Inflation

Types and Effects

Inflation – Meaning and Types
Inflation is a situation in which there is a persistent rise in the general price level.
In other words it is a situation in which there is an upward movement in the average level of prices.
According to Coulborn it is a situation in which “too much money chasing too few goods” that is the
availability of goods is less when compared to the supply of money. When there is inflation value of
money decreases persistently. Value of money is the purchasing power of money or the quantity of
goods and services that a unit of money can purchase.

There are several types of inflation which are classified on different basis. Based on the rate, inflation
can be classified as Creeping, Walking, Running and Galloping inflation.

a. Creeping Inflation: When the rise in prices is very slow, that is less than 3% per annum, it is called
creeping inflation. It is mild inflation and it is considered as good for economic growth
b. Walking Inflation: When prices rise moderately and the annual inflation rate is 3% to 10% . It is
called walking inflation. Inflation at this rate is a warning signal for the government.
c. Running Inflation: When prices rise rapidly and the rate of increases is 10% to 20% per annum, it is
called running inflation. Its control requires strong monetary and fiscal measures and it is a
dangerous situation.
d. Galloping or Hyperinflation: When price rises between 20% to 100% per annum or even more, it is
called galloping or hyperinflation. Such a situation brings s total collapse of the monetary system
because of the continuous fall in the purchasing power of money.
 Calculation of Inflation
Inflation Rate =
[(CPI of current year – CPI of previous year)/ CPI of previous year]*100

CPI is the Consumer Price Index.

CPI = (Value of basket in current year/ Value of basket in previous year)*100

Demand Pull Inflation and Cost Push Inflation
Demand Pull Inflation
It is the result of an increase in average demand in the absence of an increase in aggregate supply or a relatively less increase in aggregate
supply. Suppose the government is following an expansionary fiscal policy and the government spend more money in the field of
education, health, etc. by printing more currency notes. In this situation there will be a sudden increase in aggregate demand in the
economy but the aggregate supply will not increase to that extent. Therefore the price level goes up. Once the economy reaches in full
employment level any further income in aggregate demand will lend to price rise without any increase in output. This can be explained
with the help of the following diagram

in this diagram, AD is the aggregate demand curve, AS is the aggregate supply curve. AS
Initially the economy is in equilibrium at point E. Y is the equilibrium level of

Price level
output and P is the price level. When aggregate demand increase AD curve
shifts upwards and the new AD curve is AD1 which intersects the AS curve at P2

point E1. here price level increase to P1 and there is an increase in output from AD2
Y to YF. Beyond the YF level of output AS curve becomes perfectly inelastic. E1
P1
E AD1
That is the output cannot be increased beyond this level of output. P AD
Hence YF is the full employment level of output. Any increase in
aggregate demand beyond this level will push the price up without Output
Y YF
any change in output the theory of demand-pull inflation is associated
with the name of J M Keynes
Cost push Inflation
It is the result of increase in cost of production. Cost of production increase mainly due to increase in wages,
increase in profit margin, or due to a supply shock which means a sudden fall in supply. Increase in cost of
production decreases the supply and when supply decreases, supply curve shifts leftwards. Therefore the price
level goes up. This is shown in the diagram. AS

Price Level
E1
P1
E
P
AD
In the diagram initially the economy is in equilibrium at point E where S2
the aggregate supply curve AS1 intersects the AD curve. This is full
S1
employment
equilibrium where output is YF and P is the price level. When aggregate Y YF
Output
supply
decrease the AS curve shifts leftwards and the new supply curve is AS2 which
intersects the AD curve at EI. therefore the price level goes up to P1 and
output
decrease to Y.
 Causes of Inflation
Causes of inflation can be classified under demand side causes and supply side causes.

Demand side causes

In an economy when aggregate demand increase without an equivalent increase in aggregate supply,
there will be excess demand and the price level goes up. This leads to demand pull inflation. The
following are the important causes of demand pull inflation.
I. Increase in money supply – This is the most important reason for inflation. When the monetary
authority increase the money supply, cash in hand with the people increase and hence they spend
more money. Thus aggregate demand increase.
II. Increase in disposable income – Disposable income increases due to an increase in per capita
income or reduction in taxes. Increase in disposable income also increase cash in hand with the
III. Increase in government expenditure – When the government follow an expansionary fiscal policy government
expenditure will increase and as a result demand for goods and services also increase
IV. Deficit financing – It means government spends more money than its revenue. The deficit may be met by
printing more currency notes. This also increase money supply as well as total spending in the economy.
V. Cheap money policy – If the interest rates are low in the economy incentives to save will be less. Hence people
spend more money and thus aggregate demand increases.
VI. Increase in population – When population increases the number of buyers also increases and thus aggregate
demand increases.
Supply Side Causes
When aggregate demand increases and aggregate supply does not keep up with aggregate demand, cost push
inflation will be the result. There are different reasons for inadequate aggregate supply.
VII. Shortage of capital and other complementary factors – To increase production and aggregate supply more
capital and other complimentary factors like raw materials, electricity, etc. are needed. When there is a shortage
of such factors there will be less aggregate supply and as a result price level goes up.
[Link] in wages – When wage rate increases cost of production also increases. As a result supply falls and
price level goes up.
IX. Speculative hoarding – When traders hoard goods and create artificial scarcity to get more profit, price will
increase.
X. Natural calamities – Natural calamities like drought, earthquake etc. reduces production and aggregate supply.
XI. Increase in exports – When exports increases availability of goods in the domestic market decreases.
XII. Industrial disputes – Industrial disputes will affect industrial production and aggregate supply.
Effects of Inflation
Effects of inflation can be studied under
1. Effects on distribution of income, 2. Effects of investment and production, [Link] and
political effects
1. Effects on distribution of income and wealth
The effects of inflation on distribution of income and wealth can be viewed as the effects on
fixed income group and flexible income group. When there is inflation the poor and the middle
class whose income is relatively fixed will lose but the flexible income group categories
businessmen, industrialists, traders, real estate holders and speculators gain and the income
distribution change in favour of them. These categories are analyses one by one.
a) Debtors and Creditors: During inflation, debtors gain and creditors lose. Because of inflation
value of money decreases and therefore people who lend their money, when they get it back
its value will be less and they can purchase only less amount of goods and services.
b) Salaried classes and wage earners: Since the income of these two group will adjust to inflation
very slowly they will lose when there is inflation.
c) Investors: Those who invest in shares will gain because companies will make more profit
when there is inflation. On the other hand those who invest in bonds and debentures which
carry fixed returns will lose.
d) Businessmen: Since price goes up business people get more profit and they gain from inflation
2. Effects on investment and production
When there is inflation people will have tendency to spend more and save less. Hence there will
be less savings and less investment in the economy which will adversely affect production.
Inflation also discourages foreign investment.
However in the initial stages, production and traders get more profit because of price rise. Hence
they produce their maximum and thus production goes up. But later, inflation increases wage rate
and price of raw materials. Hence cost of production increase and as a result output may decrease.
Besides inflation may lead to misallocation of resources because producers will divert their
resources from the production of essential commodities to those goods which gives them
maximum profit. Another adverse impact of inflation is black marketing. Traders may hoard
stock of goods to create artificial scarcity to make more profit by selling it at a higher price.
3. Social and political impact
Inflation makes the rich richer and the poor poorer. Hence people will be unhappy. Because of the
rising cost of living, workers resort to strikes which lead to loss in production. To make more
profits, people resort to hoarding, black marketing, adulteration, manufacture of substandard
commodities, speculation, etc. Corruption spreads in every walk of life. All this reduces the
efficiency of the economy. Thus there will be social unrest in the economy.
If hyperinflation persists and the value of money continues to fall, ultimately leads to the collapse
of the monetary system. Further, rising prices also encourage agitations and protests by political
parties opposed to the government. This may lead to the downfall of the government.
Measures to control inflation
There are three important ways in which inflation can be controlled
1. Monetary policy measures
2. Fiscal policy measures
3. Other measures
1. Monetary policy measures
These are the measures adopted by the central bank of a country to control credit and money
supply in an economy. Price stability and economic growth are the two main objectives of
monetary policy. Monetary policy measures can be classifies as a) Quantitative credit control
measures b) Selective or qualitative credit control measures
a) Quantitative Credit Control Measures
Quantitative controls aim at regulating the overall volume of bank credit, without
considering purpose for which credit is used. The important quantitative measures are
I. Bank Rate Policy – the Bank rate is the rate at which the central Bank rediscount approved
bills of exchange. According to RBI, it is the rate at which bills of exchanges and commercial
papers are rediscounted or bought. During inflation, the central bank raises the bank rate due to
which the cost of borrowing goes up. As a result, commercial banks borrow less money from
the central bank. With the reduced borrowings from the central bank, the flow of money from
Further as the central bank raises the interest rate, the commercial banks also raise their lending rate to the public, there
by making the borrowings costlier. Hence people take less loans from the commercial banks and spend less money. This
helps to reduce money supply as well as aggregate demand in the economy.
Higher rate of interest creates an adverse environment for business activities and hence business activities contracted.
Similarly, higher rate of interest is an incentive to save more and spend less. All such changes in the economy because
of s higher rate of interest reduces the total spending as well as aggregate demand in the economy.
Increase in bank rate is called dear money policy and decrease in the bank rate is called cheap money policy. When
bank rate is Increased cost of borrowing increases and hence money becomes dearer and when it is decreased money
becomes cheaper.
II) Reserve Ratio – depending upon the economic conditions central bank increase or decreases the reserves that every
commercial bank should keep in the central bank. There are two types of reserve ratios:
Cash Reserve Ratio (CRR) – Every commercial bank should keep a certain percentage of their total deposits (net
demand and time deposits) in the central bank in the form of cash reserve. This is mandatory and this percentage
is called CRR. According to RBI it is the average daily balance that a commercial bank is required to maintain with
the RBI as a percentage of its total deposits. When there is inflation the central bank increase the CRR. This reduces
the availability of cash with the commercial banks and their lending capacity decreases. Hence people get less money
in the form of loans from the commercial banks and it helps to control inflation.
Statutory Liquidity Ratio (SLR) – this is another type of reserve that every commercial bank should keep.
commercial bank should keep a certain percentage of their total deposits in the form of safe and liquid asset such as
unencumbered government securities, cash and gold. When there is inflation SLR is increased and it helps to decrease
bank credit and to ensure solvency of commercial banks. Increase in SLR compels commercial banks to invest in
government securities. While reserves under CRR is kept in the Central Bank, under SLR it is kept in the commercial
bank itself. Further while CRR is cash reserves, SLR can be in the forms of cash, gold or securities. When CRR
regulates the flow of money in the economy, SLR ensures the solvency of the bank.
III) Open market operation – Open market operation operations means the sale and purchase of government
securities and bonds by the central bank. When there is inflation the government securities are sold via
commercial banks to the public such that a certain amount of bank deposits is transferred to the central bank as
the public purchase government securities. As a result, the credit creation capacity of the commercial banks
reduces.
b) Selective or Qualitative Credit Control Measures
Under this method, extension of credit to essential purposes is encouraged and to non-essential purposes is
discouraged. Hence these methods not only prevent the flow of credit into undesirable channels but also direct
the flow of credit to useful channels. The important selective credit control measures are:
I. Margin Requirements – Margin means that proportion of the value of security against which loan is not
given. In other words ‘Margin refers to the difference between market value of securities and the amount of
loan granted against these securities’. For productive purposes margin requirements will be less.
II. Regulation of Consumer Credit – Under this method the central bank lay down terms and conditions for the
proper regulation of consumer credit given by the commercial banks of a country. Regulation of consumer
credit restricts the amount of credit that might be given by commercial banks, restricts the time that might
be available for repaying the loan, fixing the down payments etc.
III. Morel Suasion – These are the informal request by the central bank to commercial banks to contract credit
in times of inflation and to expand credit in times of depression. The central bank issues periodical letters to
commercial banks and discussion are held with authorities of commercial banks in this respect.
IV. Direct Action – Central bank direct action against erring banks. It may involve refusal by the central bank to
rediscount bills or cancellation of license.
2. Fiscal Policy Measures
These are the measures taken by the government to control the aggregate demand in the economy. The
main instruments of fiscal policy are i) Public revenue ii) Public expenditure iii) Public borrowing
I. Public Revenue – The main source of public revenue is tax. When there is inflation the government
want to reduce the total spending in the economy and hence tax is increased. Increase in direct taxes
decreases the disposable income of the people and hence they spend less money.
II. Public Expenditure – During inflation the government cut down its expenditure on developmental
activities and welfare programmes. This reduces government demand for goods and services as well as
private income. When the government spend less money, income of the individuals decreases. Hence
aggregate demand decreases.
III. Public Borrowing – when there is inflation the government will delay the repayment of public debt. At
the same time the government should borrow more money from the public.
3. Other Measures
Other measures include the measures taken by the government to increase the supply of goods and
services, price control, wage control etc.
i. Increasing the Supply of goods and services – When there is price rise government take various
measures to increase the supply of goods and services. This can be done by importing essential
products, banning the export of such items and by encouraging the production of essential
commodities.
ii. Price Control – Direct measures can be taken to control the price of goods and services. Essential
commodities can be distributed through the public distribution system at reduced prices.
iii. Wage Control – Wage control helps to prevent the escalation of cost of production during inflation and
thus cost push inflation can be controlled.
Repo rate and Reverse repo rate
Repo rate is the rate at which RBI provides overnight liquidity to bank against the collateral of government
and other approved securities. In other words, it is simply the rate at which RBI lends short term funds to
commercial banks when they are facing s financial crunch. In this case, a repurchasing agreement is signed
by both the parties stating that the securities will be repurchasing by the commercial banks on a later date at a
predetermined price.
Bank rate and repo rate are not the same. In general, repo rate focuses on providing funds to banks for a
very short period where as bank rate focuses on long term funds requirements of the commercial banks. In
the case of bank rate there is no repurchasing agreement signed and bank rate is usually higher than the
repo rate.
Reverse repo rate is the rate at which the RBI absorbs liquidity on an overnight basis from commercial
banks. In other words, when a commercial bank has excess funds, they can deposit the same in central bank
and earn interest in the form of reverse repo rate. The Reserve bank uses this tool when it feels that there is
too much money floating in the banking system. An increase in the reverse repo rate means that the banks
will get a higher rate of interest from RBI. As a result, banks prefer to deposit their money to central bank.
Repo rate and reverse repo rates are also used to control money supply in the economy. When there is excess
money supply in the economy these two rates are increased.