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Inflation explained: types, causes, effects without diagrams

Inflation and unemployment are the two most talked-about words in the contemporary society.

These two are the big problems that plague all the economies.

Almost everyone is sure that he knows what inflation exactly is, but it remains a source of great deal of confu­sion because it is difficult to define it unam­biguously.

1. Meaning of Inflation:

Inflation is often defined in terms of its supposed causes. Inflation exists when money supply exceeds available goods and services. Or inflation is attributed to budget deficit financing. A deficit budget may be financed by the additional money creation. But the situation of monetary expansion or budget deficit may not cause price level to rise. Hence the difficulty of defining ‘inflation’.

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Inflation 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 inflation as ‘a persistent and appreciable rise in the general level or aver­age of prices’. In other words, inflation is a state of rising prices, but not high prices.

It is not high prices but rising price level that con­stitute inflation. It constitutes, thus, an over­all increase in price level. It can, thus, be viewed as the devaluing of the worth of money. In other words, inflation reduces the purchasing power of money. A unit of money now buys less. Inflation can also be seen as a recurring phenomenon.

While measuring inflation, we take into ac­count a large number of goods and services used by the people of a country and then cal­culate average increase in the prices of those goods and services over a period of time. A small rise in prices or a sudden rise in prices is not inflation since they may reflect the short term workings of the market.

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It is to be pointed out here that inflation is a state of disequilib­rium when there occurs a sustained rise in price level. It is inflation if the prices of most goods go up. Such rate of increases in prices may be both slow and rapid. However, it is difficult to detect whether there is an upward trend in prices and whether this trend is sus­tained. That is why inflation is difficult to define in an unambiguous sense.

Let’s measure inflation rate. Suppose, in December 2007, the consumer price index was 193.6 and, in December 2008, it was 223.8. Thus, the inflation rate during the last one year was

223.8- 193.6/ 193.6 x 100 = 15.6

As inflation is a state of rising prices, de­flation may be defined as a state of falling prices but not fall in prices. Deflation is, thus, the opposite of inflation, i.e., a rise in the value of money or purchasing power of money. Disinflation is a slowing down of the rate of inflation.

2. Types of Inflation:

As the nature of inflation is not uniform in an economy for all the time, it is wise to distin­guish between different types of inflation. Such analysis is useful to study the distribu­tional and other effects of inflation as well as to recommend anti-inflationary policies. Infla­tion may be caused by a variety of factors. Its intensity or pace may be different at different times. It may also be classified in accordance with the reactions of the government toward inflation.

Thus, one may observe different types of inflation in the contemporary society:

A. On the Basis of Causes:

(i) Currency inflation:

This type of infla­tion is caused by the printing of cur­rency notes.

(ii) Credit inflation:

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Being profit-making institutions, commercial banks sanction more loans and advances to the public than what the economy needs. Such credit expansion leads to a rise in price level.

(iii) Deficit-induced inflation:

The budget of the government reflects a deficit when expenditure exceeds revenue. To meet this gap, the government may ask the central bank to print additional money. Since pumping of additional money is required to meet the budget deficit, any price rise may the be called the deficit-induced inflation.

(iv) Demand-pull inflation:

An increase in aggregate demand over the available output leads to a rise in the price level. Such inflation is called demand-pull in­flation (henceforth DPI). But why does aggregate demand rise? Classical economists attribute this rise in aggre­gate demand to money supply. If the supply of money in an economy ex­ceeds the available goods and services, DPI appears. It has been described by Coulborn as a situation of “too much money chasing too few goods.”

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Keynesians hold a different argu­ment. They argue that there can be an autonomous increase in aggregate de­mand or spending, such as a rise in con­sumption demand or investment or government spending or a tax cut or a net increase in exports (i.e., C + I + G + X – M) with no increase in money sup­ply. This would prompt upward adjust­ment in price. Thus, DPI is caused by monetary factors (classical adjustment) and non-monetary factors (Keynesian argument).

DPI can be explained in terms of Fig. 4.2, where we measure output on the horizontal axis and price level on the vertical axis. In Range 1, total spending is too short of full employment out­put, YF. There is little or no rise in the price level. As demand now rises, out­put will rise. The economy enters Range 2, where output approaches towards full employment situation. Note that in this region price level begins to rise. Ul­timately, the economy reaches full em­ployment situation, i.e., Range 3, where output does not rise but price level is pulled upward. This is demand-pull in­flation. The essence of this type of in­flation is that “too much spending chas­ing too few goods.”

Demand-Pull Inflation

(v) Cost-push inflation:

Inflation in an economy may arise from the overall increase in the cost of production. This type of inflation is known as cost-push inflation (henceforth CPI). Cost of pro­duction may rise due to an increase in the prices of raw materials, wages, etc. Often trade unions are blamed for wage rise since wage rate is not completely market-determinded. Higher wage means high cost of production. Prices of commodities are thereby increased.

A wage-price spiral comes into opera­tion. But, at the same time, firms are to be blamed also for the price rise since they simply raise prices to expand their profit margins. Thus, we have two im­portant variants of CPI wage-push in­flation and profit-push inflation.

Any­way, CPI stems from the leftward shift of the aggregate supply curve:

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B. On the Basis of Speed or Intensity:

(i) Creeping or Mild Inflation:

If the speed of upward thrust in prices is slow but small then we have creeping inflation. What speed of annual price rise is a creeping one has not been stated by the economists. To some, a creeping or mild inflation is one when annual price rise varies between 2 p.c. and 3 p.c. If a rate of price rise is kept at this level, it is con­sidered to be helpful for economic development. Others argue that if annual price rise goes slightly beyond 3 p.c. mark, still then it is considered to be of no danger.

(ii) Walking Inflation:

If the rate of annual price increase lies between 3 p.c. and 4 p.c., then we have a situation of walking inflation. When mild inflation is allowed to fan out, walking inflation appears. These two types of inflation may be described as ‘moderate inflation’.

Often, one-digit inflation rate is called ‘moder­ate inflation’ which is not only predict­able, but also keep people’s faith on the monetary system of the country. Peoples’ confidence get lost once moderately maintained rate of inflation goes out of control and the economy is then caught with the galloping inflation.

(iii) Galloping and Hyperinflation:

Walking inflation may be converted into running inflation. Running inflation is danger­ous. If it is not controlled, it may ulti­mately be converted to galloping or hyperinflation. It is an extreme form of inflation when an economy gets shatter­ed.”Inflation in the double or triple digit range of 20, 100 or 200 p.c. a year is labelled “galloping inflation”.

(iv) Government’s Reaction to Inflation:

In­flationary situation may be open or suppressed. Because of anti-infla­tionary policies pursued by the govern­ment, inflation may not be an embar­rassing one. For instance, increase in income leads to an increase in con­sumption spending which pulls the price level up.

If the consumption spending is countered by the govern­ment via price control and rationing device, the inflationary situation may be called a suppressed one. Once the government curbs are lifted, the sup­pressed inflation becomes open infla­tion. Open inflation may then result in hyperinflation.

3. Causes of Inflation:

Inflation is mainly caused by excess demand/ or decline in aggregate supply or output. Former leads to a rightward shift of the aggregate demand curve while the latter causes aggregate supply curve to shift left­ward. Former is called demand-pull inflation (DPI), and the latter is called cost-push infla­tion (CPI). Before describing the factors, that lead to a rise in aggregate demand and a de­cline in aggregate supply, we like to explain “demand-pull” and “cost-push” theories of inflation.

(i) Demand-Pull Inflation Theory:

There are two theoretical approaches to the DPI—one is classical and other is the Keynesian.

According to classical economists or mon­etarists, inflation is caused by an increase in money supply which leads to a rightward shift in negative sloping aggregate demand curve. Given a situation of full employment, classi­cists maintained that a change in money supply brings about an equiproportionate change in price level.

That is why monetarists argue that inflation is always and everywhere a monetary phenomenon. Keynesians do not find any link between money supply and pricelevel causing an upward shift in aggregate demand.

According to Keynesians, aggregate demand may rise due to a rise in consumer demand or investment demand or govern­ment expenditure or net exports or the com­bination of these four components of aggreate demand. Given full employment, such in­crease in aggregate demand leads to an up­ward pressure in prices. Such a situation is called DPI. This can be explained graphically.

DPI: Shifts in AD Curve

Just like the price of a commodity, the level of prices is determined by the interaction of aggregate demand and aggregate supply. In Fig. 4.3, aggregate demand curve is negative sloping while aggregate supply curve before the full employment stage is positive sloping and becomes vertical after the full employ­ment stage is reached. AD1 is the initial aggregate demand curve that intersects the aggregate supply curve AS at point E1.

The price level, thus, determined is OP1. As ag­gregate demand curve shifts to AD2, price level rises to OP2. Thus, an increase in aggre­gate demand at the full employment stage leads to an increase in price level only, rather than the level of output. However, how much price level will rise following an increase in aggregate demand depends on the slope of the AS curve.

(ii) Causes of Demand-Pull Inflation:

DPI originates in the monetary sector. Mon­etarists’ argument that “only money matters” is based on the assumption that at or near full employment excessive money supply will in­crease aggregate demand and will, thus, cause inflation.

An increase in nominal money supply shifts aggregate demand curve rightward. This enables people to hold excess cash bal­ances. Spending of excess cash balances by them causes price level to rise. Price level will continue to rise until aggregate demand equals aggregate supply.

Keynesians argue that inflation originates in the non-monetary sector or the real sector. Aggregate demand may rise if there is an increase in consumption expenditure following a tax cut. There may be an autonomous increase in business investment or government expendi­ture. Government expenditure is inflationary if the needed money is procured by the gov­ernment by printing additional money.

In brief, increase in aggregate demand i.e., in­crease in (C + I + G + X – M) causes price level to rise. However, aggregate demand may rise following an increase in money supply gen­erated by the printing of additional money (classical argument) which drives prices up­ward. Thus, money plays a vital role. That is why Milton Friedman argues that inflation is always and everywhere a monetary phenom­enon.

There are other reasons that may push ag­gregate demand and, hence, price level up­wards. For instance, growth of population stimulates aggregate demand. Higher export earnings increase the purchasing power of the exporting countries. Additional purchasing power means additional aggregate demand. Purchasing power and, hence, aggregate de­mand may also go up if government repays public debt.

Again, there is a tendency on the part of the holders of black money to spend more on conspicuous consumption goods. Such tendency fuels inflationary fire. Thus, DPI is caused by a variety of factors.

(iii) Cost-Push Inflation Theory:

In addition to aggregate demand, aggregate supply also generates inflationary process. As inflation is caused by a leftward shift of the aggregate supply, we call it CPI. CPI is usu­ally associated with non-monetary factors. CPI arises due to the increase in cost of produc­tion. Cost of production may rise due to a rise in cost of raw materials or increase in wages.

However, wage increase may lead to an in­crease in productivity of workers. If this hap­pens, then the AS curve will shift to the right- ward not leftward—direction. We assume here that productivity does not change in spite of an increase in wages.

Such increases in costs are passed on to consumers by firms by rais­ing the prices of the products. Rising wages lead to rising costs. Rising costs lead to rising prices. And, rising prices again prompt trade unions to demand higher wages. Thus, an inflationary wage-price spiral starts. This causes aggregate supply curve to shift leftward.

CPI Shifts in AS Curve

This can be demonstrated graphically where AS1 is the initial aggregate supply curve. Below the full employment stage this AS curve is positive sloping and at full em­ployment stage it becomes perfectly inelastic.

Intersection point (E1) of AD1 and AS1 curves determine the price level (OP1). Now there is a leftward shift of aggregate supply curve to AS2. With no change in aggregate demand, this causes price level to rise to OPand output to fall to OY2. With the reduction in output, employment in the economy de­clines or unemployment rises. Further shift in AS curve to AS3results in a higher price level (OP3) and a lower volume of aggregate out­put (OY3). Thus, CPI may arise even below the full employment (YF) stage.

(iv) Causes of Cost-Push Inflation:

It is the cost factors that pull the prices up­ward. One of the important causes of price rise is the rise in price of raw materials. For in­stance, by an administrative order the govern­ment may hike the price of petrol or diesel or freight rate. Firms buy these inputs now at a higher price. This leads to an upward pres­sure on cost of production.

Not only this, CPI is often imported from outside the economy. Increase in the price of petrol by OPEC com­pels the government to increase the price of petrol and diesel. These two important raw materials are needed by every sector, espe­cially the transport sector. As a result, trans­port costs go up resulting in higher general price level.

Again, CPI may be induced by wage-push inflation or profit-push inflation. Trade unions demand higher money wages as a compen­sation against inflationary price rise. If in­crease in money wages exceed labour produc­tivity, aggregate supply will shift upward and leftward. Firms often exercise power by push­ing prices up independently of consumer de­mand to expand their profit margins.

Fiscal policy changes, such as increase in tax rates also leads to an upward pressure in cost of production. For instance, an overall in­crease in excise tax of mass consumption goods is definitely inflationary. That is why govern­ment is then accused of causing inflation.

Finally, production setbacks may result in decreases in output. Natural disaster, gradual exhaustion of natural resources, work stop­pages, electric power cuts, etc., may cause ag­gregate output to decline. In the midst of this output reduction, artificial scarcity of any goods created by traders and hoarders just simply ignite the situation.

Inefficiency, corruption, mismanagement of the economy may also be the other reasons. Thus, inflation is caused by the interplay of various factors. A particular factor cannot be held responsible for any inflationary price rise.

4. Effects of Inflation:

People’s desires are inconsistent. When they act as buyers they want prices of goods and services to remain stable but as sellers they expect the prices of goods and services should go up. Such a happy outcome may arise for some individuals; “but, when this happens, others will be getting the worst of both worlds.”

When price level goes up, there is both a gainer and a loser. To evaluate the conse­quence of inflation, one must identify the na­ture of inflation which may be anticipated and unanticipated. If inflation is anticipated, peo­ple can adjust with the new situation and costs of inflation to the society will be smaller.

In reality, people cannot predict accurately fu­ture events or people often make mistakes in predicting the course of inflation. In other words, inflation may be unanticipated when people fail to adjust completely. This creates various problems.

One can study the effects of unanticipated inflation under two broad head­ings:

(a) Effect on distribution of income and wealth; and

(b) Effect on economic growth.

(a) Effects of Inflation on Distribution of Income and Wealth:

During inflation, usu­ally people experience rise in incomes. But some people gain during inflation at the ex­pense of others. Some individuals gain be­cause their money incomes rise more rapidly than the prices and some lose because prices rise more rapidly than their incomes during inflation. Thus, it redistributes income and wealth.

Though no conclusive evidence can be cited, it can be asserted that following catego­ries of people are affected by inflation differ­ently:

(i) Creditors and debtors:

Borrowers gain and lenders lose during inflation because debts are fixed in rupee terms. When debts are repaid their real value declines by the price level increase and, hence, creditors lose. An individual may be interested in buying a house by taking loan of Rs. 7 lakh from an in­stitution for 7 years.

The borrower now wel­comes inflation since he will have to pay less in real terms than when it was borrowed. Lender, in the process, loses since the rate of interest payable remains unaltered as per agree­ment. Because of inflation, the borrower is given ‘dear’ rupees, but pays back ‘cheap’ ru­pees. However, if in an inflation-ridden economy creditors chronically loose, it is wise not to advance loans or to shut down business.

Never does it happen. Rather, the loan-giving institution makes adequate safeguard against the erosion of real value. Above all, banks do not pay any interest on current account but charges interest on loans.

(ii) Bond and debenture-holders:

In an economy, there are some people who live on interest income—they suffer most. Bondhold­ers earn fixed interest income: These people suffer a reduction in real income when prices rise. In other words, the value of one’s sav­ings decline if the interest rate falls short of inflation rate. Similarly, beneficiaries from life insurance programmes are also hit badly by inflation since real value of savings deterio­rate.

(iii) Investors:

People who put their money in shares during inflation are expected to gain since the possibility of earning of business profit brightens. Higher profit induces own­ers of firm to distribute profit among inves­tors or shareholders.

(iv) Salaried people and wage-earners:

Any­one earning a fixed income is damaged by in­flation. Sometimes, unionised worker suc­ceeds in raising wage rates of white-collar workers as a compensation against price rise. But wage rate changes with a long time lag. In other words, wage rate increases always lag behind price increases. Naturally, inflation results in a reduction in real purchasing power of fixed income-earners.

On the other hand, people earning flexible incomes may gain during inflation. The nominal incomes of such people outstrip the general price rise. As a re­sult, real incomes of this income group in­crease.

(v) Profit-earners, speculators and black marketers:

It is argued that profit-earners gain from inflation. Profit tends to rise during inflation. Seeing inflation, businessmen raise the prices of their products. This results in a bigger profit. Profit margin, however, may not be high when the rate of inflation climbs to a high level.

However, speculators dealing in business in essential commodities usually stand to gain by inflation. Black marketers are also ben­efited by inflation.

Thus, there occurs a redistribution of in­come and wealth. It is said that rich becomes richer and poor becomes poorer during infla­tion. However, no such hard and fast gener­alisation can be made. It is clear that someone wins and someone loses during inflation.

These effects of inflation may persist if in­flation is unanticipated. However, the redistributive burdens of inflation on income and wealth are most likely to be minimal if inflation is anticipated by the people. With anticipated inflation, people can build up their strategies to cope with inflation.

If the annual rate of inflation in an economy is anticipated correctly people will try to protect them against losses resulting from inflation. Workers will demand 10 p.c. wage increase if inflation is expected to rise by 10 p.c.

Similarly, a percent­age of inflation premium will be demanded by creditors from debtors. Business firms will also fix prices of their products in accordance with the anticipated price rise. Now if the en­tire society “learn to live with inflation”, the redistributive effect of inflation will be mini­mal.

However, it is difficult to anticipate prop­erly every episode of inflation. Further, even if it is anticipated it cannot be perfect. In addi­tion, adjustment with the new expected infla­tionary conditions may not be possible for all categories of people. Thus, adverse redistributive effects are likely to occur.

Finally, anticipated inflation may also be costly to the society. If people’s expectation regarding future price rise become stronger they will hold less liquid money. Mere hold­ing of cash balances during inflation is unwise since its real value declines. That is why peo­ple use their money balances in buying real estate, gold, jewellery, etc. Such investment is referred to as unproductive investment. Thus, during inflation of anticipated variety, there occurs a diversion of resources from priority to non-priority or unproductive sectors.

(b) Effect on Production and Economic Growth:

Inflation may or may not result in higher output. Below the full employment stage, inflation has a favourable effect on production. In general, profit is a rising function of the price level. An inflationary situation gives an incen­tive to businessmen to raise prices of their prod­ucts so as to earn higher volume of profit. Ris­ing price and rising profit encourage firms to make larger investments.

As a result, the multi­plier effect of investment will come into opera­tion resulting in a higher national output. How­ever, such a favourable effect of inflation will be temporary if wages and production costs rise very rapidly.

Further, inflationary situation may be as­sociated with the fall in output, particularly if inflation is of the cost-push variety. Thus, there is no strict relationship between prices and output. An increase in aggregate demand will increase both prices and output, but a supply shock will raise prices and lower output.

Inflation may also lower down further pro­duction levels. It is commonly assumed that if inflationary tendencies nurtured by experi­enced inflation persist in future, people will now save less and consume more. Rising sav­ing propensities will result in lower further outputs.

One may also argue that inflation creates an air of uncertainty in the minds of business community, particularly when the rate of in­flation fluctuates. In the midst of rising infla­tionary trend, firms cannot accurately estimate their costs and revenues. That is, in a situa­tion of unanticipated inflation, a great deal of risk element exists.

It is because of uncertainty of expected inflation, investors become reluc­tant to invest in their business and to make long-term commitments. Under the circum­stance, business firms may be deterred in in­vesting. This will adversely affect the growth performance of the economy.

However, slight dose of inflation is neces­sary for economic growth. Mild inflation has an encouraging effect on national output. But it is difficult to make the price rise of a creep­ing variety. High rate of inflation acts as a dis­incentive to long run economic growth. The way the hyperinflation affects economic growth is summed up here. We know that hyper-inflation discourages savings.

A fall in savings means a lower rate of capital forma­tion. A low rate of capital formation hinders economic growth. Further, during excessive price rise, there occurs an increase in unpro­ductive investment in real estate, gold, jewel­lery, etc. Above all, speculative businesses flourish during inflation resulting in artificial scarcities and, hence, further rise in prices.

Again, following hyperinflation, export earn­ings decline resulting in a wide imbalances in the balance of payment account. Often gallop­ing inflation results in a ‘flight’ of capital to foreign countries since people lose confidence and faith over the monetary arrangements of the country, thereby resulting in a scarcity of resources. Finally, real value of tax revenue also declines under the impact of hyperinfla­tion. Government then experiences a shortfall in investible resources.

Thus economists and policymakers are unanimous regarding the dangers of high price rise. But the consequence of hyperinfla­tion are disastrous. In the past, some of the world economies (e.g., Germany after the First World War (1914-1918), Latin American coun­tries in the 1980s) had been greatly ravaged by hyperinflation.

The German inflation of 1920s was also catastrophic:

During 1922, the German price level went up 5,470 per cent. In 1923, the situation wors­ened; the German price level rose 1,300,000,000 (1.3 billion) times. By October of 1923, the post­age in the lightest letter sent from Germany to the United States was 200,000 marks. But­ter cost 1.5 million marks per pound, meat 2 million marks, a loaf of bread 200,000 marks, and an egg 60,000 marks! Prices increased so rapidly that waiters changed the prices on the menu several times during the course of a lunch!! Sometimes, customers had to pay the double price listed on the menu when they observed it first!!! A photograph of the period shows a German housewife starting the fire in her kitchen stove with paper money and children playing with bundles of paper money tied together into building blocks!

Currently (September 2008), Indian economy experienced an inflation rate of al­most 13 p.c.—an unprecedented one over the last 16 or 17 years. However, an all-time record in price rise in India was struck in 1974-75 when it rose more than 25 p.c. Anyway, peo­ple are ultimately harassed by the high dose of inflation. That is why, it is said that ‘infla­tion is our public enemy number one.’ Rising inflation rate is a sign of failure on the part of the government.

 

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