INFLATION

• INFLATION- A rise in the general level of prices; a sustained rise in the

general level of prices; persistent increases in the general level of prices; an
increase in the general level of prices in an economy that is sustained over
time; rising prices across the board—is inflation.
• In case the general price level rises, each unit of money buys fewer goods
and services. Consequently, inflation also reflects erosion in the
purchasing power of money.

TYPES OF INFLATION

Based On Coverage or Scope

Comprehensive Inflation: When the prices of all commodities rise in the

entire economy, it is known as Comprehensive Inflation. (Economy wide
inflation)

• Sporadic Inflation: Time when prices of only a few commodities in some

regions (areas) rise, it is called Sporadic Inflation. It is sectional in nature.
For example, increase in food prices due to bad monsoon (winds that bring
seasonal rains in India).

Based On Rising Prices

• Creeping Inflation: When prices rise by not more than (i.e. Up to) 3% per
annum (year)
• Chronic Inflation: If creeping inflation persists (continues to increase) for a
longer period, then it is often called as Chronic or Secular Inflation
• Walking/trotting Inflation: When prices rise by more than 3%, but less
than 10% per annum (i.e., between 3%, and 10% per annum), it is called as
Walking Inflation.
• Moderate Inflation-It happens when prices rise by less than 10% per
annum (single digit inflation rate). It is a stable inflation and not a serious
economic problem.
• Running Inflation: A rapid acceleration in the rate of rising prices is called
Running Inflation. It occurs when prices rise between 10% to 20% per annum
(double-digit inflation rate)
• Galloping/jumping Inflation: If prices rise by dual or triple digit inflation rates
like 30% or 400% or 999% yearly, then the situation can be termed as
Galloping Inflation.
• Hyperinflation- refers to a situation where the prices rise at an alarming high
rate. when prices rise above 1000% per annum (quadruple or four- digit
inflation rate), it is termed as Hyperinflation. Examples of hyperinflation
Hungary in the year 1946 and Zimbabwe during 2004-2009.

CAUSES OF INFLATION

DEMAND PULL-
• Demand-pull inflation exists when aggregate demand for a good or service
outstrips aggregate supply. It starts with an increase in consumer demand.
Sellers meet such an increase with more supply. But when additional supply
is unavailable, sellers raise their prices. The first cause is growing economy.
• Higher inflationary expectation- Once people expect inflation, they will buy
things now to avoid higher future prices. That increases demand, which then
creates demand-pull inflation. Once expectation of inflation sets in, it's hard
to eradicate.
• Over-expansion of money supply either due to expansionary monetary policy
or expansionary fiscal policy.
• Strong brand, itself created by marketing. Marketing can create high
demand for certain products.
• Technological innovation. A company that creates a new technology owns
the market until other companies figure out how to copy it. People will
demand products with technologies that create a real improvement in their
daily lives.

COST PUSH OR SUPPLY SHOCK

• Cost push inflation is inflation caused by an increase in prices of inputs like

labour, raw material, etc. or the level of supply falls. The increased price
of the factors of production leads to a decreased supply of these goods. While
the demand remains constant, the prices of commodities increase causing a
rise in the overall price level.
• Cost-push inflation occurs when demand is inelastic. For example, demand
for petroleum.
• Wage increases- when workers have enough leverage to force it. This
eventually increases input costs of the producers.
• Government regulation and taxation- These rules can reduce supplies of
many other products. Taxes on cigarettes and alcohol were meant to lower
demand for these unhealthy products. U.S government subsidies of ethanol
production led to soaring food prices in 2008.
STRUCTURAL INFLATION-

• Structural inflation is inflation that results from changes in the structure of

demand and supply. Under the influence of changes in the structure of demand
and supply, some branches will experience an increase in demand for their
products, while in the case of others, this demand will fall. If prices and wages in
branches reducing their production will be inflexible towards this reduction,
while prices and wages in branches increasing production will increase, then
the overall level of both prices and wages in the economy will grow. The
discussed phenomenon will become stronger when the supply will be inflexible
and will not be able to adapt immediately to the changes taking place.

MEASUREMENT OF INFLATION

Main set of inflation indices for measuring price level changes in India –

Wholesale Price Index (WPI) - The WPI, where prices are quoted from
wholesalers, is constructed by Office of Economic Affairs, Ministry of Commerce
and Industries. Wholesale price, the price at which goods are traded in bulk.
• WPI continues to constitute three major groups—Primary Articles, Fuel and
Power, and Manufactured Products. The new series of the WPI has been
released by the Government with the revised base year as 2011-12. The
prices used for compilation do not include indirect taxes in order to remove
impact of fiscal policy.
• A new Wholesale Food Price Index (WPFI) has been introduced— combining
the Food Articles (belonging to the group Primary Articles) and Food Products
(belonging to the group Manufactured Products). Together with the Consumer
Food Price Index (CPFI) released by National Statistical Office

The wholesale price index basket has no representation of the services

sector and all the constituents are only goods whose prices are captured at
the wholesale/producer level.
CONSUMER PRICE INDEX (CPI)-

• The CPI measures the average change in prices over time that consumers
pay for a basket of goods and services, commonly known as inflation.
Essentially it attempts to quantify the aggregate price level in an
economy and thus measure the purchasing power of a country’s unit of
currency. The weighted average of the prices of goods and services that
approximates an individual’s consumption patterns is used to calculate
CPI.
• CPI is based only a basket of select goods and is calculated on prices
included in it, it does not capture inflation across the economy as awhole.
• Two Ministries – Ministry of Statistics and Programme Implementation
(MOSPI) and Ministry of Labour and Employment (MOLE) are engaged in
the construction of different CPIs for different groups/sectors. CPI inflation
is also called as retail inflation as the prices are quoted from retailers.
Following are the various CPIs.
 • CPI for all India or CPI combined.
• CPI for Agricultural Labourers (AL)
• CPI for Rural Labourers (RL); and
• CPI for Industrial Workers (IW)
• CPI by MOSPI (NSO)

The NSO, which comes under MOSPI, is constructing the rural, urban and the
combined CPIs. They are published from 2011 onwards. In April 2014, the RBI
has selected the all India CPI combined (of NSO) as the inflation index to target
inflation under its new inflation targeting monetary policy framework. RBI’s
decision has made the CPI as the prime inflation index.

CPI’s By Ministry of Labour And Employment

The Labour Bureau, Ministry of Labour and Employment (MOLE) are preparing
different indices for various categories of people. These were CPI for Rural Laborers
(CPI-RL), CPI for Agricultural Laborares (CPI-AL) and CPI for Industrial Workers
(CPI-IW). There was a CPI for Urban Non- Manual Employees (CPI-UME), but it
was discontinued from April 2010.

Index Agency Base Number of

Year Commodities
WPI Office of Economic Affairs, 2011-12 697
Ministry of Commerce and
Industries
CPI al India, CPI- NSO, Ministry of Statistics and 2012 448 (rural)
Urban And Rural Programme Implementation 460 (urban)

CPI-AL CPI-RL CPI- Labour 1986-87 B

IW 1986-87
2001

GDP DEFLATOR-
• GDP price deflator measures the difference between real GDP and nominal
GDP. Nominal GDP differs from real GDP as the former doesn’t include
inflation, while the latter does. As a result, nominal GDP will most often be
higher than real GDP in an expanding economy.

GDP PRICE DEFLATOR = (NOMINAL GDP ÷ REAL GDP) X 100

• GDP deflator is available only on a quarterly basis along with GDP estimates,
whereas CPI and WPI data are released every month.

PHILLIP’S CURVE
• The Phillips curve given by A.W. Phillips shows that there exists an inverse
 relationship between the rate of unemployment and the rate of increase in
nominal wages.
• A lower rate of unemployment is associated with higher wage rate or
inflation, and vice versa. In other words, there is a tradeoff between wage
inflation and unemployment.
• Reason: during boom, demand for labour increases. Due to greater
bargaining power of the trade union, wage increases.
• However, the implications of Phillips curve have been found to be true only in
the short term. Phillips curve fails to justify the situations of stagflation, when
both inflation and unemployment are alarmingly high

EFFECTS OF INFLATION
The impacts of inflation are multidimensional. It impacts various sectors and
segments of the economy as-
• Debtors and Creditors- lenders suffer and borrowers benefit out of
inflation. The opposite effect takes place when inflation falls. During
inflation when the prices rise (and the real value of money goes down), the
debtors pay back less in real terms than what they had borrowed, and thus,
to that extent they are gainers. On the other hand, the creditors get less in
terms of goods and services than what they had lent and stand to lose to that
extent. Interest Rates- If interest rates on savings accounts are lower than
the rate of inflation, then people who rely on interest from their savings will
be poorer.
• Cost Of Borrowing- High inflation may also lead to higher borrowing costs for
businesses and people needing loans and mortgages as financial markets
protect themselves against rising prices and increase the cost of borrowing
on short and longer-term debt. There is also pressure on the government to
increase the value of the state pension and unemployment benefits and other
welfare payments as the cost of living climbs higher
• Business Competitiveness- If one country has a much higher rate of
inflation than others for a considerable period of time, this will make its
exports less price competitive in world markets. Eventually this may show
 through in reduced export orders, lower profits and fewer jobs, and also in a
worsening of a country’s trade balance. A fall in exports can trigger negative
multiplier and accelerator effects on national income and employment.

• Income Redistribution- One risk of higher inflation is that it has a

regressive effect on lower-income families and older people in society. This
happen when prices for food and domestic utilities such as water and
heating rises at a rapid rate.
• Wages- Inflation increases the nominal (face) value of wages, while their real
value falls. That is why there is a negative impact of inflation on the purchasing
power and living standard of wage employees. Dearness Allowance is given by
Government to 57eutralize this impact
• Investors- Different kinds of investors are affected differently by inflation
and deflation. One can invest in bonds and debentures which yield a fixed
rate of interest income or one can invest in real estate or equities (shares)
whose returns (dividends) rise and fall with profits earned by the
companies concerned. When prices rise, the returns on equities go up on
account of the rise in profits, while the bonds and debenture- holders gain
nothing as their incomes remain fixed.
• Government- In a mixed economy, the public sector is affected by fluctuations
in price level. As prices rise, the government has to spend more on goods and
services including raw materials for carrying through their project. Estimates
are revised and taxes are raised. On the other hand, when prices fall, the
government sector or the public sector has to incur fewer costs.
• Entrepreneurs- When prices rise, producers, traders’ speculators and
entrepreneurs stand to gain on account of windfall profits because prices rise
at a faster rate than cost of production, besides, there is time- lag between the
two. Moreover, they gain because the prices of their inventories (stock)group.
• Public Morale- Inflation results in arbitrary redistribution of wealth
favoring businessmen and debtors and hurting consumers, creditors, petty
shopkeepers, small investors and fixed income earners. This lowers the
public moral. The ethical standards and the public moral had fallen to
miserably low levels during the period of hyper-inflation in Germany.

IMPORTANT TERMS ASSOCIATED WITH INFLATION

• Bottleneck Inflation - This inflation takes place when the supply falls
drastically, and the demand remains at the same level.
• Inflation Spiral - An inflationary situation in an economy which results out
of a process of wage and price interaction ‘when wages press prices up and
prices pull wages up’ is known as the inflationary spiral. It is also known as
the wage-price spiral.
• Reflation -It is a situation often deliberately brought by the government to
reduce unemployment and increase demand by going for higher levels of
economic growth. Governments go for higher public expenditures, tax cuts,
interest rate cuts, etc.
• Stagflation - Stagflation is a situation in an economy when inflation and
unemployment both are at higher levels, contrary to conventional belief.
When the economy is passing through the cycle of stagnation (i.e., long
period of low aggregate demand in relation to its productive capacity) and the
government shuffles with the economic policy, a sudden and temporary price rise is
seen in some of the goods—such inflation is also known as stagflation. Stagflation is
basically a combination of high inflation and low growth.
• Skewflation - A price rise of one or a small group of commodities over a
sustained period of time is called skewflation.
• Deflation- When the general level of prices is falling over a period of time this
is deflation.
• Disinflation is a decrease in the rate of inflation – a slowdown in the rate of
increase of the general price level of goods and services in a nation's gross
domestic product over time.
• Core Inflation – It refers to the price increase excluding volatile fluctuation of
prices of food and energy. Also known as Structural Inflation.
• Headline Inflation - Headline Inflation is the measure of total inflation
within an economy. It includes price rise in food, fuel and all other
commodities.
• Base Effect - It refers to the impact of the rise in price level (i.e., last year’s
inflation) in the previous year over the corresponding rise in price levels in the
current year (i.e., current inflation. The index has increased by 20 points in all
the three years, viz., 2008, 2009 and 2010. However, the inflation rate
(calculated on ‘year-on-year’ basis) tends to decline over the three years from
20 percent in 2008 to 14.29 percent in 2010. Current Inflation Rate = [(Current
Price Index – Last year’s Price Index)] ÷ Last year’s Price Index] x 100
• Inflationary Gap - The excess of total government spending above the
national income (i.e., fiscal deficit) is known as inflationary gap. This is
intended to increase the production level, which ultimately pushes the
prices up due to extra-creation of money during the process.
• Deflationary Gap - The shortfall in total spending of the government (i.e., fiscal
surplus) over the national income creates deflationary gaps in the economy.
This is a situation of producing more than the demand and the economy usually
heads for a general slowdown in the level of demand. This is also known as the
output gap.
• Inflation Tax - Inflation erodes the value of money and the people who
hold currency suffer in this process. As the governments have authority of printing
currency and circulating it into the economy (as they do in the case of deficit
financing), this act functions as an income to the governments. This is a
situation of sustaining government expenditure at the cost of people’s income. This
looks as if inflation is working as a tax. That is how the term inflation tax is also
known as seigniorage.