INFLATION

• Inflation refers to a continuous rise

in general price level which reduces
the value of money or purchasing
power over a period of time.
 Types of Inflation
• On the basis of coverage and scope:
Comprehensive Inflation : When the prices of all
commodities rise throughout the economy it is
known as Comprehensive Inflation. Another
name for comprehensive inflation is Economy
Wide Inflation.
Sectoral/Sporadic Inflation : When prices of only
few commodities in few regions (areas) rise, it
is known as Sporadic Inflation. For example,
rise in food prices due to bad monsoon (winds
bringing seasonal rains in India).
• On the basis of Government control:
Open Inflation : When government does not attempt to
restrict inflation, it is known as Open Inflation. In a
free market economy, where prices are allowed to
take its own course, open inflation occurs.
Suppressed Inflation : When government prevents
price rise through price controls, rationing, etc., it is
known as Suppressed Inflation.
However, when government controls are removed,
Suppressed inflation becomes Open Inflation.
• On the basis of Rate of Inflation:
Creeping Inflation : When prices are gently rising, it is
referred as Creeping Inflation. It is the mildest form of
inflation and also known as a Mild Inflation. According
to R.P. Kent, when prices rise by not more than (up to)
3% per annum (year), it is called Creeping Inflation.
Walking Inflation : When the rate of rising prices is
more than the Creeping Inflation, it is known as
Walking Inflation. When prices rise by more than 3%
but less than 10% per annum (i.e between 3% and 10%
per annum), it is called as Walking Inflation.
Running Inflation : A rapid acceleration in the rate of
rising prices is referred to as Running Inflation. When
prices rise by more than 10% per annum, running
inflation occurs.
Galloping Inflation : According to Prof. Samuelson, if
prices rise by double or triple digit inflation rates like
30% or 400% or 999% per annum, then the situation
can be termed as Galloping Inflation. When prices rise
by more than 20% but less than 1000% per annum (i.e.
between 20% to 1000% per annum), galloping inflation
occurs. It is also referred as Jumping inflation.
• Hyperinflation : Hyperinflation refers to a
situation where the prices rise at an alarming
high rate. The prices rise so fast that it
becomes very difficult to measure its
magnitude. However, in quantitative terms,
when prices rise above 1000% per annum it is
termed as Hyperinflation
• On the basis of different causes:
Deficit Inflation: Deficit inflation takes place due to deficit
financing. The method used by
a government to finance its budget deficit, that is,
to cover the difference between its tax receipts and
its expenditures. The main choices are to issue bonds or
to print money.
Credit Inflation : Credit inflation takes place due to
excessive bank credit or money supply in the economy.
Profit Inflation : When entrepreneurs are interested in
boosting their profit margins, prices rise.
Tax Inflation : Due to rise in indirect taxes, sellers charge high
price to the consumers.
Wage Inflation : If the rise in wages in not accompanied by a
rise in output, prices rise.
Export-Boom Inflation : Considerable increase in exports may
cause a shortage at home (within exporting country) and
results in price rise (within exporting country)
Import Price-Hike Inflation : If a country imports goods from a
foreign country, and the prices of imported goods increases
due to inflation abroad, then the prices of domestic products
using imported goods also rises .
 Theories of Inflation
• Demand-pull inflation happens when the level of
aggregate demand grows faster than the underlying level
of supply.
• This may be easier to imagine, if you think of supply as the
level of capacity. If our capacity to produce is growing at
3%, and the level of demand grows at the same rate or
slower then we don't have a problem. We can produce all
we need. However, if our capacity grows at 3%, but
demand grows faster, then we have a problem. In effect we
have 'too much money chasing too few goods', and we can't
manage to produce all we need. Something has to give,
and it is prices that are forced up, therefore causing
inflation.
 Explanation of diagram
• In Keynesian theory, increased employment results in
increased aggregate demand (AD), which leads to
further hiring by firms to increase output.
• Due to capacity constraints, this increase in output will
eventually become so small that the price of the good
will rise.
• At first, unemployment will go down, shifting AD1 to
AD2, which increases demand (noted as "Y") by (Y2 -
Y1).
• This increase in demand means more workers are
needed, and then AD will be shifted from AD2 to AD3,
but this time much less is produced than in the previous
shift, but the price level has risen from P2 to P3, a much
higher increase in price than in the previous shift. This
increase in price is called inflation.
 Causes of Demand-Pull
Inflation
• Growing Economy:When families feel
confident that they will get raises and better
jobs, that their homes and other investments will
increase in value, and that the government is
doing the right thing in guiding the economy,
they will spend more instead of saving.
• They will also borrow more, either with auto
or home loans, or credit cards. If they don't
borrow too much, this is actually a healthy cause
of inflation. It creates gradual and steady price
increases.
• Expectation of inflation is a second reason
for demand-pull inflation.
  Once people expect inflation, they will buy
things now before prices go up further in the
future. This increases demand, which then
created demand-pull inflation. Once
expectation of inflation sets in, it is very
difficult to eradicate.
• Discretionary fiscal policy is a third
creator of demand-pull inflation. As the
government spends more in any particular
segment of the economy, it drives up
demand.
 Cost-Push Inflation
• Cost-push inflation happens when costs
increase independently of aggregate demand.
• Cost push inflation is inflation caused by an increase in
prices of inputs like labour, raw material, etc.
• The increased price of the factors of production leads to
a decreased supply of these goods.
•  In this case, the overall price level increases due to
higher costs of production which is reflected in terms of
increased prices of goods and commodities which
majorly use these inputs.
• This is inflation triggered from supply side, i.e. because
of less supply.
 Causes of Cost-push Inflation
• First, cost-push inflation can be created by
companies that achieve a monopoly over an
industry. This has the same effect as reducing
the supply because the company controls the
supply of that good.
• Wage inflation is a second creator of cost-push
inflation. This is when wage-earners have the
power to force through wage increases, which
companies then pass on to consumers in the
form of higher prices. This generally happens
due to the formation of powerful labour unions.
• Natural disasters are third factor for
cost-push inflation. This happened right
after Japan's earthquake, which disrupted
the supply of auto parts. It also occurred
after Hurricane Katrina, when oil
refineries were destroyed, causing gas
prices to skyrocket.
 Measures to Control Inflation
• Inflation develops into a Hyper-Inflation
if not controlled in the initial stages.
Therefore, it becomes essential for the
Govt. to take various steps to control
Inflation.
Basic causes of Inflation are:
• a) Excess money supply in the economy.
• b) Excess purchasing power in the hands
of public.
Measures to Control Inflation
• Monetary Measures
• Fiscal Measures
• Other Measures
• Monetary Measures: These measures are
adopted by the Central Bank of a country;
RBI (in case of India). These are:
• a) Increase in bank-rate.
• b) Sale of Govt. securities in open market.
• c) Increase in Cash Reserve Ratio.
• Bank-Rate is the rate at which the
Central-Bank lends credit to domestic
banks of the country. Increase in bank-rate
increases the cost of credit, i.e. credit
becomes dearer.Increased cost of credit
discourages business-men and consumers
to take loans. This kind of controlled
money-supply discourages inflationary
pressures in the economy.
• Sale of Govt. securities in the open-market:
Govt. controls the money-supply by issuing
securities in public. Govt. securities are issued
by Govt. to raise the funds necessary to meet its
expenditure. The securities are issued in the
form of bonds and debentures with a certain
maturity period. Selling of these securities to
public results in blocking of purchasing power
of public. Therefore, sale of securities can help
regulate inflation.
• Increase in Cash Reserve Ratio: Banks in
India are required to hold a certain percentage of
deposits in the form of cash. The banks deposit
such cash with the RBI.
Remaining amount with the bank after maintaining
Cash Reserves with the RBI is called as the
Credit-creation capacity of that bank. Higher the
CRR, lower will be the credit creation capacity
of the banks and vice-versa. Thus, by increasing
CRR, RBI can reduce money-supply in the
economy and hence inflation.
• Fiscal Measures: These are the measures
adopted by Govt. to affect the purchasing
power of the public. These include:
• Govt. expenditure
• Taxation
• Public-borrowing
• Debt-management
• Over-Valuation
• Govt. expenditure: Govt. releases money into the
economy every-time it meets its expenditure. Excess
money-supply in the economy increases inflation. In
order to control Inflation, the Govt. has to reduce its
expenditure.
• Taxation: It is necessary to take-away the excess
purchasing power of public by the way of taxation. It
helps to moderate the demand for goods and services
to match the supply. Increase in tax-rates and
imposing of new taxes can help control inflation.
• Public-Borrowing: Govt. borrows money from
house-holds and business-men by way of bonds.
The public-borrowing absorbs the excess
purchasing power from the public by mobilising
private-savings. Decrease in purchasing power
of public ultimately reduces inflation.
• Debt-Management: Govt. can control public-
debt in a strict manner in order to control excess
money-supply in the economy. Govt. also
controls credit-expansion of commercial banks.
• Over-Valuation means increasing the value of
domestic currency in terms of foreign
currency. Over-valuation discourages foreign
individuals and business-men as they are
required to pay more for same quantity of
goods. Therefore, the supply of goods gets
diverted from foreign market to domestic
market. It, thus, helps to balance demand and
supply levels in domestic market
 Inflationary Gap
• Inflationary Gap is an excess of total disposable
income over the value of available supply of goods at
a specified price-level sufficient to cause an inflation
of prices.

• Inflationary Gap is the difference between what the

population will try to consume out of their income and
the amount available for consumption at pre-inflation
prices.
• Inflationary gap causes a rise in price level which is
called inflation.
• Inflationary gap = Total expenditure - National
income at the level of full employment
 Inflationary Gap
S.N Particulars Amount (Cr)

1 National Income being paid 1800

2 Taxes 400

3 Disposable Income 1400(1800-400)

4 Gross National Output (at pre- 1500

inflation prices)

5 War Purchases 300

6 Available output for public 1200(1500-300)

7 Inflationary Gap 200(1400-1200)

• Inflationary Gap can be explained with the
help of an example.
• Supposing, the total output of country during
war amounts to Rs.1500 crore.
• Out of it, the products worth Rs. 300 crore are
bought by Govt. for war-purposes.
• Thus, the Civilian population is left with goods
worth Rs.1200 crore (Rs. 1500-Rs 300) for its
consumption.
• However, monetary income of people is Rs.1800 crore, of
which Govt takes away Rs 400 crore by way of taxes.
• Thus, the disposable income of people is reduced to Rs.1400
crore (Rs. 1800-Rs400).
• It means people are prepared to spend Rs. 1400 crore but the
supply of goods and services available at existing prices
amounts to Rs. 1200 crore only.
• Thus, the gap between total demand and supply is of Rs. 200
crore.(1400cr-1200cr).
• This gap is called Inflationary Gap.
• Because of this Gap, the prices will continue to rise till there is
an equilibrium between demand and supply.
• In the figure, Income is shown on x-axis and
Consumption(C), Investment(I) and Govt.
expenditure(G) on y-axis.
• AS is Aggregate Supply curve.
• Supposing, OY level of income represents full
employment level of income.
• AD(C+I+G) is Aggregate Demand curve.
• It indicates that at OY full employment level of
income, AD is more than AS by BE.
• Hence, BE is called Inflationary Gap.
• When the investment is excess then the real savings and it is
above the level of employment, is called inflationary gap.
So the excess of consumption and investment (C+I) cover the
full employment gap.

The national income here rises in money terms. The value of

money falls short and a country is in the grip of inflation. The
desired aim is that economy should operate at the level of full
employment. The economy should not operate below the level
of full employment. There are two methods of measuring the
inflationary gap :

Inflationary gap = Total expenditure - National income at the

level of full employment.
Inflation gap = Investment in terms of money - real saving at
the level of full employment.
 Controlling an Inflationary Gap
The government may use monetary or fiscal policy to help reduce
the size of the inflationary gap.

1) This would involve controlling total spending by either increasing

interest rates or raising taxation.
2) An improvement in the supply-side performance of the economy
would also achieve this. 
• Monetary Policy: Higher interest rates to curb consumer demand 
• Fiscal Policy: A rise in the burden of taxation to reduce real
disposable incomes 
• Supply-side Policy: Measures to increase productivity and
efficiency. This leads to a rise in aggregate supply and reduces the
amount of excess demand in the long run.
 Inflationary gap
• Inflationary gaps can arise when the
economy has grown for a long time on the
back of a high level of aggregate demand.
• Total spending may rise faster than the
economy's ability to supply goods and
services.
• As a result, actual GDP may exceed
potential GDP leading to a positive output
gap in the economy.