Inflation

Demand-Pull Inflation, Cost-push inflation, Supply-side inflation Open Inflation, Repressed

Inflation, Hyper-Inflation, are the different types of inflation. Increase in public spending, hoarding,
tax reductions, price rise in international markets are the causes of inflation. These factors lead to
rising prices. Also, increasing demands causes higher prices which leads to Inflation. In this article,
we will discuss the meaning of inflation and what causes it.
What is Inflation?

According to many classical writers, inflation is a situation when too much money chases too few
goods and services. Inflation is measured by the Consumer Price Index(CPI).

Therefore, there is an imbalance between the money supply and the Gross Domestic Product (GDP).
There are many types of inflation like demand-pull inflation, cost-push inflation, supply-side
inflation. But Inflation can be divided into two broad types:

1. Open inflation – when the price level in an economy rises continuously and
2. Repressed inflation – when the economy suffers from inflation without any apparent rise in prices.

According to Keynes, inflation is an imbalance between the aggregate demand and aggregate supply
of goods and services. Therefore, if the aggregate demand exceeds the aggregate supply, then the
prices keep rising.
Causes of Inflation

Having understood the inflation meaning, let’s take a quick look at the factors that cause inflation.

Primary Causes - In an economy, when the demand for a commodity exceeds its supply, then the
excess demand pushes the price up. On the other hand, when the factor prices increase, the cost of
production rises too. This leads to an increase in the price level as well.

Increase in Public Spending - In any modern economy, Government spending is an important

element of the total spending. It is also an important determinant of aggregate demand. Usually, in
lesser developed economies, the Govt. spending increases which invariably creates inflationary
pressure on the economy.

Deficit Financing of Government Spending - There are times when the spending of Government
increases beyond what taxation can finance. Therefore, in order to incur the extra expenditure, the
Government resorts to deficit financing. For example, it prints more money and spends it. This, in
turn, adds to inflationary pressure.

Increased Velocity of Circulation - In an economy, the total use of money = the money supply by
the Government x the velocity of circulation of money. When an economy is going through a
booming phase, people tend to spend money at a faster rate increasing the velocity of circulation of
money.

Population Growth - As the population grows, it increases the total demand in the market. Further,
excessive demand creates inflation.

Hoarding - Hoarders are people or entities who stockpile commodities and do not release them to
the market. Therefore, there is an artificially created demand excess in the economy. This also leads
to inflation.
Genuine Shortage - It is possible that at certain times, the factors of production are short in supply.
This affects production. Therefore, supply is less than the demand, leading to an increase in prices
and inflation.

Exports - In an economy, the total production must fulfill the domestic as well as foreign demand. If
it fails to meet these demands, then exports create inflation in the domestic economy.

Trade Unions - Trade union work in favor of the employees. As the prices increase, these unions
demand an increase in wages for workers. This invariably increases the cost of production and leads
to a further increase in prices.

Tax Reduction - While taxes are known to increase with time, sometimes, Governments reduce
taxes to gain popularity among people. The people are happy because they have more money in their
hands. However, if the rate of production does not increase with a corresponding rate, then the
excess cash in hand leads to inflation.

The imposition of Indirect Taxes - Taxes are the primary source of revenue for a Government.
Sometimes, Governments impose indirect taxes like excise duty, VAT, etc. on businesses. As these
indirect taxes increase the total cost for the manufacturers and/or sellers, they increase the price of
the product to have a minimal impact on their profits.

Price-rise in the International Markets - Some products require to import commodities or factors
of production from the international markets like the United States. If these markets raise prices of
these commodities or factors of production, then the overall production cost in India increases too.
This leads to inflation in the domestic market.

Non-economic Reasons - There are several non-economic factors which can cause inflation in an
economy. For example, if there is a flood, then crops are destroyed. This reduces the supply of
agricultural products leading to an increase in the prices of the commodities.

Investment in Gold, Real estate, stocks, mutual funds, and other assets are some of the ways to deal
with Inflation.
Advantages and Disadvantages of Inflation

Inflation can be construed as either a good or a bad thing, depending upon which side one takes, and
how rapidly the change occurs.

Advantages

It means the price levels increase, but for an economy to run healthily, wages should also be rising.
Inflation is a sign that an economy is flourishing. The Reserve Bank of India (RBI) considers the
range of 4-5% as an ideal situation for inflation in India. Following are some of its advantages:

o Slow inflation aids economic growth

o Better than deflation as it does not lead to recession
o Allows adjustment of prices
o Helps in adjustment of real wages

Disadvantages

On the other hand, now let’s take a quick look at the disadvantages of Inflation:

o May lead to uncertainty and lower investments

o Higher rate of inflation can lead to lower growth and instability
o Reduces international competitiveness
o Distorts the planning process
o May also give rise to speculative investment
o May result in a decline in the value of savings
o May lead to inequality in the income distribution
How is Inflation Measured?

It can be measured through the following indexes:

1. Consumer Price Index (CPI)

2. Wholesale Price Index (WPI)

Points of
CPI WPI
Difference

It is the average change in prices of the goods and/ It measures the changes in the prices of
or services over time that the consumer pays for a Meaning goods sold and traded in bulk by the
basket of goods and/ or services wholesale businesses to other businesses.

It is used to measure inflation. The rate of

The RBI and other statistical agencies study the CPI
inflation is the difference between the
in order to understand the price change of various Uses
WPI calculated at the start and end of a
commodities and keep inflation under control.
year.

Computed
Ministry of Statistics and Program Implementation Ministry of Commerce & Industry
by

CPI = (Cost of basket divided by Cost of basket in (WPI of end of year – WPI of beginning of
Formula
the base year) multiplied by 100 year)/WPI of beginning of year x 100
How to Control Inflation?

Now, let’s have a quick look at some of the methods with which inflation can be controlled:

 Monetary Policy - The Central Bank can increase the interest rates, making borrowing more
expensive and savings more attractive. This would lead to a lower growth of consumer spending and
an increase in investment.

 Controlling money supply - As part of the monetary policy, many countries have set up an inflation
target. The reason for this is if people believe the inflation target is credible, then it will also help to
decrease inflation expectations. It will result in a controlled inflation.

 Fiscal policy - The government can increase the rate of taxes and may also cut its spending. This will
not only improve the government’s budget situation but also help reduce demand in the economy.
Both these policies will help in reducing inflation by reducing the growth of total demand.

 Wage control - If inflation is caused due to wages, then limiting the growth of wages can also help to
control inflation. Lower wage growth will help in reducing cost-push inflation along with moderating
the demand-pull inflation.

 Supply-side policies - Inflation is many times caused by lack of competitiveness and rising costs of
raw materials. Supply-side policies may enable the economy to become more competitive and it will
also help in controlling inflationary pressures.

Other methods to control inflation are:

o ncreasing population
o Having a rational-wage policy
o Price control
o Rationing
o Importing high-demand commodities
o Controlling hoarding and speculation
o Decreasing exports
Effects of Inflation

Creditors lose and debtors gain during inflation because debts are fixed in rupee
Creditors & Debtors terms. When debts are repaid by debtors, their real value declines due to the price
level increase and hence creditors lose in monetary terms.

Bond & Debenture Bondholders earn fixed interest income thus such individuals suffer a reduction in
holders real income when price rises.

Individuals who invest money in shares during inflation are expected to gain since the
Investors
possibility of earning business profit increases.

Salaried individuals & Individuals earning a fixed income are negatively affected due to inflation, resulting
wage-earners in a reduction in the real purchasing power of the fixed-income earners.

Profit-earners,
Profits tend to rise during inflation as businessmen raise the prices of their products
speculators, black
which ultimately results in greater profits.
marketers
Recent Trends in Inflation in India

o India’s growth in the first quarter of 2020-21 at -23.9% showed one of the highest
contractions globally.
o The 2020-21 real GDP growth for India is forecast in the range of -5.8% as per the RBI’s
Survey of Professional Forecasters to -14.8% as per Goldman Sachs
o The Organisation for Economic Cooperation and Development (OECD) projected a
contraction of 10.2% in the financial year 2021 for the Indian economy.
o The annual projections also show a strong likelihood of even the nominal GDP growth
showing a contraction for 2020-21
Is Inflation Good or Bad?

Too much inflation is generally considered bad for an economy, while too little inflation is also
considered harmful. Many economists advocate for a middle ground of low to moderate inflation, of
around 2% per year.

Generally speaking, higher inflation harms savers because it erodes the purchasing power of the
money they have saved; however, it can benefit borrowers because the inflation-adjusted value of
their outstanding debts shrinks over time.

What are the impacts of inflation on economic activities?

The following points highlight the six major effects of inflation.

1. Effects on Distribution of Income and Wealth: The impact of inflation is felt unevenly by the different
groups of individuals within the national economy—some groups of people gain by making big fortune and
some others lose. We may now explain in detail this effect of inflation on different groups of people:

(a) Creditors and debtors: During inflation creditors lose because they receive in effect less in goods and
services than if they had received the repayments during a period of low prices. Debtors, on other hand, as
a group gain during inflation, since they repay their debts in currency that has lost its value (i.e., the same
currency unit will now buy less goods and services).

(b) Producers and workers: Producers gain because they get higher prices and thus more profits from the
sale of their products. As the rise in prices is usually higher than the increase in costs, producers can earn
more during inflation. But, workers lose as they find a fall in their real wages as their money wages do not
usually rise proportionately with the increase in prices. They, as a class, however, gain because they get
more employment during inflation.

(c) Fixed income-earners: Fixed income-earners like the salaried people, rent-earners, landlords, pensioners,
etc., suffer greatly because inflation reduces the value of their earnings.

(d) Investors: The investors in equity shares gain as they get dividends at higher rates because of larger
corporate profits and as they find the value of their shareholdings appreciated. But the bondholders lose as
they get a fixed interest the real value of which has already fallen.

(e) Traders, speculators, businesspeople and black-marketers: They gain because they make more profits
from the persistent rise in prices.

(f) Farmers: Farmers also gain because the rise in the prices of agricultural products is usually higher than the
increase in the prices of other goods.

Thus, inflation brings a shift in the pattern of distribution of income and wealth in the country, usually
making the rich richer and the poor poorer. Thus during inflation there is more and more inequality in the
distribution of income
 2. Effects on Production: The rising prices stimulate the production of all goods—both of consumption and
of capital goods. As producers get more and more profit, they try to produce more and more by utilising all
the available resources at their disposal.

But, after the stage of full employment the production cannot increase as all the resources are fully
employed. Moreover, the producers and the farmers would increase their stock in the expectation of a
further rise in prices. As a result hoarding and cornering of commodities will increase.

But such favourable effects of inflation upon production are not always found. Sometimes, production may
come to a standstill position despite rising prices, as was found in recent years in developing countries like
India, Thailand and Bangladesh. This situation is described as stagflation.

3. Effects on Income and Employment: Inflation tends to increase the aggregate money income (i.e., national
income) of the community as a whole on account of larger spending and greater production. Similarly, the
volume of employment increases under the impact of increased production. But the real income of the
people fails to increase proportionately due to a fall in the purchasing power of money.

4. Effects on Business and Trade: The aggregate volume of internal trade tends to increase during inflation
due to higher incomes, greater production and larger spending. But the export trade is likely to suffer on
account of a rise in the prices of domestic goods. However, the business firms expand their businesses to
make larger profits.

During most inflation since costs do not rise as fast as prices profits soar. But wages do not increase
proportionate with prices, causing hardships to workers and making more and more inequality. As the old
saying goes, during inflation prices move in escalator and wages in stairs.

5. Effects on the Government Finance: During inflation, the government revenue increases as it gets more
revenue from income tax, sales tax, excise duties, etc. Similarly, public expenditure increases as the
government is required to spend more and more for administrative and other purposes. But the rising prices
reduce the real burden of public debt because a fix sum has to be paid in instalment per period.

6. Effects on Growth: A mild inflation promotes economic growth, but a runaway inflation obstructs
economic growth as it raises cost of development projects. Although a mild dose of inflation is inevitable and
desirable in a developing economy, a high rate of inflation tends to lower the growth rate by slowing down
the rate of capital formation and creating uncertainty.

But inflation, especially a runaway inflation, is an unstable situation. It makes the business world uneasy and
uncertain. Society gets disturbed as there grows discontentment among the salaried people and they
demand an increase in their wages and salaries.

The middle-class people suffer hard as the real value of their income becomes very low. Inflation is also
unjust as it makes one class of people richer and the other poorer. But the most serious effect of inflation
from the standpoint of the economy is that it makes the economic environment of business unstable.