DEFINITION of 'Inflation'

Inflation is the rate at which the general level of prices for goods and services is rising and, consequently,
the purchasing power of currency is falling. Central banks attempt to limit inflation, and avoid deflation, in order
to keep the economy running smoothly.

nflation means a sustained increase in the general price level. However, this increase in the cost of living
can be caused by different factors. The main two types of inflation are
1.

Demand pull inflation this occurs when the economy grows quickly and starts to overheat
Aggregate demand (AD) will be increasing faster than aggregate supply (LRAS).

2.

Cost push inflation this occurs when there is a rise in the price of raw materials, higher taxes,
e.t.c

1. Demand Pull Inflation

This occurs when AD increases at a faster rate than AS. Demand pull inflation will typically occur when
the economy is growing faster than the long run trend rate of growth. If demand exceeds supply, firms will
respond by pushing up prices.
Simple diagram showing demand pull inflation

2. Cost Push Inflation

This occurs when there is an increase in the cost of production for firms causing aggregate supply to shift
to the left. Cost push inflation could be caused by rising energy and commodity prices. See: Cost Push
inflation
3. Wage Push Inflation
Rising wages tend to cause inflation. In effect this is a combination of demand pull and cost push inflation.
Rising wages increase cost for firms and so these are passed onto consumers in the form of higher
prices. Also rising wages give consumers greater disposable income and therefore cause increased
consumption and AD. In the 1970s, trades unions were powerful in the UK. This helped cause rising
nominal wages; this was a significant factor in causing inflation.
4. Imported Inflation.
A depreciation in the exchange rate will make imports more expensive. Therefore, the prices will increase
solely due to this exchange rate effect. A depreciation will also make exports more competitive so will
increase demand.

5. Temporary Factors.
The inflation rate can also increase due to temporary factors such as increasing indirect taxes. If you
increase VAT rate from 17.5% to 20%, all goods which are VAT applicable will be 2.5% more expensive.
However, this price rise will only last a year. It is not a permanent effect.
Inflation is the devastating condition when prices just keep going up, eating away at yourstandard of living.
There are three main causes: demand-pull, cost-push, and monetary expansion.

Demand-Pull Inflation
Demand-pull inflation is the most common. It's simply whendemand for a good or service increases so much
that it outstrips supply. If sellers maintain the price, they will sell out. They soon realize now have the luxury of
raising prices, creating inflation.
Many circumstances can lead to demand-pull inflation. A growing economy can create some inflation as
people feel confident about the future and spend more. As long as inflation stays within limits, this could
actually benefit economic growth. That's because it creates an expectation of inflation, which can contribute
to further demand-pull inflation. As people expect further inflation, they make their purchases sooner to avoid
further price increases. The Federal Reserve has set aninflation target to manage the public's expectation of
inflation. The inflation target is currently set at 2%, as measured by the core inflation rate.
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Cost push inflation can be caused by many factors

1. Rising wages
If trades unions can present a common front then they can bargain for higher wages. Rising wages are a key
cause of cost push inflation because wages are the most significant cost for many firms. (higher wages may
also contribute to rising demand)
2. Import prices
One third of all goods are imported in the UK. If there is a devaluation then import prices will become more
expensive leading to an increase in inflation. A devaluation / depreciation means the Pound is worth less,
therefore we have to pay more to buy the same imported goods.

In 2011/12, the UK experienced a rise in cost-push inflation, partly due to the depreciation in the Pound
against the Euro. (also due to higher taxes)
3. Raw Material Prices

The best example is the price of oil, if the oil price increase by 20% then this will have a significant impact
on most goods in the economy and this will lead to cost push inflation. E.g. in early 2008, there was a
spike in the price of oil to over $150 causing a temporary rise in inflation.
4.

Profit Push Inflation

When firms push up prices to get higher rates of inflation. This is more likely to occur during strong
economic growth.
5. Declining productivity
If firms become less productive and allow costs to rise, this invariably leads to higher prices.
6. Higher taxes
If the government put up taxes, such as VAT and Excise duty, this will lead to higher prices, and therefore
CPI will increase. However, these tax rises are likely to be one-off increases. There is even a measure of
inflation (CPI-CT) which ignores the effect of temporary tax rises/decreases.
CPI-CT is less volatile because it ignores the effect of taxes. In 2010, some of the UK CPI inflation was
due to rising taxes.

What else could cause inflation?

Rising house prices
Rising house prices do not directly cause inflation, but they can cause a positive wealth effect and
encourage consumer led economic growth. This can indirectly cause demand pull inflation
Printing more money
If the Central Bank prints more money, you would expect to see a rise in inflation. This is because the
money supply plays an important role in determining prices. If there is more money chasing the same
amount of goods, then prices will rise. Hyperinflation is usually caused by an extreme increase in the
money supply
However, in exceptional circumstances such as liquidity trap / recession, it is possible to increase the
money supply without causing inflation. This is because in recession, an increase in the money supply
may just be saved, e.g. banks dont increase lending but just keep more bank reserves.

Controlling Inflation: 3 Important Measures

to Control Inflation
Some of the important measures to control inflation are as follows: 1. Monetary Measures 2.
Fiscal Measures 3. Other Measures.
Inflation is caused by the failure of aggregate supply to equal the increase in aggregate
demand. Inflation can, therefore, be controlled by increasing the supplies of goods and services
and reducing money incomes in order to control aggregate demand.
The various methods are usually grouped under three heads: monetary measures, fiscal
measures and other measures.
1. Monetary Measures:
Monetary measures aim at reducing money incomes.

(a) Credit Control:

One of the important monetary measures is monetary policy. The central bank of the country
adopts a number of methods to control the quantity and quality of credit. For this purpose, it
raises the bank rates, sells securities in the open market, raises the reserve ratio, and adopts a
number of selective credit control measures, such as raising margin requirements and
regulating consumer credit. Monetary policy may not be effective in controlling inflation, if
inflation is due to cost-push factors. Monetary policy can only be helpful in controlling inflation
due to demand-pull factors.

(b) Demonetisation of Currency:

However, one of the monetary measures is to demonetise currency of higher denominations.
Such a measures is usually adopted when there is abundance of black money in the country.

(c) Issue of New Currency:

The most extreme monetary measure is the issue of new currency in place of the old currency.
Under this system, one new note is exchanged for a number of notes of the old currency. The
value of bank deposits is also fixed accordingly. Such a measure is adopted when there is an
excessive issue of notes and there is hyperinflation in the country. It is a very effective measure.
But is inequitable for its hurts the small depositors the most.
2. Fiscal Measures:
Monetary policy alone is incapable of controlling inflation. It should, therefore, be supplemented
by fiscal measures. Fiscal measures are highly effective for controlling government expenditure,
personal consumption expenditure, and private and public investment.
The principal fiscal measures are the following:

(a) Reduction in Unnecessary Expenditure:

The government should reduce unnecessary expenditure on non-development activities in order
to curb inflation. This will also put a check on private expenditure which is dependent upon
government demand for goods and services. But it is not easy to cut government expenditure.
Though this measure is always welcome but it becomes difficult to distinguish between essential
and non-essential expenditure. Therefore, this measure should be supplemented by taxation.

(b) Increase in Taxes:

To cut personal consumption expenditure, the rates of personal, corporate and commodity taxes
should be raised and even new taxes should be levied, but the rates of taxes should not be so
high as to discourage saving, investment and production. Rather, the tax system should provide
larger incentives to those who save, invest and produce more.
Further, to bring more revenue into the tax-net, the government should penalise the tax evaders
by imposing heavy fines. Such measures are bound to be effective in controlling inflation. To
increase the supply of goods within the country, the government should reduce import duties
and increase export duties.

(c) Increase in Savings:

Another measure is to increase savings on the part of the people. This will tend to reduce
disposable income with the people, and hence personal consumption expenditure. But due to
the rising cost of living, people are not in a position to save much voluntarily.
Keynes, therefore, advocated compulsory savings or what he called deferred payment where
the saver gets his money back after some years. For this purpose, the government should float
public loans carrying high rates of interest, start saving schemes with prize money, or lottery for
long periods, etc. It should also introduce compulsory provident fund, provident fund-cumpension schemes, etc. All such measures increase savings and are likely to be effective in
controlling inflation.

(d) Surplus Budgets:

An important measure is to adopt anti-inflationary budgetary policy. For this purpose, the
government should give up deficit financing and instead have surplus budgets. It means
collecting more in revenues and spending less.

(e) Public Debt:

At the same time, it should stop repayment of public debt and postpone it to some future date till
inflationary pressures are controlled within the economy. Instead, the government should borrow
more to reduce money supply with the public.
Like monetary measures, fiscal measures alone cannot help in controlling inflation. They should
be supplemented by monetary, non-monetary and non-fiscal measures.
3. Other Measures:
The other types of measures are those which aim at increasing aggregate supply and reducing
aggregate demand directly.

(a) To Increase Production:

The following measures should be adopted to increase production:
(i) One of the foremost measures to control inflation is to increase the production of essential
consumer goods like food, clothing, kerosene oil, sugar, vegetable oils, etc.
(ii) If there is need, raw materials for such products may be imported on preferential basis to
increase the production of essential commodities,
(iii) Efforts should also be made to increase productivity. For this purpose, industrial peace
should be maintained through agreements with trade unions, binding them not to resort to
strikes for some time,
(iv) The policy of rationalisation of industries should be adopted as a long-term measure.
Rationalisation increases productivity and production of industries through the use of brain,
brawn and bullion,
(v) All possible help in the form of latest technology, raw materials, financial help, subsidies, etc.
should be provided to different consumer goods sectors to increase production.

(b) Rational Wage Policy:

Another important measure is to adopt a rational wage and income policy. Under hyperinflation,
there is a wage-price spiral. To control this, the government should freeze wages, incomes,
profits, dividends, bonus, etc.
But such a drastic measure can only be adopted for a short period as it is likely to antagonise
both workers and industrialists. Therefore, the best course is to link increase in wages to
increase in productivity. This will have a dual effect. It will control wages and at the same time
increase productivity, and hence raise production of goods in the economy.

(c) Price Control:

Price control and rationing is another measure of direct control to check inflation. Price control
means fixing an upper limit for the prices of essential consumer goods. They are the maximum

prices fixed by law and anybody charging more than these prices is punished by law. But it is
difficult to administer price control.

(d) Rationing:
Rationing aims at distributing consumption of scarce goods so as to make them available to a
large number of consumers. It is applied to essential consumer goods such as wheat, rice,
sugar, kerosene oil, etc. It is meant to stabilise the prices of necessaries and assure distributive
justice. But it is very inconvenient for consumers because it leads to queues, artificial shortages,
corruption and black marketing. Keynes did not favour rationing for it involves a great deal of
waste, both of resources and of employment.
Conclusion:
From the various monetary, fiscal and other measures discussed above, it becomes clear that to
control inflation, the government should adopt all measures simultaneously. Inflation is like a
hydra- headed monster which should be fought by using all the weapons at the command of the
government.