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MEANING OF INFLATION
It is defined differently by different writers
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e prices are rising" Crowther
" a continuing increase in the general price level"Brooman
"a persistent and appreciable rise in the general level of prices"
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The demand for goods increases due to the increase in the supply of money without any increase in
the supply of goods
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Types of Inflation
There are different types of inflation
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Creeping InflationIt is themild form of inflation
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Almost 3%
increase in price per annum is called creeping inflation
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Here increase in prices by
3% to 6% per annum
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Galloping or Hyper InflationPrices rise every moment and there is no limit to prices rise
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Open InflationPrices are permitted to rise without being suppressed by government
Suppressed InflationPrice rises are controlled by the government
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Eg
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Sporadic InflationRise in the price level in some sectors of the economy
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Under this situation supply cannot be increased at short notice
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Price level rises
in all sectors of the economy
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Prices rise due to rising costs associated with higher wages
and diminishing returns in production
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Ratchet InflationThere is excessive aggregate demand in certain sectors and inadequate in others
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Prices
rise in the excess demand sectors
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The net effect
is an overall increase in the price level
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Price rises in the capital good industry
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Thus the aggregate price level is pushed upwards which results
in inflation
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Mark-up is based on anticipation of future costs and prices
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When demand is higher the mark-up tends to be
higher and less when demand is low and costs are high
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Bottleneck Inflation Inflationary situation before full employment due to the imperfect elasticity
of supply of goods, is known as bottleneck inflation
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Supply is limited due to a number of bottlenecks like
a
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b
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c
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d
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Reflation A type of inflation occurring during the recovery from a depression or recession in which
prices are restored to a so called desirable level by decreasing the purchasing power of money
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Disinflation A reduction in the rate of inflation is known as disinflation
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The Classical Theory Of Inflation

Based on quantity theory of money, which states level of prices (P) depends on the supply of
money (M)
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P = f(M)
Inflation caused by a rise in money supply
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V -velocity of circulation of money
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P -general level of prices and
T -volume of transactions
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So any increase in M must lead to a proportional rise in P
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Remedy for inflation is a reduction in the quantity of money
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Demand Pull Inflation

Inflation caused by an increase in aggregate demand is called demand-pull inflation
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A shift in the
aggregate demand curve can arise as a result of an increase in private as well as government
expenditures
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Price level

S

P2
P1
D2

P0

D1
S

0

D0
Y0

Real income

Real national income is measured on the X axis, price level on the Y axis
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When the aggregate demand curve shifts from

DOto

D1, the price level rises form P0 to P1
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This will cause the aggregate demand curve to shift upward again, causing the price
level to rise further
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3
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This additional AD is created because of the
increase in real factors
(1)increase in consumption due to increase in mps
(2) increase in investment due to increase in the MEI
(3) increase in government expenditure
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This increase in AD while AS is
kept constant, create a demand –supply gap
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According to Keyns
these inflationary gap is the reason for inflation
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He defined the concept of inflationary gap as the gap between
theplanned expenditure and the real output available at full employment
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For
Keyns expenditure at less than full employment is not inflationary, the price rise may generate
additional employment and output
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The concept of inflationary gap can be explained by using the 'Keynesian cross'
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At point E1 resources are
fully employed
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Suppose the government increase its spending by
E1E2= ∆G
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But, since there is full employment, additional resources (capital and labour) would not be
available in response to the additional demand
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This creates an inflationary pressure in the
economy
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Therefore, E1E2 is inflationary
gap
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Cost-Push Inflation (Supply Side Inflation)

Inflation caused by an increase in costs is referred to as cost-push inflation
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Here prices are pushed up by increased cost of
production
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Wage-push inflation is caused by
rising money wage rates
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Wage push inflation is impossible in an economy, in which wage rates are determined by
purely competitive market forces
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Profit-Push Inflation is another variant of supply inflation
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This will result in
an increase in price level
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Mixed Inflation (Mixed Demand – Pull& Cost - Push Inflation)
Inflation due to a combination of demand-pull and cost-push factors called mixed inflation
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Suppose an inflationary process begins with excess demand
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The rise in money wages is not the
result of cost push forces
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This will raise
prices
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Thus both demand-pull and cost push forces are supplementary
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Sectoral Demand-Shift Theory Of Inflation

Introduced by Charles Schultze
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If prices and wage rates
are inflexible downwards in the sectors in which demand decreasing, and prices and wage rates
rise in the sectors to which demand increases, the overall price and wage level will rise
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Excess demand for goods and services in the expanding sectors pushes up prices in these sectors
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This higher prices and wages 'spill over' into
other sectors of the economy, spreading the inflation
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One is through higher wages in the expanding sectors leading to higher demand for goods
and services in other sectors
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Soindustries in the contracting sectors react to these higher wages by
increasing their prices
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6
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To explain inflation in less developed countries
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So some sectors of
the economy are characterized by shortages of supply relative to demand whereas other sectors
are characterized by underutilization of resources and excess capacity
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Resources GapLess developed countries are trying to industrialize their economies based
on government spending
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So there is excessive dependence on 'deficit financing' which results in excess
increases in the supply of money which leads to inflation
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Food Bottleneck The domestic supply of food grains in less developed countries is not
increasing sufficiently to match the increase in demand from increasing population and
urbanization
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Thus food grain prices play a major
role in the inflation of less developed countries
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Foreign Exchange Bottleneck less developed countriesimport increases greater than the
increase in export
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The shortage of
foreign exchange will lead to an increase in the price level in two ways
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The prices of such goods increase
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Thus the shortage of foreign exchange is another cause of inflation in less developed
countries
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Infrastructural Bottlenecks Because of the resource gap, the government is not able to
allot sufficient resources for the adequate growth of infrastructure facilities
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The result is inflation
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2
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4
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6
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Decline purchasing power
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The value of notes and coins falls
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Degree of risk associated with investment in the economy increases
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7
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Butreal incomes remain constant
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SACRIFICE RATIO
It is the amount of output lost when the inflation rate is reduced by one percentage
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MEASUREMENT OF INFLATION IN INDIA
There are three indices used in the measurement of inflation
1
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A single index is calculated for all the goods and services in the basket for the
country as a whole
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The market basket is periodically updated
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They are,
i
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monthly basis
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It is computed on a

ii
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The CPI-AL basket covers 260 commodities
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CPI for Urban Non-Manual Employees (CPI-UNME)
The base year is 1984-85
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iv
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2
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Wholesale Price Index (WPI)

The WPI series is compiled, computed and reported on a monthly basis
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Does not cover services and
non tradable commodities
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i
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The number of
primary articles is 102
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12%
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Fuel Power Light and Lubricants include 19 items like coal, petroleum products and
electricity
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91%
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Manufactured Products includes 555 items like sugar, cotton textiles, chemicals, cement,
iron and steel, machinery and tools etc
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97%
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The WPIat the end of a
particular month in the current year is compared with the WPI on the same day in the
previousyear
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GDP Deflator
GDP deflator is the ratio of GDP at current prices to GDP at constant prices
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GDP deflator is available
only annually with a long lag of over one year
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Money Supply -The prices rise whenever the supply of money increases faster than the supply
of goods in an economy
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Defense Expenditure
production
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Credit Facilities Sometimes the commercial banks may grant loans easily leading to an
increase in the supply of money and the demand for goods
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During war the supply of money increases without any increase in the supply of goods
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Deficit Finance results in an increase in the supply of money leading to inflation
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Hoarding result in a reduction in the supply of goods in the market and an increase in the prices
of goods
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Increase in Wages and Cost of Production
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An increase in the cost of production will result in an increase in
price level
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Natural Calamities Natural calamities like failure of monsoon, floods etc reduces the supply
of goods
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EFFECTS OF INFLATION
1
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Though the debtors return the same amount of money,
the value of money is less than when they borrowed the money
2
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This is due to the fact that prices
rise faster than the increase in salaries
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Wage earners may gain or lose depending upon the speed with which their wages adjust to
rising prices
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People like pensioners, recipients of interest income etc lose when prices are rising
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Equity Holdersgain during inflation because of the rise in dividend payment and an increase in
share prices
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Farmers gain during inflation because prices of the farm products increase more than the
cost of production
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As the price level is increasing production is encouraged
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The level of employment, output and income increase up to the
point of full employment
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Inflation tends to increase the inequalities in the distribution of income and wealth
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9
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When prices rise more rapidly in the domestic economy than foreign countries it will result in
a reduction in the exports and an increase in imports, thereby making the balance of payments
unfavourable for the country
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1
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2
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3
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Strikes, lockouts and labour unrest
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Political agitations resulting in the fall of government
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Declining moral values
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Monetary Measures
Measures adopted by the central bank of a country to control inflation
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Higher Rediscount Rate (Bank Rate)
excess activity based on borrowed funds
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Therefore regulates

2
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A rise in reserve requirements
reduces the amount of demand deposits in the banking system
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3
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Sale of government securities by the central bank to the public leads
to fall

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