INFLATION AND TRADE CYCLES

1) Define inflation. Explain its types.

Inflation refers to the rise in the prices of most goods and services of daily or common
use, such as food, clothing, housing, recreation, transport, consumer staples
etc. Inflation measures the average price change in a basket of commodities and
services over time.

The three types of Inflation are Demand-Pull, Cost-Push and Built-in inflation.

Demand-pull Inflation: It occurs when the demand for goods or services is higher
when compared to the production capacity. The difference between demand and
supply (shortage) result in price appreciation.

Cost-push Inflation: It occurs when the cost of production increases. Increase in prices
of the inputs (labour, raw materials, etc.) increases the price of the product. 

Built-in Inflation: Expectation of future inflations results in Built-in Inflation. A rise in

prices results in higher wages to afford the increased cost of living. Therefore, high
wages result in increased cost of production, which in turn has an impact on product
pricing. The circle hence continues. 

2) Write a short note on Demand-pull Inflation.

The term demand-pull inflation usually describes a widespread phenomenon. That is,
when consumer demand outpaces the available supply of many types of consumer goods,
demand-pull inflation sets in, forcing an overall increase in the cost of living.

Demand-pull inflation is a tenet of Keynesian economics that describes the effects of an

imbalance in aggregate supply and demand. When the aggregate demand in an economy
strongly outweighs the aggregate supply, prices go up. This is the most common cause
of inflation.

In Keynesian economic theory, an increase in employment leads to an increase

in aggregate demand for consumer goods. In response to the demand, companies hire
more people so that they can increase their output. The more people firms hire, the more
employment increases. Eventually, the demand for consumer goods outpaces the ability
of manufacturers to supply them.

3) Write a short note on Cost-pull Inflation.

In this case, the overall price level increases due to higher costs of production which
reflects in terms of increased prices of goods and commodities which majorly use these
inputs. This is inflation triggered from supply side i.e. because of less supply. The
opposite effect of this is called demand pull inflation where higher demand triggers
inflation.
Apart from rise in prices of inputs, there could be other factors leading to supply side
inflation such as natural disasters or depletion of natural resources, monopoly,
government regulation or taxation, change in exchange rates, etc. Generally, cost push
inflation may occur in case of an inelastic demand curve where the demand cannot be
easily adjusted according to rising prices.

4) What is Inflationary-gap?

An inflationary gap is a macroeconomic concept that measures the difference between the
current level of real gross domestic product (GDP) and the GDP that would exist if an
economy was operating at full employment.

5) What are the effects of Inflation? Explain the measures to control Inflation.

The following are the effects of Inflation-

a)  Effects on Distribution of Income and Wealth

b) Effects on Production 
c)  Effects on Income and Employment
d) Effects on Business and Trade
e) Effects on the Government Finance 
f) Effects on Growth.

a) Effects on Distribution of Income and Wealth:

The impact of inflation is felt unevenly by the different groups of individuals within the
national economy—some groups of people gain by making big fortune and some others
lose.

b) Effects on Production:

The rising prices stimulate the production of all goods—both of consumption and of
capital goods. As producers get more and more profit, they try to produce more and more
by utilising all the available resources at their disposal.
But, after the stage of full employment the production cannot increase as all the resources
are fully employed. Moreover, the producers and the farmers would increase their stock
in the expectation of a further rise in prices. As a result hoarding and cornering of
commodities will increase.
But such favourable effects of inflation upon production are not always found.
Sometimes, production may come to a standstill position despite rising prices, as was
found in recent years in developing countries like India, Thailand and Bangladesh. This
situation is described as stagflation.

c) Effects on Income and Employment

Inflation tends to increase the aggregate money income (i.e., national income) of the
community as a whole on account of larger spending and greater production. Similarly,
the volume of employment increases under the impact of increased production. But the
real income of the people fails to increase proportionately due to a fall in the purchasing
power of money.

d) Effects on Business and Trade

The aggregate volume of internal trade tends to increase during inflation due to higher
incomes, greater production and larger spending. But the export trade is likely to suffer on
account of a rise in the prices of domestic goods. However, the business firms expand
their businesses to make larger profits.
During most inflation since costs do not rise as fast as prices profits soar. But wages do
not increase proportionate with prices, causing hardships to workers and making more
and more inequality. As the old saying goes, during inflation prices move in escalator and
wages in stairs.

e) Effects on the Government Finance 

During inflation, the government revenue increases as it gets more revenue from income
tax, sales tax, excise duties, etc. Similarly, public expenditure increases as the
government is required to spend more and more for administrative and other purposes.
But the rising prices reduce the real burden of public debt because a fix sum has to be
paid in instalment per period.

f) Effects on Growth.

A mild inflation promotes economic growth, but a runaway inflation obstructs

economic growth as it raises cost of development projects. Although a mild dose of
inflation is inevitable and desirable in a developing economy, a high rate of inflation
tends to lower the growth rate by slowing down the rate of capital formation and creating
uncertainty.

Controlling inflation is an important part of RBIs functioning core. There are certain
measure that are employed by the Central bank to restrict inflation and control cash flow.
Here are a few of those methods. Repo rate is the percentage with which RBI (Reserve
Bank of India) lends money to commercial banks. The repo rate is very important in
terms of the monetary outflow from the government. The repo rate comes into play
usually when commercial banks are short of money and needs to lend from the RBI.
Another important instrument is the CRR (Cash Reserve Ratio) which is employed by the
RBI as the amount commercial banks need to keep with them by default. Reverse Repo
Rate is another consideration, as it is the rate at which commercial banks lend money to
the RBI. Here are the practical uses of all three of these banking terms.

Repo Rate

Whenever commercial banks face a shortage of funds, they can approach the RBI for a
loan. The repo rate is the rate at which it would be possible for commercial banks to
borrow money from the RBI. Repo rate is often used by the government as a tool for
inflation. Whenever the government wants to restrict the flow of money in the economy,
it can increase the repo rate as a deterrence for commercial banks to borrow money. Thus,
repo rate makes for a very important financial instrument that is reflexively used to
restrict the quantity of cash.

CRR (Cash Reserve Ratio)

CRR is another measure that excels in controlling the amount of money the commercial
banks are able to circulate into the economy. This is because CRR represents a certain
amount of money that commercial are by law stipulated to keep with the RBI. Inflation
can be directly controlled by the central government simply by means of increasing the
CRR rate and thereby restricting the ability of commercial banks to to lend money.

Reverse Repo Rate

Reverse Repo rate is the rate at which the RBI borrows from commercial banks. This is
part of a liquidity adjustment facility employed by central banks to resolve short term
cash shortages that an economy might end up facing. Reverse repo rate is usually set 1
percentile lower than the existing repo rate. This is also done in a bid to control inflation
as reverse repo rate helps RBI extract money from the economy when it feels like there is
excessive cash rolling about in the economy.

The Need to Control Inflation

When the quantity of money rises above a certain threshold, the increased buying power
of the consumer class can lead to a shortage of goods and services. This is because
capitalism, that thrives on the idea that infinite resources can be employed to satiate the
needs of a growing demographic is slightly flawed. This is what generates the need for
measures like the repo rate, CRR and the Reverse Repo Rate. They help restrict cash flow
and keep inflation in check. These measures help bring a certain balance to the whole
economic framework that the world laboriously functions under.
Central bank uses certain methods to inordinately function and maintain a level of
balance to the Indian economy. The aspects mentioned in this article are a few of those
methods that help keep the economy fresh and vibrant. This is because controlling
inflation is a highly critical step in the direction of conceiving a system that is financially
reaching equilibrium.

6) Write a short note on Philips curve.

The Phillips curve is an economic concept developed by A. W. Phillips stating that

inflation and unemployment have a stable and inverse relationship. The theory claims that
with economic growth comes inflation, which in turn should lead to more jobs and less
unemployment.

7) Define index numbers.

An index number is an economic data figure reflecting price or quantity compared with a

standard or base value. The base usually equals 100 and the index number is usually
expressed as 100 times the ratio to the base value.

8) Define the terms consumer price index and wholesale price index with suitable
examples.
Consumer price index: A comprehensive measure used for estimation of price changes in
a basket of goods and services representative of consumption expenditure in an economy
is called consumer price index. A USD/CAD rate of 1.25 means 1 US dollar is
equivalent to 1.25 Canadian dollars. The USD/CAD exchange rate is affected by
economic and political forces on both, and the price level of a basket of goods and
services.

Wholesale price index: WPI measures the changes in the prices of goods sold and traded
in bulk by wholesale businesses to other businesses. Primary articles is a major
component of WPI, further subdivided into Food Articles and Non-Food Articles.Food
Articles include items such as Cereals, Paddy, Wheat, Pulses, Vegetables, Fruits, Milk,
Eggs, Meat & Fish, etc.
Non-Food Articles include Oil Seeds, Minerals and Crude Petroleum.

9) What are trade cycles? Explain the phases with diagrams.

A trade cycle refers to fluctuations in economic activities specially in employment, output

and income, prices, profits etc. A full trade cycle has got four phases: (i) Recovery, (ii)
Boom, (iii) Recession, and (iv) depression. The upward phase of a trade cycle or
prosperity is divided into two stages—recovery and boom, and the downward phase of a
trade cycle is also divided into two stages—recession and depression.

a) Recovery:
In the early period of recovery, entrepreneurs increase the level of investment which in
turn increases employment and income. Employment increases purchasing power and this
leads to an increase in demand for consumer goods.
As a result, demand for goods will press upon their supply and it shall, thereby, lead to a
rise in prices. The demand for consumer’s goods shall encourage the demand for
producer’s goods.
The rise in prices shall depend upon the gestation period of investment. The longer the
period of investment, the higher shall be the price rise. The rise of prices shall bring about
a change in the distribution of income. Rent, wages, interest do not rise in the same
proportion as prices.
Consequently, the margin of profit improves. The wholesale prices rise more than retail
prices. The prices of raw materials rise more than the prices of semi-finished goods and
the prices of semi-finished goods use more than the prices of finished goods.

b)   Boom:
The rate of investment increases still further. Owing to the spread of a wave of optimism
in business, the level of production increases and the boom gathers momentum. More
investment is possible only through credit creation. During a period of boom, the
economy surpasses the level of full employment and enters a stage of over full
employment.

c)  Recession:
The orders for raw materials are reduced on the onset of a recession. The rate of
investment in producers’ goods industries and housing construction declines. Liquidity
preference rises in society and owing to a contraction of money supply, the prices falls. A
wave of pessimism spreads in business and those markets which were sometime before
sellers markets become buyer’s markets now.

d)  Depression:
The main feature of a depression is a general fall in economic activity. Production,
employment and income decline. The prices fall and the main factor responsible for it is,
a fall in the purchasing power.

The distribution of national income changes. As the costs are rigid in nature, the margin
of profit declines. Machines are not used to their full capacity in factories, because
effective demand is much less. The prices of finished goods fall less than the prices of
raw materials.

10) Briefly explain Hawtrey’s monetary theory.

The Pure Monetary Theory was proposed by Hawtrey, according to him the changes in

the money flows in the economy cause the fluctuations in the level of economic activities.
Thus, this theory posits that the business cycle is caused due to the fluctuations in
the monetary and credit markets.

The fluctuations in the supply of money and the bank credit are the main causal factor of
a cyclical process. With an increased supply of money, the prices rise, profit increases,
total output increases and thus overall growth takes place. On the other hand, if the supply
of money falls, then the price fall, profits decline, total output falls as production
activities become sluggish, and the economy enters into the depression phase.

The principle factor behind the supply of money is the credit created by the banking
system. The economy observes the upswing with the expansion of bank credit and
continues to expand as long as the banks create the credit. The banks expand the credit
facility because the situation is as such that they find profitable to offer the credit at a
relatively lower interest rate. This encourages the entrepreneurs to undertake productive
activities and avail the benefits of bank credits.

Till the process of credit expansion continues, the general level of price increases as after
a certain limit, the rate of increase in the demand will be more than the supply rate. The
supply increases at a lower rate because of limited production capacity and the gestation
period of new investments. Thus, credit expansion helps in accelerating the economy and
at the same time helps in the price rise. The economy observes the upswing and enters
into the expansion phase.

After a point of time, the banks might restrain the credit expansion at the prevailing rate
because their cash and reserves got depleted due to the increase in loans and advances,
withdrawal of deposits for quicker returns, reduced inflow of deposits, etc. With the
contraction of credit, the businessmen can no longer obtain bank credit for furthering their
business activities. As a result of this, the expansion slows down and marks the beginning
of the downswing.