Inflation
Inflation is defined as a sustained increase in the general price level. Now, two things
should be noted in this regard. Firstly, inflation describes the situation of rising price level. If
the general price level remains to be stable at a high level without having any occurrence of
increase in price level, the situation will not be considered to be an inflationary situation.
Again, if the price level slightly rises from a low level to slightly a high level, although there
happens to be a slight increase in price level, it will be said that inflation has occurred.
Secondly, inflation does not imply that the prices of all goods and services are rising without
exception. Since a large number of different categories of goods and services are produced in
an economy, it may happen that prices of some goods and services are falling at some point
of time. However an inflationary situation describes an upward trend in the aggregate
(general/average) price level. That is if there happens to be an increase in the average price
level (despite of the fact that prices of some commodities have fallen), it will be regarded as
an inflationary situation. Just in the opposite manner, if there happens to be a fall in the
aggregate price level, the situation will be regarded as a deflationary situation.
Inflation is calculated as the weighted average of the prices of different commodities. In this
regard, the two mostly used measures are Consumer Price Index (CPI) and GDP deflator.
The inflation rate can be expressed as the percentage change in the general price level, that is,
𝝅𝒕 =
𝑷𝒕 −𝑷𝒕−𝟏
𝑷𝒕−𝟏
× 𝟏𝟎𝟎
Demand-pull and Cost-push inflation:
In Economics, we broadly talk about two types of inflation, namely, the demand-pull and the
cost-push inflation.
Demand-pull inflation is caused by the pressure of excess demand in the market. From the
basic microeconomic theory, it is already known that the price of any commodity is
determined from the intersection (equality) of the demand and supply. If there develops a
situation of excess demand, it puts an upward pressure on price. This simple microeconomic
logic can be extended to the context of macroeconomics also. In a macroeconomic sense, the
aggregate price level in the economy is determined from the intersection (equalization) of
aggregate demand (AD) of goods and services and aggregate supply (AS) of goods and
services. So, if the AD exceeds the AS, there will be an upward pressure on the aggregate
price level. This type of inflation (increase in price level) is called the demand-pull inflation.
Demand-pull inflation is illustrated in the below figure.
Initially, equilibrium was taking place at point E where the aggregate demand curve DD0 and
the aggregate supply curve SS intersected each other. Correspondingly, the price level was
OP0. Now because of any demand-pull factors (such as increase in the population or national
income in a country) the AD curve shifts rightward from DD0 to DD1. Now, given the supply
curve SS, there happens to be an increase in price level from OP0 to OP1. In this case,
inflation stops only when the aggregate price level reaches the equilibrium shown by F.
On other hand, if there appears to be increase in the cost of production because of say,
increase in the prices of inputs/raw materials, according to the microeconomic theory, supply
curve would be shifted leftward. This implies, the suppliers are ready to supply the same
quantity at a higher price than before. This in effect causes a reduction in equilibrium output.
Now, if this microeconomic concept is extended to the field of macroeconomics, it can be
clearly pointed out that any increase in the cost of production will cause a leftward shift in the
AS schedule. And as an immediate consequence, the aggregate level of output will fall and
the aggregate price level will increase. Since this type of inflation is caused by an increase in
the cost of production, this is known as cost-push inflation.
Cost-push inflation is depicted in the below diagram.
The initial equilibrium was taking place at point A where the demand curve DD0 and the
supply curve SS0 intersected. Now if the cost of production rises due to increase in wages of
the workers and/or due to increase in the costs of raw materials and/or due to imposition of
sales tax or excise duties by the govt., the sellers would not be willing to sell the same
quantity at the previous price level. Thus the same quantity will be sold a higher price than
before. This implies the supply curve will be shifted upward. Therefore, given the unchanged
AD, the equilibrium price level would be rising. This upward increase in price level due to
supply side factors can be regarded as the cost-push inflation. In the figure, the suppliers will
be willing to sell the OQ0 amount of quantity at a much higher price causing the supply curve
to shift upward from SS0 to SS1. As a result, the equilibrium price will rise from OP0 to OP1.
Impacts of inflation:
(i)
(ii)
Fall in real income:
Real income defines the purchasing power of money income. This can be
expressed as –
Real income = Nominal income / price level.
Now if there happens to be a sustained rise in the price level causing inflation,
there would be a fall in the real income for the given nominal (money) income of
the fixed income groups. In this way, inflation affects workers, salaried employees
and also the pension beneficiaries.
Inequality in the distribution of income:
Inflation causes an increase in the profit incomes of business men and
entrepreneurs, but it chokes off the real income of the salaried people. So inflation
also has a contribution in raising inequality in the distribution of income and
wealth.
(iii) Upsets the planning process:
Inflationary pressure upsets the entire planning process in an economy. When the
prices of goods, materials and factor services increase continuously, then more
money needs to be spent up for the completion of any investment project. If
sufficient financial resources are not raised by the government, plan targets are to
be curtailed.
(iv)
Adverse effect on capital accumulation:
If the inflation lasts for a prolonged period causing sustained decline in the
purchasing power of money, people will find it more preferable to hold goods and
services compared to money. Because they would fear that the purchasing power
would money will be continuously falling in the future. This, in effect, will cause
people to have immediate consumption instead of consumption in future. So, their
desire to save will be reduced. At the same time, their ability to save will also be
reduced as given their nominal (money) income; they need to spend more on their
preferred baskets of goods and services. When both ability and willingness to save
get reduced, smaller amount of fund will be available for investments. Therefore,
the process of capital accumulation will be adversely affected.
(v)
Increase in speculative investment:
As the price level tends to rise, people may express their desire to make
investment on purchasing shares, land etc for gaining some quick profits. Even
though this can help in the growth process, but it cannot really create productive
capital in the economy.
(vi)
Lenders will lose:
In case of loan contract, inflation causes a loss to the lenders and gain to the
borrowers. Because as the purchasing power of money is falling, the money
received by the lenders will be of lesser value.
(vii) Adverse effect on export income:
If inflation causes an increase in the prices of export items, then the demand for
export items may fall in the foreign market casing a fall in export income for the
domestic country.
(viii) Greater tendency of hoarding:
Some dishonest businessmen may hoard essential commodities at the time of
inflation in order to create artificial crisis in the market and thereby they earn
quick profits.
Inflation control policies:
In order to control inflation, it is important to know what the reason behind inflation is.
Inflation can occur from the excess demand situation arising in the commodity market
(known as the demand-pull inflation) and from the lack of supply in the market due to
increase in costs of production (known as the cost-push inflation). These two types of
inflation cannot be controlled by the same set of policies. Demand-pull inflation can be
controlled by reducing the pressure of aggregate demand (AD) in the economy. This is done
in two ways –
1. Monetary policies
This kind of policies talks about controlling the supply of money in the economy and
thereby reducing the pressure of inflation. Now, the supply of money can be reduced
in many ways. It can be reduced by withdrawing the paper notes and coins from
circulation. But usually this kind of step is not taken as the major portion of money
supply consists of bank deposits or bank credits. So, the government more focuses on
restricting the flow of credit in the economy utilising its various credit control
measures –
(i)
Bank rate:
The bank rate refers to the discount rate at which the central bank rediscounts
the bills of exchange submitted by the commercial banks to take loans from
the central bank. In India, it indicates the interest rate at which the commercial
banks borrow credit money from the RBI. So, bank rate is the cost of
borrowing credit money from the commercial banks.
During the period of inflation or upswing in economic activities, the central
bank raises bank rate. An increase in bank rate causes the commercial banks to
take fewer loans from the central bank as it would be more costly for the
commercial banks to take loans from the central bank as they need to pay high
rates of interest. So, when the commercial banks will give loans to the public,
they will again charge high rates of interest. So, increase in bank rate also
causes an increase in market interest rate, hence people will also be taking
lesser loans. As a result, supply of credit money will be reduced and this will
cause a reduction in aggregate demand also.
(ii)
Open market operations:
This refers to the purchase and sale of government securities or treasury bills
in the open market by the central bank to the non-bank public, or the
commercial banks or the non-bank financial institutions. During the period of
inflation or upswing in economic activities, the central bank sells the securities
in the open market. This causes the commercial banks to lose their excess
reserves. So their credit creation capacity gets reduced. And thereby by
controlling the volume of credit the central bank helps to reduce the pressure
of aggregate demand in the economy.
(iii)
Cash reserve ratio:
Each and every commercial bank has to maintain a stipulated proportion of
their total deposits as the required reserve with the central bank. This
proportion is known as the cash reserve ratio (CRR).
During the periods of inflation, the central bank raises the CRR. This causes a
fall in the credit creation capacity of the commercial banks and therefore, the
total volume of credit in the economy gets reduced.
(iv)
Statutory liquidity ratio:
Along with CRR, the commercial banks also need to maintain a given portion
of their total liquid assets with the central bank. This is known as SLR. During
the phases of inflation or economic boom, the central bank raises the SLR to
reduce the volume of credit and thereby the money supply in the economy.
2. Fiscal policies
Fiscal policy refers to the government’s policy instrument of changing the tax rates
and government expenditure in order to control the economy. In order to control the
inflationary pressure, government can either increase the tax rates or can reduce the
government expenditure.
An increase in tax rate would be causing people to have lesser amount of money in
their hands. So they will be cutting down their consumption expenditures. As a result,
the AD will also go down and thereby reducing the inflation.
On the other hand, a reduction in government expenditure can take place through
reduction in government transfer and subsidy payments (for instance, pension,
unemployment benefits, fuel subsidy etc) and will also cause a reduction in AD as
government expenditure is one of the major determining factors of AD. With a fall in
the AD, the inflationary pressure in the economy can also be reduced.
These polices of cutting government expenditure or raising the tax rates are known as
contractionary fiscal policies as they reduce employment and income opportunities in
the economy.
Now, as mentioned earlier the above measures are typically implemented for
controlling demand-pull inflation. In case of the cost-push inflation, there are some
direct measures such as –
(i)
Direct control:
It refers to the measures such as wage freeze, putting upper limits on the prices
of imported inputs such as electricity, coal etc.
(ii)
Other measures
Under this category, one can mention the policies such as augmenting the
supplies of commodities in the domestic market by increasing imports,
increasing domestic production etc. But it should be kept in mind that if the
imports exceed the exports, then the country will face BOP deficit which is not
desirable for the economy.