Inflation
What is Inflation?
Inflation is a sustained rise in the level of prices of Goods and Services over a
considerable period of time.
What are the reasons of Inflation?
There are two reasons of Inflation:
(i) Demand pull:
Increase in prices due to increase in demand over the same level of supply or
the supply decreases with the same level of demand.
It is the condition when too much money is chasing the limited goods and
services
(ii) Cost Push:
Increase in the price of goods and services, occurs due to reduced supplies
due to increase in factor input costs.
It occurs due to increase of prices of raw materials, process or calamity.
In this, demand of goods and service does not decrease.
Advantages of Inflation:
A moderate inflation rate reduces the real value of debt. If there is deflation, the
real value of debt increases leading to a squeeze on disposable incomes.
Moderate rates of inflation allow prices to adjust and goods to attain their real
price.
Moderate rates of wage inflation, allow relative wages to adjust. Nominal wages
are sticky downwards. With moderate inflation, firms can freeze pay rises for
less productive workers – to effectively give them a real pay cut.
Inflation
Moderate rates of inflation are a sign of a healthy economy. With economic
growth, we usually get a degree of inflation.
Disadvantages of Inflation:
High inflation rates tend to cause uncertainty and confusion leading to less
investment. It is argued that countries with persistently higher inflation, tend to
have lower rates of investment and economic growth.
Higher inflation leads to lower international competitiveness, leading to fewer
exports and a deterioration in the current account balance of payments. In a fixed
exchange rate, e.g. the Euro – this is even more problematic as countries do not
have the option of devaluation.
Menu costs. – This is the cost of changing price lists.
Inflation and stagnant wage growth lead to declining incomes.
Inflation can reduce the real value of savings, which might particularly affect old
people who live on savings. However, it does depend on whether interest rates
are higher than the inflation rate.
Inflation will reduce the real value of government bonds. Investors will demand
higher bond yields to compensate; this will increase the cost of debt interest
payments
Hyper-inflation can destroy an economy. If inflation gets out of hand, it can
create a vicious cycle, where rising inflation, causes higher inflation
expectations, which in turn pushes prices even higher. Hyper-inflation can wipe
out the savings of the middle-classes, and redistribute wealth and income
towards those with debt and assets and property.
Costs of reducing inflation. To restore price stability, Governments/Central
Banks need to pursue deflationary fiscal/monetary policy. However, this leads to
lower aggregate demand and often a recession. The cost of reducing inflation – is
unemployment, at least in the short-term.
Types of Inflation.
(i) Low Inflation / Creeping Inflation: {2% to 9%}
Low Inflation takes place in a longer period and the range of increase is usually
in ‘single digit’. Such inflation has also been called as ‘Creeping Inflation’.
Ex: India
(ii) Galloping Inflation:
A ‘very high inflation’ running in the range of double-digit or triple digit (i.e., 20
per cent, 100 per cent or 200 per cent in a year).
Other names: hopping inflation, jumping inflation and running or runaway
inflation.
(iii) Hyperinflation:
A large and accelerating inflation which might have the annual rates in million or
even trillion.
Ex: Germany after the WWI in early 1920s. At the end of 1923, prices were 36
billion times higher than two years earlier.
Venezuela saw an annual inflation of over 53 million per cent by 2019.
Inflation
The currency of Zimbabwe was declared worthless in wake of rise in annual
inflation to 9 billion trillion per cent by 2008
(iv) Bottleneck Inflation / Structural Inflation:
This takes place when the supply falls drastically and the demand remains at the
same level.
Such situations arise due to supply side hurdles, hazards or mismanagement.
This could be put in the ‘demand-pull inflation’ category.
(v) Core Inflation:
It shows price rise in all goods and services excluding energy and food articles.
Because the prices of energy and food articles are very volatile in nature.
Since 2015-16, a new core-core inflation is also measured by India which
excludes food, fuel & light, transport and communication.
(vi) Skewflation:
Sustained price rise in one or few of the Goods and Services.
Other terms related to Inflation.
(i) Inflationary Gap:
The difference between the Actual Aggregate Demand and the Aggregate
Demand at Full Employment is Inflationary Gap.
AD1 = Aggregate Demand at Full Employment
AD2 = Actual Aggregate Demand
AD2 – AD1 = Inflationary Gap
Increase in prices due to excess demand due to Govt investments, credits etc.
(ii) Deflationary Gap:
The gap between the Aggregate Demand at Full Employment and the lowered
Actual Aggregate Demand would lead to decline in amount of prices as a result
of which this gap is called Deflationary Gap.
Inflation
Prices come down due to decrease in demand due to recession, low confidence
and other reasons.
(iii) Inflation Tax: An increase in price due to inflation which act as a tax is known as
Inflation Tax.
(iv) Inflationary Spiral: A situation in which prices increase, then people are paid more in
their jobs, which then causes the price of goods and services to increase again, and so on
(v) Inflation Accounting: Inflation accounting refers to the method used to rectify issues
arising from historical cost accounting during high inflation and hyperinflation and
adjust the financial statements according to price indexes. Inflation accounting
comprises two methods: Current Purchasing Power and Current Cost Accounting.
Good and Bad Inflation?
Measures to control Inflation.
(i) Supply Side Method:
Import: Fulfilling the supply by importing goods and services. It is a short-
term method.
Upscaling: Adopting a measure to increase the production more than earlier
produced to fulfill the demand. It is a long-term method.
(ii) Demand Side Method
Austerity Measure: A measure of the reducing the demand of goods and
services than earlier.
Monetary Measures: A measure of increasing the Repo rates, which means
increase in the rate of borrowing money. It is not effective in daily need
items.
(iii) Cost Side Method:
By cutting taxes on high price items;
Efficiency: Increasing the efficiency of production through technological
advancement to reduce prices. It is a long-term method.
Impacts or Effects of Inflation
The borrowers are benefitted whereas creditors are get hit due to increasing inflation.
Increase in demand
Investments are increased because of high demands and cheap loans {as the borrowers
are benefitted}.
Holding money or cash in hand becomes costly.
Expenditure goes down due to inflation. The consumptions would decrease.
Measuring the Inflation:
There are two methods of measuring the inflation:
(i) WPI {Wholesale Price Index}
Also known as Headline Inflation.
The government always talks about and announces the WPI.
There is a basket of mix of commodities and in those commodities the
price change is measured at the end of the week as compared to the same
week last year.
Inflation
Week 10 of 2015
x 100
Week 10 of 2014
Recently the base year has been changed to 2011-12 and the basket
consists 676 items.
(ii) CPI {Consumer Price Index}
It is based on the experience of the price of a person who is living in the
county.
It is calculated differently for different kind of categories of people.
It is used to announce the DA (Dearness Allowance) for the government
employees.
DA: It is extra allowance given other than the salary to combat the
increase in prices.
PPI:
Impacts of Inflation on Trade
If the currency appreciates↑ exports come down ↓ and imports go up.
BoP {Balance of Payment)}: The difference between the exports and the imports is
BoP. If you export more than you have a balance of payment, which is positive. If you
import more then your balance of payment is negative.
