UNIT 7 INFLATION: CONCEPT, TYPES

AND MEASUREMENT
Structure
7.0 Objectives
7.1 Introduction
7.2 Measurement of Price Level
7.2.1 Definition of Index Number
7.2.2 Types of Index Numbers

7.3 Inflation Defined

7.4 Types of Inflation
7.4.1 Moderate Inflation
7.4.2 Galloping Inflation
7.4.3 Hyper-Inflation
7.4.4 Stagflation
7.4.5 Deflation
7.4.6 Core Inflation

7.5 Let Us Sum Up

7.6 Answers/ Hints to Check Your Progress Exercises

7.0 OBJECTIVES
After going through this unit you should be in a position to
 explain the concept of inflation;
 explain how inflation is measured;
 distinguish between various types of price indices to measure inflation; and
 identify the types of inflation;

7.1 INTRODUCTION
We come across the term inflation very often in newspapers. The reason why it
holds such importance is because of its adverse effects on an economy as well as
people. A question that could arise at this point is in what way does inflation
affect our everyday life? Let us illustrate with the help of a single household.
Inflation, in simple words, is a steady rise in the prices of various goods and
services. Given the level of the money income, a household consumes a group
of commodities at a given price level. With inflation, the price level goes up. So
with the same level of money income, the household could consume a smaller
amount of the commodities than it was consuming earlier. Alternately, to maintain
the earlier level of consumption this household now needs to have more money.


Dr. Gurleen Kaur, Assistant Professor, Sri Guru Govind Singh College of Commerce, University of
Delhi.
Inflation and For example, suppose the household has a monthly income of Rs.100, consumes
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the entire income on a single commodity A and does not save anything. If the
price of commodity A is assumed to be Rs. 4 then the household consumes 25
units of A in a month. Now suppose, the price of commodity A goes up from
Rs.4 to Rs.5. The household will be able to consume only 20 units of commodity
A.
To maintain the level of consumption at 25 units of A per month, the household
needs to have a monthly income of Rs. 125. Thus, we see that with inflation, one
unit of money purchases a smaller amount of goods than it was doing earlier. In
other words, with inflation, purchasing power of money goes down.
In the above example, consumption of the household comprises one commodity
only. But for a typical household, consumption involves a variety of goods and
services. As a result, increase in the price of one commodity need not affect
household consumption adversely if there is a decline in the price of some other
good. Therefore, to ascertain the effect of inflation we need to take into
account the change in the prices of all the goods consumed by the household.
To do that, we need to find the change in the general level of prices. Therefore,
before defining inflation we discuss the meaning of price level and the
changes in it.

7.2 MEASUREMENT OF PRICE LEVEL

We are familiar with the term ‘price’ of a product. What do we mean by the term
‘price level’? What is the difference between the two? And how do we measure
price level? These are some of the questions we try to answer in the present
section.
In simple terms price is defined as the rate at which goods and services are
exchanged for money. It is the amount of money received for selling or, paid for
buying, one unit of a commodity (or services) in an exchange economy.
The term price level is an aggregate concept. It relates to the price of a basket of
goods and services. See that we do not refer to the price of a single
commodity but to a group of goods and services taken as a whole. Therefore,
when we talk of a change in the price level it is always in reference to a group of
commodities. Since the prices of commodities differ, in order to measure a change
in the price level of a group of commodities, it is necessary to use index numbers.
More specifically, we have to use price index. Let us understand the idea of an
index number in an elementary form.
7.2.1 Definition of Index Number
An index number is a concept which enables us to compare the changes in a
group of distinct, but related, variables in two or more time periods.
A price index is used for comparing changes in the general level of prices of a
group of commodities. Generally a price index refers to changes in the prices
obtained over time. It is expressed by putting a particular period (called the
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‘base period’) equal to 100 and the price level for other periods are expressed Inflation: Concept,
Types and
relative to this base. For example, when we say, the wholesale price index has Measurement
gone up this year with respect to last year, we are taking last year price level as
the base or, the reference point = 100. With respect to it we measure the change
in the price level this year.
The price relative of an individual item is the ratio of its current price to its
price in a base period. The simplest price index for a given commodity can be
expressed as
It,o = 100 (pt / po) … (7.1)
where pt and po denote prices in the current period ‘t’ and the base period
‘0’ respectively.
For instance, if price of a kilo of potato goes up from Rs. 8 in 2017 to Rs. 10
in 2018, then the price index in this case would be:
I2017,2018 = 100 (10/8) = 125 …(7.2)
This index shows a 25 per cent increase in the price of potato over the year. In
other words, you need 25 per cent more money to maintain your consumption of
potatoes at the same old level.
7.2.2 Types of Index Numbers
Index numbers could be of various types, depending upon its purpose and
methodology. So far as price index is concerned, there are two main types of price
indices, viz., Wholesale Price Index (WPI) and Consumer Price Index (CPI). Both
the price indices are different in terms of i) the goods and services included, ii)
the weights assigned to each category of goods and services, and iii) the prices
(whether wholesale or retail) taken into account.
As it is not possible to consider all goods and services (because of time and
resource constraints), the index numbers are estimated on the basis of a sample
survey. The numerical value of two price indices will be different depending upon
three factors, viz., (i) the commodities included in construction of the index, (ii)
the weights assigned to each commodity, and (iii) the base year of the price index.
Thus while comparing two price indices we should take into account the above
factors. We will discuss about index numbers in greater detail later in the course
‘Statistical Methods for Economics’.
Wholesale Price Index (WPI)
The WPI is the price of a representative basket of wholesale goods. This index
measures the changes in price of goods and services at the wholesale market. In
India the WPI is published by Office of the Economic Adviser, Department for
Promotion of Industry and Internal Trade, Ministry of Commerce and Industry,
Government of India.
The data are collected at the first point of bulk sale in the domestic market. The
prices used are ‘wholesale prices for primary articles, administered prices for fuel

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Inflation and items and ex-factory prices for manufactured products’. One advantage of the
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WPI is that it has a long history, dating back to January 1942, which makes it
useful for assessing long-term trends in inflation. The WPI also covers a broad
range of goods, from raw materials to finished manufactures. A major limitation
of the WPI is that it excludes the services sector which has a major contribution to
GDP.
Consumer Price Index (CPI)
Consumer Price Index measures changes over time in general price level of goods
and services that households acquire for consumption purposes. The CPI numbers
in India are widely used i) as a macroeconomic indicator of inflation, ii) as a tool
for inflation targeting by the RBI, iii) for monitoring price stability by the
government, iv) for indexation of dearness allowance to employees, and v) as
deflator for national accounts. The CPI is published by the Central Statistics
Office (CSO), Government of India. You might have come across the term
‘headline inflation’ in newspapers and various reports. It refers to inflation based
on the comprehensive consumer price index.
Check Your Progress 1
1) If a country is experiencing inflation, the change in the nominal national
product will (choose the correct alternative)
a) be falling faster than the rate of inflation
b) equal the change in the real national product
c) understate the value of national income
d) overstate the change in the real value of production
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2) Distinguish between wholesale price index and consumer price index.

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7.3 INFLATION DEFINED

With the background of prices and price level in view we go on to the
definition of inflation. We mentioned earlier that inflation is defined as a
persistent rise or, a tendency towards persistent rise in the general level of
prices. The adjective ‘persistence’ has to be taken note of. The reason is, if
price level goes up today but falls tomorrow then it may not imply inflation, but
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only short-term fluctuations in prices. The term ‘general price level’ is also Inflation: Concept,
Types and
important since, over a period of time, prices of some commodities may have Measurement
gone up while some others may have actually fallen. As a result, on the
whole, the average of these prices may remain constant or even go down.
Similarly if the price of a group of commodities, which constitute a small
fraction of the total value of output of the economy, would go up, then again it
might not be inflationary as such. That is, the effect of rise in prices of such
commodities might be too small so as to affect the average price level of all the
commodities. Thus we see that inflation is a macroeconomic phenomenon and is
not concerned with the rise in the price of a particular commodity, or, a small
group of commodities.
In Section 7.1, it was pointed out how inflation is likely to affect a household
with fixed money income. In many cases, however, some of the income classes
actually benefit from inflation or at the least may remain unaffected by it. We
will discuss the causes and effects of inflation in the next Unit.

7.4 TYPES OF INFLATION

On the basis of the severity of inflation or, the rate of acceleration in prices we
can divide inflation into three different types, viz., moderate, galloping and
hyper-inflation. Further, there are some other related concepts which we discuss
below.
7.4.1 Moderate Inflation
When the general price level increases slowly but steadily, it is known as
moderate inflation. In the case of India, the Monetary Policy Committee (MPC)
resorts to inflation targeting at a rate of 4 per cent per annum. The rate of
inflation as per targets should not be outside the range of 2 per cent to 6 per cent
per annum.
7.4.2 Galloping Inflation
Steady and fairly high rate of increases in the general price level is known as
galloping inflation. The rate of inflation runs into two digits (20 per cent, 40 per
cent, etc.) and sometimes even as high as three digits (i.e., 200 per cent).
Some Latin American countries like Brazil and Argentina had experienced
inflation rates of over 100 per cent in the 1970s.
7.4.3 Hyper-Inflation
Hyper-inflation is a situation where the rate of inflation is very high. Thus the
value of money gets eroded rapidly. In order to cope with such a situation,
households minimize their holdings of local currency. Generally it happens in an
economy which faces wars and their aftermath, socio-political upheavals or other
crisis. In these situations it is very difficult to impose tax on the residents by the
government, which leads to fiscal deficit and government has to finance it
primarily through money creation rather than imposing taxes or borrowings. In a

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Inflation and situation of hyper-inflation, certain functions of money such as ‘a store of value’
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and ‘a medium of exchange’ are no more valid.
There have been several instances of hyperinflation in various countries. Brazil
had hyperinflation during the 1980s. A recent example of hyperinflation is
Zimbabwe during 2008-09, where prices almost doubled from one day to the next
day. The public used to spend money on food or whatever other commodities they
could, rather than holding on to money, as the value of money eroded rapidly.
According to some reports, it was impossible to estimate the rate of inflation in
2008 – it was around 79.6 billion per cent in November 2008. As a consequence,
the country abandoned its currency and allowed use of foreign currencies for
transaction in 2009.
7.4.4 Stagflation
The term stagflation (stagnation plus inflation) refers to the situation where an
economy grows very slowly or at zero rate (stagnant) and prices keep rising. The
side effects of stagflation are increase in unemployment- accompanied by a rise in
prices, or inflation. It raises economic dilemma as the actions designed to lower
inflation may worsen unemployment and vice versa. This happened during the
1970s, when crude oil prices rose dramatically, fuelling sharp inflation in
developed economies.
7.4.5 Deflation
Deflation is a situation where there is a consistent decline in price level. Here
again you have to notice the words ‘consistent’ and ‘price level’. Thus decline in
price of a single commodity cannot be terms as deflation. A situation of deflation
arises when aggregate demand is lower than aggregate supply. Thus, deflation
is characterized by a decrease in output, increase in unemployment, and general
slowing down of the economic activities.
The Great Depression of 1930s is an example of an acute deflation when
prices crashed, unemployment increased to a very high level, and GDP of the
developed countries fell sharply. There are many adverse effects of deflation.
Deflation in a modern economy is bad because it increases the real value of debt,
and discourages production in the economy as prices keep falling.
7.4.6 Core inflation
The measurement of inflation after removing the transitory or temporary price
volatility is known as ‘core inflation’. If temporary price shocks are taken into
account, they may affect the estimated overall inflation numbers, which may not
match with the actual inflation number. To eliminate this possibility, core
inflation is considered to assess actual inflation by removing the temporary
shocks and volatility. In India core inflation is calculated on the basis of price
increase in manufactured products excluding food products. Thus it does not
include agricultural commodities, fuel and energy and food products.
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Check Your Progress 2 Inflation: Concept,
Types and
1) A price index in years after the base year (Tick the correct option) Measurement
a. is never 100.
b. is always greater than 100.
c. is always less than 100.
d. can be less than, greater than, or equal to 100.
2) The CPI in 2017 was 111.5 and in 2018 was 114.1. The inflation rate is
(Tick the correct option)
a. 2.3%
b. 2.6%
c. 112.8
d. Insufficient information
3) Briefly discuss the various types of inflation.

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7.5 LET US SUM UP

Inflation is a persistent rise in the price level. When there is a rise in the price
level, there is a decline in the purchasing power of money. For measuring change
in the price level we take the help of the price index. An index number is a device
for comparing the magnitude of a group of distinct, but related, variables in two
or more time periods. There are two important types of price indices, viz.,
wholesale price index and consumer price index.
Deflation is a persistent decline in the price level. Hyper-inflation is a situation of
very high inflation, which could arise in the aftermath of wars or serious
economic crisis in an economy. The severity of most of the costs of inflation
enhances during hyperinflation. Stagflation is commonly referred to a situation of
stagnation in growth coupled with high inflation.
Core inflation is an inflation measure which excludes transitory or temporary
price volatility as in the case of some commodities such as food items, energy
products, etc.

7.6 ANSWERS/ HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) d
2) Refer to Sub-Section 7.2.2 and answer.
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Inflation and
Unemployment Check Your Progress 2
1) d
2) a
3) Refer to Section 7.4 and answer.

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