Unit IV

What is infla on? Discuss its various types.

Discuss the demand-pull infla on.

Discuss the cost push infla on.

Differen ate between infla onary gap & defla onary gap.

Present a descrip ve note on causes of infla on.

Analyze the effects of infla on.

Analyze the effect of infla on on the following segments – a. Farmer b. Fixed Salary group c.
Creditors & debtors.

Explain the various measurement of infla on.

Discuss the monetary policy measurement to control infla on.

Discuss the fiscal policy measurement to control infla on.

Discuss the direct measures to control infla on.

Infla on may be defined as ‘a sustained upward trend in the general level of prices’ and not the
price of only one or two goods. G. Ackley defined infla on as ‘a persistent and appreciable rise in
the general level or average of prices’. In other words, infla on is a state of rising prices, but not
high prices.

It is not high prices but rising price level that cons tute infla on. It cons tutes, thus, an overall
increase in price level. It can, thus, be viewed as the devaluing of the worth of money. In other
words, infla on reduces the purchasing power of money. A unit of money now buys less.

Types of Infla on:

Infla on is categorized into two broad classifica ons: on the basis of structure (qualita ve
classifica on) and on the basis of numbers (quan ta ve classifica on). These classifica ons
help in understanding infla on from different perspec ves—its causes, nature, and intensity.
1. Infla on Based on Structure (Qualita ve Classifica on)

This classifica on focuses on the causes and nature of infla on, explaining why prices rise.

(i) Core Infla on

Core infla on measures the long-term trend in price levels by excluding highly vola le
components such as food and fuel prices. These items tend to fluctuate due to seasonal changes
or interna onal price shocks, which may distort the actual infla on trend. By removing such
vola le factors, core infla on provides a clearer picture of underlying price movements and helps
policymakers in making long-term economic decisions.

(ii) Headline Infla on

Headline infla on refers to the overall infla on rate, including all goods and services in the
economy, such as food and fuel. Since it covers all price movements, it o en experiences
fluctua ons due to short-term supply shocks or seasonal varia ons. While headline infla on is a
useful indicator for general economic condi ons, it may not always reflect the long-term trend
accurately due to external influences like global oil price changes or natural disasters.

(iii) Built-in Infla on

Built-in infla on occurs when past infla onary trends influence future expecta ons. When
workers demand higher wages due to the rising cost of living, businesses compensate for the
increased labor cost by raising the prices of goods and services. This leads to a wage-price spiral,
where higher wages push prices up, which in turn leads to further wage demands. This cycle
con nues, contribu ng to persistent infla on unless controlled through policy measures such as
wage agreements and produc vity-linked pay structures.

(iv) Demand-Pull Infla on

Demand-pull infla on arises when aggregate demand (total demand in the economy) exceeds
aggregate supply (total produc on). This o en happens during periods of strong economic
growth, when consumer income rises, government spending increases, or credit availability
expands. When businesses struggle to meet the rising demand for goods and services, prices start
increasing. This type of infla on is o en seen in booming economies and is influenced by factors
like tax cuts, low interest rates, increased foreign investments, and higher government spending
on infrastructure projects.

(v) Cost-Push Infla on

Cost-push infla on occurs when the cost of produc on increases, forcing businesses to pass these
higher costs onto consumers. This can be caused by a rise in wages, higher raw material costs,
supply chain disrup ons, currency deprecia on, or increased taxes and regulatory costs. For
example, a sharp increase in crude oil prices can raise transporta on and manufacturing costs,
leading to higher prices across various industries. Unlike demand-pull infla on, which is driven by
excess demand, cost-push infla on is a result of supply-side constraints that reduce the
economy’s produc ve capacity.

2. Infla on Based on Numbers (Quan ta ve Classifica on)

This classifica on focuses on the rate or intensity of infla on, categorizing it based on how fast
prices are rising.

(i) Creeping Infla on

Creeping infla on refers to a slow and steady rise in prices, usually below 3% per year. This level
of infla on is considered normal and even beneficial for economic growth, as it encourages
consump on and investment without eroding the purchasing power of money significantly.
Central banks generally do not take aggressive ac ons against creeping infla on, as it helps in
maintaining economic stability.

(ii) Crawling Infla on

Crawling infla on represents a moderate but con nuous rise in prices, slightly higher than
creeping infla on. It indicates that infla on is gradually picking up pace, which may require some
level of policy interven on. If le unchecked, crawling infla on can turn into more severe forms
of infla on, affec ng economic stability.

(iii) Walking Infla on

Walking infla on occurs when prices rise at a no ceable rate, typically between 3% to 10% per
year. At this stage, infla on starts affec ng economic decisions, as consumers and businesses
an cipate further price increases. People may start purchasing goods in advance to avoid paying
higher prices in the future, which can further increase infla onary pressures. If walking infla on
is not controlled, it can escalate into running infla on.

(iv) Running Infla on

Running infla on is a rapid increase in price levels, usually exceeding 10% per year. At this stage,
infla on significantly reduces the purchasing power of money, making daily necessi es more
expensive. It can create economic instability, as businesses and consumers struggle to keep up
with rising costs. Governments and central banks o en implement strict monetary and fiscal
policies to control running infla on, such as increasing interest rates, reducing government
spending, or ghtening credit supply.
(v) Hyperinfla on

Hyperinfla on is an extreme and uncontrollable rise in price levels, some mes exceeding 50%
per month. This type of infla on leads to a total collapse of currency value, making money
prac cally worthless. Countries experiencing hyperinfla on o en see rapid increases in the prices
of goods and services, shortages of essen al commodi es, and a loss of public confidence in the
financial system. Notable historical examples include Germany during the 1920s (Weimar
Republic hyperinfla on), Zimbabwe in the 2000s, and Venezuela in recent years. Hyperinfla on
usually occurs due to excessive money prin ng, severe economic mismanagement, or poli cal
instability.

Demand Pull Infla on -

Demand-pull infla on occurs when the overall demand for goods and services in an economy
outpaces the economy's ability to produce them. This leads to an increase in the general price
level. It is a type of infla on caused by excessive aggregate demand (total demand in an
economy), which surpasses aggregate supply (total produc on in an economy).

It is o en associated with periods of strong economic growth, where rising consumer and
business spending leads to higher prices. This type of infla on is described as "too much money
chasing too few goods." It is basically when AD>AS.

Graphically it could be represented below –

In the above diagram with the given AS curve the aggregate demand increases from AD1 to AD*
and AD2 which pulls the prices to go up. So, because of increase in demand level, it pulls the
prices to go higher.

Reasons for Demand-Pull Infla on

1. Increase in Consumer Spending (Higher Disposable Income)

When people have more income—either due to tax cuts, wage increases, or other factors—they
tend to spend more. This increased spending boosts demand for goods and services, leading to
higher prices.

2. Expansionary Monetary Policy (Low Interest Rates)

When central banks lower interest rates, borrowing becomes cheaper. As a result, businesses take
more loans to invest in produc on, and consumers borrow more for spending, increasing overall
demand. If supply cannot keep up, prices rise.

3. Expansionary Fiscal Policy (Increased Government Spending)

When the government spends more on infrastructure, welfare programs, or defense, it injects
more money into the economy. This increases aggregate demand, which can push prices up if
supply remains constant.
4. Rapid Economic Growth & Rising Confidence

In a booming economy, businesses and consumers feel confident about the future, leading to
higher consump on and investment. This increased demand can contribute to infla on.

5. Increase in Exports (Higher Foreign Demand)

If a country’s goods and services become more a rac ve to foreign buyers, exports increase. This
raises the overall demand for goods and services, leading to infla on if domes c supply is unable
to match the surge in demand.

6. Supply Constraints & Bo lenecks

Even if demand increases moderately, supply-side constraints—such as labor shortages,

produc on capacity limits, or supply chain disrup ons—can prevent the economy from mee ng
demand, resul ng in price increases.

7. Popula on Growth & Urbaniza on

As popula on grows and more people move to ci es, demand for housing, food, transporta on,
and other goods increases. If supply doesn’t keep up, infla on can occur.

Meaning of Cost-Push Infla on

Cost-push infla on occurs when the overall price level in an economy rises due to an increase in
the cost of produc on. This means businesses face higher costs for raw materials, wages, or other
inputs and pass these costs on to consumers in the form of higher prices. Unlike demand-pull
infla on, which is driven by excessive demand, cost-push infla on originates from the supply
side—when produc on becomes more expensive, even if demand remains constant.

Cost push infla on can be represented from below diagram -

As with no change in demand when supply decreases it makes shi aggregate supply curve AS1
to AS2 and it push the prices to go up. This increase in price creates infla onary pressure. In
developing economies like India, infla on occurs mainly due to supply side or cost push infla on.

Causes of Cost-Push Infla on

1. Increase in Wages (Wage-Push Infla on)

When wages rise significantly—either due to strong labor unions, minimum wage hikes, or worker
shortages—businesses incur higher labor costs. If produc vity does not increase at the same rate,
companies pass these costs onto consumers, leading to infla on.

2. Increase in Raw Material Costs

If the price of essen al raw materials like oil, metals, or agricultural products rises, produc on
costs increase. For example, a rise in crude oil prices leads to higher transporta on and
manufacturing costs, which ul mately result in higher prices for goods and services.

3. Supply Chain Disrup ons

Shortages of key components (e.g., semiconductors in electronics, wheat in food produc on) can
reduce supply and force businesses to raise prices. Supply chain disrup ons due to natural
disasters, pandemics, or geopoli cal conflicts can also trigger cost-push infla on.

4. Deprecia on of Currency (Exchange Rate Effect)

When a country's currency loses value, imported goods become more expensive. Since many
industries rely on imported raw materials or machinery, a weaker currency increases produc on
costs, which then leads to higher prices for consumers.

5. Increase in Taxes & Regulatory Costs

Higher corporate taxes, tariffs on imports, or stricter environmental regula ons can raise the cost
of doing business. Companies typically pass these addi onal costs onto consumers, contribu ng
to infla on.

6. Rising Energy Prices

Energy is a fundamental cost in nearly all industries. A surge in electricity, gas, or fuel prices
increases produc on costs for manufacturers, logis cs companies, and even service providers,
leading to price hikes.

7. Natural Disasters & Climate Change

Floods, droughts, hurricanes, and other natural disasters can destroy crops, disrupt supply chains,
and damage infrastructure, leading to shortages and higher prices. Climate change also increases
the frequency of such disrup ons, making cost-push infla on more persistent.

8. Geopoli cal Conflicts & Wars

Wars or poli cal instability can disrupt supply chains, increase oil prices, and lead to trade
restric ons. These factors increase the cost of raw materials and transporta on, causing
infla onary pressures.

Concept of Infla onary Gap

The Infla onary Gap is an economic concept that describes a situa on where the actual output
(Gross Domes c Product or GDP) of an economy exceeds its poten al output (also called full-
employment output). This results in excessive demand, leading to rising prices and infla onary
pressures.

The concept of ‘infla onary gap’ introduced first by Keynes. This concept may be used to
measure the pressure of infla on.

If aggregate demand exceeds the aggregate value of output at the full employment level, there
will exist an infla onary gap in the economy. Aggregate demand or aggregate expenditure is
composed of consump on expenditure (C), investment expenditure (I), government expenditure
(G) and the trade balance or the value of exports minus the value of imports (X – M). Infla onary
gap is thus the result of excess demand. It may be defined as the excess of planned levels of
expenditure over the available output at base prices.

We now graphically explain this gap with the help of the Keynesian cross that we use in
connec on with the determina on of equilibrium na onal income. In the given figure aggregate
expenditure is measured on the ver cal axis and na onal income or aggregate output is
measured on the horizontal axis.

Let us assume that Yf is the full employment level of na onal income. If C + I + G + (X – M) is the
aggregate demand (AD) curve that cuts the 45° line at point A then an equilibrium income is
determined at Yf. There will not be any price rise since aggregate demand equals aggregate
supply. Now if the AD curve shi s up to AD’, equilibrium output will not increase since output
cannot be increased beyond the full employment level. In other words, because of full
employment, output cannot increase to Y*. Thus at Yf level of full employment output, there
occurs an infla onary gap to the extent of AB. The ver cal distance between the aggregate
demand and the 45° line at the full employment level of na onal income is termed the
infla onary gap.
Defla onary Gap:

If the equilibrium level of income is es mated to be below the full employment level of income
then emerges defla onary gap. If in the economy there arises insufficient aggregate demand,
equilibrium in the economy will occur to the le of the full employment income (Yf).

In other words, a defla onary gap shows the amount by which aggregate demand must be
increased so that equilibrium level of income is increased to the full employment level. Fig 11.7
shows that equilibrium level of income is OY* while full employment output is Y f.

Thus, the economy faces unemployment situa on. The distance between the 45° line and the AD
line at the full employment output situa on is referred as the defla onary gap. It is AB in the
above figure. Since aggregate demand is less than the country’s poten al output, the economy
suffers from unemployment of labour and other resources.

Effects of Infla on on Different Economic Sectors

Infla on impacts various groups in different ways depending on their financial situa on and
economic role. While some benefit from rising prices, others face difficul es in maintaining their
purchasing power and financial stability. Below is a detailed discussion of how infla on affects
different groups.
(a) Effect on Farmers

Infla on impacts Indian farmers in both posi ve and nega ve ways. Rising crop prices can
increase farmers' income, benefi ng those who produce essen al commodi es like wheat, rice,
and vegetables. However, infla on also raises the cost of inputs such as seeds, fer lizers, fuel, and
machinery, reducing profit margins. Small and marginal farmers, who depend on loans, face
higher borrowing costs due to increased interest rates. Addi onally, food infla on can lead to
government interven ons like price controls, affec ng their earnings. Unequal price transmission
o en benefits middlemen more than farmers, making infla on a mixed blessing for India's
agricultural sector.

(b) Effect on Fixed Salary Groups

People earning fixed salaries, such as government employees, teachers, and office workers, are
among the most nega vely affected by infla on. As the cost of living rises, their purchasing power
decreases because their salaries remain constant while prices for essen al goods and services,
such as food, rent, and healthcare, con nue to increase. Unless their wages are adjusted for
infla on, they face financial strain. Addi onally, if infla on persists, companies may be reluctant
to offer salary hikes, further worsening their financial situa on.

(c) Effect on Creditors and Debtors

Infla on impacts creditors (lenders) and debtors (borrowers) in opposite ways. Debtors benefit
during infla on because the real value of money decreases over me. If someone borrows
₹1,00,000 when infla on is low, and repays it when infla on is high, the actual burden of
repayment is reduced since the money paid back has less purchasing power. Creditors, on the
other hand, suffer because the money they receive in repayment has lower real value than when
they ini ally lent it. This discourages lending, leading to ghter credit markets and reduced
economic ac vity.

(d) Effect on Output and Produc on

Infla on can have both posi ve and nega ve effects on produc on. Moderate infla on
encourages businesses to expand produc on because they expect higher profits. Rising prices can
lead to increased investment in produc on facili es, crea ng more jobs and boos ng economic
growth. However, if infla on becomes too high, it creates uncertainty and raises produc on costs.
Higher prices for raw materials, wages, and transporta on reduce profit margins, leading
businesses to cut produc on or pass costs onto consumers. In extreme cases, hyperinfla on can
disrupt supply chains and halt produc on, causing economic instability.
(e) Effect on Government

The government experiences both advantages and disadvantages from infla on. On the posi ve
side, infla on increases tax revenues, as higher prices lead to higher collec on of indirect taxes
like GST and VAT. Addi onally, governments that have borrowed money benefit from infla on
because they repay loans with money that has lower real value. However, infla on also increases
government spending, especially on subsidies, welfare programs, and salaries of public
employees. If infla on is uncontrolled, the government may need to implement strict policies,
such as increasing interest rates or cu ng public spending, which can slow down economic
growth.

(f) Effect on Businessmen

Business owners may ini ally benefit from infla on if they can increase prices and earn higher
revenues. Businesses that own physical assets, such as land, factories, and inventories, see their
asset values appreciate, which strengthens their financial posi on. However, rising costs of raw
materials, labor, and borrowing can reduce their profit margins. Small businesses and startups
suffer the most because they may not have the financial capacity to absorb rising costs.
Addi onally, high infla on creates economic uncertainty, discouraging long-term investment and
expansion.

Infla on affects different groups in varying ways. While farmers, debtors, and some businessmen
may benefit in certain condi ons, fixed-income groups, creditors, and businesses facing high costs
o en struggle. Governments must carefully manage infla on to ensure price stability while
promo ng economic growth. Policies such as interest rate adjustments and fiscal measures are
essen al in controlling infla on’s adverse effects while maintaining economic balance.

Measures of Infla on

Infla on is measured using different price indices that track changes in the prices of goods and
services over me. The most commonly used measures of infla on include the Consumer Price
Index (CPI), Wholesale Price Index (WPI), Producer Price Index (PPI), and GDP Deflator. Each of
these indices serves a different purpose and helps policymakers, businesses, and consumers
understand infla on trends.
1. Consumer Price Index (CPI)

Meaning:

The Consumer Price Index (CPI) measures the average change in the price level of a basket of
goods and services consumed by households over me. It reflects the cost of living and is the
most widely used indicator for measuring infla on.

Types of CPI in India:

1. CPI for Industrial Workers (CPI-IW) – Used for wage revisions of industrial workers.

2. CPI for Agricultural Labourers (CPI-AL) – Measures infla on for rural agricultural workers.

3. CPI for Rural Labourers (CPI-RL) – Tracks price changes affec ng rural laborers.

4. CPI Combined (CPI-C) – The most commonly used CPI for overall infla on, covering both
rural and urban consumers.

Importance:

 Used by policymakers to adjust salaries, pensions, and welfare programs.

 Helps in se ng infla on targets for monetary policy decisions.

2. Wholesale Price Index (WPI)

Meaning:

The Wholesale Price Index (WPI) measures the average change in the price of goods at the
wholesale level before they reach consumers. It reflects infla on in the produc on and
distribu on sectors.

Importance:

 Used to track infla on at the producer level.

 Helps businesses and policymakers an cipate price changes before they affect consumers.

 Less relevant for measuring cost-of-living changes compared to CPI.

3. Producer Price Index (PPI)

Meaning:
The Producer Price Index (PPI) measures the average change in selling prices received by
domes c producers for their goods and services. It is similar to WPI but includes services along
with goods.

Difference Between WPI and PPI:

 WPI measures price changes at the wholesale level, excluding services.

 PPI includes both goods and services at the producer level.

Importance:

 Helps predict future CPI infla on, as producer prices eventually influence retail prices.

 Used by businesses to adjust pricing strategies.

5. Headline Infla on

Headline infla on refers to the overall infla on rate, including all goods and services in the
economy, such as food and fuel. Since it covers all price movements, it o en experiences
fluctua ons due to short-term supply shocks or seasonal varia ons. While headline infla on is a
useful indicator for general economic condi ons, it may not always reflect the long-term trend
accurately due to external influences like global oil price changes or natural disasters.

5. Core Infla on

Meaning:

Core infla on measures price changes by excluding vola le items like food and fuel, which
experience frequent price fluctua ons. It provides a more stable measure of infla on trends.

Importance:

 Helps central banks in formula ng monetary policies.

 Gives a be er long-term picture of infla onary pressures in an economy.

Measures to Control Infla on

Infla on control is crucial for maintaining economic stability, ensuring sustainable growth, and
protec ng purchasing power. Governments and central banks use various tools to regulate
infla on through monetary policy, fiscal policy, and direct measures. Each of these approaches
has dis nct mechanisms and objec ves.

1. Monetary Policy Measures to Control Infla on

Monetary policy refers to the ac ons taken by the central bank to regulate money supply, interest
rates, and credit availability in an economy. The Reserve Bank of India (RBI), like other central
banks, uses different instruments to control infla on by influencing borrowing, lending, and
consump on pa erns.

(a) Increasing Interest Rates (Tight Monetary Policy)

The central bank raises the repo rate (the rate at which banks borrow from the central bank) to
make borrowing more expensive. When loans become costly, businesses and consumers reduce
spending, leading to lower demand and, consequently, reduced infla onary pressures. Higher
interest rates also encourage savings, which reduces excess money in circula on.

(b) Open Market Opera ons (OMO)

The central bank buys and sells government securi es in the open market to control liquidity. To
reduce infla on, the central bank sells securi es, absorbing excess money from the banking
system and reducing purchasing power in the economy.

(c) Increasing Cash Reserve Ra o (CRR) and Statutory Liquidity Ra o (SLR)

 CRR is the percentage of a bank’s total deposits that must be kept as reserves with the
central bank. By increasing CRR, the central bank reduces the funds available for banks to
lend, decreasing the money supply.

 SLR is the percentage of a bank's net demand and me liabili es that must be maintained
in the form of liquid assets like gold or government-approved securi es. A higher SLR
reduces lending capacity and curbs infla on.

(d) Controlling Credit Growth

The central bank uses selec ve credit controls to discourage loans for specula ve purposes. For
instance, it may restrict credit availability for real estate and luxury goods while encouraging loans
for essen al sectors like agriculture and manufacturing.
(e) Infla on Targe ng

Many central banks adopt infla on targe ng as a framework where they set a specific infla on
rate (e.g., 4% ± 2% in India). If infla on exceeds this target, the central bank ghtens monetary
policy to bring infla on down.

2. Fiscal Policy Measures to Control Infla on

Fiscal policy refers to the use of government spending, taxa on, and borrowing to influence the
economy. Infla on can be controlled by adjus ng government revenues and expenditures to
regulate demand and supply.

(a) Reducing Government Spending

Excessive government expenditure increases demand for goods and services, contribu ng to
infla on. By cu ng down on unnecessary spending—such as subsidies, large-scale projects, and
non-essen al infrastructure—the government can reduce money circula on and curb infla on.

(b) Increasing Taxes

Higher taxa on reduces disposable income, leading to lower consumer spending and demand.
Governments may increase income tax, corporate tax, excise duty, and GST to reduce purchasing
power and control infla on. However, excessive taxa on can also slow economic growth.

(c) Reducing Budget Deficits

If the government spends more than its revenue (fiscal deficit), it o en prints more money or
borrows from the market, leading to infla on. By reducing the fiscal deficit through be er
financial management, the government can prevent excessive money supply and infla on.

(d) Controlling Public Borrowing

If the government borrows too much from banks, it competes with private businesses for funds,
driving up interest rates. High interest rates can curb infla on, but excessive borrowing can also
crowd out private investment. A balanced approach to public borrowing is essen al.

(e) Promo ng Supply-Side Policies

Fiscal policy can also focus on increasing supply to meet rising demand and prevent price hikes.
This includes:

 Inves ng in infrastructure to reduce produc on bo lenecks.

 Subsidizing essen al sectors (e.g., agriculture and energy) to lower costs.

  Encouraging private sector par cipa on to increase output.

3. Direct Measures to Control Infla on

Direct measures are government-imposed regula ons and administra ve controls aimed at
stabilizing prices and controlling infla on without significantly altering monetary or fiscal policies.
These measures are o en used in emergencies or when infla on is caused by supply-side shocks.

(a) Price Controls and Ra oning

Governments may impose price ceilings on essen al goods (such as food, fuel, and medicines) to
prevent excessive price hikes. Ra oning ensures fair distribu on of essen al commodi es when
supply is limited. However, prolonged price controls can lead to black markets and supply
shortages.

(b) Import Policies and Trade Regula ons

To control infla on, governments can reduce import du es on essen al goods, making them
cheaper and increasing supply. Conversely, export restric ons may be imposed on food grains
and other necessi es to ensure domes c availability and control prices.

(c) Wage and Income Policies

Uncontrolled wage increases can contribute to infla on through the wage-price spiral (where
higher wages lead to higher prices and vice versa). Governments may freeze wages in certain
sectors to control infla on. However, this can reduce worker mo va on and lead to labor unrest.

(d) Buffer Stock Policy

Governments maintain buffer stocks of essen al commodi es such as food grains and petroleum
products. During periods of high infla on, they release these stocks into the market to stabilize
prices. In India, the Food Corpora on of India (FCI) manages buffer stocks of wheat and rice to
control food infla on.