Inflation

Unit IV

Session 35
Meaning and Definition
Inflation means generally a considerable and persistent rise in the
general price level.
According to Pigou, “Inflation exists when money income is
expanding more than in proportion to increase in earning
activity”.
According to Coulborn, Inflation is a situation of “too much
money chasing too few goods”.
According to Ackley, “Inflation is a persistent and appreciable rise
in the general level or average of prices”.
Types of Inflation
Moderate Inflation: A single digit rate of annual inflation is
called moderate inflation or creeping inflation. Here prices
increases but at a moderate rate.
Galloping Inflation: A very high rate of inflation is called
galloping inflation. Inflation in the double or triple digit range of
20, 100 or 200 percent a year is labeled as galloping inflation.
Hyper Inflation: It takes place when prices shoot up at more than
three digit rate per annum. During the period of hyper inflation,
paper currency becomes worthless.
Demand Pull Inflation: A demand pull inflation is an inflation
created by the pressure of excess demand in the market. If for
some reason, there is an excess of demand over supply, price
tends to increase under this pressure of excess demand.
If aggregate demand exceeds aggregate supply, there will be an
upward pressure on the aggregate price level.
 The demand pull
factors (e.g. rise in
population or
national income in a
country) cause a
Price S rightward shift in the
demand curve from
D 0 to D 1. Now given
P1
the supply curve SS,
the equilibrium
D1
P0 product price will
increase form OP 0 to
D0 Op1.

Quantity

Cost Push Inflation: Suppose that there is an increase in the costs

of production of commodities. In micro economic theory it is
shown that a rise in the AC and MC of production leads to a
leftward shift of the supply curve of a commodity. This reduces
the equilibrium output of the commodity. In macro economics,
an increase in the cost of production will shift the aggregate
supply curve to the left. As a result the aggregate output of goods
and services in the economy will fall and the aggregate price
level will rise. Since this type of inflation is caused by a rise in
costs of production, it is called cost-push inflation.
 The cost of production may rise
due to the increase in wages and
costs of other materials used in
the production process. It may
also rise because of the
imposition of sales tax or excise
Price S1
duties by the government. So the
S0 suppliers would not be ready to
sell the same quantity at
B previous price. Thus, the same
P1 quantity will be sold at a higher
P0 A price than before. So there will
be an upward s hift in the supply
curve.
D Thus given the demand
curve the equilibrium product-
price will rise. This is a sign of
Quantity
cost push inflation.

Causes of Inflation
Increase in public spending
Deficit financing
Increased velocity of circulation: The rate at which money changes
hands among the people.
Population growth
Hoarding
Genuine shortages
Exports: creates shortage
Trade Unions: By demanding higher wages
Tax reduction: Leaves more money in people’s hands
Increasing cost of production
Post war economy
Effects of Inflation

(1) Effects on production

(a) Through Investment: During rising prices investment declines
(b) Switchover of Business: Many times other business opportunities
becomes profit able. People engage in trading activities and curtain
production activities.
(c) Uncertainty: During rising prices there is an atmosphere of uncertainty.
This makes entrepreneurs more and more reluctant to accept any risks in
production and leads to decrease in production.
(d) Change in the composition of production: As the income of the rich
increases, demand for luxuries increases and thereby production tends to
rise.
(e) Poor quality of output: Due to scarcity of goods there is a deterioration of
the quality of production because anything and everything that is produced is
sold.
(f) Public unrest: There are demonstrations, strikes and several other types
of agitations to secure higher wages. As a result production decreases.

(2) Effects on Distribution

(a) Creditor and debtor: Creditors lose and debtors
gains.
(b) Wage and salary earners: Lose
(c) Entrepreneurs as a class: Benefit more
(d) Investors as a class: Investors in assets which
give fixed returns tend to lose. Investors in shares
tend to gain because company earns more profit.
(e) The farmers: The income of farmers as a class
increases.
 (3) Other Effects
(a) Financial Institutions: When inflation is limited,
banks, etc. get advantages because their activities are
boosted. But as soon as price begin to rise at a faster
rate, savings get reduced and most of the financial
institutions fall in trouble.
(b) Foreign Trade: Imported items becomes cheaper
and imports increases and exports declines due to rise
in prices.
(c) Price Structure: Prices of all goods rises. But prices
of those goods whose supply is inelastic rise more. This
disturbs the entire price structure.
(d) Gap between rich and poor widens: Poor becomes
poorer and rich becomes richer.

Measures to control inflation

Monetary Policy: If the supply of money in the economy can be
decreased, prices will fall. The RBI can reduce the lending of
commercial banks in different ways for e.g. by raising the bank rate
and reserve requirements of banks by open market sales of securities,
etc.
The methods of monetary measures are (a) bank rate policy, (b)
variable cash reserve ration and © Open market operations.
Fiscal Policy: The policy of changing tax rates or the rate of
government expenditure can also be adopted. If the tax rate is
increased, less money will be left in people’s hands. As a result
demand in the market will go down. If the government reduces its
own expenditure, then, too, the demand in the market will fall
because government expenditure creates demand in the market.
Direct Control: Measures such as wage freeze, putting upper limits on
the prices of such important inputs as electricity, coal, steel, etc.
Other measures: Increasing the supplies of essential commodities in
the domestic market by increasing imports, increasing domestic
production, etc.