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Q. #: What is inflation? Also mention its relative causes, remedies and kinds.

⇒ INFLATION:

Inflation is a process in which the price is rising at a rapid rate and the money
is losing its value. In the words of Gardner Ackley, “Inflation may be defined as a
persistent and appreciable rise in general level of average of prices.” It may here
denote that rising general level of price doesn’t mean that all prices are necessarily
rising. Even during inflation, the prices of some goods may remain relatively constant
and a few others actually falling. Inflation also does not mean that prices of goods
rise evenly or proportionately. Inflation is an upward movement in the general
(average) level of prices. In Pakistan, the general price level is persistently rising
since Partition of the Subcontinent. Prices remained volatile during the decade of
1990’s ranging form 5.7% to 13% mainly because of declining economic growth,
expansionary policies, output set backs, higher taxes and a depreciation of Pakistani
rupee. The inflation rate started declining form 1998 on ward due to improved supply
position of goods, strict budgetary measures. The inflation rate was 5.7% in 1998-99.
It was brought down to 3.6% in 1992-2000 and further to 3.1% in 2002-03. The
inflation rate based on the CPI (Consumer Price Index) has averaged 4.6% during
2003-04. The slight rise in prices was the year 2004-05 mainly due to rise in the
price of wheat and an increase in the international oil price.

⇒ CAUSES OF INFLATION:

The causes of inflation are generally grouped under two main heads (a) Demand
Pull Inflation (b) Cost Push Inflation.

A. Demand Pull Inflation:

Demand pull inflation occurs when aggregate demand for goods exceeds
aggregate supply of goods at current prices, thus leading to an increase in the price
level. The factors of which bring about increase in aggregate demand for goods or
rise in the general level of prices are grouped under two separate heads; (i) Factors
operating on demand side (ii) Factors operating on the supply side.

(a) Factors operating on the demand side: These are the factors which bring
continuous rise in the general price level.

(1) Increase in money supply: An increase in money supply leads to an increase in

money income. The increase in money income raises the aggregate demand for
goods and services in the country. The supply of money increases when the govt.
resorts to deficit financing or the commercial banks expand credit. When too much
money chases too few goods, the result is an increase in general price level.

(2) Increase in Government expenditure: If there is increase in govt. expenditure

due to adoption of development and welfare activities of the country has to flight a
war, it causes as increase in govt. expenditure which leads to increase in aggregate
demand for goods and services and hence the price level goes up.
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(3) Increase in private expenditure: A continuous increase in consumption and

investment expenditure in the private sector raises the demand for goods and
services and leads to inflationary rise in prices.

(4) Increase in population: The rapid rising population exerts pressure on the
demand for goods and services. If the supply of goods and services fail to match
with the demand, the general price level moves upward.

(5) Black money: The money generated through smuggling, tax evasion etc. raises
the demand for luxury and other goods. Hence black money is also one of the
causes in raising the aggregate demand for goods and a rise in general price level.

(b) Factors causing decrease in supply of goods: If the increase in aggregate

demand for goods and services is matched by an increase in the supply of goods, it
will not cause inflationary situation. When the aggregate supply of goods is at a
slower pace than the growth in aggregate demand, it then causes inflationary rise in
prices. The following factors are identified for relatively slower growth in the supply of
goods.

(i) Lagging agricultural & industrial production: The increase in population,

incomes, employment and urbanization exert pressure on the demand for goods and
services. However, the agricultural and industrial production grows at a slower pace,
due to shortage of essential inputs like fertilizers, water, cement, iron etc. When
aggregate demand for goods and services exceeds the aggregate supply of it, it
causes a rise in the prices of agricultural and industrial goods.

(ii) Inadequate infrastructure facilities: If, in a country there is shortage of power,

transport and communication facilities are slow and inefficient, it results in the
slowing down of overall production of goods. When the supply of goods falls short of
demand, the prices go up in the country.

(iii) Long gestation period: If the time lag between investment and the production
of goods is long, the shortage of goods will arise. This will also contribute to
inflationary pressure in the economy.

B. Cost Push Inflation:

Cost push inflation occurs when there is an increase in the cost of production
of goods and is not associated with excess demand. The main causes of cost push
inflation are:

(1) Increase in money wage rate: The wage push inflation occurs when strong
labour unions manage to press for wage increases in excess of labour productivity.
Unit cost of production is thereby raised. The rise in cost of production exerts
pressure on sellers to increase prices of goods so as to get profit margin.

(2) Profit push inflation: If the producers of certain commodities have monopoly or
near monopoly power in the market, they fix up higher profit margins arbitrarily
without any increase in other elements of cost. When a few powerful firms increase
the profit margins, the smaller firms also tend to mark up their profit margins. The
higher profit margins, thus, inflate the price level.
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(3) Material push inflation: If there is increase in the prices of some basic materials
such as gas, steel, chemicals, oil etc which are used directly or indirectly in almost all
industries, it causes an increase in the cost of production and hence in the general
price level.

(4) Higher taxes: If the government levies new taxes and raises the rates of old
taxes the producers generally shift the burden of taxes on to the consumers. The
increases in the selling prices of the commodities push up the inflationary trend in
the economy.

(5) Import prices: If prices of imported goods increase, it also results in the
contribution of inflation.

⇒ KINDS OF INFLATION:

Inflation is of different types. It is generally classified on the following basis.

• On the Basis of Rate of Inflation:

(i) Creeping Inflation: It is a situation in which the rise in general price level is at a
very slow rate over a period of time. Under creeping inflation, the price level raises
upto a rate of 2% per annum. A mild inflation is generally considered a necessary
condition of economic growth.

(ii) Walking Inflation: Walking inflation is a marked increase in the rate of inflation
as compared to creeping inflation. The price rise is around 5% annually.

(iii) Running Inflation: Under running inflation, the price increases is about 8% to
10% per annum.

(iv) Galloping or Hyper Inflation: Galloping inflation is a full inflation. Keynes calls it
as the final stage of inflation. It is a stage of inflation which starts after the level of full
employment is reached. Here price level rises very rapidly within a short period.

• On the Basis of Degree of Control:

(i) Open Inflation: It is a stage when the rise in price level gets out of control. Milton
Friedman describes it as “inflationary process in which prices are permitted to rise
without being suppressed by government price control or similar measures.

(ii) Suppressed Inflation: Under this type of inflation, the government makes efforts
to check and control the rise in price level through price and rationing. When price
level is suppressed by the above short term measures, it results in many evils such
black marketing, hoarding, corruption & profiteering.

• Inflation on the Basis of Causes:

(i) Demand Pull Inflation: Inflation caused by increase in aggregate demand, not
matched by aggregate supply of goods, resulting in rise of general price level is
called demand pull inflation. Demand pull inflation to be simpler, occurs when the
demand for goods and services in the country is more than their supply. The effective
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demand for goods increases due to many factors such as increase in money supply,
increase in the demand for goods by the government, increase in the income of
various factors of production etc. In short, the excessive increase in the money
supply causes inflationary conditions. Demand pull inflation is generally
characterized by shortage of goods and shortage of workers.

(ii) Cost Push Inflation: Cost push inflation occurs when the increasing cost of
production pushes up the general price level. Cost pull inflation occurs when the
economy is below full employment with prices rising even though there is no
shortage of goods. Cost push inflation is the result of increase in wage costs
unaccompanied by corresponding increase in productivity, rise in import prices of
goods, depreciation in the external value of the currency, higher mark up etc, etc.

(iii) Profit Induced Inflation: Profit inflation is in fact categorized under cost push
inflation. When entrepreneur, due to their monopoly position raise the profit margin
on goods. It may cause profit push inflation.

(iv) Budgetary Inflation: When the government of a country occurs the deficits in
the budgets through bank borrowing and creating new money (Deficit Financing), the
purchasing power of commodity increases without a simultaneous increase in the
production of goods. This leads to rise in the general price level.

(v) Monetary Inflation: Milton Friedman is of the firm view that inflation is always
and anywhere a monetary phenomenon. According to him, inflation is caused by a
too rapid increase in the money supply and by nothing else.

(vi) Multi Casual Inflation: Inflation has a number of causes. It may be caused by
increase in money supply, excessive wage demands, excess aggregate demand for
goods, shortage of goods etc. The chief cause of inflation in one year may not be in
the next year. Since inflation is multi causal, therefore a variety of policy measures
are needed to deal with it.

• On the Basis of Employment:

(i) Partial Inflation: According to J.M. Keynes, takes place when the general price
level rises partly due to an increase in the cost of production of goods and partly due
to rise in supply of money before the full employment stage is reached.

(ii) Full Inflation: Full inflation prevails when the economy has reached the level of
full employment. Any increase in money supply beyond full employment. It is also
called as real inflation.

• Anticipated versus Unanticipated Inflation:

(i) Anticipated inflation is the rate of inflation which majority of the individual
believes will occur. When the rate of inflation (say 6%) turns out to be same (6%) we
are then in a situation of fully anticipated inflation.

(ii) Unanticipated inflation is that which comes as a surprise to majority of

individuals. It can be higher or lower than the rate of anticipated inflation.
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⇒ Remedies of inflation
The first panacea for a mismanagement nation is inflation of the currency. The
second is war. Both bring a permanent ruin. They both are the refuge of political and
economic opportunities. (Ernest Hemingway). To avoid political unrest and harmful,
social and economic effects on the economy, it is the main objective of every
government to take appropriate measures to control inflation. The main measures
which are used to control inflation are (1) MONETARY POLICY (2) FISCAL POLICY
and other measures:

1. Monetary Policy
Monetary policy is a policy that influences the economy through changes in
the money supply and available credit. Monetary policy is adopted by central bank of
a country. The various monetary measures which are used to control inflation are
grouped under two heads (a) Quantitative controls (b) Qualitative controls. They are
(1) Open market operations (2) Variation in bank rates (3) Credit rationing (4) Varying
reserve requirements (5) Varying margin requirements (6) Consumer credit
regulations.

2. Fiscal Policy
Fiscal policy is the deliberate change in either government spending or taxes to
stimulate or slow down the economy. It is the budgetary policy of the government
relating to taxes public expenditure, public borrowing and deficit financing. Fiscal
policy is based upon demand management i.e, raising or lowering the level of
aggregate demand by controlling various expenditures, government expenditure,
consumption expenditure and investment expenditure. The main fiscal measures
are:

o Changes in taxation
If the Govt: of a country brings about changes in tax rates, it can help
stabilization of prices in the country. For example. A decrease in taxes relates
increases disposable income in relation to national income hence, consumption rises
at every level of national income. With the increase in aggregate demand for goods,
the employment goes up in the country. A rise in tax rates has the opposite effect. A
rise in taxes causes a decrease in disposable income, creates a larger budget deficit
and brings relief from inflation.

o Changes in Govt. Expenditure

If inflation is at or above the level of full employment in the country, the
government can bring down price level by curtailing its own unproductive
expenditure.

o Public borrowing
Public borrowing is another effective method of controlling inflation. Public
borrowing reduces the aggregate demand for goods and hence price level.
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o Balanced budget Changes

A balanced budget decrease has a mild contractionary effect on national
income and hence on bringing down the price level.

o Control of deficit financing

For financing the budget deficit, the govt. often resorts to deficit financing . the
bank borrowing and printing of new notes increases the money supply in the country
and pushes up the price level. Deficit financing therefore, should be avoided to
control inflation.

Others Measures:
Apart from fiscal and monetary measures, the other measures which are
helpful in controlling inflation are;
(a) Price support programme.
(b) Provision subsidies.
(c) Arrangements of easy availability of goods on hire purchase to stimulate
demand.
(d) Imposing direct control on prices of essential items.
(e) Rationing of essential consumer goods in case of acute emergency holding of
Friday and Sunday markets.

Since 1950’s the control of inflation has become the chief objective of both
developing and developed countries of the world. The government therefore take
monetary, fiscal and other measures to combat inflation.