What Does Inflation Mean?

The rate at which the general level of prices for goods and services is rising,
and, subsequently, purchasing power is falling. Central banks attempt to stop
severe inflation, along with severe deflation, in an attempt to keep the
excessive growth of prices to a minimum.

Inflation: What Is Inflation?

Inflation is defined as a sustained increase in the general level of prices for
goods and services. It is measured as an annual percentage increase. As
inflation rises, every dollar you own buys a smaller percentage of a good or
service.

The value of a dollar does not stay constant when there is inflation. The
value of a dollar is observed in terms of purchasing power, which is the real,
tangible goods that money can buy. When inflation goes up, there is a
decline in the purchasing power of money. For example, if the inflation rate
is 2% annually, then theoretically a $1 pack of gum will cost $1.02 in a year.
After inflation, your dollar can't buy the same goods it could beforehand.

There are several variations on inflation:

Deflation is when the general level of prices is falling. This is the opposite
of inflation.
Hyperinflation is unusually rapid inflation. In extreme cases, this can lead to
the breakdown of a nation's monetary system. One of the most notable
examples of hyperinflation occurred in Germany in 1923, when prices rose
2,500% in one month!
Stagflation is the combination of high unemployment and economic
stagnation with inflation. This happened in industrialized countries during
the 1970s, when a bad economy was combined with OPEC raising oil prices.

In recent years, most developed countries have attempted to sustain an

inflation rate of 2-3%.

Causes of Inflation
Economists wake up in the morning hoping for a chance to debate the causes
of inflation. There is no one cause that's universally agreed upon, but at least
two theories are generally accepted:

Demand-Pull Inflation - This theory can be summarized as "too much

money chasing too few goods". In other words, if demand is growing faster
than supply, prices will increase. This usually occurs in growing economies.

Cost-Push Inflation - When companies' costs go up, they need to increase

prices to maintain their profit margins. Increased costs can include things
such as wages, taxes, or increased costs of imports.

Costs of Inflation
Almost everyone thinks inflation is evil, but it isn't necessarily so. Inflation
affects different people in different ways. It also depends on whether
inflation is anticipated or unanticipated. If the inflation rate corresponds to
what the majority of people are expecting (anticipated inflation), then we
can compensate and the cost isn't high. For example, banks can vary
their interest rates and workers can negotiate contracts that include
automatic wage hikes as the price level goes up.

Problems arise when there is unanticipated inflation:

Creditors lose and debtors gain if the lender does not anticipate inflation
correctly. For those who borrow, this is similar to getting an interest-free
loan.
Uncertainty about what will happen next makes corporations and consumers
less likely to spend. This hurts economic output in the long run.
People living off a fixed-income, such as retirees, see a decline in their
purchasing power and, consequently, their standard of living.
The entire economy must absorb repricing costs ("menu costs") as price
lists, labels, menus and more have to be updated.
If the inflation rate is greater than that of other countries, domestic products
become less competitive.

People like to complain about prices going up, but they often ignore the fact
that wages should be rising as well. The question shouldn't be whether
inflation is rising, but whether it's rising at a quicker pace than your wages.

Finally, inflation is a sign that an economy is growing. In some situations,

little inflation (or even deflation) can be just as bad as high inflation. The
lack of inflation may be an indication that the economy is weakening. As
you can see, it's not so easy to label inflation as either good or bad - it
depends on the overall economy as well as your personal situation.

Inflation: How Is It Measured?

Measuring inflation is a difficult problem for government statisticians. To do
this, a number of goods that are representative of the economy are put
together into what is referred to as a "market basket." The cost of this basket
is then compared over time. This results in a price index, which is the cost of
the market basket today as a percentage of the cost of that identical basket in
the starting year.

In North America, there are two main price indexes that measure inflation:

Consumer Price Index (CPI) - A measure of price changes in consumer

goods and services such as gasoline, food, clothing and automobiles. The
CPI measures price change from the perspective of the purchaser. U.S. CPI
data can be found at the Bureau of Labor Statistics.
Producer Price Indexes (PPI) - A family of indexes that measure the average
change over time in selling prices by domestic producers of goods and
services. PPIs measure price change from the perspective of the seller. U.S.
PPI data can be found at the Bureau of Labor Statistics.

You can think of price indexes as large surveys. Each month, the
U.S. Bureau of Labor Statistics contacts thousands of retail stores, service
establishments, rental units and doctors' offices to obtain price information
on thousands of items used to track and measure price changes in the CPI.
They record the prices of about 80,000 items each month, which represent a
scientifically selected sample of the prices paid by consumers for the goods
and services purchased.

In the long run, the various PPIs and the CPI show a similar rate of inflation.
This is not the case in the short run, as PPIs often increase before the CPI. In
general, investors follow the CPI more than the PPIs.
Types of Inflation

Inflation is a situation of sustained and inordinate increase in the prices of

goods and services. Read on to understand the various types of inflation.
When there is a rise in general price level for all goods and services it is
known as inflation. An inflationary movement could be because of the rise
in any single price or a group of prices of related goods and services.

Types of Inflation

There are four main types of inflation. The various types of inflation are
briefed below.

Wage Inflation: Wage inflation is also called as demand-pull or excess

demand inflation. This type of inflation occurs when total demand for goods
and services in an economy exceeds the supply of the same. When the
supply is less, the prices of these goods and services would rise, leading to a
situation called as demand-pull inflation. This type of inflation affects the
market economy adversely during the wartime.

Cost-push Inflation: As the name suggests, if there is increase in the cost of

production of goods and services, there is likely to be a forceful increase in
the prices of finished goods and services. For instance, a rise in the wages of
laborers would raise the unit costs of production and this would lead to rise
in prices for the related end product. This type of inflation may or may not
occur in conjunction with demand-pull inflation.

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. A point noteworthy is pricing
power inflation does not occur at the time of financial crises and economic
depression, or when there is a downturn in the economy. This type of
inflation is also called as oligopolistic inflation because oligopolies have the
power of pricing their goods and services.

Sectoral Inflation: This is the fourth major type of inflation. The sectoral
inflation takes place when there is an increase in the price of the goods and
services produced by a certain sector of industries. For instance, an increase
in the cost of crude oil would directly affect all the other sectors, which are
directly related to the oil industry. Thus, the ever-increasing price of fuel has
become an important issue related to the economy all over the world. Take
the example of aviation industry. When the price of oil increases, the ticket
fares would also go up. This would lead to a widespread inflation throughout
the economy, even though it had originated in one basic sector. If this
situation occurs when there is a recession in the economy, there would be
layoffs and it would adversely affect the work force and the economy in
turn.

Other Types of Inflation

Fiscal Inflation: Fiscal Inflation occurs when there is excess government

spending. This occurs when there is a deficit budget. For instance, Fiscal
inflation originated in the US in 1960s at the time President Lydon Baines
Johnson. America is also facing fiscal type of inflation under the
presidentship of George W. Bush due to excess spending in the defense
sector.

Hyperinflation: Hyperinflation is also known as runaway inflation or

galloping inflation. This type of inflation occurs during or soon after a war.
This can usually lead to the complete breakdown of a country’s monetary
system. However, this type of inflation is short-lived. In 1923, in Germany,
inflation rate touched approximately 322 percent per month with October
being the month of highest inflation.

What is Inflation?
The measure of price increases within a set of goods and services over a
period of time is known as inflation. The most common gauge of inflation is
known as the CPI, or consumer price index, which measure the price
increases (decreases) of basic consumer goods and services. The GDP
deflator is another very important measure of inflation as it measures the
price changes in goods that are produced domestically. In effect, inflation
decreases the value of your money and makes it more expensive to buy
goods and services.
Causes OF Inflation
There are a few different reasons that can account for the inflation in our
goods and services; let's review a few of them.
Demand-pull inflation refers to the idea that the economy actual demands
more goods and services than available. This shortage of supply enables
sellers to raise prices until an equilibrium is put in place between supply and
demand.
The cost-push theory , also known as "supply shock inflation", suggests that
shortages or shocks to the available supply of a certain good or product will
cause a ripple effect through the economy by raising prices through the
supply chain from the producer to the consumer. You can readily see this in
oil markets. When OPEC reduces oil supply, prices are artificially driven up
and result in higher prices at the pump.
Money supply plays a large role in inflationary pressure as well. Monetarist
economists believe that if the Federal Reserve does not control the money
supply adequately, it may actually grow at a rate faster than that of the
potential output in the economy, or real GDP. The belief is that this will
drive up prices and hence, inflation. Low interest rates correspond with a
high levels of money supply and allow for more investment in big business
and new ideas which eventually leads to unsustainable levels of inflation as
cheap money is available. The credit crisis of 2007 is a very good example
of this at work.
Inflation can artificially be created through a circular increase in wage
earners demands and then the subsequent increase in producer costs which
will drive up the prices of their goods and services. This will then translate
back into higher prices for the wage earners or consumers. As demands go
higher from each side, inflation will continue to rise.
Effects OF Inflation
The effects of inflation can be brutal for the elderly who are looking to retire
on a fixed income. The dollars that they expect to retire with will be worth
less and less as time goes on and inflation goes higher.
When the balance between supply and demand spirals out of control, buyers
will change their spending habits as they meet their purchasing thresholds
and producers will suffer and be forced to cut output. This can be readily
tied to higher unemployment rates. When extremes arise in the
supply/demand structure, imbalances are created.
The mortgage crisis of 2007 is a great example of this. Home prices were
increasing at a very rapid rate from 2002 to 2005 and got to the point where
the prices became too high, forcing buyers to step aside. This lack of
demand forced sellers to drop prices back to a point where there is demand.
As I write this article, this equilibrium has still not come into the real estate
market. This is due to many factors, as you will read in our mortgage crisis
article, but the extreme acceleration of inflation in home prices is directly
correlated to the pullback we are seeing.
A similar example can be seen in the internet euphoria in the stock market
back in 1998 to 2000. This rapid acceleration in stock prices eventually
became unsustainable and led to a disastrous fall.
The point that is being made is that if inflation is not contained and rises at
an unsustainable rate; the stronger the impact on the other side. There is a
saying; "the bigger they are, the harder they fall".
 INFLATION DRAGON - IT'S GROWTH AND TENTACLES

A.D. Sharma*

One of the most important topics in economic discussions today is price

inflation. Sometimes it assumes serious political implications. What are the
determining factors of price inflation? How does inflation occur? How does
it affect the process of economic growth? Can we make out different
categories of inflation and can we determine as to which of its types is a
lesser evil for the economy and which one is to be detested? There is no
denying that inflation has to be fought hard and the country be relieved of its
grip.

Types

There can be demand-pull inflation or cost-push inflation. Or else, there

can be inflation resulting from a quick price rice of a particular commodity
due to failure of a crop and the supply of the concerned commodity falling
short of demand. Such an inflation is not much of a cause of worry. The
effect of such a price rise can reverse in the following year. Inflation is bad
when all commodities or at least most of the commodities are affected by
price escalations. Such an inflation can upset the very apple-cart of the
whole economy. It can disturb the structure of any entrepreneurial
expectations and disturb the whole production system.

Prices had escalated by 18.2 per cent in 1980-81 when the prices of most
of the commodities and services had shot up.

The economic scenario in the country in the recent past has been
dominated by unprecedented happenings. Prices, particularly of vegetables
had touched a new high. Vegetables, had gone almost out of reach for the
ordinary people. A routine economic explanation of this will be an excess of
demand over supply. Numerous factors determine the volume of demand
and supply for any given period.
 Theoretically speaking, it can be said that supply may be affected by cost
of production, availability of inputs and technology. But India is a special
case where supply is affected by factors not easily controllable. The reasons
are not far to seek. The Indian economy is dominated by the primary sector,
depending largely on nature, low per capita income and lack of education.
But at the same time it has a technologically advanced industrial sector, fast
means of communication and liberal economic policies.

When we look at the history of price rise, the statistics clearly

demonstrates that inflation is caused due to factors not within human
control. Over the decades prices have been increasing following droughts or
floods. Fear of scarcities has also aggravated it.

Agrarian Economy

India is a country where two-thirds of its population still depends on

agriculture for livelihood. Almost 20 percent of India's exports consists of
primary goods. A 25 per cent of GDP is earned from the primary sector.
Even a large section of industrial sector also depends on agriculture for raw
material and other inputs. Still it largely depends on the mercy of nature.

Too much or too little rain may bring misery and suffering for the whole
economy and its people. And a good monsoon can bring hopes of prosperity
and satisfaction. The reason is not far to seek. Only 33 per cent of the sown
area in India is irrigated through modern means while the rest of the farms
are dependent on the mercy of nature which can be good, bad or indifferent.
Being close to the equator, India has to suffer frequent storms as well. What
will be the degree of volatility in an economy under such conditions can be
anybodyÕs guess. The unimaginably high prices of some of the vegetables
and cereals in the past few months are examples of natureÕs niggardliness.
Statistics shows that inflation occurs whenever there has been either too
much or too little rain.

Of late, the rate of inflation has been around 8 per cent. The outcome of
dependence on nature is multifold. In the first place the agricultural products
become short in supply. Secondly, the prices inflate since their demand
remains at the same level, causing disparity in supply and demand. Thirdly,
the cost of production of industrial goods using inputs from the primary
sector also increases due to short supply. As an outcome the prices of these
goods go up while their supply gets reduced.

There have been years when the prices and the inflation rate were as high
as 22.7 per cent as happened in 1973-74.

Excess Money Supply

Talking in terms of aggregates, an excess of money supply over the

supply of goods and services will always result in an immediate upsurge in
prices. This is because an effective demand increases at the given level of
supply.

In case of India, money supply has increased 332 times over the past 47
years (1951-1997) whereas the volume of total production (GNP) has
increased only 108 times during the same period. No one can blame the
heavens for the present state of economy. Heavy deficit financing has been
the main culprit.

Nothing much has to be said about black money and its role in causing
inflation. Any money which is unaccounted for will mostly be spent on
consumption and, that too, on conspicuous consumption. One thing that
cannot be debated is that whenever there will be excess of money or
purchasing power over supply, the natural outcome will be inflation. In fact,
money inflation always causes price inflation.

Patterns

Another significant factor behind inflation is that an average Indian

consumer spends a considerable percentage of his income on food, whereas
in any developed country this proportion is very meagre. The basic reason
for this is that the per capita income in India is very low at only $ 390 per
year according to World Development Report 1998 compared to $ 28740 in
USA and $ 37850 in Japan.

Naturally, if there is scarcity of food articles or even its apprehension, the

increase in their prices fuels inflation. It will naturally upset the consumption
pattern of an average consumer and may put a question mark on the
economic system as a whole. Any rise in wages is absorbed in the increased
prices, leaving no room for improving the living standards of the common
people.It hurts the psychology of the masses.

Hoarding

Hoarding is usually referred to in the context of profiteers and black

marketers. No doubt, unscrupulous businessmen resort to hoarding with the
aim of reaping high profits. This happens whenever there is even an
apprehension of scarcity. So, whenever a monsoon is unfavourable, goods
go out of market even though new crops are yet to come and they may not
be affected by the bad season at all. This creates tension and panic. Although
there is no scarcity as such, the profiteer creates it artificially. The panic-
struck consumer makes frantic purchases and the demand escalates. This
artificial scarcity and undue increase in demand leads to an increase in prices
and a vicious circle of created scarcity and panic buying starts, aggravating
the situation.

Solution

A well planned, reasonable and balanced intervention by the government

can perhaps offer a panacea.

The interests of the economy and the society are served only when
interests of both the consumer and the seller are adequately protected.

Free play of market forces is justified only in theory. In practice many

other things should be taken care of such as the availability of resources, the
state of technology and infrastructure, the level of awareness and reasoning
and the capacity to absorb imperfections.

A country like India with an ever-increasing population and dominated by

the primary sector where nature plays a significant role and even an
apprehension of scarcities can create panic, cannot really be left to its fate in
the hands of the market forces.

The public distribution system has to be geared up, made more effective
and efficient. A tough control over possible hoarders, profiteers and self-
seeking elements is a must. The supply and demand sides have to be
regulated. This is necessary till the economy develops itself fully to sustain
any jerk without losing balance.

What is also very essential is that the people have to understand the facts
and logistics of price inflation. They have to ignore the short-term causes
and have to resist artificial panic created by forces out to destabilise the
economy. This will certainly take away much of the steam out of the gory
play of the forces stoking inflation.