Inflation

Definition of Inflation
 Inflation signifies a situation which is
characterized by a rising trend in the general
level of prices.
 Inflation is a persistent rise in general price level
rather than a once-for-all rise in it.
 Two important features of recent inflation
 First, the rate of inflation in recent years has been
very high as compared to the inflation experienced
earlier during peace period.
 Inflation coexists with a high rate of unemployment
 Meaning of Inflation
 In the words of Friedman,” Inflation is always and everywhere
a monetary phenomenon and can be produced only by a more
rapid increase in the quantity of money than output”
 Hicks define inflation" Our present troubles are not of
monetary character and it is continuous rise in prices”
 Johnson defines inflation as sustained rise in prices
 Brooman defines it as a continuing increase in the general
price level
 Shapiro defines inflation” as a persistent and appreciable rise
in the general level of prices”
 Inflation is statistically measured in terms of percentage
increase in the price index, as a rate per cent per unit of time.
 Consumer Price Index
 The most common measure of inflation is
that of the Consumer Price Index or “CPI”
as calculated by the Bureau of Labour
Statistics( the BLS)
 The particular index is based on the prices
of a basket of goods which represents the
purchasing behaviour of some average
urban consumer.
 Types of Inflation
 Sustained rise in prices may be of various magnitudes
 Creeping inflation-a sustained price rise of 2 per cent per annum
which is regarded as safe and essential for economic growth
 Walking inflation -3 to 7 per cent but less than 10 which is a
warning signal for the govt to control it
 Running inflation-10 to 20 % which affects the poor and middle
class adversely
 When prices rise very fast at double and triple digits from more
than 20 to 100 per cent per annumwhich makes a complete
nonsense of the monetary and economic system
 Types of inflation
 War-time inflation, post-war inflation, peace-
time inflation
 Comprehensive and sporadic inflation
 Open and suppressed inflation
 Suppressed inflation is condemned as it breeds a
number of evils like black market, hierarchy of
price controllers, rationing officers, and
uneconomic diversion of productive resources
from essential industries to non-essential
industries.
 Types of inflation based on the
causes inducing inflation
 Credit inflation
 Deficit inflation
 Scarcity inflation
 Profit inflation
 Foreign-trade induced inflation
 Tax inflation
 Cost inflation
 Demand inflation
 Demand-pull Inflation
 Inflation is caused by a situation where by
the pressure of aggregate demand for
goods and services exceeds the available
supply of output
 When aggregate demand for all purposes-
consumption,investment and government
expenditure-exceeds the supply of goods
at current prices, there is rise in prices.
 Demand –pull inflation
 Graph

Price level

Aggregate demand and aggregate supply

 Demand-pull inflation and wage-
price spiral
 A rise in prices reduces the real consumption of
the wage earners.
 They will press for higher money wages to
compensate them for higher cost of living
 It will lead to higher prime costs of production
and leading to further rise in prices
 Workers will demand for further rise in wages
 Wages and prices chase each other, and the
process of inflation gathers momentum
 Monetarist Version
 Monetarists explain the emergence of excess demand
and the resultant rise in prices on account of the
increase in money supply in the economy
 M/P – kY > 0 –(C+I) --- p
 Friedman and other modern quantity theorist do not
believe in the full-employment of labor and other
resources, and therefore, they admit the possibilities of
increase in output
 When growth in money supply is greater than the
growth in output.
 Fisher’s Equation of exchange: MV=PQ
 Causes of Demand –Pull Inflation

 Increase in Public expenditure

 Increase in Investment
 Increase in marginal propensity to
consume
 Increasing Exports and surplus balance of
payments
 Diversification Resources
 Cost-push inflation
 Inflation initiated by by an increase in costs due to rise
in wages which are not justifiable either on grounds of a
prior rise in productivity or costs of living.( wage-push)
 Any autonomous increase in costs such as rise in prices
of imported goods or an increase in indirect taxes may
initiate an cost-push inflation.
 Sometimes monopolistic and oligopolistic producers may
increase prices to increase profitability(profit-push)
 Many times, cost-push inflation occurs as a result of
combination of wage-push and profit-push inflation
 Inflationary Gap
 Excess demand inflation can also be explained in terms
of the inflationary gap.
 Inflationary gap is measured as an excess of planned
expenditure over the available output at pre-inflation
prices.
 It is the amount by which aggregate expenditure would
exceed aggregate output at the full-employment level of
income.
 Inflationary gap is the excess of the actual aggregate
effective demand in the economy over the aggregate
supply at the full employment level.
 Graph
expenditure
 Inflationary gap explained by the
example
 Gross National Income at current prices Rs 250 crores
 Taxes 60 crores
 Disposable income Rs. 190 crores
 GNP at pre-inflation prices 200
 Government Expenditure 80
 Output available for consumption at pre-inflation prices
Rs 120 Crores
 Inflationary gap Rs 70 Cr
 If 20 per cent is saved, then Rs 152 cr would be left to
create demand for goods worth Rs 120 cr
 How can the inflationary gap be
wiped out?
 By increasing savings so that aggregate demand
is reduced. But this may lead to deflationary
tendencies.
 Another solution is to raise the value of available
output to match the disposable income. But
output cannot be increased during the short-run
because factors are already fully employed.
 Inflationary gap can be closed by increasing tax
and reducing expenditure.
 Monetary policy can also be used to decrease
the money stock.
 Mixed demand –pull cost-push
inflation
 Excess demand and cost-push forces
operate simultaneously and
interdependently in an inflationary
process.
 Thus inflation is mixed demand –pull and
cost-push when price changes reflect
upward shifts in both aggregate demand
and supply functions
 Structural inflation
 Structural rigidities as the principal cause of inflation in
such developing countries as Argentina,Brazil and CHILE
 Inflation is necessary with growth.According to this
view,as the economy develops,rigidities arise which lead
to structural inflation
 Rise in investment expenditure financed by increased
money supply to finance it are only the proximate
factors and not the ultimate factors responsible for
inflation.
 Increases in non-agricultural incomes accompanied by
high growth rate of population that tend to increase the
demand for goods
 Structural bottlenecks
 Various bottlenecks such as lack of infrastructural facility
i,.e.,lack of power, transport and fuel and lack of
voluntary savings which force the govt. to resort to
excessive deficit financing
 Structural factors such as gross disparity in the land
ownership, defective land tenure system, technological
backwardness of agriculture which hamper adequate
growth in output
 The prices of agricultural goods rise-leads to general
price level- third wages
 These factor are rooted in the social, political and
economic structure
 Causes of inflation in developing
countries
 Huge investment expenditure to accelerate capital
formation to obtain rapid economic growth leads to a
sharp increase in demand for consumer goods, especially
the agricultural products. Since in under-developed
countries there is no excess capacity in the system, the
supply of goods cannot be increased sufficiently.
 Income elasticity of demand for food is very high,
because vast majority of the people are under-nourished.
It increases the food prices.
 Once prices of agricultural goods rises,they are likely to
an inflationary spiral.
 Deficit Financing
 Causes of Inflation
 Factors affecting demand
 Increase in money supply
 Increase in disposable income
 Increase in consumer spending
 Cheap monetary policy
 Deficit financing
 Expansion of the private sector
 Black money
 Repayment of public debt
 Increase in exports
 Factors affecting supply
 Shortage of factors of production
 Industrial disputes
 Natural calamities
 Artificial scarcities
 Increase in exports
 Lop-sided production
 Law of diminishing returns
 International factors
 Measures to control inflation
 Fiscal measures
 Reduction in unnecessary Expenditure
 Increase in taxes
 Increase in savings
 Surplus budgets
 Public debts
 Monetary measures
 Credit control
 Raising the rate of interest which can
affect the cost of credit
 Reducing the availability of credit through
open market operation and varying cash
reserve ratio and statutory liquidity ratio
 Demonetisation of currency
 Issue of new currency
 Selective credit controls
 The most important anti-inflationary measure is the
selective credit control
 Selective credit controls are meant to regulate the flow
of credit for a particular and specific purpose and it
seeks to change the distribution and allocation of credit
between its various uses
 Changes in the minimum margin for lending by the banks
against stocks of specific good kept or against other types of
goods
 The fixation of maximum limit or ceiling on advances to
individual borrowers against stocks of particular sensitive
commodities
 The fixation of minimum discriminatory rates of interest
chargeable on credit for particular purpose
 Conditions required for the
successful operation of selective
credit control
 They should be accompanied by general
credit control measures
 Success of the selective credit control also
depends on the extent to which the funds
from non-bank sources is available to the
businessman.
 Other Measures
 To increase production:
 Production of essential consumer goods like
food,clothing,kerosean oil,sugar,vegetable,oils.
 Raw materials for such products may be imported on
preferential basis to increase the production of essential
commodities
 Efforts should be made to increase the productivity
 The policy of rationalization of industries should be adopted
 Use of latest technology
 Rational wage policy
 The govt. should freeze wages,incomes,profits,dividends,bonus
 Price control and rationing-It means fixing
an upper limit for the prices of essential
consumer goods. But it is very difficult to
administer price control.
 Rationing-It aims at distributing
consumption of scarce goods so as to
make them available to a large number of
consumers.
 Effects of Inflation
 Effects on production
 Misallocation of Resources-Diversion of production from essential to
non-essential goods
 Hindrance to Capital accumulation-The saving potentiality declines
 Reduction in production-Expectation of rising prices along with rising
costs of inputs bring uncertainty
 Encourages speculation
 Fall in quality- Continuous rise in prices creates a seller’s market. They
indulge in adulteration of commodities
 Hoarding and Black marketing- Artificial scarcity of goods are created to
take advantage of rising prices
 Hinders Foreign Capital- Rising costs of materials and other inputs
makes foreign investment less profitable
 Disincentive effects Due to Income tax Bracket Creep
 Distributional Effects
 Two ways to measure the effects of inflation on the redistribution of income
and wealth
 On the basis of change in the real value of such factor incomes as
wages,salaries,rents,interest,dividends and profits
 On the basis of the size distribution of income overtime as result of inflation
 Debtors and Creditors
 Salaried Persons
 Wage earners
 Fixed Income Groups-Recipient of transfer payments,rents,interest—
Inflation redistributes income from these two groups towards the middle
income group comprising trader and businessman
 Equity holders and Investors
 Businessman, such as producers, traders and real estate holders
 Agriculturist
 Government
 Other Economic Effects
 Balance of payments
 Distortion of the Exchange rate
 Distortion of the budget and vicious circle
 Disturbance in the planning
 Lowering of International Competitiveness
 Collapse of the Monetary system
 Social and Political Consequances
 Inflation is socially harmful
 Widening the gulf between the rich and poor
 Rising prices create discontentment among the masses
 Workers resort to strikes which lead to loss in production
 Lured by profit, people resort to hoarding, black marketing,
adulteration, manufacture of substandard
commodities,speculation
 Political
 Rising prices also encourage agitations and protests by political
parties opposed to the govt.
 The increasing grievances and hardships of the masses,in
general,on account of inflation may prepare them to revolt
against society and the state.
 The Relation Between
Unemployment and Inflation
 The Phillips curve examines the
relationship between the rate of
unemployment and the rate of money
wage changes.
 It expresses an inverse relationship
between the rate of unemployment and
the rate of increase in money changes
Rate of change in money wages

Percentage of unemployed labour force

Explanation of the Phillips Curve
 Behaviour of organised labour
 Capacity of organised labour to obtain wage increases
varies inversely with unemployment rate in the labour
market.When unemployment rate is low and the
labour market is also buoynt and the producers make
good profit.So employers agree to grant”excessive
wage increases”
 Nature of business activity-In a period rising business
activity when unemployment falls with increasing
demand for labour,the employers will bid up wages
Explanation given by R.G.Lipsey
 Original Phillips curve was an observed statistical
relation which was explained theoretically by
Lipsey as resulting from the behaviour of labour
market in disequilibrium through excess
demand.
 Trade-off between Unemployment and Inflation-
Society, can opt for low unemployment,but only
at the price of higher rate of inflation.Or it can
opt for price stability,but at the cost of a high
unemployment rate.
 Policy Implications
 It suggests the extent to which monetary
and fiscal policies can be used to control
inflation without high levels of
unemployment. It provides a guideline to
the authorities about the rate of inflation
which can be tolerated with a given level
of unemployment