Inflation

Meaning of Inflation

Inflation is a sustained increase in the aggregate price levels. It refers to a state of rising prices and not a
state of high prices.

Types of Inflation
The types of inflation observed in an economy depend on the rate of increase in the price levels and are
follows:
 Creeping inflation is inflation where the price level increases at a very
slow rate of 2–2.5% per annum.
 Walking inflation is inflation where the general price level of the
economy increases at the rate of 5–6% per annum.
 Running inflation is inflation where the general price level increases
faster and the rate of increase in price level is about 10% per annum.
The inflation rate becomes a double digit figure.
 Hyperinflation is inflation where the general price level increases at the
rate of 200% or more per month. Here, the price rise is ten or even a
hundred-fold in a month.

Demand Pull Inflation

Demand pull inflation refers to the inflation generated by the pressure of excessive demand in an
economy. If there is an excess of aggregate demand in the economy over aggregate supply, the general
price level will tend to increase, which leads to inflation.

 The following are the three factors which cause demand-pull inflation:
o Population pressure: Heavy population pressure led to an increase in the demand for food items
and other essential goods in the Indian market. This excess demand condition in the product
market led to a price rise and it is termed demand-pull inflation.
o Growing government expenditure: A continuous increase in the government expenditure on
infrastructural development and other developmental plans is essential. This generates more
employment and income opportunities. It means additional purchasing power for the public to
demand more goods and services.
o Growing supply of money: Increasing government expenditure and the credit policy of the
government lead to an increase in flow of money within the economy. This in turn leads to an
increase in demand for goods and services within the economy.

Cost-Push Inflation
An increase in the general price level of an economy with an increase in the average cost of production is
called cost-push inflation. Cost-push factors are increase in the wage rate and increase in the prices of
raw materials. Producers increase the prices of goods and services to maintain the profit rates after an
increase in the cost of production.
 Factors responsible for the causes of cost-push inflation:
o Rise in wages: Rise in wages is considered a determinant of cost-push inflation. Because of trade
unions, workers have organised strongly to get higher wages. This rise in wage cost may lead to
the imposition of higher product price by producers. Hence, when the average prices of different
consumption goods increase, workers would again demand for higher wages.
o Increase in the price of basic materials: Basic materials such as steel, chemicals and oil are used
directly or indirectly in major industries. Thereby any increase in the prices of these basic materials
affects the entire economy and the prices tend to increase.
o Higher taxes: Increase in taxes such as excise duties, sales tax and value added tax, where
taxpayers can easily shift the burden of tax to the others, leads to an increase in the prices of
different commodities.

Effects of Inflation

 Effects on Purchasing Power of Money

Purchasing power of money means the amount of goods
and services which a unit of money can buy. During
inflation, people will be able to consume lesser goods and
services than before, i.e. real income declines.

 Effects on Production
When hyperinflation occurs in an economy because of
uncertainty, there will be a negative effect in the production.
It disrupts the price system and encourages hoarding.
Hyperinflation reduces savings and capital accumulation
which adversely affects production.

 Effects on Distribution
o Fixed income groups: People who receive a fixed income are hit the hardest during periods of
rising prices as their incomes remain fixed. The middle class, who by hardwork take care of their
children's education, find it difficult to survive in times of serious inflation.
o Borrowers: 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 goods
and services than what they had lent and hence lose in that
context.
o Investors: When prices rise, the returns on equities go up on
account of the rise in profits, while the bond and debenture
holders gain nothing as their income remains fixed. By the same
logic, holders will lose during depression, while the debenture and
bond holders will stand to gain.
Control of Inflation

Monetary Measures

The three monetary policies of the Reserve Bank of India to

control credit:
 Bank rate policy: The increase in the bank rate increases
the cost of borrowing which reduces the borrowings of the
commercial banks from the Central Bank. Consequently, the flow
of money from the commercial banks to the public reduces.
Therefore, inflation is controlled to the extent it is caused by
bank credit.
 Cash reserve ratio (CRR): While controlling inflation, the
Central Bank raises the CRR which reduces the lending capacity
of commercial banks. Consequently, the flow of money from
commercial banks to the public decreases. In the process, it
halts the rise in prices to the extent it is caused by bank credits to the public.
 Open market operations: While controlling inflation, the Central Bank sells government securities to
the public through banks. This results in the transfer of part of the bank deposits to the Central Bank
account and reduces the credit creation capacity of commercial banks.

Fiscal Measures
Fiscal measures to control inflation include taxation, government expenditure and public borrowings. The
choice of fiscal measures for controlling inflation depends on the causes of excess demand as follows:
 Government expenditure: When excess demand is caused by the government expenditure more than
real output, the most effective measure is to cut down on public expenditure. A cut in public
expenditure reduces not only the government’s demand for goods and services but also private
consumption expenditure. Therefore, the excess demand decreases more than a given cut in public
expenditure.
 Taxation: When excess demand is caused by private expenditure such as the expenditure by the
households and firms, taxation of income is a more appropriate measure to control inflation. Taxation
of income reduces disposable income. As consumer demand is a function of disposable income,
consumer demand decreases because of taxation. Thus, a well-designed taxation policy reduces
aggregate demand and thereby brings inflation under control.
 Public borrowing: Borrowings by the government to fund budget deficits uses idle money lying with
banks and financial institutions for productive functions by investing it. When the government borrows
money from the market, it reduces the purchasing power of the public.

Other Measures
 Price Control: When the government resorts to price control, a maximum retail price of goods and
services is fixed. The primary objective is to prevent the price rise of scarce goods and to ration the
use of the commodity. This measure is adopted to control hyperinflation.
 Wage Control: Wage control is used to combat inflation when wages tend to rise much faster than
productivity. The government controls wage rise directly by imposing a ceiling on the wage incomes in
both private and public sectors.
 Increase in Output: By increasing the level of output, the prices of essential consumer goods are
maintained at a low level. Also, the government initiates a liberal import policy to overcome the
shortfall of goods in the market.

Change in Wholesale Price Level

Year Base Year
2004–05 = 100
2005–06 4.50%
2006–07 6.60%
2007–08 4.66%
2008–09 8.06%
2009–10 3.80%
2010–11 9.55%
2011–12 7.55%
Wholesale Price Level
Source: Reserve Bank of India

Anti-Inflation Measures taken by the Government

Anti-inflation policy means the measures taken to counteract inflation. The government undertakes these
measures because the effect of inflation has harmful influences on an economy.
 Monetary measures: The government has adopted credit control measures to restrict the further rise in
the supply of money in the economy. On 20 April 2010, the Reserve Bank of India (RBI) announced a
new monetary policy. The repo rate, cash reserve ratio (CRR) and reverse repo rate were all raised by
25 basis points to tackle inflation. The repo rate has been increased to 5.25%, the reverse repo rate to
3.75% and the CRR to 6%.
o Repo rate: It is the rate at which the RBI lends funds to commercial banks. It has direct influence
on the economy.
o Reverse repo rate: It is the rate at which interest is provided to commercial banks for their
overnight deposits at the RBI.
o CRR: It is the rate at which commercial banks have to maintain a percentage of the deposits with
the RBI as reserves.
 Rationing and price control: The government has introduced a rationing system for essential
commodities to ensure their proper supply.
 Maintenance of buffer stock: Sufficient stock of food grains is kept to intervene in the market to
maintain prices at a reasonable level.
 Cut in custom duties: The custom duties on essential commodities should be reduced to increase the
supply of these commodities in the domestic market.
 Increase in agricultural production: The government has announced procurement prices for several
crops to encourage farmers to produce more food grains.
 Reduction in demand: Saving is encouraged among people to reduce their demand for commodities in
the market. Hence, the price will be controlled to a certain extent.