UNIT 1

TOPIC 2: INFLATION

CONCEPT

– Inflation means sharp increase in prices as a result of excessive

increase in the quantity of money.
Supply of money as the cause of inflation:
– Coulborn: Too much money chasing too few goods (Supply of goods
is less, and supply of money is high. When excessive supply of money
– demand will increase).
– Hawtrey: Issue of too much currency
– Kemmerer: Too much currency in relation to the physical volume of
business being done.
1. Quantity Theory Approach: Increase in quantity of money causes
inflationary rise in prices.
Weaknesses: 1. Hyperinflation in Germany after WW2 – Not able to
explain. Price level was the cause – increase in money supply was the
effect.
2. Not able to explain Depression Economy (decreased demand,
income, employment, etc.) When demand is less, producers don’t
invest. During depression – increase of money supply – producers
invest - increased demand, increased output, increased employment,
increased income level. Quantity theorists not applicable during
depression.
2. Excess Demand Approach: Sole cause of inflation is persistent
demand in the economy.
This excessive demand is not able to meet the supply of goods and
services. It happens when there is full employment. Ex: War economy,
5-year plans – government is spending lot of money. Demand
increases. During war period, all the fop is employed to the full.
Government has to meet the war expenditure. Government is
employing more and more FOP. Although fully employed, government
is still spending.

Conclusion: No difference between both the approaches, although the

second one is more popular.

CAUSES:

I. Factors causing increase in demand:

- Increase in public expenditure: Government spends. For welfare.
Govt. increases in exp – increased income – increased employment –
increased demand.
- Increase in private expenditure: Private individuals see scope for
profit and invest. More employment. More income. More demand.
Increase in public expenditure – leads to increase in private
expenditure. A private individual will only produce when there is
profit. They invest. They hire FOP. Increased demand in FOP –
Increases the demand for consumer goods and services made by
private individuals. Again, income of FOP increases. Again, demand is
increased.
- Reduction in taxes: Government, sometimes, reduces taxes.
Sometimes, deliberately. Taxes reduced – disposable income of
individual increases – Purchasing power increases. Demand is
increased.
- Repayment of past internal debts: Government also takes loans
from us (by floating govt. bonds, securities, NSC – national saving
certificate). When government pays back – now we have increased
money supply (Principal Amount + Rate of Interest). Purchasing power
will increase – demand will increase.
- Rapid growth of population: When population increases – they
increase demand for shelter – increase demand.
- Cheap monetary policy: Central banks or government may follow
CMP – government reduces ROI in the economy. Maybe deliberate or
due to increased supply of money. Banks now have large amount
funds. They will charge less ROI. Since supply of money is higher, its
price (ROI) will be lower. More people will take loans now. More
demand for goods will be created.
- Deficit Financing: When there is gap between expenditure and
revenue of the government. Revenue > Exp – Surplus. Exp > Revenue
– Deficit. Since government has to make that expenditure. Several
ways to fill this gap. Government may borrow from RBI. Or ask RBI to
print more money. Increased supply of money - Inflation. Increased
investment – increased employment – increased income – increased
demand.
– Black money: Unaccounted wealth in the economy. Spent in our
economy itself. Whenever black money increases, increased demand
in the economy.
– Demonstration Effect: Because of increased consumer demand.
When we try to imitate the patterns of richer countries. When we see
rich people purchasing hi fi mobiles, cars. They demonstrate in front
of us. In a bid to emulate them, we also wish to purchase them.
Increased demand.

DUE TO ALL THIS INCREASED DEMAND – INFLATION.

Aggregate demand rises, and the aggregate supply is not able to meet
the aggregate rise in demand and hence there is pressure on the prices
and prices rise. The prices rise because people are demanding the
commodity, but the supply is not able to match the demand – pressure
on price – hence, price rises (inflation).

II. Factors causing decrease in supply

(the supply is not able to meet demand – decreased supply &
increased demand – price rises)

1. Shortage of FOP: In an economy it happens that FOP are

scarce. In any economy there might be shortage of FOP.
Irrespective of whether the economy is
developed/underdeveloped/developing - shortage of FOP is
there. Continuous shortage of FOP – hamper the production
of goods and services. Shortage of capital in the economy –
machinery/plant/equipment – then producers won’t be able
to install new technology – supply won’t be able to meet the
demand. Hence, shortage of supply.

2. Industrial Disputes: Disputes between employer and

employee. There have been huge strikes and lockouts in
industries. There had been conflicts been employer and
employee. Employers want high profits. Employees want high
wages and bonus. Both of these objectives are in opposite
direction. If wages are increased, profits will decline and vice
versa. This conflict leads to industrial disputes. If employers
resort to lockouts to blackmail the workers and if the
employees resort to strikes to blackmail the employers. In
both the cases, strike and lockout - the production suffers.
Production suffering means shortage of supply. More the
number of industrial disputes, more will be the shortage of
supply.
3. Natural Calamities: When natural calamities happen
(earthquake, famine, flood, cyclone, or bad monsoons, etc.) –
production is hampered, and supply is restricted.
4. Obsolete Technology: Technology has a direct relationship
with supply. When the technology is advanced – when we
have new machinery, new technical knowhow – it will lead to
increase in supply. Advanced technology reduces the time
required for producing the commodities. It enhances the
efficiency of machines/labor and helps in
maintaining/upgrading the quality of the output. If obsolete
technology is used – it restricts the supply.
5. Scarcity of Resources: Same as shortage of fop. If any
resource which is used in production is scarce – it leads to
shortage of supply.
6. Artificial Scarcities: Sometimes the scarcities are created
artificially. The producers and shopkeepers deliberately
restrict the supply. Although goods are available but still
artificial scarcity is created by shopkeepers or producers so
that the price of the product increases. Example: In current
times, although there is high demand for covid resources – but
there are cases of hoarding by some shopkeepers to increase
the price- artificial scarcity.
7. Increased Exports: Sometimes it happens that the
commodities that are domestically produced – are exported
abroad. If a lot number of commodities are exported abroad –
then scarcity of that commodity arises for domestic use.
8. Lopsided Production: It happens when production has not
taken place taking into account the demand in the economy.
Or maybe the demand is for consumer goods or production
has taken place of say, luxury goods. Producers not able to
assess the demand. Due to this underestimated demand –
supply not able to meet demand.
9. Hoarding by customers: Sometime consumers also start
hoarding for personal consumption– whenever there is
uncertainty – when people don’t know if lockdown will be
extended. During such times, people start hoarding essential
commodities. Supply restricted.
10. International Factors: There might not be inflation in the
home country. But if raw material is imported from a country
where prices are very high (i.e., they have inflation) – then the
home country will also get them at a higher price – higher cost
of production – PRICES WILL RISE.
Due to all this supply shortage – PRICES RISE. INFLATION.

WHETHER DEMAND INCREASES OR SUPPLY DECREASES –

THERE WILL BE PRESSURE ON THE PRICE – INFLATION.

2 TYPES OF INFLATION

1. DEMAND PULL INFLATION:

- Same as excess demand approach.
- If there are unemployed resources in the
economy i.e., there are fop which still lie
unemployed. As long as there are unemployed
resources in the economy, an increase in
investment will lead to increase in employment,
income and output.
- After the full employment, output ceases to rise
and hence there arises inflation
2. COST PUSH INFLATION

- Happens due to cost factors.

- It is caused by increased wages enforced by trade unions and
increased profits induced by employers.
- Various factors by which cost push inflation takes place:
1. Wage Push Factors – When the wages of the laborers rise in higher
speed than their productivity. A labor has the power to produce the
commodity, that is, meeting the supply side. At the other side, laborer
creates demand also, because he is getting employment and will
create demand for these goods and services. If the productivity of the
laborer, the supply – matches the demand of the laborer – No
problem, equilibrium. Problem arises when this equilibrium is
disturbed. Example: if wages (demand) increase, but the productivity
is not increasing – then dis equilibrium. Then trade unions press the
employers to grant the wages in excess of the productivity of the
laborer. They are able to escalate the wages of the laborers, but on
the other side the productivity of the laborer is not increased. When
this happens, that is wages increasing – THE COST OF THE
PRODUCTION FOR THE PRODUCER INCREASES TOO – IN TURN, THE
PRODUCERS WILL INCREASE THE PRICES TO MAINTAIN PROFITS.
Inflation. Again, trade unions will push for increase in wages because
of the increase in prices. WAGE – COST SPIRAL. WAGE INCREASES –
COST INCREASES – PRICE INCREASES – COST OF LIVING INCREASES –
AGAIN PUSH FOR WAGE INCREASE.

2. Profit Push Factors – These are from the side of the producers. In
real life, oligopolies and monopolies firms exist which are able to raise
the prices of the products to offset the cost of labor and other
production. Sellers are able to increase the prices because of their
market power. Also called - Sellers inflation, Market power inflation.

3. Sectoral Inflation – Any one particular sector of the economy may

be experiencing inflation. Say, the industrial sector is facing inflation.
Now, the price of the industrial commodities (steel, raw material, etc.)
may increase. These commodities may be used by agricultural or
service sector. Since the prices are high, the prices of the agricultural
or service sectors will also increase because they are using the raw
material whose price is already high. This inflation shifts from one
sector to another.

4. Imported Raw Materials – There may be certain raw material which

may be from abroad for making final goods in the home country. If the
prices of these materials are high and they are imported – then the
cost of production will increase – prices of the final goods made from
these raw materials will also increase.

All these factors lead to cost push factors which leads to cost push
inflation. It happens due to the increase in cost of producers in the
economy.

INFLATIONARY GAP
- Concept given by Keynes
- It represents the technique of statistically measuring the pressure of
inflation.
- It is defined as excess of anticipated expenditure (demand side) over
available output (supply side). Three types of expenditure – Consumer
Expenditure (C), Government Expenditure (G), and
Producer/Investment Expenditure (I). This is the demands side. What
will they spend on? Goods and services (available output) – Supply
side. Inflation is this excess of anticipated expenditure over the
available output in the economy.
- Anticipated expenditure depends upon the net disposable income
• NDI = Money Income – Taxes – Savings
• Total Expenditure = C + I + G

• IG = NDI – Real Output

(TOTAL OUTPUT = TOTAL INCOME = TOTAL EMPLOYMENT)

OE is a 45-degree line, shows the equilibrium level. It shows all those
points where total output = aggregate expenditure. OE is therefore
the equilibrium line.
But the actual consumption will not always be on the equilibrium line,
it will be somewhere near the equilibrium line.
C +I+G line shows the actual consumption level in the economy, this is
the actual consumption level in the economy. This line cuts the
equilibrium line at point N, so the point N is the equilibrium level
where total exp = total output. So, O Y is the total output in the
economy. The total expenditure is NY because the expenditure line is
cutting the equilibrium line at point N. Since, this is 45-degree line, NY
= OY, that is, total expenditure is equal to total output. This is the full
employment level. Suppose the government increases its expenditure
further. The expenditure line shifts upwards (C+I+G’), this is the new
expenditure line because of the increase in government expenditure.
Now, this expenditure line is cutting the equilibrium line at point M.
Now, total expenditure is MY1. But since there is full employment of
resources at OY itself.
Gap of YY1 is there.
How much is the increased expenditure? PN. Initially total expenditure
was NY. This PN expenditure is in excess of the available output.
Available output is just OY.
PN is the inflationary gap in the economy.
Aggregate expenditure of demand is in excess of the available output.
Prices will increase.

How can this inflationary gap be removed?

Increase in taxes and reduction in expenditure. Reduce the demand
side and increase the supply side. But since the supply side is restricted
due to full employment of resources so the demand side has to
changed. Government can increase the taxes to reduce the demand
or the net disposable income in the pockets of the people, or
government can also resort to forced savings on part of public.
Governments might deliberately float savings schemes and ask people
to invest in them so that somehow the purchasing power of people
may go to the government and it may not be there for furthering
demand in the economy. Government can resort to public borrowing,
public debt – in the form of investment in government securities,
bonds, saving certificates, etc. That much amount of money will be
locked with the government and the public will not have access to that
money, and again the purchasing power will be reduced. Also, the
government can import those goods and services which are necessity
goods. These are some ways by which inflationary gap can be removed
from the economy.

MEASURING INFLATION
– Price index numbers are the tools to measure inflation in an
economy. They are weighted averages of prices of many commodities.
– It reduces all the distinct prices for the class of goods in question to
a single number.
– Wholesale Price Index (WPI): AT WHOLESALE RATE. When inflation
is calculated based on wholesale prices of wide variety of goods. When
we want to calculate on the wholesale level. This is very popular.
Because in wholesale purchases, the prices of the goods are less. So,
the inflation rate is showed less. Government wants that. If you want
actual inflation – based on CPI, not on WPI. Because we don’t
purchase in wholesale all the time.
– Consumer Price Index (CPI): AT RETAIL RATE. Weighted sum
(weights are assigned to the commodities. If proportion of income
spent on food items is greatest, then higher weight will be assigned to
food items. Say clothing forms a very small proportion of the income,
which is spent by the consumer, then a lesser amount of weight will
be assigned to that item) of prices of set of goods and services that
statistical agency of government determines through consumer
expenditure surveys of typical consumer purchases in a year. When
we want to calculate on retail level. Based on these surveys, certain
commodities are taken into account and the average of prices of these
commodities is taken to calculate one particular consumer price index
number.
- Suppose you want to calculate the pressure of inflation in the rural
areas, then you have to construct index numbers for people living in
villages only. We cannot take into account the index numbers of
people living in urban areas and then conclude. This will be misleading.
Index numbers show the average of prices of certain commodities
which are used by certain sections of consumers (or the target
population) in the society.
– CPI-IW (of Industrial Workers), CPI-AL (of Agricultural Laborers), CPI-
RL (of Rural Laborers), CPI-UNME (Urban Non-Manual Employees –
those workers living in urban areas but not doing manual work).
– Cost of living index: It is used for adjusting the salaries of the fixed
income groups – government employees. Wages are linked to the cost
of living index. Whenever there is an increase in the cost of living
index, there will be increase in wages.
- Producer Price Index: Producers also purchase certain commodities
because for production purposes, they need to purchase raw
materials, intermediate goods, machines, tools, etc. So, the prices of
these products are also measured. Method of calculation is same, only
producer goods are taken into account.

CALCULATION:

2010 – base year. Why base year? To have a standard year to compare
with.
Cost of basket calculated how? Price * quantity.
CPI of base year is always 100.

So, the prices have increased by 75% in year 2011 as compared to the
base year price index.
IR 2010 – 75%
IR 2011 – 42.8%
Problem with calculation of CPI: The basket of commodities remains
the same for several years, which should not be the case because the
baskets keep changing, or the proportion of income spent on these
commodities changes, or the importance of those particular
commodities also changes. Example: 20-30 years ago, kerosene had
an important place in the consumption expenditure of the consumer
because LPG, etc., were not there. But, today, when use of LPG has
become so frequent – it has gained a prominent place in the
expenditure basket rather than kerosene. Therefore, if no new basket
of commodities are assigned and changed with time – misleading
picture.

GDP Deflator
- In CPI we only take into account those commodities which form a
prominent part of the consumer’s expenditures, in GDP deflator, we
take into account ALL of the commodities which have been produced.
- It is a measure of prices of all domestically produced final goods and
services produced in a year.
- This measure shows the extent to which the increase in GDP has
happened due to increase in prices rather than the output.
- GDP Deflator = (Nominal GDP/Real GDP) / 100.
- Example: In 2018 – we were producing 10 commodities. In 2019 – we
are producing only 8 commodities, but the prices of these
commodities have increased so that the GDP in 2019 > 2018. Now, if
we only see the GDP figures – we will say that our development has
increased, production capacity has increased but only after correcting
the GDP with the GDP deflator that we get to know that the economy
has not developed rather the increase was because of increase in
prices and not because of the number of commodities which have
been produced because the total number of commodities which have
been produced has rather declined.

Difference between CPI and GDP Deflator:

1. CPI takes into account a fixed basket of commodities, whereas the
GDP deflator takes into account the prices of the commodities that are
currently produced in the economy. In CPI, the commodities remain
the same till the time new expenditure survey is conducted – one
basket of commodities has been designated and it remains the same
for calculation of CPI for subsequent years. Whereas, in case of GDP
deflator, every year if any new set of commodities are produced –
then the prices of all these commodities are taken into account while
calculating the GDP deflator.
2. Deflator reflects the prices of all goods produced domestically,
whereas CPI measures prices of all goods bought by the consumer.
Airplanes sold to airforce, jets, fighter pilots – bought by airforce or
the government, not the consumers. Prices of these commodities will
go into calculation of GDP deflator because this is a commodity which
is being produced domestically. Most consumers purchase mobile
phones and suppose Consumer Expenditure Survey shows that iPhone
forms an important place in the consumption basket of the target
population for whom CPI is calculated. Previously iPhones not made
in India, but still a part of consumption basket of consumers – so price
of iPhone will be a part of the calculation of CPI.
3. In CPI we only take into account those commodities which form a
prominent part of the consumer’s expenditures, in GDP deflator, we
take into account ALL of the commodities which have been produced.
Deflator captures inflation across whole of the economy, because the
prices of all the commodities are taken into account, whereas CPO
captures inflation for only a basket of commodities for particular
consumers. CPI-RL: shows inflation only of rural areas. GDP deflators
shows inflation across whole of the economy.

Difference between Deflator and WPI:

- WPI numbers have no representation of the services sector, it only
constitutes the goods. Whereas, deflator measures changes in the
prices of both the goods and services. GDP deflator – Goods and
Services. WPI – Wholesale prices of Goods.
GDP deflator figures are available on a first, quarterly and then annual
estimate, whereas CPI and WPI figures are released every month.

Some Concepts:

- Creeping Inflation: when price level rises around 2%.

- Walking: price rise by 3-7%.
- Running: price rise by 10-20%.
- Galloping/Hyper Inflation: price rise by 20% and above.
- Stagflation: economy experiencing stagnation and inflation both. It
has a combination of unemployment rate and inflation rate. Keynes –
beyond the level of full employment when there is an increase in
money supply – inflation. Stagflation is a paradoxical situation where
the economy is experiencing inflation and unemployment both. It
occurs in cost push type of inflation in economy. The principle cause
of stagflation – restriction in aggregate supply. It happens when there
is a constraint on supply in the economy. When supply reduced – fall
in output, employment and the price level rise through a chain of
events. This reduction in supply may be due to several factors – 1.
When the rise in money wages forces the firms to reduce the
production and employment. Rise in money wages in in excess of the
productive capacity of the laborers. Only money wages increasing,
productive capacity of laborers not increasing. Happens because of
rigidities in the wage structure because of strong trade union. – At the
time of agreement, when the laborers are hired: escalator clause:
when the cost of living index increases – the wages will increase. What
happens is that the wages go on increasing but the productivity of the
laborers does not increase. When the wages are increased, the cost of
production of the producers is also increased and then the producers
reduce the production, restrict supply and reduce employment and
hence the price level increases.
Ways to control stagflation:
1. Linking increase in money wages to increase in productivity: When
there is a rise in money wages due to the escalator clause there should
be one more condition that the workers must also enhance their
productivity too. If there is a link – equilibrium is maintained and
demand and supply gap is reduced. No restriction in supply. No
inflation.
2. Level of taxes, especially indirect taxes can reduced: Like excise and
sales tax (now it is GST) levied on production of commodities because
of which cost of production of producers increase, and hence
restriction in supply. So, government can think of reducing the taxes
on production of commodities.

- Structural Inflation: when prices rise due to structural rigidities in

the economy. Why stagflation is happening for so many years?
Because of structural inflation. Structural rigidities – underdeveloped
and developing countries which are taking up development programs
– it happens that it leads to inflationary situation. When development
takes place, inflation is a necessary outcome. Inflationary situations
arise with the growth, development of the economy. Why? Inherent
features like obsolete technologies of these underdeveloped
economies. When development programs take place – transition from
tradition to modern economies. Modern economy stage has not yet
arrived. During the transition – a lot of changes take place, because of
which inflationary situations arise. How? Chain of events. In an
underdeveloped economy – population growth rate is high -> high
demand of agricultural goods -> supply is less (because output of
agricultural goods is inelastic – meaning it will take time to increase
the agricultural commodities because there is a certain period when
crops are grown. Output is less also because of inherent structural
rigidities - Defective land system, lack of irrigation facilities, not proper
warehouse/storage system, lack of finance and marketing facilities) -
> leads to inflationary situations/PRICE RISE -> cost of living index
increase -> wages of laborers rises (because since demand for
agricultural products is high, there is also a high demand for
agricultural laborers) -> pushes up the demand for goods and services
-> Inflation.
Solution? Import agricultural goods from abroad. But in such
economies, it cannot be imported to a large extent because of lack of
availability of foreign exchange? Why lack for forex? Because the
exports of this country also cannot be increased because such
commodities are primary sector economies and the demand for such
commodities is inelastic in the foreign market. So, the exports are
restricted. Therefore, country can’t import a lot amount of food
grains, tech, machines, capital goods for enhancing the development
programs in the country. So, seeing this rigidity in increasing the
imports and the exports, the country adopts industrialization along
with import substitution model (producing those goods which are
imported from abroad). When this industrialization along with import
substitution model takes place, the industries in these countries are at
infant stage, not yet mature enough. Since, they aren’t mature
enough, the government adopts protection (protects the indigenous
or domestic industries from foreign competition. Government does
not allow industries in the foreign countries to compete with domestic
countries.) Because of this protection – dearth of commodities – price
rise. Only indigenous producers are producing, and the production
hasn’t matured enough to cater to the demands of the population and
the foreign investors are not coming because the government is
adopting protection. Leads to rise in prices.
The nature of the tax system and budgetary processes are also marred
by the rigidities in the economy. Then because of all these factors –
inflation. Because of inflation, real value of government revenue also
falls. Why? Because tax rates are imposed based on certain
percentages of incomes. Money income is not rising and purchasing
power is declining.
On the government expenditures side – the real money value
increases. Government allocates certain money to certain
sectors/programs. Normally they take long time to take place. In this
time gap, real value of money is falling because of the rise in prices.
Government borrows money from central banks. Central banks may
print more notes for meeting the demand of government. This will
lead to inflation. (Because people’s purchasing power will increase,
demand will rise but supply won’t be able to meet the demand).
Methods to Control Inflation:

Question: Describe the various monetary, fiscal and directly

productive policies adopted by the monetary and fiscal authorities for
controlling inflation in the country.

I. DIRECT METHODS: directing affecting the demand and supply

causes of inflation
1. Increase Production: First thing – Meet the restriction in supply,
remove the constraints in supply. How to do it? Production.
Production of essential goods.
a. Essential Goods: When the population is rising, the demand for
essential goods rises. The government should focus on production of
these essential commodities so that the government is able to provide
food, clothing and shelter to the rising population.
b. Import Raw Materials: For focusing on essential goods, the
government can import raw materials from abroad.
c. Increasing Productivity of Labor: Also, the government can increase
the productivity of labor. Productivity dependent on factors like –
environment and conditions of employment – proper ventilation and
facilities.
d. Government Support: For all of this to become possible,
government support must be there – by providing subsidies, tax
incentives, tax benefits, etc., so that production of commodities can
take place.

2. Rational Wage Policy: Even though escalator clause should be there

but then the increase in wages should be linked with the productivity
of the labor also. When there is a link between productivity and wages
– then equilibrium will be maintained.

3. Price Controls: Government can also adopt price controls, that is,
for essential commodities, especially food grains, etc., government
can follow administered price policy, that is, the government can
deliberately fix the prices of the products, that is the prices of these
goods won’t go beyond this. Example: Food grains, sugar, kerosene –
administered price policy. Why? To provide the commodities at prices
within the range of the poor people.

4. Rationing: Government distributes food grains to needy, that is, BPL

people. It distributes these commodities to people at affordable
prices. It is done through government fair price shops, where the food
grains and other essential items are sold to BPL people at affordable
prices. So, the rationing of these essential commodities can also be
done.

II. MONETARY METHODS

MONETARY METHODS – the monetary policy, which is adopted by the
Central Bank, so, a lot of tools of MM are there – Bank Rate, CRR, SLR,
OMO (tools adopted by Central Bank to control credit in the economy.

All 3 are same – 1. The tools of the Monetary Policy, 2. the tools by
which central bank can control credit in the economy, and 3. the
monetary methods to control inflation.
Q. Discuss monetary methods to control inflation.
Q. Discuss the tools by which central bank can control credit by the
commercial banks in the economy
Q. Discuss the monetary methods adopted by central bank in the
economy.
Answer of all 3:
Will discuss in next topic.
1. Credit Control
a. Bank Rate
b. Reserve Ratios – CRR & SLR
c. Open Market Operations

2. Demonetization
Notes of certain denomination are discontinued, and they have to be
returned to the government and new notes have to be taken.
This method is also applied to control inflation although not very
effective. Not resorted to frequently.

III. FISCAL METHODS

FM are the fiscal policy of the government which relates to taxation
and the expenditure policy of the government, that is, the public
revenue and the public expenditure policy of the government.

1. Reducing Expenditure: Government can reduce its expenditure

because reducing expenditure will lead to decline in demand and,
hence, income of the country. Where does government spend
money? Developmental projects. So, DP cannot be discontinued just
like that, because it is essential for the economy. But unnecessary or
unproductive type of expenditures can be reduced.
2. Increasing Taxes: Because the purchasing of public is enhanced in
inflationary situations, this purchasing power can be curtailed through
increase in taxes. So, the government can increase the taxes, either
the income tax or the indirect taxes, etc., so that some disposable
income of the public is reduced and there is curtailment in the
purchasing power.
3. Increasing Savings: The government can induce the public to
increase its savings by floating various saving schemes, in the form of
National Saving Certificates. Government can also force the public to
invest in such schemes, example government employees can be asked
to invest in these schemes to reduce their purchasing power.
4. Surplus Budget: Government can also follow surplus budget, where
revenue is greater than expenditure. So, government can reduce
expenditure on one hand and government can increase the public
revenue by increasing the taxes, etc. on the other hand so that there
is surplus government budget and hence demand is controlled in the
economy.
5. Public Debt: Government can resort to Public Debt, that is, it can
ask for loans from the public, by floating government bonds and
securities, etc., which the public can invest in or the commercial banks
can purchase – so that money is transferred from banks and public to
the government. And there is reduced purchasing power for the time
being.

Effects of Inflation:

Inflation does not affect all the sections of the society equally, but it
will affect differently to different sections of people in the society.

I. Effect on Redistribution of Wealth: During inflation, there is

redistribution of wealth in the economy, so that the income
distribution may be in favor of certain sections of the society, that is,
they are benefited from it and it may be against certain other sections
of the society who are at a loss because of inflation.
1. Debtors and Creditors: Debtors are the ones who take loans,
creditors are ones who give loans. Inflation will affect debtors
positively, and creditors negatively. Debtors gain, creditors lose. Why?
Because the real value of money falls when they give back borrowed
money.
2. Salaried Persons/Fixed Income Groups: They are affected
negatively. Value of money falls.
3. Equity Holders: People who are holding shares of a company are
affected positively. Because of price rise, companies are benefited.
Since they are benefited, share prices will increase. Shareholders will
also be benefited.
4. Businessmen: Producers, businessmen are benefited by inflation
because the prices of commodities have increased, and so have their
profits.
5. Agriculturists: Landlords are affected positively, but agricultural
laborers get fixed wages, so they are affected negatively.

II. Effect on Production

1. Misallocation of resources: Means that there is lopsided production
of the commodities. The resources are scarce, and these scarce
resources are allocated for production of various commodities. “What
to produce” problem of the economy – has to be decided according to
the demand that is created in the economy. During inflation, the
resources and fop are allocated in a lopsided manner wherein a
greater amount of resources are allocated for the production of
unnecessary items, that is, the luxury items – which are demanded by
the richer people.
2. Changes in system of transactions: During inflation, value of money
is declining rapidly. Anyone who has liquid money with them – they
don’t want to hold this liquid money with them. Since value of money
is declining, people want to have lesser stock of liquid money with
them. They want to exchange cash with some other item/asset which
has a higher value at that time. They exert a lot of effort in changing
this money asset into other assets, such as gold, such as real estate,
shares of company, etc.
3. Fall in quality of commodities: Inflation creates a situation which is
called the “seller’s market” (seller want to increase the amount of
production because there is profit. In a bid to produce more, the
quality of the output declines. There is a compromise with the quality
of commodities produced. There may be adulteration of goods) or
“seller’s inflation”.
4. Hoarding and black marketing: During inflation, prices are
increasing. So, producers or all those who have a stock of the
commodities, withhold it so that the prices may increase further. They
don’t let supply to come out in market. Although goods and services
ARE produced. They are there in their go downs and have the
inventories lying. But still they don’t make it available in the market
and wait for the prices to increase further, in order to make profit.
5. Reduction in savings: People are left with lesser amount of
disposable income because the value of money is falling during time
of inflation and since value of money is falling, people are able to
purchase less items in terms of goods and services or they have to part
with more units of money to get the same amount of goods and
services.
6. Hinders foreign capital: Foreign capital is very sensitive. It not just
only depends on the amount of profits in the country but also the
climate, economic climate, political climate in the country. When
there is galloping inflation, the economic climate in the country is not
very stable. There are too much fluctuations in the prices because of
which there is a lot of uncertainty in the market. This uncertainty is
very detrimental for attracting foreign capital. So, if such climate is
there, it will hinder foreign capital.
7. Encourages Speculation: There are rising prices, rising profits – so
the producers speculate on a lot of activities in order to make quick
profits. Instead of engaging in productive activities, they speculate on
various types of securities, bonds, shares, etc. A lot of time and effort
is wasted in this. Although certain level of speculation is important in
the share market but too much of speculation brings uncertainty in
the market.

Other effects of Inflation:

1. Balance of Payment (BoP): BOP is a record of all economic

transactions which take place between the home country and the rest
of the world. Or, it is a record of import and export taking place
between the home country and the rest of the world. For imports, we
have to make payments to the foreign country. For exports, we get
payment from foreign country. When e > i then surplus situation for
the country, our earning is more than the spending. Whereas if i > e,
then our spending of foreign exchange is greater than our earning of
foreign exchange. This deficit situation is not very good, because it
leads to outflow of forex from the country. But during inflation, when
prices are rising – foreign countries may not buy goods from our
country because the prices of the commodities are rising. This may
lead to deficit situation of BOP.

2. Social: Socially too, it is not a good atmosphere in the country

because it widens the gap between the rich and the poor, a lot of
corruption, hoarding, black marketing, adulteration is there. So,
socially the climate is not good during such times because the gap
between the rich and the poor is widened.

3. Political: Politically, a lot of agitations and protest go on. When

prices are rising, the government is criticized. Political climate of the
country is affected because a lot of mistrust for the government is
there. There may be chances of a downfall of the government.

4. Government: For the government, it helps in the collection of more

revenue, when the income of people is increasing. But the real income
of the government, that is in the form of tax collections, declines. Real
value of taxes are declined because inflation is increasing. Public
expenditure also increases because there are rising production costs
of the public projects. The prices of even the public projects rises, so
if the government wants to go on with any developmental activity,
like, in the form of making of roads, infrastructure, etc., so prices of
raw materials has increased – therefore, Public Exp. also increases.

5. Collapse of monetary system: Hyper inflationary situation leads to

collapse of many systems, as happened in Germany after WW2.
Galloping inflation in Germany which led to the decline of the German
Mark (currency). Collapse of monetary system.