What is inflation? In economics, inflation is a rise in the general level ofprices of goods and services in an economy over aperiod of time. The term inflation in other words , refers to thedevaluation of the currency. General price level rise implies each unit of currencybuys fewer goods and services.
1. Wholesale Price Index (WPI): is the index that isused to measure the change in the average pricelevel of goods traded in wholesale market.2. Consumer Price Index (CPI): which is A measureof the cost of a fixed “market basket” of consumergoods and servicesHow is Inflation measured?Value of the market basketin the current periodValue of the market basket inthe base periodCPI = x 100 = PRICE INDEX
Demand pull inflationCost push inflationCauses Of Inflation In A Nutshell
Causes Of Inflation1. A change in the price of money which is usually afluctuation in the commodity price of the goldbacking the currency.2. Excessive bank credit in the economy or Currencydepreciation resulting from an increased supply ofcurrency relative to the quantity of redeemablemetal backing the currency.3. Consensus view is that a long sustained period ofinflation is caused by money supply growing fasterthan the rate of economic growth.
Causes Of Inflation (Cont..)6. Due to hoarding.7. A change in the value or production costs of thegood.8. Considerable increase in exports may cause ashortage at home (within exporting country) andresults in price rise (within exporting country). Thisis known as Export-Boom Inflation.9. Inflation is caused by excess demand in relationto supply of all types of goods and services due toa rapid increase in population.
How to Control Inflation?1. Monetary measures2. Fiscal measures3. Wage and price controls4. Other Measures5. Two Group Of ThoughtsThese are broad ways of controlling inflation in aneconomy:
1. MONETARY MEASURESThe most important and commonly used method tocontrol inflation is monetary policy of the Central Bank.Most central banks use high interest rates and slow growthof the money supply as the traditional way to fight orprevent inflation. Monetary measures used to control inflation include:o Bank Rate Policy or Credit Controlo Cash Reserve Ratioo Open Market Operations.o Maintaining Gold Standardo Fixed Exchange Rates
Bank rate policy is used asthe main common tool against inflation. Whenthe central bank raises the bank rate, it is said tohave adopted a dear money policy. The increase inbank rate increases the cost of borrowing whichreduces commercial banks borrowing from thecentral bank. Consequently, the flow of moneyfrom the commercial banks to the public getsreduced. Therefore, inflation is controlled to theextent it is caused by the bank credit.oBank rate policy/Credit Control
oCash Reserve Ratio (CRR) :To control inflation, thecentral bank should raise the CRR which reducesthe lending capacity of the commercial banks.Consequently, flow of money from commercialbanks to public decreases.
oOpen Market Operations:Open market operationsrefer to sale and purchase of government securitiesand bonds by the central bank. To controlinflation, central bank should sell the governmentsecurities to the public through the banks. Thisresults in transfer of a part of bank deposits tocentral bank account and reduces credit creationcapacity of the commercial banks.
o Maintaining Gold StandardThe gold standard is a monetary systemin which a regions common media of exchange arefreely convertible into pre-set, fixed quantities ofgold. The standard specifies how the gold backingwould be implemented, including the amount ofgold per currency unit. Economies based on thegold standard rarely experience inflation above 2percent annually. Thus inflation here isdetermined by the growth rate of the supply ofgold relative to total output.
oFixed exchange ratesUnder a fixed exchange ratecurrency regime, a countrys currency is tied invalue to another single currency or to a basket ofother currencies (or sometimes to anothermeasure of value, such as gold). A fixed exchangerate is usually used to stabilize the value of acurrency, vis-a-vis the currency it is pegged to. Itcan also be used as a means to control inflation.However, as the value of the reference currencyrises and falls, so does the currency pegged to it.
2. FISCAL MEASURESFiscal measures to control inflationinclude taxation, government expenditure andpublic borrowings. The government can also takesome protectionist measures (such as banning theexport of essential items such as pulses, cerealsand oils to support the domesticconsumption, encourage imports by loweringduties on import items etc.)
Reduction in Unnecessary Expenditure Increase in Taxes Increase in Savings Surplus BudgetsSome Common Fiscal Measures:
3. WAGE AND PRICE CONTROLSAdjust wages as prices fluctuate.Wage and price controls have been successful inwartime environments in combination with rationing.Notable failures of their use include the 1972imposition of wage and price controls by RichardNixon.Successful examples include the Prices And IncomesAccord in Australia and the Wassenaar Agreement inthe Netherlands.Only effective as a short term measure.
OTHER MEASURESTo Increase Production:This quenches the excessdemand of a commodity and lowers its price.Cost-of-living allowance:In many countries, employmentcontracts, pension benefits, and governmententitlements are tied to a cost-of-living index, typicallyto the CPI. A cost-of-living allowance (COLA) adjustssalaries based on changes in a cost-of-living index.18
Two Groups Of Thoughts Monetarists emphasize keeping the growth rate ofmoney steady, and using monetary policy to controlinflation (increasing interest rates, slowing the rise inthe money supply). Keynesians emphasize reducing aggregate demandduring economic expansions and increasing demandduring recessions to keep inflation stable. Control ofaggregate demand can be achieved using bothmonetary policy and fiscal policy.