Chapter 13

Inflation
Inflation
Definition of Inflation
 Inflation refers to a situation in which prices of
goods and services persistently rise at a fast
pace and value of money falls.
 Features of Inflation
 Inflation is a monetary phenomenon
 Inflation is a post full employment
phenomenon
 Inflation means rise in the overall price level
Inflation
Inflation
Price Index
 Inflationis measured by price index . Price
index measures the changes in average
prices of goods and services.
Price Index Numbers
Wholesale Price Index (WPI)
 WPI indicates general change in the
wholesale prices of the goods. It indicates
change in the general price level in the
economy.
 Food Basket or Farmer’s basket- A food
basket is a constant set of general goods
produced in an economy whose prices are
tracked over time. The basket is used to
measure inflation overtime such as with
consumer price index.
Consumer Price Index (CPI)
A consumer price index measures
changes in the price level of a weighted
average market basket of consumer
goods and services purchased by
households. Such index numbers include
food, clothing, fuel and lighting, housing,
education etc.
Wholesale Price Index (CPI)
Types of Inflation
Types of Inflation
 Creeping Inflation- When prices rise about 2
percent annually it is called as Creeping
Inflation. Here rise in prices is very slow like that
of a snail or creeper.
 This inflation is regarded safe and essential for
economic growth. An increase in prices of
goods and services leads to an increase in
profit margin . This induces the producers to
undertake more investment. As a result, the
level of output and employment increases in
the economy. Inflation thus keeps the
economy away from stagnation.
Types of Inflation
 Walking or Trotting Inflation- When the
rate of rise in prices is in the range
between 3 to 6 per cent per annum or
less than 10 per cent it is called as walking
or trotting inflation.
 Walking inflation is a warning signal for the
government to control it before it turns
into running inflation.
Types of Inflation
 Running Inflation – When prices rise rapidly
at a speed of around 10 percent to 20
percent per annum it is called running
inflation.
 Such an inflation affects the poor and
middle class people adversely.
Government should take necessary steps
to control it, otherwise it will convert into
hyper inflation.
Types of Inflation
 Hyper Inflation or Galloping Inflation-
When prices rise very fast at double or
triple digit rates more than 20 to 100 per
cent per annum or more, it is usually
called hyper or galloping inflation.
 Such a situation brings total collapse of
the monetary system because of the
continuous fall in the purchasing power of
money.
Types of Inflation
Demand Pull Inflation
 Demand pull inflation refers to a situation
in which prices rise because the demand
for goods and services exceeds their total
supply available at current prices . It is
also known as excess demand inflation.
Demand Pull Inflation
Causes of Demand Pull
Inflation
 Increase in Money Supply- Supply of
money includes currency with the public
and demand deposits at banks. If supply
of money increases then the aggregate
demand also increases.
 Increase in Disposable Income-When the
disposable income of the people
increases it raises their demand for goods
and services leading to demand pull
inflation.
Causes of Demand Pull
Inflation
 Increase in Population- Increase in population
means increased demand for consumer
goods. It increases the aggregate demand
for goods and services and puts pressure on
the existing supply of goods and services.
 Exports- Sometimes exports create shortages
in the domestic economy. It creates inflation
in the domestic economy.
 Increase in government expenditure-
Government spending creates job
opportunities. So the demand increases which
pushes up the price level.
Cost Push Inflation
Cost Push Inflation
Cost Push Inflation
When the prices instead of being pulled up
by demand factors may also be pushed up
as a result of rise in the cost of production, it
is called as cost push inflation.
Causes of Cost Push Inflation
 Rise in Wages- The workers have organized trade unions
which have succeeded in getting higher wages for their
members.
 Increase in the price of raw materials-Cost push inflation is
also caused by increase in the price of inputs like
petroleum, steel, basic chemicals etc.
 Higher Taxes-Another important cause of cost push inflation
is the imposition of higher taxes on goods like excise duties,
sales tax etc. These taxes are largely passed over by the
producers to the consumers by the amount of taxes.
 Genuine shortages- Sometimes the shortages are not
artificial but genuine. If for some reason, the factors of
production are in short supply, production will be affected.
 Hoarding- Sometimes the hoarders pile up the goods and
do not release them in the market.
Causes of Cost Push Inflation
Effects of Inflation
 Effects on Purchasing Power of Money-
Inflation reduces the purchasing power of
money. In the times of inflation, people
buy lesser amount of goods and services
than before. Real income of people will
decline.
Effects of Inflation
 Effects on Production-
 Misallocation of Resources- Producers divert
their resources from the production of
essential goods to non essential goods from
which they expect higher profits.
 Reduction in Saving- When prices rise rapidly,
more money is now needed to buy the same
amount of goods and services than before. It
reduces saving and investment.
Effects of Inflation
 Discourages Foreign Capital- Inflation discourages
the inflow of foreign capital into the country.
Foreigners do not like to invest in those countries
where prices are rising.
 Hoarding- During inflation, the hoarding of larger
stock of goods becomes profitable. As a result of
this, the available supply of goods in relation to
increasing monetary demand decreases. This
results in black marketing.
 Fall in Quality- Inflation tends to create a seller’s
market . Sellers have now command on prices
because of excessive demand in the market .
Sellers do not bother much about the quality.
Effects on Distribution
 Debtors and Creditors- During inflation,
debtors gain but the creditors lose.
 When prices rise, the value of money falls. The
debtors gain because they now pay less in
terms of goods and services . The purchasing
power of money was high when they had
borrowed but low at the time of return.
Creditors lose. Though they get back the
same amount of money which they lent, they
get less in terms of goods and services.
Effects on Distribution
 Wage and Salaried Class or Fixed Income Group-
Fixed income group suffer during inflation. Due to
inflation, purchasing power of money falls. As a
result of it, fixed income earners tend to buy less
amount of goods and services than before.
 Business Community- Businessmen tend to gain
during inflation because
 Prices of their inventories go up and their profit
increases.
 Prices rise at a faster rate than the cost of
production.
 They are generally borrowers of money for business
purposes.
Effects on Distribution
 Investors- Inflation has a mixed effect on the
investors. Investors in fixed interest earning assets (
like bonds, debentures and deposits) are the
losers. Investors in shares of the companies tend to
gain during inflation. Shareholders get dividend.
 Farmers- Farmers generally gain during inflation as
they can sell their crops at a higher price .Farmers
are also borrowers.
 Small farmers do not gain much during inflation as
the major portion of their produce is not marketed
but instead kept for self consumption.
Control of Inflation
Control of Inflation
Control of Inflation
Control of Inflation
Monetary Measures
 Issue
of New Currency- It is an extreme
monetary measure. Under it, new
currency is issued in place of the old
currency . One rupee note can be
exchanged for a number of notes of the
old currency.
Fiscal Measures
 Reduction in Public Expenditure-
Expenditure on non developmental
activities like defence should be
reduced. Such expenditure only increases
the purchasing power in the hands of
people without any corresponding
increase in output.
Fiscal Measures
 Increase in Taxes- To cut private consumption
expenditure, there should be increase in taxes.
Both direct and indirect taxes reduce the
disposable income of the tax payers and thereby
reduce their consumption expenditure.
 Public Borrowings- Through public borrowings the
government takes away the excess purchasing
power from public . This will reduce aggregate
demand and hence the price level.
 Policy of Surplus Budgets- In order to control
inflation, the government should give up deficit
financing and instead have surplus budgets.
Other Measures
 Price Control and Rationing- Under price
controls, the government fixes the maximum
price at which certain commodities can be
sold. No one can charge more than these
prices . Maximum price is set below the free
market equilibrium price. Price ceiling is likely
to create a shortage of goods . Price control
policy is generally accompanied by rationing.
Government fixes the quota of certain
commodities which are to be given to the
consumers at the controlled price.
Other Measures
 Increase in Production- Inflation arises
partly due to excessive aggregate
demand and partly due to less supply of
goods. Resources should be diverted from
the production of luxury goods to the
production of mass consumption goods
like food, clothing, vegetable, oil, sugar
etc.