (previous year) ×100

Inflation is measured ‘point-to-point’. It means that the reference dates for the annual inflation is January 1 to January 1 of two consecutive years (not for January 1 to December 31 of the concerned year).

 

Causes of Inflation—

Inflation occurs due to an imbalance between demand and supply of money, changes in production and distribution cost or increase in taxes on products.

When economy experiences inflation, the value of currency reduces.

[1] Demand-Pull Inflation—

Demand-pull inflation occurs when the price level is pulled up by an excess demand.

Either the demand increases over the same level of supply, or the supply decreases with the same level of demand and thus the situation of demand-pull inflation arise.

[2] Cost-Push Inflation—

An increase in factor input costs (i.e. wages and raw materials) pushes up prices. The price rise which is the result of increase in the production cost is cost-push inflation.

[3] Inflation is caused by an increase in the supply of money which leads to increase in aggregate demand.

[4] Increase in Disposable Income.

[5] Cheap monetary policy.

[6] Black money.

[7] Increase in exports.

[8] Increasing in public expenditure.

[9] Repayment of public debt.

 

Measures to check inflation—

[a] Inflation can be checked by controlling the supply of money.

[b] To check inflation government should put strict restrictions on the issue of money by the central bank.

[c] Central bank should pursue credit control policy. In order to control the credit it should increase the bank rate, raise minimum cash reserve ratio etc.

[d] Government should drastically scale down its non-essential expenditure.

[e] To control the over valuation of money it is essential to encourage imports and discourage exports.

[f] Increase in the production.

[g] Demonetize currency of higher denominations.

[h] Issue of new currency.

[i] Those goods which are in scarcity should be imported as much as possible from other countries and their export should be discouraged.

[j] Investment in those industries should be increased wherein more production of goods can be generated over a short period of time.

[k] Taxes should be raised.

[l] New taxes should be levied.

[m] Increase in savings.

 

Types of Inflation

Creeping Inflation—

This type of inflation takes place in a longer period and the range of increase is usually in ‘single digit’.

This type of inflation occurs when the price level persistently rises over a period of time at a mild rate.

Galloping Inflation—

Inflation in the double or triple digit range of 20, 100 or 200 percent a year is called galloping inflation.

Many Latin American countries such as Argentina, Brazil had inflation rates of 50 to 700 percent per year in the 1970s and 1980s.

 

Hyperinflation—

It is a stage of very high rate of inflation.

In such inflation not only range of increase is very large but the increase takes place in a very short span of time, prices shoot up overnight.

Hyperinflation occurs when the prices go out of control and the monetary authorities are unable to impose any check on it.

Germany had witnessed hyperinflation in 1920’s.

 

Some inflationary terms—

Inflationary Gap—

Inflationary gap is explained as the planned expenditure in excess of output available at full employment level.

Inflationary gap is when the aggregate demand exceeds the productive potential of the economy.

It causes only inflation, without increasing the level of output.

The inflationary gap generates only money income without creating matching real output because the economy is in full employment equilibrium.

Deflationary Gap—

If aggregate demand is for a level of output less than the full-employment level, then a situation of deficient demand exists.

Deficient demand gives rise to a ‘deflationary gap’, which causes the economy’s income, output and employment to decline, thus pushing the economy into under-employment equilibrium.

Inflation Tax—

By printing money instead of raising income or sales taxes, the government is taxing money holdings instead of income or sales.

If the supply of money increases then the value of existing money falls, so creating a type of tax on existing holders of money.

An important feature of the inflation tax is that people are taxed in proportion to the amount of money they hold.

Inflationary Spiral—

Inflationary spiral is a situation in which prices increase, then people are paid more in their jobs, which then causes the price of goods and services to increase again, and so on.

Reflation—

Reflation is the act of stimulating the economy by increasing the money supply or by reducing taxes, there by seeking to bring the economy back up to the long-term trend, following a dip in the business cycle.

Governments go for higher public expenditures, tax cuts, interest rate cuts, etc.

Deflation—

Deflation is a decrease in the general price level of goods and services.

It occurs when the inflation rate falls below 0%.

It increases the real value of money of a nation; this allows one to buy more goods with same amount of money.

Causes of Deflation— Shift in supply & demand curve, Reduction in money supply, Technological development, Increases in supply of goods & Decrease in supply of money.

Effects of Deflation— Decreasing nominal prices for goods & services, Increasing buying power of cash money, Decreased investment, Benefits recipient of fixed income.

Stagflation—

Stagflation is a situation in which inflation and unemployment exist together in the economy.

In this situation inflation rate is high, the economic growth rate slows down, & unemployment remains steadily high.

Effects of Stagflation— Reduction in the value of money, Increase in prices of goods, High Unemployment, Poor economic growth, Effect on fixed income group.

 

Effects of Inflation—

During periods of inflation, debtors gain and creditors lose. In other words, lenders suffer and borrowers benefit out of inflation.

Inflation leads to a fall in real incomes.

There is a negative impact of inflation on the purchasing power and living standard of the wage employees.

Salaried workers lose when there is inflation.

There is a negative impact of inflation on fixed income group.

Persons who hold shares or stocks of companies gain during inflation.

Investment in the economy is boosted by the inflation in the short-run.

Tax-payers suffer while paying their direct and indirect taxes.

With every inflation the currency of the economy loses its exchange value in front of a foreign currency.

Export increases during inflation.

Import decreases during inflation.

In the case of a developed economy, inflation makes trade balance favourable while for the developing economies inflation is unfavourable for their trade balance.

Inflation increases employment in the short-run but becomes neutral or even negative in the long run.