GROUP D

MODULE - 4
inflation
What is Inflation?
Inflation is a quantitative measure of the
rate at which the average price level of
a basket of selected goods and services in an
economy increases over a period of time.
It is the constant rise in the general level of
prices where a unit of currency buys less
than it did in prior periods. Often expressed
as a percentage, inflation indicates a
decrease in the purchasing power of a
nation’s currency.
 Understanding
Inflation
 As prices rise, a single unit of currency
loses value as it buys fewer goods and
services. This loss of purchasing power
impacts the general cost of living for the
common public which ultimately leads
to a deceleration in economic growth.
The consensus view among economists is
that sustained inflation occurs when a
nation's money supply growth outpaces
economic growth.
To combat this, a country's appropriate
monetary authority, like the central bank,
then takes the necessary measures to
keep inflation within permissible limits
and keep the economy running smoothly.
Causes of Inflation
 Causes of Inflation

Rising prices are the root of inflation,

though this can be attributed to different
factors. In the context of causes, inflation is
classified into three types: Demand-Pull
Inflation, Cost-Push Inflation, and Built-In
Inflation.
 Demand-Pull Effect
Demand-pull inflation occurs when the
overall demand for goods and services in
an economy increases more rapidly than
the economy's production capacity. It
creates a demand-supply gap with higher
demand and lower supply, which results
in higher prices. 
For instance, when the oil producing
nations decide to cut down on oil
production, the supply diminishes. It leads
to higher demand, which results in price
rises and contributes to inflation.

Additionally, an increase in money supply

in an economy also leads to inflation. With
more money available to individuals,
positive consumer sentiment leads to
higher spending. This increases demand
and leads to price rises.
Money supply can be increased by the
monetary authorities either by printing
and giving away more money to the
individuals, or by devaluing (reducing
the value of) the currency. In all such
cases of demand increase, the money
loses its purchasing power.
Demand pull inflation using AD-AS
diagram
Demand-pull inflation can be illustrated
with aggregate demand and supply
curves. Consider the fig. in which
aggregate demand and aggregate supply
are measured along the X-axis and
general price level along the Y-axis.
 Curve AS represents the aggregate supply
which rises upward in the beginning but
when full-employment level of aggregate
supply OYF is reached, aggregate supply
curve AS takes a vertical shape.
This is because after the level of full
employment, supply of output cannot be
increased. When aggregate demand
curve is AD1 the equilibrium is at less
than full- employment level where price
level OP1 is determined.
Now, if the aggregate demand increases
to AD2, price level rises to OP2 due to the
emergence excess of demand at price
level OP1.
It will be noticed that here the rise in
price level has also brought about
increase in aggregate output supplied
from OY1 to OY2.
If the aggregate demand further
increases to AD3, the price level rises to
OP3 under the pressure of more demand.
But since he aggregate supply curves is
yet sloping upward, increase in aggregate
demand from AD2, to AD3 has -used the
increase in output from OY2 to OYF.
 If aggregate demand further increases,
say to AD4 only price level raises to
OP4 with output remaining constant at
YF.
 OYF is the full-employment level or
output and aggregate supply curve is
perfectly inelastic at YF.
 Cost-Push Effect
Cost-push inflation is a result of the
increase in the prices of production
process inputs. Examples include an
increase in labor costs to manufacture a
good or offer a service or increase in the
cost of raw material.
These developments lead to higher cost
for the finished product or service and
contribute to inflation.
Cost push inflation using AD-AS
approach
The cost-push inflation can also be
illustrated with the aggregate demand and
supply curves. Consider Fig., where
aggregate supply and demand are
measured along the X-axis and price level
along the Y-axis.
 AD is the aggregate demand curve and
AS1 and AS2 curves are aggregate supply
curves.
Now, when wages increase, and as a result
cost of production rises, the aggregate
supply curve would shift upward to the left.
As will be seen in Fig. when there is an upward
shift in the aggregate supply curve from AS1 to
AS2 due to the rise in wages, price level rises
from OP1 to OP2.
Thus, in this case when aggregate demand
curve remains the same, price level rises due to
rise wages which has caused leftward shift in
the supply curve. An important feature of cost-
push inflation is that this causes not only rise
in price level but brings about a fall in
aggregate output.
 Thus in Fig. when price level rises from OP1 to
OP2  aggregate output falls from OY1 to OY2.
 Built-In Inflation
Last but not least, expectations of future
inflation cause built-in inflation.
That means, when prices rise, workers
expect (and demand) higher wages to
maintain their cost of living. However,
higher wages result in higher costs of
production, which leads to higher prices,
and the spiral begins.
Because of this circular dependency,
built-in inflation is sometimes also
referred to as the wage-price spiral.
At this point, it is important to note that
the expectations that cause built-in
inflation always originate from either
persistent demand-pull or significant
cost-push inflation in the past.
 In other words, built-in inflation doesn’t
occur on its own. It always needs a
catalyst or a trigger to kick it off.
Types of Inflation Indexes
Depending upon the selected set of goods
and services used, multiple types of
inflation values are calculated and
tracked as inflation indexes. Most
commonly used inflation indexes are
the Consumer Price Index (CPI) and
the Wholesale Price Index (WPI).
The Consumer Price Index
The CPI is a measure that examines
the weighted average of prices of a basket
of goods and services which are of
primary consumer needs. They include
transportation, food, and medical care.
CPI is calculated by taking price changes
for each item in the predetermined basket
of goods and averaging them based on
their relative weight in the whole basket.
The prices in consideration are the retail
prices of each item, as available for
purchase by the individual citizens.
Changes in the CPI are used to assess
price changes associated with the cost of
living, making it one of the most
frequently used statistics for identifying
periods of inflation or deflation. 
The Wholesale Price Index
The WPI is another popular measure of
inflation, which measures and tracks the
changes in the price of goods in the
stages before the retail level.
While WPI items vary from one country
to other, they mostly include items at the
producer or wholesale level.
For example, it includes cotton prices for
raw cotton, cotton yarn, cotton gray
goods, and cotton clothing.
 Although many countries and
organizations use WPI, many other
countries, including the U.S., use a similar
variant called the producer price index
(PPI).
The Producer Price Index
The producer price index is a family of
indexes that measures the average change
in selling prices received by domestic
producers of goods and services over time.
The PPI measures price changes from the
perspective of the seller and differs
from the CPI which measures price
changes from the perspective of the buyer.
In all such variants, it is possible that the
rise in the price of one component (say
oil) cancels out the price decline in
another (say wheat) to a certain extent.
Overall, each index represents the
average weighted cost of inflation for the
given constituents which may apply at
the overall economy, sector or
commodity level.
Inflation rate in India
Inflation rate in India was 5.5% as of May
2019, as per the Indian Ministry of
Statistics and Programme Implementation.
This represents a modest reduction from
the previous annual figure of 9.6% for
June 2011.
Inflation rates in India are usually quoted
as changes in the Wholesale Price Index
(WPI), for all commodities.
Many developing countries use changes
in the consumer price index (CPI) as their
central measure of inflation. In India, CPI
(combined) is declared as the new
standard for measuring inflation (April
2014).
CPI numbers are typically measured
monthly, and with a significant lag,
making them unsuitable for policy use.
India uses changes in the CPI to measure
its rate of inflation.
The WPI measures the price of a
representative basket of wholesale goods.
In India, this basket is composed of three
groups: Primary Articles (22.62% of total
weight), Fuel and Power (13.15%) and
Manufactured Products (64.23%).
Food Articles from the Primary Articles
Group account for 15.26% of the total
weight.
The most important components of the
Manufactured Products(Food products
19.12%) Group are Chemicals and Chemical
products (12%); Basic Metals, Alloys and
Metal Products (10.8%); Machinery and
Machine Tools (8.9%); Textiles (7.3%) and
Transport, Equipment and Parts (5.2%).
WPI numbers were typically measured
weekly by the Ministry of Commerce and
Industry. This makes it more timely than
lagging and infrequent CPI statistic. However,
since 2009 it has been measured monthly
instead of weekly.
Measures for Controlling Inflation

1) Monetary Measures
The government of a country takes
several measures and formulates policies
to control economic activities. Monetary
policy is one of the most commonly used
measures taken by the government to
control inflation.
a) Rise in Bank Rate
The bank rate is the rate at which the
commercial bank gets a rediscount on
loans and advances by the central bank.
The increase in the bank rate results in
the rise of rate of interest on loans for the
public. This leads to the reduction in
total spending of individuals.

The main reasons for reduction in total

expenditure of individuals are as follows:
(1) Making the borrowing of money
costlier
Refers to the fact that with the rise in the
bank rate by the central bank increases
the interest rate on loans and advances by
commercial banks. This makes the
borrowing of money expensive for
general public.
Consequently, individuals postpone their
investment plans and wait for fall in
interest rates in future.
The reduction in investments results in
the decreases in the total spending and
helps in controlling inflation.

(2) Creating adverse situations for

businesses
Implies that increase in bank rate has a
psychological impact on some of the
businesspersons. They consider this
situation adverse for carrying out their
business activities.
Therefore,they reduce their spending and
investment.

(3) Increasing the propensity to save

refers to one of the most important reason
for reduction in total expenditure of
individuals. It is a well-known fact that
individuals generally prefer to save money
in inflationary conditions. As a result, the
total expenditure of individuals on
consumption and investment decreases.
b) Direct Control on Credit Creation
The central bank directly reduces the
credit control capacity of commercial
banks by using the following methods:
(1) Performing Open Market Operations
(OMO)
Refers to one of the important method used
by the central bank to reduce the credit
creation capacity of commercial banks. The
central bank issues government securities
to commercial banks and certain private
businesses.
In this way, the cash with commercial banks
would be. spent on purchasing government
securities. As a result, commercial bank would
reduce credit supply for the general public.
(2) Changing Reserve Ratios
Involves increase or decrease in reserve ratios
by the central bank to reduce the credit
creation capacity of commercial banks. For
example, when the central bank needs to
reduce the credit creation capacity of
commercial banks, it increases Cash Reserve
Ratio (CRR). 
As a result, commercial banks need to
keep a large amount of cash as reserve
from their total deposits with the central
bank. This would further reduce the
lending capacity of commercial banks.
Consequently, the investment by
individuals in an economy would also
reduce.
2)Fiscal measures
Apart from monetary policy, the
government also uses fiscal measures to
control inflation. The two main
components of fiscal policy are
government revenue and government
expenditure.
In fiscal policy, the government controls
inflation either by reducing private
spending or by decreasing government
expenditure, or by using both.
Itreduces private spending by increasing
taxes on private businesses. When private
spending is more, the government
reduces its expenditure to control
inflation.
However, in present scenario, reducing
government expenditure is not possible
because there may be certain on-going
projects for social welfare that cannot be
postponed.
Besides this, the government expenditures
are essential for other areas, such as defense,
health, education, and law and order. In
such a case, reducing private spending is
more preferable rather than decreasing
government expenditure.

When the government reduces private

spending by increasing taxes, individuals
decrease their total expenditure.
3) Price Control
Another method for ceasing inflation is
preventing any further rise in the prices of
goods and services. In this method,
inflation is suppressed by price control, but
cannot be controlled for the long term.
In such a case, the basic inflationary
pressure in the economy is not exhibited in
the form of rise in prices for a short time.
Such inflation is termed as suppressed
inflation.
The historical evidences have shown that price
control alone cannot control inflation, but only
reduces the extent of inflation.
For example, at the time of wars, the
government of different countries imposed
price controls to prevent any further rise in the
prices. However, prices remain at peak in
different economies.
This was because of the reason that inflation
was persistent in different economies, which
caused sharp rise in prices. Therefore, it can be
said inflation cannot be ceased unless its cause
is determined.
APPENDIX
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