INFLATION

Inflation is a general increase in the price level of goods and services in an economy over time, which
reduces the purchasing power of money. It is typically measured by the Consumer Price Index (CPI),
which tracks the price changes of a basket of goods and services consumed by households. Inflation is
usually expressed as a percentage increase in the CPI over a specific period, such as a year

Types of Inflation

A. On the Basis of Causes:

1. Currency inflation
2. Credit inflation
3. Deficit-induced inflation
4. Demand-pull inflation
5. Cost-push inflation

B. On the Basis of Speed or Intensity:

1. Creeping or Mild Inflation
2. Walking Inflation
3. Galloping and Hyperinflation
4. Government’s Reaction to Inflation

Causes of Inflation

1. Demand-Pull Inflation Theory:

There are two main theoretical approaches to the DPI: classical and Keynesian. The classical or
monetarist view is that inflation is caused by an increase in money supply, which leads to a rightward
shift in negative sloping aggregate demand curve. In contrast, Keynesians do not see a direct link
between money supply and price level, and argue that aggregate demand may rise due to a variety
of factors including consumer demand, investment demand, government expenditure, net exports,
or a combination of these. When aggregate demand rises beyond full employment levels, it causes
upward pressure on prices, which is known as DPI.

2. Causes of Demand-Pull Inflation

DPI (Demand-Pull Inflation) originates in the monetary sector, according to monetarists. They argue
that excessive money supply near full employment will cause inflation by increasing aggregate
demand, which can be measured by a rightward shift in the aggregate demand curve. This leads to
an increase in the price level until aggregate demand equals aggregate supply. On the other hand,
Keynesians argue that inflation originates in the non-monetary or real sector, caused by an increase
in consumption expenditure, business investment, government expenditure, or printing additional
money. Other factors that may push aggregate demand and price level upwards include population
growth, higher export earnings, repayment of public debt, and the tendency of holders of black
money to spend more on conspicuous consumption goods.

3. Cost-Push Inflation Theory:

CPI, which is caused by a leftward shift of the aggregate supply curve due to an increase in the cost of
production. This can be caused by a rise in raw material costs or an increase in wages, which can lead
to a wage-price spiral, causing the AS curve to shift leftward. However, if wage increases lead to
increased productivity, the AS curve can shift rightward. Rising costs are passed on to consumers by
firms, resulting in rising prices and further demands for higher wages.

4. Causes of Cost-Push Inflation

The rise in cost factors such as raw material prices, wage-push inflation, profit-push inflation, and
fiscal policy changes contribute to CPI or cost-push inflation. External factors such as OPEC's increase
in petrol prices can also lead to a rise in CPI. Production setbacks caused by natural disasters,
exhaustion of resources, and work stoppages can also reduce output, while artificial scarcity of goods
by traders and hoarders can worsen the situation. Inefficiency, corruption, and mismanagement can
also contribute to inflation, indicating that no single factor is solely responsible for inflationary price
rises.

Effects of Inflation:

(a) Effect on distribution of income and wealth; and

(b) Effect on economic growth

1. Effects of Inflation on Distribution of Income and Wealth:

Inflation can result in a redistribution of income and wealth. While some people experience a rise in
incomes during inflation, others may lose out as prices rise faster than their incomes. The impact on
individuals varies depending on whether their money incomes rise more rapidly than prices or vice
versa.

(i) Creditors and debtors:

During inflation, borrowers benefit and lenders lose because debts are fixed in rupee terms.
Borrowers pay back less in real terms than when they borrowed, while creditors' real value of
loans decline due to the increase in price levels. However, loan-giving institutions make adequate
safeguard against the erosion of real value, and banks do not pay interest on current accounts
but charge interest on loans.

(ii) Bond and debenture-holders

Inflation negatively affects those who rely on interest income, such as bondholders and
beneficiaries of life insurance programs, as their fixed income loses value with rising prices. The
real value of their savings decreases if the interest rate is lower than the inflation rate.

(iii) Investors

Investing in shares during inflation can be profitable as businesses may earn higher profits, which
could lead to higher dividends for shareholders.

(iv) Salaried people and wage-earners

Inflation has different effects on people depending on their income type. Fixed income earners
suffer a reduction in real purchasing power, while flexible income earners may gain during
inflation. Unionized workers may succeed in raising wage rates, but with a long time lag, and
flexible income earners may have a higher chance of gaining during inflation.

(v) Profit-earners, speculators and black marketers

During inflation, profit earners, businessmen, speculators, and black marketers are expected to
gain, as profit tends to rise, prices of products increase, and there is a possibility of earning
business profit. However, fixed income earners, bondholders, and beneficiaries from life
insurance programs are damaged by inflation. Flexible income earners may gain during inflation
as their nominal incomes outstrip the general price rise. Inflation leads to a redistribution of
income and wealth. While rich may become richer and poor may become poorer, there is no
hard and fast generalization that can be made as someone wins and someone loses during
inflation.

2. Effect on Production and Economic Growth:

Inflation can have both positive and negative effects on the economy. It can stimulate production
and profit for businesses, leading to more investment and higher national output, but only up to
a certain point. If wages and production costs rise too quickly, it can lead to a decrease in output.
Inflation also creates uncertainty for businesses, making them hesitant to invest and commit to
long-term plans. A moderate level of inflation can be beneficial for economic growth, but high
rates of inflation can discourage savings, hinder capital formation, and result in a flight of capital
to other countries. In addition, hyperinflation can lead to unproductive investment and a decline
in export earnings, creating a wide imbalance in the balance of payment account and a shortfall
in investable resources for the government.