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Inflation is commonly understood as a situation of substantial and rapid general increase

in the price level and consequent fall the value of money over a period of time. Inflation
means persistent rise in the general level of prices. Inflation is a long term operating
dynamic process. By and large, inflation is also a monetary phenomenon. It is usually
characterized by an overflow of money and credit. In fact, the root cause of inflation is
the expansion of money supply beyond the normal absorbing capacity of the economy.
The behavior of general prices is measured through price indices. The trend of price
indices reveals the course of inflation or deflation in the economy. Crowther defines
inflation as “a state in which the value of money is falling, ie., prices are rising”.
Professor Samuelson defines “Inflation occurs when the general level of prices and costs
is rising”.

Types of Inflation.

On different grounds, economists have classified inflation into various types. According
to the rate inflation there are four types of inflation.

• Moderate Inflation
• Running Inflation
• Galloping Inflation
• Hyper Inflation

Moderate inflation is a mild and tolerable form of inflation. It occurs when prices are
rising slowly. When the rate of inflation is less than 10 per cent annually, or it is a single
digit annual inflation rate, it is considered to be moderate inflation in the present day
economy. It does not disrupt the economic balance. It is regarded as stable inflation in
which the relative prices do not get far out of line. When the movement of price
accelerates rapidly, running inflation emerges. Running inflation may record more than
100 per cent rise in prices over a decade. Thus, when prices rise by more than 10 per cent
a year, running inflation occurs. When prices are rising at double or triple digit rates of
20,100 or 200 per cent a year, the situation may be described as galloping inflation.
Galloping inflation is really a serious problem. It causes economic distortions and
disturbances.

In the case of hyper inflation prices rise is very severe. It is over 1000 per cent per year.
There is at least a 50 per cent price rise in a month, so that in a year it rises to about 130
per cent times. Hyper inflation is a monetary disease.

Two Types of Inflation on the Basis of Cause of Origin: They are Demand Pull Inflation
and Cost Push Inflation.

Demand Pull Inflation: According to the demand-pull theory, prices rise in response to
an excess of aggregate demand over existing supply of goods and services. It is also
called excess-demand inflation. In the excess-demand theories of inflation, excess
demand means aggregate real demand for output in excess of maximum feasible, or
potential, or full employment, output (at the going price level). The demand-pull theorists
point out that inflation (demand-pull) might be caused, in the first place, by an increase in
the quantity of money. Demand-pull or just demand inflation may be defined as a
situation where the total monetary demand persistently exceeds total supply of real goods
and services at current prices, so that prices are pulled upwards by the continuous upward
shift of the aggregate demand function. Causes of Demand-pull inflation are

• Increase in Public Expenditure.


• Increase in Investment.
• Increase in money supply.

Cost Push Inflation: Cost push inflation or cost inflation is induced by the wage-
inflation process. This is especially true for a Country like India, where labour intensive
techniques are commonly used. Theories of cost-push inflation (also called sellers’ or
mark-up inflation) came to be put forward after the mid-1950s.They appeared largely in
refutation of the demand-pull theories of inflation and three important common
ingredients of such theories are 1) that the upward push in costs is autonomous of the
demand conditions in the concerned market 2) that the push forces operate through some
important cost component such as wages, profits (mark up), or materials cost.
Accordingly, cost-push inflation can have the forms of wage-push inflation, profit-push
inflation, material-cost push inflation, or inflation of a mixed variety in which several
push factors reinforce each other and that the increase in costs is passed on to buyers of
goods in the form of higher prices, and not absorbed by producers. Thus, a rise in wages
leads to a rise in the total cost of production and a consequent rise in the price level,
because fundamentally, prices are based on costs. It has been said that a rise in wages
causing arise in prices may , in turn , generate an inflationary spiral because an increase
would motivate the workers to demand more wages.

Causes of Inflation

1. Over- Expansion of Money Supply: Many a times a remarkable degree of


correlation between the increase in money and rise in the price level may be
observed. The Central Bank (India’s RBI) should maintain a balance between
money supply and production and supply of goods and services in the economy.
Money supply exceeds the availability of goods and services in the economy, it
would lead to inflation.
2. Increase in Population: Increase in population leads to increased demand for
goods and services. If supply of commodities are short, increased demand will
lead to increase in price and inflation.
3. Expansion of Bank Credit: Rapid expansion of bank credit is also responsible for
the inflationary trend in a country.
4. Deficit Financing: Deficit financing means spending more than revenue. In this
case government of India accepts more amount of money from the Reserve Bank
India (RBI) to spend for undertaking public projects and only the government of
India can practice deficit financing in India. The high doses of deficit financing
which may cause reckless spending, may also contribute to the growth of the
inflationary spiral in a country.
5. High Indirect Taxes: Incidence of high commodity taxation. Prices tend to rise on
account of high excise duties imposed by the Government on raw materials and
essentials.
6. Black Money: It is widely condemned that black money in the hands of tax
evaders and black marketers as an important source of inflation in a country.
Black money encourages lavish spending, which causes excess demand and a rise
in prices.
7. Poor Performance of Farm Sector: If agricultural production especially foodgrains
production is very low, it would lead to shortage of foodgrains, will lead to
inflation.
8. High Administrative Pricing
9. Other reasons are capital bottleneck, entrepreneurial bottlenecks, infrastructural
bottlenecks and foreign exchange bottlenecks.

Effects of Inflation

1. Effects of Inflation on Business Community: Inflation is welcomed by


entrepreneurs and businessmen because they stand to profit by rising prices. They
find that the value of their inventories and stock of goods is rising in money
terms. They also find that prices are rising faster than the costs of production, so
that their profit is greatly enhanced.
2. Fixed Income Groups: Inflation hits wage-earners and salaried people very hard.
Although wage- earners, by the grace of trade unions, can chase galloping prices,
they seldom win the race. Since wages do not rise at the same rate and at the same
time as the general price level, the cost of living index rises, and the real income
of the wage earner decreases.
3. Farmers: Farmers usually gain during inflation, because they can get better prices
for their harvest during inflation
4. Investors: Those who invest in debentures and fixed-interest bearing securities,
bonds, etc, lose during inflation. However, investors in equities benefit because
more dividend is yielded on account of high profit made by joint-stock companies
during inflation.
5. Inflation will lead to deterioration of gross domestic savings and less capital
formation in the economy and less long term economic growth rate of the
economy.

Knowing Inflation

By inflation one generally means rise in prices. To be more correct inflation is persistent
rise in the general price level rather than a once-for-all rise in it, while deflation is
persistent falling price. A situation is described as inflationary when either the prices or
the supply of money are rising, but in practice both will rise together. These days
economies of all countries whether underdeveloped, developing as well developed suffers
from inflation. Inflation or persistent rising prices are major problem today in world.
Because of many reasons, first, the rate of inflation these years are much high than
experienced earlier periods. Second, Inflation in these years coexists with high rate of
unemployment, which is a new phenomenon and made it difficult to control inflation.

An inflationary situation is where there is ‘too much money chasing too few goods’. As
products/services are scarce in relation to the money available in the hands of buyers,
prices of the products/services rise to adjust for the larger quantum of money chasing
them.

Inflation in Indian Context

Inflation is no stranger to the Indian economy. The Indian economy has been registering
stupendous growth after the liberalization of Indian economy. In fact, till the early
nineties Indians were used to ignore inflation. But, since the mid-nineties controlling
inflation has become a priority. The natural fallout of this has been that we, as a nation,
have become virtually intolerant to inflation. The opening up of the Indian economy in
the early 1990s had increased India’s industrial output and consequently has raised the
India Inflation Rate. While inflation was primarily caused by domestic factors (supply
usually was unable to meet demand, resulting in the classical definition of inflation of too
much money chasing too few goods), today the situation has changed significantly.

Inflation today is caused more by global rather than by domestic factors. Naturally, as the
Indian economy undergoes structural changes, the causes of domestic inflation too have
undergone tectonic changes. The main cause of rise in the rate of inflation rate in India is
the pricing disparity of agricultural products between the producer and consumers in the
Indian market. Moreover, the sky-rocketing of prices of food products, manufacturing
products, and essential commodities have also catapulted the inflation rate in India.
Furthermore, the unstable international crude oil prices have worsened the situation.

Defining causes of Inflation

What exactly is the nature of this inflation which has the nation in its grip? The different
causes of inflation which are experienced in Indian economy in a large proportion would
be:-

• Demand-pull inflation: This is basically when the aggregate demand in an


economy exceeds the aggregate supply. It is also defined as `too much money
chasing too few goods’. Bare-boned, it means that a country is capable of
producing only 100 items but the demand is for 105 items. It’s a very simple
demand-supply issue. The more demand there is, the costlier it becomes. Much
the same as the way real estate in the country is rising.
• Cost-push inflation: This is caused when there is a supply shock. This represents
the condition where, even though there is no increase in Aggregate Demand,
prices may still rise. I.e. non availability of a commodity would lead to increase in
prices. This may happen if the costs of especially wage cost rise.
• Imported Inflation: This is inflation due to increases in the prices of imports.
Increases in the prices of imported final products directly affect any expenditure-
based measure of inflation. They play an important role in driving the rise in
domestic prices. The rise in the global prices of crude oil and agricultural
commodities, including food grains, and industrial products, and setbacks to
global economy resulting from sub-prime mortgage disaster and US recession
have contributed to India’s inflation.

Other Causes:

• When the government of a country print money in excess, prices increase to keep
up with the increase in currency, leading to inflation.
• Increase in production and labor costs, have a direct impact on the price of the
final product, resulting in inflation.
• When countries borrow money, they have to cope with the interest burden. This
interest burden results in inflation.
• High taxes on consumer products, can also lead to inflation. An increase in
indirect taxes can also lead to increased production costs.
• 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.
• Debt, war and other issues that cause a drastic financial blunder can also cause the
inflation.

Measuring Inflation

Inflation in India is mainly estimated on the basis of fluctuations in the wholesale price
index (WPI). The wholesale price index comprises of the following indices:

• Domestic Wholesale Price Index (DWPI)


• Export Price Index (EPI)
• Import Price Index (IPI)
• Overall Wholesale Price Index (OWPI)

The WPI consists of about 435 items and has three broad categories. They are:-

• Primary Articles (weight of 22.0253) – 22% Index


• Fuel, Power, Light, and Lubricants (weight of 14.2262) - 14% Index
• Manufactured Products (weight of 63.7485) – 64% Index

The base year of the WPI is 1993-94. The base year usually chosen is one where there
has been fairly less volatility. The Indian WPI figure is released weekly on every
Thursday. But recently the government has approved the proposal to release a wholesale
price based inflation data on a monthly basis, instead of every week. The new series of
WPI based inflation with 2004-05 as the base year would be launched soon. The move is
aimed at improving the accuracy of the inflation data.
The monthly release of WPI is a widely-followed international practice. And, it is
expected to improve the quality of data. Collection of price data of manufactured
products will, accordingly, have a monthly frequency consistent with the practice of
release of WPI. The new series of WPI based inflation with 2004-05 as the base year
would be launched soon. However, the government will continue to release a weekly
index for primary articles, and commodities in the fuel, power, light and lubricants
groups. The weekly index will facilitate monitoring of prices of agricultural commodities
and petroleum products, which are sensitive in nature.

Problems of Inflation

It has been reported that the manufacturing capacity in India is running around 95 per
cent, which usually means it is running at full capacity. Therefore, when the price of
manufactured products is increasing, it means that demand is usually higher than supply
and that is a clear case of demand-pull inflation.

On the primary goods front, which consists of fruits, vegetables, food-grains etc, it is not
that straight-forward. It has certainly been all over the news that the prices of fruits and
vegetables are increasing and a trip to the supermarket or local grocery shop will testify
to that. Although it is a clear case of demand-pull inflation, on the other, it is also a bit of
a supply shock when one considers the fact that there is an abnormally high percentage of
fruits and vegetables that goes to waste because of the lack of cold-storage facilities.
Some estimates say 50 per cent of produce goes to waste and that is a conservative
number.

The fuel price hike is a straight example of cost push inflation. When OPEC (The
Organization of the Petroleum Exporting Countries) was formed, it squeezed the supply
of oil and this caused oil prices to rise, contributing to higher inflation. Since oil is used
in every industry, a sharp rise in the price of oil leads to an increase in the prices of all
commodities.

The in depth problems due to inflation would be:

• When the balance between supply and demand goes out of control, consumers
could change their buying habits, forcing manufacturers to cut down production.
• Inflation can create major problems in the economy. Price increase can worsen
the poverty affecting low income household.
• Inflation creates economic uncertainty and is a dampener to the investment
climate slowing growth and finally it reduce savings and thereby consumption.
• The producers would not be able to control the cost of raw material and labor and
hence the price of the final product. This could result in less profit or in some
extreme case no profit, forcing them out of business.
• Manufacturers would not have an incentive to invest in new equipment and new
technology.
• Uncertainty would force people to withdraw money from the bank and convert it
into product with long lasting value like gold, artifacts.
The imbalances inflation has created in the Indian economy:-

• It has created a new rich class in social and political lives who are corrupt
themselves and also corrupt the overall society.
• The increased prices reduced the capacity to save and people preferred present
consumption to future consumption.
• It has provided protection and subsides to industries which bred inefficiency.
• It has lead to misallocation of resources due to distortion of relative prices and
finally a redistribution of wealth from the poor to the rich.
• It disturbs balance of payments.

Curbing Inflation

There are several reasons why we should worry about the spike in the inflation rate.
Inflation is a tax on the poor and long-term lenders. Inflation is already too high, though
it is definitely not at economy-wrecking levels. But it’s best to be serious about the threat
it poses. Inflation has emerged as the biggest risk to the global outlook, having risen to
very high levels across the world, levels that have not been generally seen for a couple of
decades. Currently, in India, we go through boom-and-bust cycles; sometimes GDP
growth rates are very high and sometimes GDP growth rates drop sharply. This boom-
and-bust cycle is unpleasant for every household. There is a powerful international
consensus that stabilizing inflation reduces this boom-and-bust cycle of GDP growth.

India is facing the problem of inflationary pressure because of the increase in Aggregate
Demand while Aggregate Supply is respectively constant. The inflationary pressure faced
by Indian Economy is due to Demand-Pull inflation i.e. Aggregate Demand > Aggregate
Supply. Thus to curb inflation need to fill the gap between Aggregate Demand and
Aggregate Supply. For this either we need to increase Aggregate Supply or decrease
Aggregate Demand that can hamper economic development. To increase Aggregate
Supply either there is a need to increase production capacity of all current production
units or to build new production plants.

Treasury Inflation-Protected Securities (or TIPS) are the inflation-indexed bonds


issued by the RBI Treasury. These securities were first issued in 1997. The principal is
adjusted to the Consumer Price Index, the commonly used measure of inflation. The
coupon rate is constant, but generates a different amount of interest when multiplied by
the inflation-adjusted principal, thus protecting the holder against inflation. TIPS are
currently offered in 5-year, 7-year, 10-year and 20-year maturities. 30-year TIPS are no
longer offered. In addition to their value for a borrower who desires protection against
inflation, TIPS can also be a useful information source for policy makers: the interest-rate
differential between TIPS and conventional Treasury bonds is what borrowers are willing
to give up in order to avoid inflation risk. Therefore, changes in this differential are
usually taken to indicate that market expectations about inflation over the term of the
bonds have changed. The interest payments from these securities are taxed for federal
income tax purposes in the year payments are received