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What is Inflation

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What is Inflation

Uploaded by

Tankadhara Padhan
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© © All Rights Reserved
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Download as DOCX, PDF, TXT or read online on Scribd
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What is Inflation?

Inflation is a rise in the general level of prices of goods and services in an economy over a period
of time.

When the general price level rises, each unit of currency buys fewer goods and services.
Therefore, inflation also reflects an erosion of purchasing power of money.

According to Crowther, “Inflation is State in which the Value of Money is Falling and the Prices
are rising.”

In Economics, the word ‘inflation’ refers to General rise in Prices Measured against a Standard
Level of Purchasing Power.

Here are several variations on inflation used popularly to indicate specific meanings.

 Deflation is when the general level of prices is falling. It is the opposite of inflation. Also
referred to as Disinflation.The lack of inflation may be an indication that the economy is
weakening.
 Hyperinflation is unusually rapid inflation in very short span of time. In extreme cases, this can
lead to the breakdown of a nation’s monetary system with complete loss of confidence in the
domestic currency. One of the earlier examples of hyperinflation occurred in Germany in early
1920s after the First World War, when prices rose 2,500% in one month.
 Stagflation is the combination of high unemployment with high inflation. This happened in
industrialized countries during the 1970s, when a bad economy was combined with OPEC
raising oil prices led to low growth.

Inflation is all about prices going up, but for healthy economy wages should be rising as well.
The question shouldn’t be whether inflation is rising, but whether it’s rising at a quicker pace
than your wages, if the answer is a Yes only then inflation is problematic.
Finally, inflation is a sign that an economy is growing. The RBI considers the range of 4-5 % as
comfort zone of inflation in India.

Impact or Effect of Inflation :


 Inflation affects the pattern of production, a shift in production pattern takes place from
consumer goods to luxury goods.
 On Investment: Inflation discourages entrepreneurs in investing as the risk involved in the future
production would be very high with less hope for returns.Uncertainty about the future purchasing
power of money discourages investment and savings.
 Inflation also results in black marketing. Sellers may stock up the goods to be sold in the future,
anticipating further price rise.
 The effect of inflation is felt on distribution of income and wealth and on production.
 People with fixed income group are the worst sufferers of inflation.Those living off a fixed-
income, such as retirees, see a decline in their purchasing power and, consequently, their
standard of living.
 The entire economy must absorb repricing costs (“menu costs”) as price lists, labels, menus and
more have to be updated.
 If the inflation rate is greater than that of other countries, domestic products become less
competitive.
 They add inefficiencies in the market, and make it difficult for companies to budget or plan long-
term.
 On Exchange rate and trade: There can also be negative impacts to trade from an increased
instability in currency exchange prices caused by unpredictable inflation.
 On Taxes: Higher income tax rates on taxpayers. Government incurrs high fiscal deficit due to
decreased value of tax collections.
 On Export and balance of trade: Inflation rate in the economy is higher than rates in other
countries; this will increase imports and reduce exports, leading to a deficit in the balance of
trade.

Causes of Inflation:
There is no one cause that’s universally agreed upon, but at least two theories are generally
accepted while the debate still goes on:

1. Demand-Pull Inflation – This theory can be summarized as “too much money chasing
too few goods”. It is a mismatch between demand and supply , if demand is growing
faster than supply, prices will increase. This usually occurs in growing economies as
more people gain purchasing power while the supply is not able to catch up to growing
demand.When the government of a country print money in excess, prices increase to keep
up with the increase in currency, leading to inflation.
2. Cost-Push Inflation – When production costs go up, there is an increase in prices to
maintain profit margins. Increased costs can include things such as wages, taxes, or
increased costs of imports.
3. Demand pull vs Cost Push Inflation• If demand pull inflation is present in the economy,
the government must bear the cost of excessive spending and monetary authorities are to
be blamed for “cheap money policy”• On the contrary, if cost push is the real cause for
inflation then the trade union are to blamed for excessive wage claim, industries for
acceding them and business firms for marking- up profits aggressively.

Measurement of Inflation
Inflation is measured by calculating the percentage rate of change of a price index, which is
called the inflation rate.

Inflation is often measured either in terms of Wholesale Price Index or in terms of Consumer
Price Index.

 Wholesale Price Index(WPI) : The Wholesale Price Index is an indicator designed to measure
the changes in the price levels of commodities that flow into the wholesale trade
intermediaries.The index is a vital guide in economic analysis and p

olicy formulation. It is a basis for price


adjustments in business contracts and projects. It is also intended to serve as an additional source
of information for comparisons on the international front.
 Consumer Price Index (CPI) : Consumer price index is specific to particular group in the
population. It shows the cost of living of the group. It is based on the changes in the retail prices
of goods or services. Based on their incomes, consumer spends money on these particular set of
goods and services. There are different consumer price indices. Each index tracks the changes in
the retail prices for different set of consumers.

More on the Price indexes in India, click here.

Measures to control inflation:


Effective policies to control inflation need to focus on the underlying causes of inflation in the
economy.There are two broad ways in which governments try to control inflation. These are-

1. Fiscal measures. 2. Monetary measures


 Monetary Policy: Monetary policy can control the growth of demand through an increase in
interest rates and a contraction in the real money supply. For example, in the late 1980s, interest
rates went up to 15% because of the excessive growth in the economy and contributed to the
recession of the early 1990s.
 Monetary measures of controlling the inflation can be either quantitative or qualitative. Bank rate
policy, open market operations and variable reserve ratio are the quantitative measures of credit
control, by which inflation can be brought down. Qualitative control measures involve selective
credit control measures.
 Bank rate policy is used as the main instrument of monetary control during theperiod of
inflation. When the central bank raises the bank rate, it is said to haveadopted a dear money
policy. The increase in bank rate increases the cost ofborrowing which reduces commercial
banks borrowing from the central bank.Consequently, the flow of money from the commercial
banks to the public getsreduced. Therefore, inflation is controlled to the extent it is caused by the
bankcredit.
 Cash Reserve Ratio (CRR) : To control inflation, the central bank raises the CRR which
reduces the lending capacity of the commercial banks. Consequently,flow of money from
commercial banks to public decreases. In the process, ithalts the rise in prices to the extent it is
caused by banks credits to the public.
 Open Market Operations: Open market operations refer to sale and purchaseof government
securities and bonds by the central bank. To control inflation,central bank sells the government
securities to the public through the banks.This results in transfer of a part of bank deposits to
central bank account andreduces credit creation capacity of the commercial banks.

Lets look into fiscal policy now.

 Fiscal Policy:
 Higher direct taxes (causing a fall in disposable income).
 Lower Government spending.
 A reduction in the amount the government sector borrows each year .
 Direct wage controls – incomes policies Incomes policies (or direct wage controls) set limits on
the rate of growth of wages and have the potential to reduce cost inflation.
 Government can curb it’s expenditure to bring the inflation in control.
 The government can also take some protectionist measures (such as banning the export of
essential items such as pulses, cereals and oils to support the domestic consumption, encourage
imports by lowering duties on import items etc.).

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