BBA 1ST SEM/ 1ST YEAAR

MACRO ECONOMICS (BM111)

(UNIT-3)

INFLATION
Inflation is regarded as a major economic problem everywhere. Inflation has been experienced by all the
countries, irrespective of their political system and the stage of their economic development. In fact, inflation has
emerged as one of the most important contemporary economic issues all over the world.

MEANING/DEFINITION OF INFLATION

 Inflation is generally defined as a process of persistent and appreciable rise in the general level of prices. It
is important to note a number of important things in this definition of inflation.
 Inflation refers to a process of rising prices and not a state of high prices. It shows a state of disequilibrium
between the aggregate demand and aggregate supply at the existing prices, necessitating a rise in the
general price level.
 Inflation refers to a situation of appreciable or considerable rise in prices. This implies that every type of
rise in price level is not inflationary in character. A modest and gradual rise in the price level, say between
1 to 2 per cent per annum, is essential in achieving and maintaining high level of employment and
satisfactory rate of economic. Such a rise in price level is essential for toning up and healthy functioning
of the economy and, therefore, is not regarded as inflationary rise. It is only when the price rise becomes
excessive and unhealthy that it is regarded as inflationary in character.
 Rise in prices should not only be appreciable but prolonged in order to be called as inflationary price rise.
Inflation does not refer to a one-time rise in the price level but rather to persistent rise in the price level.
Moreover, rise in the price level for a short period of time, say 6 months or a year, is not regarded as
inflationary in nature. It is only when price increase continues over a long period that it is regarded as
inflationary in nature. Fourth, inflation is measured as the rate of increase in the price level as indicated by
the price index.
 Inflation is generally measured in terms of GNP (Gross National Product) deflator or CPI (Consumer
Price Index).

TYPES OF INFLATION
1. Creeping Inflation-Creeping inflation occurs when there is a sustained rise in prices over time at a mild rate,
say around 2 to 3 per cent per year. It is also known as mild inflation. This type of inflation is not much of a
problem.
2. Walking or Trotting Inflation-When the rate of rise in inflation is of intermediate range of 3 to 6 per cent per
annum, it is called walking or trotting inflation.
3. Running Inflation-When the sustained rise in prices is over 8 percent, and generally around 10 per cent per
annum, it is called running inflation. It normally shows two-digit inflation. Running inflation is a warning signal
indicating the need for controlling it.
4. Hyper or Galloping Inflation-Hyper inflation occurs when monthly increase in prices is 20 per cent to 30 per
cent or more. At this stage, there is no limit to price rise, and price rise goes out of control. Money becomes
almost worthless causing severe hardships to people. There is complete collapse of the currency and economic
and political life is disrupted. Such a hyper inflation was witnessed in Germany in 1923 when hundreds of
thousands of families were ruined by inflation. It is possible to distinguish between two types of inflation on the
basis of the degree of control exercised over the rising prices, viz. open inflation and suppressed inflation.

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5. Open Inflation-Inflation is open when there is no barrier to price rise. It occurs in the economy where there are
no controls and checks on price rise. In the words of Milton Friedman, it is an inflationary process in which prices
are permitted to rise without being suppressed by government price controls or similar techniques." Rising prices
by large magnitude is the symptom of open inflation.
6. Suppressed Inflation-Suppressed inflation refers to a situation when there exista inflationary pressures in the
economy, but prices are controlled by certain administrative measures such as price control and rationing. Price
increases are suppressed (or repressed) here. However, prices rise by large magnitude after the price controls are
removed. The symptoms of suppressed inflation are long queues of buyers at government controlled ration shops,
the existence of excess demand and black markets. Wartime government controls on prices of essential
commodities are examples of suppressed inflation.

EXPLANATION OF INFLATION

The traditional explanation of inflation runs in terms of forces operating from the demand and supply sides.
Inflation originating from the demand forces is commonly referred to as demand-pull inflation. On the other hand,
inflation originating from the forces operating from the supply side is known as cost-push inflation.
 Demand-pull Inflation-Demand-pull inflation occurs when the demand services exceeds the supply
available at existing prices, i.e. when for goods and there is excess demand for goods and services. This is
a situation of disequilibrium which can be corrected partly by increase in prices and partly by increase in
output unto full-employment level, and entirely by increase in prices beyond full-employment level.
Excess demand pulls up the price level and results in emergence of inflation. Demand-pull inflation is
illustrated in Fig.1. Aggregate demand curve shows different quantities of goods and services demanded
in the entire economy at various prices. Like the market demand curve, aggregate demand curve is
negatively sloping. Aggregate supply curve slopes upward to the right till the full employment output
level, and becomes perfectly inelastic thereafter. It shows that an increase in output is associated with
increase in prices till the attainment of full-employment, and output cannot increase thereafter.

In Fig. 1, AD1, curve intersects AS curve at E₁. giving Y1, and P1, the original output and price respectively. An
increase in aggregate demand shifts the aggregate demand curve to AD2. This leads excess demand of EH at P,
price necessitating an increase in output and price to eliminate excess demand. New equilibrium takes place at E2,
corresponding to intersection of AD2, with AS. Excess demand pulls up the price and output to P 2 and Y₂
respectively. Thus, one-time shift in aggregate demand gives rise to one-time increase in price. As we know,
inflation refers to a persistent rather than one-time rise in the price level. If there is another and then yet another
increase in demand and thereby rightward shift in the AD curves, there will be another and then yet another

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increase in the price level. It is obvious from Fig. 1. that upto full-employment level of output (YF), an increase in
demand results in increase in both output (Y₂. Y3 etc.) and the price level (P₂, P3, etc.) This happens till AD3
demand curve and corresponding P3, price level. But increase in aggregate demand thereafter leads to increase in
the price level only. For example, a shift in aggregate demand curve from AD 3, to AD4, results in equilibrium
shifting from E3, to E4, as a consequence of which price level rises from P3, to P4, but output remains at Y Keynes
describes such a rise in price level after the attainment of full-employment output as pure inflation.
Increase in aggregate demand may originate either through real factors or monetary factors. Among the various
real factors that may produce rightward shift of aggregate demand curve are increase in government spending, a
decrease in taxes, an increase in consumption expenditure, an increase in export demand, an increase in
investment expenditure etc. On the monetary side, demand-pull inflation may result mainly from increase in
money supply. However, there is disagreement among economists over the relative importance of monetary and
real factors causing inflationary rise in prices. According to some economists, like Milton Friedman, inflation is
always and everywhere a monetary phenomenon produced by a sharp increase in money supply. Other
economists, like J.R. Hicks, feel that real factors play crucial role in producing inflationary rise in prices.

 Cost-Push Inflation-Another explanation of inflation is in terms of forces operating from the supply side
or the cost side. It is known as supply or cost theory of inflation, popularly known as cost-push inflation.
Cost-push inflation refers to inflationary rise in prices which arises due to increase in costs. Cost-push
inflation is caused mainly by increase in wage cost and increase in profit margin. The primary cause of
cost-push inflation is the rise in money wages in excess of rise in productivity of labour. Strong trade
unions are able to press employers to grant money wage-rate increase greater than the increase in the
productivity of labour. This leads to increase in per unit cost. As a consequence, producers raise their
prices to cover the higher cost. A series of increases in wage rates leads to a series. of increase in prices-
inflation. This is wage-push variant of cost-push inflation.
Another variant of cost-push inflation is profit-push inflation. Oligopolist and monopolist firms raise the price of
their products so as to earn higher profits. A series of increase in the profit margins will lead to increase in cost of
production and thereby prices, resulting in inflationary rise in prices.
Cost-push inflation is illustrated in Fig. 2. Initially, AD curve intersects AS1, curve at E₁, giving P1, and Y1, as the
equilibrium price and quantity respectively. An increase in cost of production due to increase in wage-rate or
increase in profit margin results in upward shift of aggregate supply schedule to AS2, indicating that the same
quantity is supplied at a higher price. With the aggregate demand schedule remaining unchanged, an upward shift
of aggregate supply schedule to AS2, shifts the equilibrium to E2 This results in increase in price level (P2) and
decrease in output (Y₂). Similarly, a further increase in supply price resulting from increase in wage rate or profit
margin shifts the aggregate supply curve to AS3. As a consequence, price rises to P3, and output falls to Y3. A
series of increase in cost of production will result in a series of upward shifts in aggregate supply curves leading
to inflationary rise in prices. It is important to note that rise in the price level in case of cost-push inflation is
associated with decrease in the level of output and employment Economists use the term stagflation to explain the
situation when sustained and substantial rise in prices are accompanied by declining output and rising
unemployment. The successive reductions in output and employment that result in case of cost-push inflation will
stop the cost-push inflation.

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MEASURING INFLATION (PRICE INDICES & INFLATION)

Price Indices & Inflation

It is easy to measure changes in the prices of individual commodities, but how does one work out what is the
overall price increase of a whole basket of commodities? This is what a price index does. There are broadly two
kinds of indices-a Wholesale Price Index (WPI) and a Consumer Price index (CPI). Since the former measures
changes in wholesale prices, it reflects producer inflation the inflation facing producers in terms of inputs; while
the latter measures changes in retail prices and hence inflation as it affects the consumers.

We can group goods and services into broad categories and construct index numbers for each group and monitor
the behavior of such price indices. For instance, we can have a price index for food items, an index for textiles, an
index for industrial raw-materials, index for machinery and equipment and so on.

The Wholesale Price Index (WPI) and Consumer Price Index (CPI) are two price indices which are largely
used in analysis of price behavior.

Inflation is 'increase in general price level' When one mentions about inflation, one is referring to the rate of
change of one of the two price indices - either WPI or CPI. Generally speaking. the of inflation indicates the rate
at which purchasing power of money is being eroded.

 WPI (Wholesale Price Index) indicates the inflation in selected commodities which are consumed by
industry as well, for example, steel, coal etc. Broadly any change in WPI is the indicator of the change in
cost of raw-material which may affect the demand. In this case, prices are taken from the wholesale
market for calculating the index.

 CPI (Consumer Price Index) indicates the inflation in commodities which are used by the direct
consumers. If income of the consumer remains constant, the increase in CPI means decrease in purchasing
power of the consumer. Here, we take retail prices of product to calculate CPI.

WPI and CPI can show quite different rates of change and can often move in opposite directions. This is because
they cover different groups of goods and the weights used are quite different. From the consumers point of view,

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CPI is the relevant index. Whereas from manufacturers' or inducting view point, WPI is the relevant index. In
drawing inferences from price indices, these aspects must be kept in view.

 PPI (Producers' Price Index)-A third category of index number is called Producers' Price Index (PPI).
The PPI measures price change from producers' viewpoint as against CPI which measures price change
from consumers' view point. PPI is being used in most of the developed countries of the world, for
example USA. In India, the government has constituted an expert Working Group for examining the
feasibility of switching from WPI to PPI.

Calculating Inflation Rate

Inflation rate for a period, (a year) is the percentage increase in price index compared to the previous year. The
formula is as follows:-

CAUSES OF INFLATION

1. Increase in Money Supply-The first major cause of inflation is increase in the money supply in the economy.
Increase in money. supply represents an increase in purchasing power with the people Unless increase in
purchasing power is offset by increase in supply of goods and services, it will exercise an upward pressure on
prices. Increase in money supply results primarily from increase in demand deposits by commercial banks. This
leads to an increase in bank loans and investment expenditure, and thereby increase in aggregate spending.) Some
of the modern economists, known as monetarists, explain inflation in terms of increase in money supply.
According to Friedman, "inflation can be produced only by a more rapid increase in quantity of money than in
output."
2. Deficit Financing-Deficit financing is another important cause of inflationary rise in prices. In India, deficit
financing is taken to mean the excess of government expenditure over current revenue and public borrowing. This
deficit is financed by borrowing from the central bank. Deficit financing, therefore, leads to increase in money
supply, and hence is responsible for the price rise, In the past the government had to resort to deficit financing
during the abnormal situations like wars. But nowadays, in most of the developing countries, the government uses
the policy of deficit financing to get funds even for developmental purposes.
3. Increase in Public Expenditure-Increase in public expenditure. may lead to increase in prices by increasing
the aggregate demand. Public expenditure is one important component of aggregate demand. It increases
aggregate demand directly by increasing the demand for goods and services by the government and indirectly by
increasing the factor incomes in the form of wages and salaries of government employees. Non-developmental
expenditure of the government, expenditure incurred on non-developmental activities like defence and

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administration, in particular, is inflationary-inclined.) It generates income without creating supply of goods and
services in the economy. Thus, non-developmental expenditure by the government creates money-income, and
thereby demand for goods and services in the economy. This results in rise in prices.
4. Increase in Investment Expenditure-Increase in business outlays in the form of investment expenditure is
also responsible for rise in prices. (Investment expenditure has a long gestation period. It creates incomes in the
form of wages, dividends, etc. immediately, but leads to increase in output of goods and services only after a
time-gap. Thus, increase in investment expenditure exercises an upward pressure on prices, particularly in the
short run, by increasing the demand for goods and services.
5. Increase in Export Demand-Another factor responsible for rise in domestic prices is the increased foreign
demand for domestic goods and services. Export demand is an important component of aggregate demand. An
increase in export demand, therefore, results in an increased aggregate demand for goods and services produced
in an economy. Given the supply of goods and services, this creates at situation of excess demand and gives rise
to demand-pull inflation.
6. Increase in Population-Increase in population is another factor for inflationary rise in prices, particularly in
the Indian context. Increase in population means increased demand for most of the consumer goods. It increases
the aggregate demand for goods and services and puts pressure on the existing supply of goods and services. So
far we have explained the forces operating from the demand side. Now we shall explain the supply-side factors
responsible for rise in the price level:
7. Higher Wage Rates-Higher wage rates are responsible for rise in prices in an important way. Modern
economies are characterized by the presence of strong trade unions. They are able to pressurise the entrepreneurs
to grant them increase in money wages in excess of increase in labour productivity. This results in increase in cost
of production Entrepreneurs would like to shift this increased wage cost to the consumers by charging higher
prices for the commodities. This sets in what is known as wage-price spiral. A rise in the price level leads to
higher cost of living and, thereby, a fall in real wages. Trade unions demand higher money wages to neutralize
this fall in real wages. This increase in money wages is once again passed on to the consumers in the form of
higher prices. And thus the inflationary. spiral goes on.
8. Higher Taxes-Another cause of rise in prices is imposition of higher taxes, mainly indirect taxes like excise
duties, sales tax, etc. Indirect taxes are largely passed on by the producers to the consumers by increasing the
prices of goods and services by the amount of taxes. For example, prices of consumer durables like electronic
goods rise because of higher excise duties imposed upon them
9. Higher Administered Prices- In many countries prices of crucial commodities are determined
administratively by the government. For example, prices of food grains in India are determined by the
government as a matter of policy. These administered prices are raised regularly by the government to promote
the interest of producers. A price hike of such basic goods is likely to raise the general price level and thereby
generate inflationary trend.
10. Supply Shocks-Supply shocks in the form of higher oil prices by the OPEC (Organization of Petroleum
Exporting Countries) is a major factor for price rise in recent years. Petroleum prices are of crucial importance
because petroleum products are used, directly or indirectly. in almost all the sectors of the economy) Therefore,
increase in their prices affect significantly the cost structure of almost all industries and commodities. Periodic
increase in oil prices has given continual boost to the general price level.
11. Hoarding-Hoarding of commodities, especially by the traders for profiteering, is also responsible for rise in
prices. During the period of scarcity and rising prices, traders, merchants and even consumers. indulge in
hoarding of commodities; goods go underground and this adds to the problem of scarcity and rise in prices.

EFFECTS OF INFLATION
1. Effects on Production-While a mild degree of inflation activates the economy by increasing investment,
production and employment. Hyper inflation has various adverse effects on production. The main adverse effects
of inflation on production are:

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  Sharp rise in prices create conditions of uncertainty in the economy The conditions of uncertainty in the
economy have adverse and dampening effect on investment and production activity.
 Inflation affects the patterns of production During inflation profits rise sharply. Therefore, businessmen,
traders and merchants are able to indulge in luxuries. As a result, resources are diverted from the
production of essential commodities to luxuries.
 Inflation causes misallocation of resources in the economy in other ways also. It leads to hoarding. The
traders and merchants indulge in hoarding in order to earn higher profits in future. Consumers also start
hoarding the essential goods in anticipation of rise in prices in future. This act of hoarding on the part of
traders and consumers creates scarcity of goods in the market. It also encourages black marketing in the
essential commodities.
 A serious effect of inflation is that it encourages speculation on the part of producers. The entrepreneurs
start indulging in speculative activities in order to make easy and quick profits. As a result, productive
activities in the economy suffer.
 Inflation reduces the degree of competition in the economy. It creates a situation of sellers market in the
sense that producers are able to sell whatever they produce. Therefore, inefficient producers are protected.
It results in building up even technically inefficient plants and equipments.
2. Effects on the Distribution of Income-Inflation leads to inequitable and arbitrary redistribution of income and
wealth in the society. It results in redistribution of income and wealth because it does not affect all sections of the
society in the same way. During inflation, a section of the society may gain while another section may lose. An
advantage accruing to one group of people may be at the cost of the other groups. It is like robbing Peter to pay
Paul. Effects of inflation on different sections of the society are discussed below:
 Debtors and Creditors-During the period of inflation, debtors as a group stand to gain while creditors tend
to lose Debtors benefit during inflation because they had borrowed money when the purchasing power of
money was higher and they return it when its purchasing power is lower due to price rise: Though they
pay the same rate of interest and same amount when they return the loan in terms of their face value, in
real terms they pay less. For example, if a person has borrowed 1,000 for a year, and the price level has
increased by 10 per cent during the year, he will return the same amout of ? 1,000, but its real value would
have fallen by 10 per cent due to rise in prices. Inflation would have opposite effect on creditors. They
tend to lose during inflation since the loan repaid and interest received would have less real-value as a
result of rise in prices. They receive the same amount in money terms but less amount in real terms.
 Profit Earners-Entrepreneurs, traders, merchants, etc. whose incomes are derived from profits tend to
benefit during inflation. It has been generally observed that when prices are rising, profits are generally
higher than anticipated. Entrepreneurs tend to earn windfall profits because rise in prices leads to increase
in factor prices and cost of production only after some time interval. Moreover, entrepreneurs earn profits
due to increase in the value of the stock of goods and raw materials they possess.
 Wage earners and Salaried Class-Wage earners and salaried class tend to lose during inflation. Though in
the modern economies wages and salaries are linked with the cost of living. even then labourers and the
salaried class are likely to lose during inflation mainly for two reasons: Firstly, in most cases increase in
wages and salaries generally fail to keep pace with the rising prices. Secondly, though wages and salaries
eventually rise during inflation, there is a time lag between the price rise and increase in wages and
salaries. As a result, wage earners and salaried class lose during the intervening period. In fact, wage-
earners tend to lose more in those sectors where the workers are not in the form of trade unions.
 Investors-Inflation has a mixed effect on the investors. Some investors tend to gain while others are likely
to lose during inflation. It is possible to distinguish between two types of investors, viz. (a) investors in
equities, and (b) investors in fixed interest-earning assets. Investors in shares of the companies or in unit
trusts gain during inflation since dividends increase as a result of increase in corporate profits. On the
other hand, small investors who invest their money in the form of bonds, debentures and deposits with the
commercial banks tend to lose because they receive a fixed interest income from such investment.

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  Pensioners-Pensioners and similarly placed fixed-income groups suffer during inflation. Retired people
who survive on pensions are likely to lose during inflation for two reasons: Firstly, in many cases pension
is fixed so that the money income of the pensioners remains the same during inflation. Even where
pensions of the retired civil servants, retired army personnel and other retired persons are periodically
revised, the increase in pensions does not keep pace with the rising prices. Secondly, pensioners keep their
savings in the form of bank and postal deposits which give them a fixed income in the form of interest.
 Farmers-Farmers as a group stand to gain during inflation. Farmers, like other producers, tend to gain
because the prices of agricultural products outpace the increase in prices of farm inputs. Moreover,
farmers are generally debtors and like other debtors they gain during inflation as far as their debt burden is
concerned. However, it is doubtful whether small farmers gain during inflation since they do not market
much of their produce.
3. Adverse Effect on Savings-Inflation is likely to have adverse effect on savings Inflation wipes out savings
completely. The real value of accumulated cash evaporates. Small savers, who put their savings in the form of
bank deposits, National Saving Certificates and other. Government securities, find the real value of their
investment falling. by a large magnitude during the period of rising prices. This reduces the motivation for
savings.
4. Effects on the Balance of Payments-Inflation generally has an adverse effect on the balance of payments. If
rate of inflation in our country is higher than in other countries, the competitiveness of our country's products in
the world market would decrease. Our exportable would become relatively expensive in the world market, leading
to fall in exports. On the other hand, our importable would. become relatively cheaper and this would increase our
imports. Thus, demand for country's exports would decrease and demand for its imports would increase. This
would adversely affect the balance of payments.
5. Effects on Public Revenue-Inflation is likely to have favorable effect on public revenue. The Government
would get more revenue. from taxes during inflation. As prices rise, the revenue earned from. indirect taxes, such
as excise duties, sales tax, etc. will also increase. Moreover, revenue from direct taxes, such as income tax, will
rise at a faster rate than the growth of money incomes due to progressive tax system in most of the countries.
6. Confidence in the Currency-A high rate of inflation can undermine the confidence of people in the currency.
When people lose confidence in the currency, money cannot function as money. People will not like to hold
currency. This will lead to flight from money. Monetary system ultimately breaks down. People start preferring
commodities over money in their transactions. This is what happened in Germany during the hyper inflation of
1923. There was such a breakdown of public confidence in money that they refused to accept mark. Money gave
place to barter system of exchange.
7. Social and Moral Degradation-Periods of hyperinflation are often associated with social and moral
degradation. Inflation has led to thefts, robberies and widespread corruption. It is the period during which small-
time crimes thrive. Corruption breeds in during inflation not only among businessmen but also among
government officials and politicians.
8. Political Instability-Continuous inflation in many cases has shaken the foundations of the political system. It
has become a major political issue during many elections. History is full of instances when many a government
lost power because of persistent rise in prices. For example, Nazi Revolution in Germany was the outcome of
hyper inflation of 1923.

DEFLATION

Deflation is the opposite of inflation. Different economists have defined it differently.

 According to Prof. Crowther "Deflation is that state of the economy where the value of money is rising or
the prices are falling.”
 According to Prof. Pigou, “ Deflation is that state of falling prices which occurs at that time when the
output of goods and services increase more rapidly than the volume of money income in the economy.”

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  Deflation has been best defined by Prof. Paul Einzing as "a state of disequilibrium in which a contraction
of purchasing power tends to cause, or is the effect of a decline of the price level."

CAUSES OF DEFLATION

1. Change in Capital Market Structures

When many different companies are selling the same goods or services, they typically lower their prices as a
means to compete. Often, the capital structure of the economy changes and companies have easier access to
debt and equity markets, which they can use to fund new businesses or improve productivity.
2. Increased Productivity
Innovative solutions and new processes help increase efficiency, which ultimately leads to lower prices.
Although some innovations only affect the productivity of certain industries, others may have a profound effect
on the entire economy.
3. Decrease in Currency Supply
Currency supplies generally decrease due to actions taken by central banks, often with the explicit aim of
tamping down inflation. For instance, when the Federal Reserve was first created, it considerably contracted the
U.S. money supply. Unfortunately, it’s easy for currency supply reductions to spiral out of control.
4. Austerity Measures
Deflation can be the result of decreased governmental, business, or consumer spending, which means
government spending cuts can lead to periods of significant deflation. For example, when Spain initiated
austerity measures in 2010, preexisting deflation began to spiral out of control in that country.
5. Deflationary Spiral (Persistent Deflation)
Once deflation rears its ugly head, it can be very difficult to get the economy under control. While the actual
mechanics of persistent deflation are complicated, the crux is that true deflation is self-reinforcing.

EFFECTS OF DEFLATION

Deflation has different impact on different sections of the society Effect of deflation can be seen distinctly on
producers, consumers, traders, investors, laboures, debtors creditors, farmes etc.
(a) Effect on Producers etc. and Traders: The producers traders are the worst hit during deflation. During
deflation the prices of the commodities go down rapidly, but the cops of the product does not go down to the
same extent and with the same speed. This leads to the main reason of loss for the producers.
Falling demand, falling prices and lower profits are some other major reasons that lead to the trouble of the
traders producers during deflation.
(b) Investors: There are mainly two types of investors. The first category is of the investors who get a fixed rate
of interest (or derive fixed income). They gain as the prices of the various commodities go down but their income
remains constant.
The second category of investors are those whose income differ with the profitability of the business (or derive
variable income). These investors tend to lose as the profit margins of the business go down during deflation, so
their share of profits also goes down.
(c) Salaried and Wage Class: The salaried and the wage class have a fixed income. Their income cannot be cut
down easily (as it is a human tendency of not stepping down from their present stand to a lower status) specially
due to presence of strong trade unions, During deflation the prices fall and the value of money goes up. Indirectly
the purchasing power of the money also goes up. But a reduction in wage/salary is not possible. These people
gain.
(d) Consumers: As the purchasing power of money goes up all consumers tend to gain.
(e) Debtors: Debtors lose during deflation as they have to pay back the debt at the time when purchasing power
of money is rising. In other words we can say that they return the money at a higher value, than the time they had
procured it.

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(f) Creditors: Creditors tend to gain during deflation, because during deflation the value of money is rising
continuously. They get their money back along with interest at a higher purchasing power than what they had
given.
(g) Farmers: Farmers have a double loss during deflation. Firstly, the value of their crop goes down, as prices are
falling and secondly farmers are usually debtors. They are at a losing end. To conclude, deflation is just the
opposite of Inflation. It is rightly said that "Inflation is unjust and Deflation is undesirable.

PHILLIPS CURVE

 Concept given by A.W. Phillips, British Economist in 1958.

 Phillips curve gives certain inverse relationship between unemployment rate and inflation rate. (also rate
of wage rise or wage inflation as wage increase tend to be associated with higher inflation rates.
 The theory claims that with economic growth comes inflation, which in turn should lead to more jobs and
less unemployment.
KEY TAKEAWAYS
 The Phillips curve states that inflation and unemployment have an inverse relationship. Higher inflation
is associated with lower unemployment and vice versa. 3
 The Phillips curve was a concept used to guide macroeconomic policy in the 20th century, but was called
into question by the stagflation of the 1970's. 2
 Understanding the Phillips curve in light of consumer and worker expectations, shows that the
relationship between inflation and unemployment may not hold in the long run, or even potentially in the
short run.

GRAPHICAL PRESENTATION

Interpretation

• Low unemployment rate is found at high inflation rate • High unemployment rate is found at low inflation
rate
• As rate of inflation increases, curve becomes steeper but as inflation rate declines, curve becomes flatter.
• High unemployment is necessary for maintaining non inflationary price stability.
• Wage-push inflation can be eliminated if country is prepared to accept high unemployment rate.

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DEFLATION AND DISINFLATION

At times the readers gets confused between deflation and disinflation. Here it should be noted that deflation is that
state of affairs in which every fall in prices increases unemployment, reduces output and curtails income of the
community. Whereas, on the other hand, Disinflation is the process of reversing inflation by adopting anti-
inflationary measures by the authorities, which does not cause any decline in the existing level of employment,
output and income.

REFLATION

 Reflation and Inflation are seemingly similar words, to some extent.

 "Reflation is inflation deliberately undertaken to relieve a depression".
 In other words, reflation is a type of controlled inflation. Reflation is an antidose applied by the
government to curb deflation. When deflation operates at extreme, prices of goods and services fall to
extremely low levels. At such a time government may resort to reflation. Under reflation the government
may expand the money supply with a view of pushing up the prices to the normal level. Reflation may
also be carried out to make the economy recover from an extreme depression.

SIMILARITIES BETWEEN INFLATION AND REFLATION

1. The supply of money in the economy increases the conditions.

2. Both lead to rise in existing price level in the economy.

DIFFERENCES BETWEEN INFLATION AND REFLATION

1. Inflation may be optional or natural. Reflation is only optional, usually carried out by the government.
2. Inflation usually occurs in the form of trade cycle. Reflation is carried during the period of recovery in a trade
cycle.
3. Under inflation prices rise rapidly in an uncontrolled manner. Under reflation price rises slowly in a controlled
manner.
4. If proper check is not applied on inflation it may ruin the economy. On the other hand inflation brings
improvement in a ruined economy.

INFLATION, DISINFLATION, DEFLATION, REFLATION DISTINGUISHED-A DIAGRAMMATIC

ILLUSTRATION

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STAGFLATION
A combination of high and persistent inflation and high unemployment is known as stagflation. Stagflation is an
economic event in which the inflation rate is high, economic growth rate slows, and unemployment remains
steadily high. Such an unfavorable combination is feared and can be a dilemma for governments since most
actions designed to lower inflation may raise unemployment levels, and policies designed to decrease
unemployment may worsen inflation.
(i) Inflation without Growth
(ii) Stagnation with persistent inflation (Samuelson & Nordhaus).
Stagflation is an economic condition when stagnant economic growth, high unemployment, and high inflation
combine together. Basically, inflation plus stagnant growth equals stagflation. The term emerged during the 1973-
1975 recession.

GROWTH

STAGFLATION INFLATION

UNEMPLOYMENT

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CAUSES OF STAGFLATION

There is no consensus among economists on the causes of stagflation. Each economics school offers its own view
on its origins. However, two main theories may be derived: supply shock and poor economic policies.

The supply shock theory suggests that stagflation occurs when an economy faces a sudden increase or decrease in
the supply of a commodity or service (supply shock), such as a rapid increase in the price of oil. In such a
situation, prices surge, making production costlier and less profitable, thus slowing economic growth.

A second theory states that stagflation can be a result of a poorly made economic policy. For example, the
government can create a policy that harms industries while growing the money supply too quickly. The
simultaneous occurrence of these policies can lead to slower economic growth and higher inflation.

MEASURES TO CONTROL INFLATION

1. Monetary Measures-Monetary policy aims at controlling the supply of money by influencing its availability
and cost of bank money or bank credit. The central bank in every country is entrusted with the task of enforcing
monetary policy. It is essential to adopt restrictive or dear monetary policy to combat inflation. Restrictive
monetary (policy is characterized by reducing the availability of bank credit and increasing the cost of credit.
Two types of instruments can be adopted to implement anti inflationary and restrictive monetary policy, which
are discussed below:
 Quantitative Measures- Quantitative measures aim at influencing the overall availability of bank credit
and its cost. Open market operations, bank rate and legal reserve ratio are the main quantitative credit
control measures. As part of the open market operations, the central bank is required to sell government
securities to public and financial institutions so as to reduce the cash reserves of the commercial banks.
Similarly, the central bank can increase the minimum reserve ratio which the commercial banks are
required to keep with the central bank. An increase in the legal reserve ratio will reduce the cash reserves
of the commercial banks. The fall in the cash reserves of the commercial banks will force them to reduce
their total advances and loans. Another measure which can be adopted by the central bank to control
inflation is to increase the bank rate. The rise in the bank rate will lead to increase in the lending rate by
the commercial banks on their loans and advances. This will reduce the amount of loans taken by the
customers of the commercial banks as the lending becomes costly.
 Selective Credit Control Measures-Selective credit control measures aim at influencing the purpose for
which bank credit is made available and thereby affect the direction of bank credit. The central bank can
increase the margin requirements in case of certain commodities so as to reduce the amount of bank credit.
available to traders dealing in those commodities) Similarly, the central bank can issue directives to
commercial banks prohibiting them from lending against certain commodities or in certain regions so as to
curb inflationary pressures in selected economic activities. In the same way, the central bank can reduce
bank credit to the consumers for the purchase of durable consumer goods by regulating the consumer
credit. The central bank can also advise, appeal and persuade the commercial banks by using moral
suasion to achieve the same purpose.
The effectiveness of the monetary policy depends upon the extent of control which the central bank has on the
money market and the degree of cooperation which it can get from the commercial banks and other financial
institutions. However, monetary policy is not very effective in curbing inflation, particularly in developing
countries.

2. Fiscal Measures-Fiscal policy also can be used to control inflation. Fiscal policy is the policy of government
expenditure and government revenue. fiscal policy can be used to reduce aggregate demand and thereby control
demand-pull inflation Contractionary fiscal policy is the policy of reducing government expenditure and
increasing government revenue. The main tools of fiscal policy are:
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  Public Expenditure-Public expenditure, i.e. expenditure by the government, is an important component
of aggregate demand. In order to control inflation it is essential that government expenditure must be
reduced. However, part of the government expenditure is of essential nature and, hence, cannot be
reduced. Therefore, what is important is that unproductive expenditure of government, to some extent is
non-essential in nature, must be reduced. For example, expenditure on defense and unproductive works
should be reduced.
 Taxation-The major plank of anti-inflationary fiscal policy is to increase the tax burden by increasing the
tax rate and by imposing new taxes. Direct taxes can be used for this purpose. Direct taxes like income
tax, corporate tax, etc. reduce the disposable income of the taxpayers and thereby reduce their
consumption expenditure. At the same time, tax system should be so evolved as to promote saving habits
among the people and also provide incentives for undertaking productive investment.
 Public Borrowing-Public borrowing, i.e. borrowing by the government from public, can also be used in
controlling inflation Public borrowing enables the government to meet its expenditure and thereby reduces
the need for deficit financing. Moreover, public borrowing helps in reducing the amount of purchasing
power and thereby total demand in the economy. However, if people give loans to the government out of
their savings rather than by curtailing their expenditure, total demand may not fall.
Thus, a decrease in government expenditure and increase in government's revenue, producing a surplus budget, is
the type of fiscal policy which can be used to control inflation.

3. Control on Deficit Financing-The policy of deficit financing leads to rise in prites. Excessive deficit financing
is an important cause of inflationary pressures in developing countries like India. Therefore, it is important that
the government should take steps to use the policy of deficit financing to a limited extent only.

4. Income Policy-In order to curb cost-push inflation, there is need for adopting appropriate income policy. The
primary objective of income policy is to ensure that wages, salaries and other incomes should increase in tune
with increase in productivity. This would mean that higher incomes do not result in increase in cost per unit and
thereby prices. However, it is difficult to implement such a policy, particularly with regard to wage income in
view of the pressure of the trade unions. Trade unions normally pressurize entrepreneurs for increase in wage
rates to compensate for increase in cost of living.

5. Price Controls and Rationing- direct measure to control inflation is to introduce price controls and rationing
of essential goods. Under price control policy, the government fixes the maximum price at which certain
commodities could be sold. Since the maximum price is set below the free market equilibrium price, price ceiling
is likely to create scarcity of commodity. Therefore, price control policy is often accompanied by rationing. Under
rationing a specified quantity of goods is given to consumers at the controlled price. Price controls and rationing
may be an effective policy in controlling inflation. However, there are various practical difficulties in
implementing this policy. Firstly, price controls and rationing can be introduced on a limited scale for a few
commodities only. Secondly, price control is likely to give rise to black market. Black market is the market where
goods are sold unlawfully at higher prices than the controlled price.

6. Increasing the Availability of Goods-The basic solution to the problem of inflation is to increase the
availability of goods in the economy. The following measures need to be taken to increase the availability of
goods:
 Production should be increased. More specifically, production of inflation-sensitive goods need to be
increased by allocating more resources, providing subsidies and removing bottlenecks impeding
production of these goods.
 Domestic production of essential goods may be supplemented by imports of these goods so as to reduce
shortages and minimize inflationary pressures.

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