INFLATION
4.1 Introduction
❑It is the gradual rise in prices of goods and services
within a particular economy wherein, the purchasing
power of consumers decreases, and the value of the
cash holdings erode.
❑Inflation measures the average price change in a
basket of commodities and services over time.
❑The opposite and rare fall in the price index of this
basket of items is called deflation.
❑In India, the Ministry of Statistics and Programme
Implementation (MoSPI) measures inflation
4.2 Causes of Inflation
❑Demand-Pull Inflation: When aggregate demand
surpasses the available goods and services, it leads to
demand-pull inflation. Causes of demand pull
inflation are:
❑Depreciation of rupee and Increase in Forex reserve.
❑Lower interest rates cause a rise in consumer spending
and higher investment.
❑During festivals or special events, consumer spending
often surges, driving up prices.
❑Cost-Push Inflation: Rising production costs, such as
higher wages or increased raw material prices, can
result in cost-push inflation.
❑A spike in oil prices can increase production costs for
various industries, causing them to raise prices.
4.2 Causes of Inflation
❑Monetary Inflation: An increase in the money supply
beyond the growth of goods and services can lead to
monetary inflation.
❑Central banks printing more money or lowering interest
rates excessively, leading to increased liquidity.
❑Supply Chain Disruptions: Disruptions in the supply
chain, such as natural disasters or global crises, can
reduce the availability of goods, causing prices to rise.
❑The COVID-19 pandemic caused supply chain disruptions
and shortages of various goods.
❑Imported Inflation: A depreciation of the domestic
currency can make imported goods more expensive,
contributing to inflation.
❑Geopolitical events like the Russia-Ukraine war can elevate
global oil prices, leading to imported inflation in oil-
dependent countries such as India.
4.3 Types of Inflation- Based on Causes
❑Headline Inflation: Total inflation in the economy
includes inflation in a basket of goods that includes
commodities like food and energy.
❑Headline inflation may not present an accurate picture of
an economy’s inflation trend since sector-specific
inflationary spikes are unlikely to persist.
❑Core Inflation: Change in the costs of goods and
services but this excludes primary articles, food, etc.
because of volatility/short term fluctuations.
❑Core Inflation is a reflection of a Headline inflation that
may not present an accurate picture of an economy’s
inflation trend since sector specific inflationary spikes are
unlikely to persist.
❑It was first used in 2000-01 in India but later fell out of
fashion as prices in India depend more on food articles and
energy requirements.
❑Since 2015-16, new core-core inflation is also measured by
India, which excludes food, fuel, light, transport, and
communication.
4.3 Types of Inflation- Based on Causes
❑Profit Induced Inflation: If the producers, due to their
monopoly position, tend to mark-up their profit margin,
it will lead to profit-induced inflation.
❑Structural Inflation: Due to the weak structure of the
institutions and markets in the economies, mostly the
developing and low-income ones experience this kind of
inflation.
❑E.g., Artificial shortage of foods/ goods due to hoarding
and Poor agriculture produce due to poor monsoons,
inadequate irrigation facilities etc
4.3 Types of Inflation- Based on Speed
❑Creeping Inflation (1-4%): When the rate of inflation
slowly increases over time. For example, the inflation rate
rises from 2% to 3%, to 4% a year.
❑Walking Inflation (2-10%): When inflation is in single
digits – less than 10%. Central Banks will be increasingly
concerned.
❑Running Inflation (10-20%): When inflation starts to rise
at a significant rate. It is usually defined as a rate between
10% and 20% a year.
❑Galloping Inflation (20%-1000%): This is an inflation rate
of between 20% up to 1000%. At this rapid rate of price
increases, inflation is a serious problem and will be
challenging to bring under control.
❑Hyperinflation: Inflation rising at a very fast rate, can lead
to a total collapse of the currency and economic crisis. E.g.
Germany in the 1920s, Zimbabwe in the 2000s, and
Venezuela in the 2010s.
4.4 Base Effect and Inflation Targeting
❑Base Effect: It relates to inflation in the corresponding
period of the previous year, if the inflation rate was too
low in the corresponding period of the previous year,
even a smaller rise in the Price Index will give a high rate
of inflation.
❑Inflation Targeting: It is a monetary policy where the
central bank sets a specific inflation rate as its goal and
adjusts its monetary policy to achieve that rate.
❑The RBI and Government of India signed a Monetary
Policy Framework Agreement in 2015.
❑ RBI would aim to contain consumer price inflation at
4% with (+/-) 2% tolerance
4.6 Key Terms
❑Skewflation: It is the skewed rise in the price of ❑Reflation: Reflation is the act of stimulating the
some items while remaining item prices remain the economy after a period of economic slowdown or
same. E.g. Seasonal rise in the price of onions. contraction.
❑Stagflation: The situation of rising prices along with ❑Inflationary Gap: An inflationary gap exists when the
falling growth and employment. Inflation is demand for goods and services exceeds production
accompanied by an economic recession. A due to higher levels of employment, increased trade
combination of Inflation and unemployment (usually activities, or elevated government expenditure. The
in the time of Recession). real GDP can exceed the potential GDP, resulting in an
inflationary gap.
❑Disinflation: Reduction in the rate of inflation.
Example: a fall in the inflation rate from 8% to 6%. ❑Deflationary Gap: Similar in concept to the
inflationary gap, it represents the Shortfall in total
❑Deflation: Fall in the level of prices of goods and spending over national income.
services.
❑Inflation Tax: Due to price rise, wages increase, as
❑Depression: Economic depression is a sustained, wage increases taxes on this increase, generates more
long-term downturn in economic activity revenue for the government.
4.6 Key Terms
❑Inflation Premium: Bonus brought by inflation to
borrowers. Real interest rate (nominal IR adjusted to
inflation) << Nominal interest rate (charged on lending).
❑Inflation Spiral: Wage-price spiral i.e. when wages
press prices up and prices pull wages down.
❑Cobweb Phenomenon: Explains large scale
fluctuations in the prices of Pulses in the Indian Market.
❑If prices were higher in the previous year, more farmers
would sow pulses in the current year leading to its over-
production and subsequent decline in the prices.
❑The lower prices in the current year disincentive the
farmers from growing crops in the next cropping season,
leading to underproduction and subsequent increase in the
prices.