CONTENTSglimpse of what isto comeDefinition & OriginTypes of InflationCauses of InflationEffect of InflationMeasuring of InflationControlling of Inflation“ Inflation is when you pay fifteen dollars for theTen dollars haircut you used to get for five dollars, when you had hair ”
Layman Rise in PriceTechnical SpeakingIt is a rise in the general level of prices of goods andservices imbalance between the quantity of money andtrade needs
That IS……………1950’s 1 rupee =2000’s 1 rupee =MilkyBAR0
ORIGIN• The term “Inflation” originated as devaluation of currency and not rise in price ofas we now know it.•In times when gold was used as currency,the government or the King used dilution asa measure to raise the profits throughSeigniorage.•This practiced increased the money supplybut at the same time lowered the relativevalue of each coin. Due to this , more coinswere needed for the same goods &services.
There are many types of Inflation as described by the Economistbut three important types are:• Creeping Inflation• Running Inflation• Hyper Inflation
1) Creeping Inflation “When the rise in prices is very low like that of a snail orcreeper, is called Creeping Inflation”. It is the mildest form of inflation and also known as a MildInflation or Low Inflation. The general level of prices rise at a moderate rate over along period of time. According to R.P. Kent, when prices rise by not morethan (up to) 3% per annum (year), it is called CreepingInflation
2) Running Inflation A rapid acceleration in the rate of rising prices is referredas Running Inflation. When prices rise by more than 10% per annum, runninginflation occurs. Economists have not suggested a fixed range formeasuring running inflation, we may consider price risebetween 10% to 20% per annum (double digit inflationrate) as a running inflation. Persistent running inflation reduces the savings in theeconomy and results in slowdown in economic growth.
2) Hyper Inflation Prices rise very fast at double or triple digitrate. In quantitative terms, when prices riseabove 1000% per annum Also called Runway or Galloping Inflations. The prices rise so fast that it becomes verydifficult to measure its magnitude. Many Latin American countries like Argentina and Brazilhad inflation rates of 50 to 700 percent per year in the1970s and 1980s. Many developed and industrialized countries like Italy andJapan also witnessed the hyper inflation in the past.
Inflation is caused due to several economic factors: When the government of a country print money inexcess, prices increase to keep up with the increase incurrency, leading to inflation. Increase in production and labor costs, have a directimpact on the price of the final product, resulting ininflation.There are two main causes for inflation which is stated asbelow: Demand Pull Cost Push
1) Demand PullThis type of inflation happens when the aggregatedemand increases more than the supply Demands pull inflation, where in the economy demandsmore goods and services than what is produced.
Demand Pull Inflation in AD-AS GraphThe reasons for the shift in AD curve canbe either real or monetary factors.It is due to:The real factorsThe monetary factorsAD0AD1ASP0P1Y0Y2Y1O XYPriceLevel
Real Factors:The real factors can be increase or decrease in the tax receipts andcorresponding increase or decrease in government expenditure. Otherfactors 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 printingrubbles, the inflation rate per month increased to 25 percent per month andthe annual inflation rate was 1355 percent.
2) Cost PushWhen prices rise due to growing cost ofproduction of goods and services, it isknown as Cost-Push (Supply-side) Inflation.For e.g. If wages of workers are raised thenthe unit cost of production also increases.As a result, the prices of end-products orend-services being produced andsupplied are consequently hiked.AS0AS1ADP0P1Q0Q1O XYPriceLevelQuantity
Positive EffectProbably the most significant effect of inflation is its effecton the revenues of the government. When inflation is higherthan previously thought and planned with, the revenues ofthe government increases, which is good as the budgetbalance of the government improves. The reason whyrevenues of the government increases when inflationincreases is because the government has higher taxrevenues. For example a company sells its products andservices at higher prices, which increases the total incomeof the company, which in turn increases the gross (beforetax) profits of the company (provided that all other factorsinfluencing profits remain constant). Greater before taxprofits result in greater taxes paid to the government.Negative Effect• Uncertainty about future inflation may discourage investment and saving.• Where fixed exchange rates are imposed, higher inflation than in tradingpartners economies will make exports more expensive and tend toward aweakening balance of trade.• Menu costs: Firms must change their prices more frequently, which imposescosts, for example with restaurants having to reprint menus.
Measured InflationTo illustrate the method of calculation, in January 2007, theU.S. Consumer Price Index was 202.416, and in January2008 it was 211.080. The formula for calculating the annualpercentage rate inflation in the CPI over the course of 2007isThe resulting inflation rate for the CPI in this one yearperiod is 4.28%, meaning the general level of prices fortypical U.S. consumers rose by approximately four percentin 2007.211.080 – 202.416-------------------------- 100 %202.416
Effective policies to control inflation need to focus on the underlyingcauses of inflation in the economy.Monetary Policy Monetary policy can control the growth of demand through anincrease in interest rates and a contraction in the real money supply.For example, in the late 1980s, interest rates went up to 15% because ofthe excessive growth in the economy and contributed to the recessionof the early 1990s. Monetary measures of controlling the inflation can be eitherquantitative or qualitative. Bank rate policy, open market operationsand variable reserve ratio are the quantitative measures of creditcontrol, by which inflation can be brought down. Qualitative controlmeasures involve selective credit control measures.
Bank rate policy is used as the main instrument of monetary controlduring the period of inflation. When the central bank raises the bank rate,it is said to have adopted a dear money policy. The increase in bank rateincreases the cost of borrowing which reduces commercial banksborrowing from the central bank. Consequently, the flow of money fromthe commercial banks to the public gets reduced. Therefore, inflation iscontrolled to the extent it is caused by the bank credit.Cash Reserve Ratio (CRR) : To control inflation, the central bank raisesthe CRR which reduces the lending capacity of the commercial banks.Consequently, flow of money from commercial banks to public decreases.In the process, it halts the rise in prices to the extent it is caused by bankscredits to the public.Open Market Operations: Open market operations refer to sale andpurchase of government securities and bonds by the central bank. Tocontrol inflation, central bank sells the government securities to the publicthrough the banks. This results in transfer of a part of bank deposits tocentral bank account and reduces credit creation capacity of thecommercial banks.
Fiscal Policy: It Majorly pertains to taxation and interestpolicies .• REDUCTION IN UNNECESSARYEXPENDITURE• INCREASE IN TAX• INCREASE IN SAVING• SURPLUS BUDGET• PUBLIC DEBT
Lack of balance in the country’s budget. Financial problem, financing the deficit of moneyby printing. Sudden increase in production costs. Significant increase in the level of energyresources. Faulty structure of the economy . Exported goods far exceeding imported ones. Too many monopolies in the economy. Imported Inflation . Problems with financial planning.
From various monetary , fiscal and othermeasures it becomes clear that to controlinflation government should adopt allmeasures simultaneously. Inflation is like a hydra-headed monsterwhich should be fought by using all theweapons at the command of the government.