DEFINITION• An increase in the general level of prices in an economy that is sustained over a period of time is called inflation.• When demand is more than the supply that may lead to inflation.
Measuring Inflation• Inflation is rate of change in the price level.• If the price level in the current year is P1 and in the previous year P0.• The inflation for the current year is [(P1 - P0) / P0] x 100
TYPES OF INFLATION1. Creeping Inflation “When the rise in prices is very low like that of a snail or creeper, is called Creeping Inflation” Here the inflation rate is upto 5% The general level of prices rise at a The general level of prices rise at a moderate rate over a long period of time
2. Running Inflation Running inflation has inflation rate between 8-10 %. A sense of urgency needs to be shown in controlling the running inflation. Persistent running inflation reduces the savings in the economy and results in slowdown in economic growth.
3. Hyper Inflation Prices rise very fast at double or triple digit rate. Also called Runway or Galloping Inflations This type of inflation is witnessed in the past in many countries. Many Latin American countries like Argentina and Brazil had inflation rates of 50 to 700 percent per year in the 1970s and 1980s. Many developed and industrialized countries like Italy and Japan also witnessed the hyper inflation in the past.
• Pricing Power Inflation: Pricing power inflation is more often called as administered price inflation. This type of inflation occurs when the business houses and industries decide to increase the price of their respective goods and services to increase their profit margins.
CAUSES OF INFLATION• Inflation is caused due to several economic factors:• When the government of a country print money in excess, prices increase to keep up with the increase in currency, leading to inflation.• Increase in production and labor costs, have a direct impact on the price of the final product, resulting in inflation.There are two main causes for inflation which is stated as below: Demand Pull Cost Push
Demand Pull: This type of inflation happens when the aggregate demand increases more than the supply Demands pull inflation, wherein the economy demands more goods and services than what is produced.
Demand Pull Inflation in AD-AS Graph Y ASThe reasons for the shiftin AD curve can be either P1 Price Levelreal or monetary factors. P0 ADIt is due to: 1 AD The real factors O 0 X Y Y Y The monetary 0 2 1 factors
Real Factors: The real factors can be increase or decrease in the tax receipts and corresponding increase or decrease in government expenditure. Other factors are investment function, consumption function and export function. The monetary Factors: Monetary factors can be increase or decrease in the money supply. Example: In 1990s when Russian government financed its budget deficit by printing rubbles, the inflation rate per month increased to 25 percent per month and the annual inflation rate was 1355 percent.
Cost Push InflationWhen cost of production increases theprice level automatically increases.Cost push inflation or supply shockinflation, wherein non availability of a commoditywould lead to increase in prices
Cost Push Inflation in AD-AS Graph Cost push theory of inflation explains the causes of inflation origination from the supply side. Cost push inflation depends on: Y ◦ Wage push inflation AS1 ◦ Profit push inflation AS0 ◦ Supply shock inflation P1 Price Level P0 AD O Q Q X 1 0 Quantity
Demand pull vs Cost Push Inflation• If demand pull inflation is correct the government must bear the cost of excessive spending and monetary authorities are to be blamed for “cheap money policy”• On the contrary, if cost push is the real cause for inflation then the trade union are to blamed for excessive wage claim, industries for acceding them and business firms for marking- up profits aggressively.
Economic Impact of Inflation : There is a wide spread impact of inflation on the economies world over. The effect of inflation is felt on distribution of income and wealth and on production.Effect of Inflation on the Distribution of Income and Wealth: The consumers stand at the loosing end, while the producers having old inventories may gain from the inflation. People with fixed income group are the worst sufferers of inflation.
• Inflation also results in black marketing. Sellers may stock up the goods to be sold in the future, anticipating further price rise.• Inflation also discourages entrepreneurs in investing as the risk involved in the future production would be very high.• Inflation also affects the pattern of production, as the shift in production pattern takes place from consumer goods to luxury goods.
Measuring Inflation Inflation is often measured either in terms of Wholesale Price Index or in terms of Consumer Price Index.Wholesale Price Index(WPI) : The Wholesale Price Index is an indicator designed to measure the changes in the price levels of commodities that flow into the wholesale trade intermediaries. The index is a vital guide in economic analysis and policy formulation, It is a basis for price adjustments in business contracts and projects. It is also intended to serve as an additional source of information for comparisons on the international front.
Consumer Price Index (CPI) :• Consumer price index is specific to particular group in the population. It shows the cost of living of the group.• It is based on the changes in the retail prices of goods or services. Based on their incomes, consumer spends money on these particular set of goods and services.• There are different consumer price indices. Each index tracks the changes in the retail prices for different set of consumers. The reason for the different indices is the differing pattern of consumers.
• There are two broad ways in which governments try to control inflation. These are-• 1. Fiscal measures.• 2. Monetary measures
Measures to control inflation• Effective policies to control inflation need to focus on the underlying causes of inflation in the economy.Monetary Policy• Monetary policy can control the growth of demand through an increase in interest rates and a contraction in the real money supply. For example, in the late 1980s, interest rates went up to 15% because of the excessive growth in the economy and contributed to the recession of the early 1990s.• Monetary measures of controlling the inflation can be either quantitative or qualitative. Bank rate policy, open market operations and variable reserve ratio are the quantitative measures of credit control, by which inflation can be brought down. Qualitative control measures involve selective credit control measures.
Bank rate policy is used as the main instrument of monetary control during theperiod of inflation. When the central bank raises the bank rate, it is said to haveadopted a dear money policy. The increase in bank rate increases the cost ofborrowing which reduces commercial banks borrowing from the central bank.Consequently, the flow of money from the commercial banks to the public getsreduced. Therefore, inflation is controlled to the extent it is caused by the bankcredit.Cash Reserve Ratio (CRR) : To control inflation, the central bank raises the CRRwhich reduces the lending capacity of the commercial banks.Consequently, flow of money from commercial banks to public decreases. In theprocess, it halts the rise in prices to the extent it is caused by banks credits tothe public.Open Market Operations: Open market operations refer to sale and purchaseof government securities and bonds by the central bank. To controlinflation, central bank sells the government securities to the public through thebanks. This results in transfer of a part of bank deposits to central bank accountand reduces credit creation capacity of the commercial banks.
Fiscal Policy: • Higher direct taxes (causing a fall in disposable income) • Lower Government spending • A reduction in the amount the government sector borrows each year (PSNCR) Direct wage controls - incomes policies Incomes policies (or direct wage controls) set limits on the rate of growth of wages and have the potential to reduce cost inflation.• Government can curb it’s expenditure to bring the inflation in control.• The government can also take some protectionist measures (such as banning the export of essential items such as pulses, cereals and oils to support the domestic consumption, encourage imports by lowering duties on import items etc.).