Inflation

Recently, inflation has come to be known as a state in

which the quantity of money in circulation expands faster
than the consequent growth of output, which causes a
continuous rise in prices

Coulbourn: too much money chasing too few goods

Kemmerer: Inflation will exist when the amount of money
in the country is in excess of the physical volume of goods
and services



Thus, it can be seen that according to the quantity theory of money, the
volume of money is responsible for the rise in prices through fall in the
value of money

Many economists do not agree that money supply alone is the cause of
inflation. The definition was modifies during the Keynesian revolution

Pigou: Defined inflation in terms of changes in money income. In his
view, inflation exists when money income is expanding more than in
proportion to income earning activity

Keynes: Linked up the concept of inflation with the phenomenon of full
employment. He relates inflation to a rise in the price level that comes
into existence after the stage of full employment. According to him,
inflation refers to a rise in price level after full employment level has been
achieved. In such a situation of price rise, output will not increase in the
economy
According to Keynes, the initial rise in prices up to the
stage of full employment is desirable for the country, as
there is an increase in output and also in employment

It relieves the economy from serious consequences of
depression, as a result of deliberate anti-deflationary
measures taken by the government, when prices fall down
to the lowest limit

The rise in prices after the full employment level may not
be good for the economy, since there is no corresponding
increase in output or employment
Types of Inflation
On the basis of
rate of inflation
Creeping
inflation
Running
inflation
Hyper inflation
(galloping/
jumping
inflation)
On the basis of
degree of control
Open inflation
Suppressed
inflation
On the basis of
causes
Credit inflation
Currency
inflation
Deficit Induced
Inflation
Demand Pull
Inflation
Cost Push
Inflation
Demand Pull Inflation
The most common cause for inflation is the pressure of ever
rising demand on a stagnant or less rapidly rising supply of goods
and services

Here, aggregate demand has been pulled above (or in excess of )
what the economy is capable of producing (or supplying) in the
short run.

An increase in aggregate demand, supply remaining constant,
will pull up the prices

Demand pull inflation occurs when there exists an excess
demand over the available supplies at the existing prices


Demand Pull Inflation
The major source of inflation is the increase in the quantity of
money

Increase in the quantity of money results from an increase in
demand deposits and expansion of credit by the banks, raising
the level of income

An increase in the disposable income causes an increase in
consumption expenditure. Such an increase in expenditure
raises the price of the good

Money supply can also rise, when the government resorts to
deficit financing to finance its economic development plans
through borrowing from the central bank and the commercial
banks. This will ultimately exert pressure on the level of prices


The expansion of aggregate demand may be the result of rapidly
rising private business outlays or expanding government
expenditure for war or economic development

Large expenditures will create huge money income and hence
demand, without a corresponding increase in the supply of real
output

During the Second World War, almost all the countries of the
world, faced demand pull inflation due to rise in the government
expenditure on an unprecedented scale

Demand Pull Inflation
Yet another factor responsible for increased demand is foreign
expenditure on domestic goods and services

This factor is important for a country that maintains an export
surplus

However, if the income generated is used on imports (or is
hoarded), it will not have inflationary effect on the economy
Demand Pull Inflation
Cost Push Inflation
Cost push inflation results from a situation, when the costs of
production of industry rise either due to increases in the prices
of raw materials, intermediate goods or an increase in wages

This will cause an increase in the prices of consumer goods

When the cost of production rises, aggregate supply curve shifts
to the left, indicating that a lesser quantity is supplied at the
prevailing prices
Higher Wage Rate:
With the growth of powerful trade unions in the modern economy, workers
successfully secure higher wages for themselves, even greater than the
increase in their productivity

When firms find that their labor cost is rising, they raise the price to cover
the higher cost

A rise in the prices of goods leads to higher cost of living or a fall in real
wages. To neutralize this fall, workers demand further hike in their wages

The ultimate burden of the rise in price, in any case, is to be borne by the
consumer.

A series of rise in wage rate and consequent rise in price builds an
inflationary pressure (wage price spiral) in the economy, called wage
push inflation
Cost Push Inflation
Higher Profit Margins:
Cost can also be increased through fixing a higher profit margin
by monopolist producers, hoarders and speculators

They are in a position to raise prices more than enough to offset
any cost increase. Others in the market are at the mercy of the
monopolists and have no choice but to accept them as given

It is relatively simple to bring down profit push inflation, as it
only involves a reduction of the selling price by the producers.
Cost Push Inflation
Higher Taxes:
Government can enhance the cost by introducing a variety of taxes and
raising the existing rates of taxes, particularly indirect taxes like excise
duties and sales taxes.
The producers shift the burden of taxes to the consumers by raising the
prices of goods

Availability and Prices of Basic Inputs:
When there is a shortage of strategic and basic raw materials and other
inputs, their prices shoot up.

A number of important inputs are controlled by the government or other
authorities. Their prices are administered by the supplying organizations

Therefore, a price hike of even one basic input may raise the general level
of prices and could be a source of cost push inflation in the economy
Cost Push Inflation
Other Factors:
Fall in agricultural production due to insufficient, excessive,
uncertain, irregular rainfall or other natural calamities like
floods, droughts, famine, etc, reduces the aggregate supply and
raises the price of agricultural goods

Similarly, fall in industrial production on account of strikes,
lock-outs, break down of power supply, governments domestic
or foreign policy may shift the supply curve upwards, resulting in
an upward trend in the prices
Cost Push Inflation
It refers to the excess of aggregate demand over the
available output on account of rising money incomes at
the full employment level

The inflationary gap arises on account of extra
expenditures by the government

To remove this inflationary gap, reduction of
government expenditure is not desirable either during
war or during the period of economic development


Inflationary gap can be bridged by

A rise in the voluntary saving by the community to reduce
the effective demand

Using a tax system through a surplus budget to wipe out
the surplus purchasing power with the people, so as to
reduce C+I by an amount equal to increase in the
government expenditure

Increasing the availability of goods and services through
imports to absorb the excess demand, though there is little
scope due to lack of unemployed resources


Effects on Production and Economic Activities

The wheels of industries are well lubricated to raise production and create
jobs through increased spending for economies suffering from deficiency
of demand
The windfall profits due to rise in prices induce firms to invest more, which
may lead to employment of unemployed manpower and unutilized
resources
This will result in capital formation and creation of more income, leading
to an increase in demand

When inflation goes beyond a certain limit, it creates chaos in the
economic system
It may result into reduction in production and rise in unemployment, as
firms find it profitable to hoard rather than to produce
Production may also be interrupted on account of bitter labor strikes by
workers whose real income fell during the inflationary period
Sometimes, producer may even decline the quality of goods produce to
secure greater profits
Effects on Distribution of Income
Inflation is accompanied by a sizable, haphazard and undesirable shifts in the
distribution of income
a) Businessmen
All businessmen gain during the inflation period. The prices of goods rise at a much
faster rate than the cost of production

There is always a time lag between increase in the price of goods and prices of inputs like
wages, interest,, rent, insurance premium, etc. Hence, their profit margins rise

The producers and traders also generate artificial scarcity of goods, causing further price
hike

Inelastic demand for the agricultural goods induces farmers to hoard goods, so as to sell
them at higher prices in the future

Also, landless agricultural workers are hit hard by inflation as their wages are not raised
by the farm owners since there is no trade unionism

Inflation gives stimulus to speculative activities due to uncertainty generated by a
continuous rising price level



Effects on Distribution of Income

b) Debtors and Creditors
A rise in price level alters the real burden of debts and hence affects
debtors as well as creditors.

Debtors are the ones who borrow money and repay it in future with
interest thereon. They gain as a result of inflation, since the real
worth of money which they repay declines on account of inflation.
Further, they forego less in terms of goods and services by repayment
during inflation, since inflation reduces the value of money and
hence the purchasing power




Effects on Distribution of Income

c) Investors
Investors and speculators in equities generally benefits due to inflation.
Shareholders on one hand earn dividends. On the other hand, they may secure
capital gains on account of rise in price of shares

Investors in fixed interest yielding securities like bond and debentures suffer, as
real income from such investments decline during inflation

When inflation is severe, the hard earned savings are completely wiped out due
to fall in the value of money

Small investors suffer the most, who keep their savings in the fixed deposit or
saving bank accounts, provident funds and insurance schemes. That is why,
people prefer to spend more in purchasing consumer goods. They are reluctant
to save



Effects on Distribution of Income

d) Fixed Income Earning Class
Wage and salary earners and other individuals with fixed incomes are most
severely hit by inflation. Increase in salaries through annual increments or
untimely payments of dearness and other allowances fail to keep pace with
rising prices

Other individuals include pensioners, fixed interest and rent earners,
whose earnings remain same or move relatively slowly, while the prices of
goods and services which they intend to purchase are rising very rapidly.

The same is the case with the holders of fixed interest bearing deposits




Other Effects

Inflation creates uncertainty in the economic activities. The entrepreneurs are
discouraged to take business risks

There is diversion of resources from the production of essential goods to luxury
goods, resulting in shortage of the essential consumer goods for the common
man. Consequently, their prices are further hiked

Foreign trade is adversely affected by inflation (demand pull or cost push)

On account of demand pull inflation, private investment increases manifold.
With real capital investment, capital formation is promoted

Investors may also hoard products to gain more profits, resulting in black
marketing.

The tax revenue of the government rises, which can finance the growing public
expenditure


Monetary Measures
Quantitative Control Measures
Bank rate
Open market operations
Variable reserve requirements

Selective Control Measures/Quantitative Measures
Regulation of consumer credit
Central banks may fix higher margin requirements for
loans according to the purposes
Fiscal Measures
a) Public Expenditure

To control price rise, the government can reduce its expenditure.
This will reduce public money from the market and hence the
demand for goods and services

It is almost suicidal to curtail defense or developmental expenditure
of the government. Further, it is of no use to give up the schemes
under various plans, that the government has already taken up

Thus, the government must keep the non-essential expenditure to
the minimum. This will also put a check on private spending, which
depend upon government expenditure
Fiscal Measures
b) Taxation
Imposition of new taxes and raising the rates of the existing taxes, on
one hand reduces the purchasing power of the people, and on the
other hand generates resources to the government for combating
inflation

Tax revenue realized by the government should be used to maintain
essential expenditure

To bring in more tax revenue, the government should penalize the
tax evaders by imposing heavy fines
Fiscal Measures
c) Public Borrowing and Debt
The main purpose of public borrowing like tax is to take away from
the public, excessive purchasing power, which, if left free, would
exert an upward pressure on the demand

If voluntary borrowing does not yield the desired results, the
government may resort to compulsory borrowing

The government should avoid paying back any of its previous loans
during inflation to prevent an increase in the circulation of money

Also, if possible, payment of part of the salary to employees should
be deferred to educe current purchasing power of people. Deferred
purchasing power can be released, when inflation comes to an end or
there is an expectation of recession in the economy
Other Measures
Price Control and Rationing
Wage Policy
Output Adjustment

It may be defined as persistent and substantial fall in the general
level of prices below full employment level

It is different from disinflation, which is the process or technique
designed to reverse the inflationary trend in prices without creating
unemployment


Causes of Deflation
On the demand side, money shortage, fall in disposable income and
fall in business outlays may lead to contraction of credit, consumption
expenditure and investment expenditure on account of tight money
policy, higher rates of taxes and falling profit margins respectively
This will have an adverse effect on the level of income and employment
in the country, resulting in deflationary situation in the country

On the supply side, over investment may cause a rapid increase in
production surpassing the demand. Such situation may breed
deflationary forces in the economy

Deflation can also arise from the anti-inflationary measures, when
their overuse may contract the money supply
Deflationary gap may be defined as the amount by which
aggregate expenditure falls short of he aggregate income at
the full employment level

To wipe out the deflationary gap, the government can raise
the expenditure by investing in public works. Alternatively,
the community may raise its consumption or investment
expenditure
Effects of Inflation
Effects on Production and Employment
During deflation, prices of goods and services are falling due to
contraction in their demand
Continuous fall in prices may cause heavy losses to the firms forcing them
to go into liquidation
In such situation, the whole economy is gripped by pessimism and
depression

Effects on Distribution
Producers, traders, real estate holders, merchants, equity holders,
speculators and farmers all lose due to fall in prices
Due to erosion of effective demand, involuntary accumulation of stocks
takes place, profit margins dwindle, etc

Monetary measures
Fiscal measures