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 some period of time. It is the rise in the general level of prices where a unit of currency effectively buys less than it did in prior periods. Often expressed as a percentage, inflation thus indicates a decrease in the purchasing power of a nation’s currency.
Inflation can be contrasted with deflation, which occurs when prices instead decline.
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.
TYPES OF INFLATION
Inflation can be classified on the basis of rate of rise in prices and on the basis of causes.
DIFFERENT INFLATION BASED ON RATE OF RISE IN PRICES
- CREEPING INFLATION
Price rise at very slow rate (less than 3%) like that of a snail or creeper is called Creeping inflation. It is regarded safe and essential for economic growth.
- WALKING OR TROTTING INFLATION
Price rise moderately at the rate of 3 to 7% (or) less than 10% is called Walking or trotting inflation. It is a warning signal to the government to be prepared to control inflation. If the inflation crosses this range, it will have serious implication on the economy and individuals.
- RUNNING INFLATION
Running inflation means price rise rapidly like the running of a horse at a rate of 10-20%. It affects the economy adversely.
- HYPERINFLATION (OR) RUNWAY (OR) GALLOPING INFLATION
The price rise at very fast at double or triple digit rate from 20 to 100% or more is called Hyperinflation (or) Runaway (or) galloping inflation. Such a situation brings total collapse of the monetary system because of the continuous fall in the purchasing power of money.
DIFFERENT INFLATION BASED ON CAUSES
- DEMAND PULL INFLATION
Demand pull inflation arises due to higher demand for goods and services over the available supply. Higher demand for goods and services arises due to increase in income of the people, increase in money supply and change in the taste and preference of people etc. In other words, demand pull inflation takes place when increase in production lags behind the increase in money supply.
- COST PUSH INFLATION
Price rise due to increased input costs like raw material, wages, profit margin etc., is called Cost push inflation.
Both demand pull inflation and cost push inflation are affected by forces of demand and supply.
FACTORS AFFECTING DEMAND
- Increase in Money Supply
Increase in money supply leads to price rise. More money available with people induces people to purchase more goods and services. It means there is an increase in demand. So, prices move upward.
- Increase in Disposable Income
The increase in the disposable income leads to higher spending on the part of households. It hikes the level of price.
- Cheap Monetary Policy
Cheap monetary policy means loan availability at very low interest rate and at easy terms. It leads to more investment by investors with loaned money. It pushes up the demand for capital goods and rise in price of the same.
- Increase in Public Expenditure
Increase in government expenditure over its income, leads to deficit budget. Increase in government spending increases the demand for consumption and capital goods and services. It increases the price of both goods and services.
- Repayment of Public Debt
The repayment of public debt borrowed by government to public leaves people with more money. It induces people to spend more. It ultimately leads to increase in price of goods and services.
FACTORS AFFECTING SUPPLY
- Shortage of Factors of production
The shortage in the factors of production viz., land, labour, and capital increases the cost of production. For example, shortage in the labour leads to higher wages. It increases the cost of production and price of goods and services.
- Industrial Disputes
Industrial disputes lead to strike or lay off. It affects the production and supply of goods. It results in increased prices.
- Natural Calamities
Natural calamities like earth quake, land slide and tsunami, affect production and supply of goods and services. The end result is price rise.
- Artificial Scarcities
Artificial scarcities created by activities like hoarding and speculative trading in commodities in the commodities future market, results in price hike.
- Increase in Exports
Increase in export of a particular commodity leads to shortage of goods in the domestic market. It pushes up prices.
- International Factors
International factors like oil price hike, shortage in production of certain commodities leads to higher import prices.
EFFECTS OF INFLATION
Inflation has impact on all the economic units. It has favorable impact on some and unfavorable impact on others. The effects are discussed under three different heads as under:
- REDISTRIBUTION OF INCOME OF WEALTH
It redistributes income from one hand to another. It leads to loss to some group of people and gain to another group of people.
- DEBTORS VS CREDITORS
In case of debtor and creditor, debtor is gainer and creditor is loser.
- PRODUCERS VS CONSUMERS
In inflationary situation, the producers stand to gain and consumers stand to lose. The producer’s profit will increase as a result of inflation. The purchasing power of money held by consumer declines. So, they have to pay more money to purchase the same amount of goods and services what they bought before inflation. Here, the income of consumer gets transferred from consumers to producers.
- FLEXIBLE INCOME GROUP VS FIXED INCOME GROUP
The flexile income groups like sellers, self employed, and employees of private concerns whose salary is adjusted according to inflation do not get affected, but fixed income groups like daily wage earners lose as the purchasing power of their income diminishes.
- DEBENTURES OR BOND HOLDERS AND SAVERS VS EQUITY HOLDERS
The Debentures or Bond holders and Savers receive fixed periodical income from their financial assets. The purchasing power of their asset remains intact only if interest rate is more than rate of inflation.
The security holder’s income depends on the profit of the company. In inflationary situation, the companies earn more profit. So, the equity holders also earn more income.
- EFFECTS ON PRODUCTION AND CONSUMPTION
The inflation may lead to fall in the demand for goods and services. It may curtail the amount of production. Inflation also leads to reallocation of resources. Sometimes, only few goods may experience price rise. In that case, the investment from other sectors may shift to these sectors.
In packaged items, in order to maintain same price per package, the producers reduce the quantity or quality or both instead of raising price. It means, less production and consumption.
- OTHER EFFECTS
- BALANCE OF PAYMENT (BOP)
High price reduces the amount of export and increases import from other countries where goods are available at cheaper rate. It results in unfavorable balance of payment.
- EXCHANGE RATE
High import and low export means high demand for foreign currencies compared to domestic currency. This depreciates domestic currency.
- SOCIAL AND POLITICAL
Higher rate of inflation leads to social and political tension. The political parties and organized group of people call for strike, hartals and stage dharnas.
MEASURES TO CONTROL INFLATION
The control of inflation needs a multi-pronged strategy. All the strategies need cooperation and harmony among them.
- MONETARY MEASURES
- CREDIT CONTROL
It is performed by Reserve Bank of India.
- DEMONETIZATION OF CURRENCY
Demonetization of currency means declaring that hereafter currencies of particular denominations are invalid. It suddenly reduces the money to the extent of money kept in those particular denominations. It is resorted to only in extreme cases.
- FISCAL MEASURES
- REDUCTION IN UNNECESSARY EXPENDITURE
Reduction of unnecessary government expenditure means less demand from government side. It brings down the price level.
- INCREASE IN DIRECT TAXES
Increase in direct taxes like income tax reduces the disposable income available with people. It means low demand from households. Less demand leads to lower price.
- DECREASE IN INDIRECT TAXES
Decrease in indirect taxes like excise duty, sales tax brings the prices down.
- SURPLUS BUDGET
Surplus budget means less expenditure than receipts. It reduces the money supply and government demand for goods and services. The price level is brought down due to this.
- TRADE MEASURES
Trade measures refer to export and import of goods and services. In case of shortage of goods in domestic market the supply can be increased through import of goods from foreign countries at low or nil import duty. The restriction in the form of import licenses has to be eased to increase import. The higher supply helps to bring down the price.
- ADMINISTRATIVE MEASURES
- RATIONAL WAGE POLICY
Rational wage policy helps to keep the cost of production under control. The cost control means price control.
- PRICE CONTROL
Direct price control also helps in inflation control. Price can be controlled by fixing maximum price limits through administered price system and subsidy from the government.
Rationing of goods in short supply keeps the demand under control so that price comes under control.
Philips curve shows the relationship between rate of inflation and rate of unemployment. It shows that the relationship is negative. That is at high rate of inflation the unemployment rate is low as show in figure below.
Stagflation refers to the situation of coexistence of stagnation and inflation in the economy. Stagnation means low National Income growth and high unemployment. The Philips curve shows that at high rate of inflation, there is low rate of unemployment. But stagflation proves the contrary.
Before 1970s, it was considered that at the time of inflation, the economy will be booming. 1970s scenario proved contrary with the existence of inflation and stagnation.
Deflation is opposite to that of inflation. The persistent and appreciable fall in the general level of prices is called as deflation. The rate of change of price index is negative. The effects, cause and measures are also in the opposite direction.
The rate of inflation at a slower rate is called disinflation. For example, if the inflation of last month was 6% and rate of inflation in the current month is 5% it is termed as disinflation.
Reflation means deliberate action of government to increase rate of inflation to stimulate economy. It is usually done to redeem the economy from deflationary situation.
The figure depicts the various rates of price changes in the economy. From the month of April to the end of May, the economy is experiencing negative rate of price range. It is called deflation. From the end of May to the mid of July, the price rate is recovering from negative zone. It is called reflation. From the mid of July, to the end of August, the price rate is moving upward in the positive territory. It is called Inflation. From September to the mid of October, the rate of price change is declining but still in the positive territory. It is called disinflation.
Headline Inflation Explained
As it includes all aspects within an economy that experience inflation, headline inflation is not adjusted to remove highly volatile figures, including those that can shift regardless of economic conditions. Headline inflation is often closely related to shifts in the cost of living, which provides useful information to consumers within the marketplace.
The headline figure is not adjusted for seasonality or for the often-volatile elements of food and energy prices, which are removed in the core Consumer Price Index (CPI). Headline inflation is usually quoted on an annualized basis, meaning that a monthly headline figure of 4% inflation equates to a monthly rate that, if repeated for 12 months, would create 4% inflation for the year. Comparisons of headline inflation are typically made on a year-over-year basis, also known as top-line inflation.
Core inflation is a measure of inflation that excludes certain items that face volatile price movements. Core inflation eliminates products that can have temporary price shocks because these shocks can diverge from the overall trend of inflation and give a false measure of inflation.
Economists usually distinguish between inflation and a relative price increase. ‘Inflation’ refers to a sustained, across-the-board price increase, whereas ‘a relative price increase’ is a reference to an episodic price rise pertaining to one or a small group of commodities. This leaves a third phenomenon, namely one in which there is a price rise of one or a small group of commodities over a sustained period of time, without a traditional designation. ‘Skewflation’ is a relatively new term to describe this third category of price rise.
In India, food prices rose steadily during the last months of 2009 and the early months of 2010, even though the prices of non-food items continued to be relatively stable. As this somewhat unusual phenomenon stubbornly persisted, and policymakers conferred on how to bring it to an end, the term ‘skewflation’ made an appearance in internal documents of the Government of India, and then appeared in print in the Economic Survey 2009-10, Government of India, Ministry of Finance.
The skewedness of inflation in India in the early months of 2010 was obvious from the fact that food price inflation crossed the 20% mark in multiple months, whereas wholesale price index (WPI) inflation never once crossed 11%. It may be pointed out that the skewflation has gradually given way to a lower-grade generalized inflation, with the economy in the middle of 2011 inflating at around 9% with food and non-food price increases roughly at the same level.
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.
Base effect refers to the phenomenon of current year index being influenced by very low or high previous year index.
Price index on January, 2017 = 110
Price index on January, 2018 = 120
Rate of inflation on January, 2018 = 120-110/110*100 = 9.09 %
Price index on March, 2018 = 180
Price index on March, 2019 = 190
Rate of inflation on March, 2019 = 190 – 180/180*100 = 5.55%
In both the cases the index number increased by 10, but the rate of inflation is different. The rate of inflation is low in second case compared to first case. This is because of the difference in previous year index.