Inflation

 Some Definitions:
 Inflation:

It is a situation in an Economy/country, when prices of Goods and Service rise in one

hand, and value of money (Purchasing power) falls on other hand.

 Deflation:

It is a situation, just opposite to inflation. When price of Goods and Services falls in one
hand and value of money ( purchasing power) rises in other hand.

“When inflation becomes negative, it leads to deflation”. It is invariably associated with

recession, i.e. negative growth in the economy.

To check deflation, the following measures can be taken to increase money supply:

 Increase Government spending.

 Lower bank rate and repo rate.
 Print more currency.
 Decrease taxes to boost demand.

 Recession:

It is a type of condition in an Economy when there is lack of liquidity in market and

there is also unemployment.

 Depression:

Extreme form of recession, which not only stick in few sectors, but also spreads in all
other sectors of the economy.

 Double Depression:

When one phase of Recession in a country is not over and there are chances of another
recession to take place.

 Stagflation:

In an Economy , when Inflation and recession co –exist, it is called Stagflation.

Case 1: Inflation + Recession

Case 2: Inflation + Unemployment + Negative Growth rate

Case 3: Inflation + Depression

 Sectoral Inflation:
 When inflation is spread in sector by sector in an Economy/country, it is called sectoral
economy.

Rise in crude oil price – Rises in price of petrol, Diesel----Transport cost increases---Prices
of General commodities increases.

 Skewflation:

Skewflation refers to the inflation in some commodities and deflation in others. It

means when price of few commodities rises while the price of other commodities remains
unchanged.

For example: Food prices may rises due to increase in the prices of onion and tomatoes
whereas prices of other commodities remain the same.

 Bottleneck Inflation:

Bottleneck inflation takes place when the supply falls rapidly and demand remains at
the same level.

It arises because if supply side hurdles, hazards and mismanagement and it is also known as
structural inflation.

 Disinflation:

When RBI decreases the money supply in market by increasing Repo rate/CRR/SLR etc to
control inflation. It is a slower rate of inflation which means that there is still rise in prices
but overall rate is low. It is simply a slowing rate of inflation.

For example: if the inflation rate for years 2016, 2017,2018,2019 are 10%, 8%, 6% and 4%
respectively. Then it show the dis-inflation in the economy as inflation is slowing down.

 Reflation:

When RBI increases the money supply in market by decreasing Repo rate/CRR/SLR etc to
increase inflation (Decrease Deflation)

 Core Inflation:

Core inflation rate measures rising prices of everything except foods and energy ( as they
are highly volatile)- eliminates energy or food sectors.

Core inflation is used to denote the extent of inflation in an economy. However, it does not
consider the inflation in food and fuel items.

Note:

 In India the highest inflation rate observed was 34.68% in they year 1974

 In India lowest inflation rate observed -11.31% in 1976

 Types of inflation (By Pace):

 Creeping Inflation:
 It is mildest form of inflation.
 It is a low inflation rate over a long period of time which is necessary for the
development of the economy.
 As per RBI -- 0 to 2%

 Chronic Inflation:
 If creeping inflation continues to increase for a longer period of time then it is often
called as Chronic or Secular inflation.

 Trotting Inflation:
 More than creeping inflation.
 As per RBI -- 2 to 5%
 Ideal inflation.

 Walking Inflation:
 Walking inflation occurs when prices rise moderately and annual inflation rate is
a single digit. This occurs when the rate of rise in prices is in the intermediate
range of 3 to less than 10 per cent.
 It is not good for an economy.

 Galloping Inflation:
 More than Trotting Inflation.
 In this state, inflation increases rapidly and crosses double digits. This is a
serious warning for the economy.
 As per RBI --- 20% and above (warning signal for RBI)
 In this condition, money loses value so fast that the normal people cant keep up
costs and prices.
 Example: Turkey (45%), Argentina (25.9%), Venezuela (22.4%).

 Running Inflation:
 A rapid acceleration in the rate of rising prices is referred to as Running inflation.
When prices rise by more than 10% per annum, running inflation occurs.

 Hyper Inflation:
 It is an extreme form of recession, where the prices rise at alarming rate,
although it is very rare.
 It refers to a very high inflation rate. In this situation, not only does the price
increases but the rate of increment in price is also high. Money becomes almost
worthless as the value of currency rapidly decreases.
 As per RBI above 100% (Uncontrolled).
 In this case, Government has to print money.
 US experienced Hyperinflation in time of civil war (Germany 1920s, Zimbabwe
2000s, Venezuela 2010s faced Hyper Inflation)
 Causes of Inflation:

 Demand Pull Inflation:

 Demand pull inflation is when the demand for a good or service is greater than supply,
allowing producers to raise prices.

Caused by-

Population growth,
High level of purchasing power,
Increasing govt. expenditure
Deficit financing
Black Money generating a parallel economy,etc.

 Cost Push Inflation:

Cost Push inflation caused by an increase in prices of inputs like labour, raw material
etc.

In other words when Prices rise due to increase in the cost of production(Input cost), is
called cost push inflation.

Cause by-

Cost of raw materials

Labour costs
Transportation costs
High tax rates
High interest rates
Infrastructure costs.
  Factors for the Decrease in Supply:

Causes by

o Lack of production
o Natural disasters
o Increment in production cost
o Inappropriate policies of the government
o Management policies of companies
 Effects of Inflation on:

i. Creditors & Debitors- Inflation redistributes wealth from creditors to debtors. Lenders
suffers & borrowers benefit.
ii. Lending: with rise in inflation, lending institutions feel the pressure of higher lending.
iii. Aggregate demand: rising inflation indicates rising aggregate demand, higher
purchasing capacity of consumers & comparatively lower supply.
iv. Investment: inverment in the economy is boosted since higher demand forces
entrepreneurs to expand production level.
v. Income: an increase in inflation, increase the nominal value of income while the real
value of income remains same.
vi. Saving: It discourages holding money. People try to hold least money with themselves
and put maximum with the banks in their savings accounts.
vii. Expenditure: increased prices lowers the consumption levels. Inflation makes
investment expenditure increase as a result of decrease value of money.
viii. Taxation: indirect taxes automatically increase with the increased prices of good.
ix. Exchange rate: the currency of the economy depreciates in case of flexible currency
regime.
x. Export: inflation gives the economy, the advantage of lower imports as foreign goods
become costlier.
xi. Import: in case of compulsory imports economy losses more foreign currency.
xii. Wage: inflation increases nominal/face value of wage while their real value falls.
There is a negative impact on purchasing power and living standard of wage
employees.
xiii. Trade balance: in case of developed economies, inflation makes trade balance
favorable.
xiv. Overall economy: a particular level of inflation is healthy for an economy called a
specific range of inflation in India.
xv. Employment: inflation increases employment in the shorter run but becomes neutral
or even negative in the longer run.
 Methods of measuring Inflation
Generally In India , Inflation can be measured by -
o Wholesale Price Index (WPI)
 o Consumer Price Index (CPI)
o Deflator (GDP Deflator)

 In India WPI was main index for measurement of Inflation till 2014.
 In April 2014, RBI adopted new consumer index (combined) as the key
measure of inflation (on the recommendation of Dipak Mohanty and Urjit
Patel Committee)

Reasons of changing the index:

 In case of WPI, we used to neglect the price of service (only the price of Goods
was taken )
 Consumer price is directly related to consumer

Difference between WPI and CPI

WPI CPI

Wholesale Price Index (WPI) is based on the Consumer Price Index (CPI) is based on the
price prevailing in the wholesale markets final prices of goods at the retail level.

Measured by Ministry of Commerce and Measured by Ministry of Statistics and

Industry with base year as 2004-05 (Changed Programme Implementation
to 2011-12 now).
Base year 2016 (updated in October in 2020)

Measures prices of Goods only Measures prices of both Goods and Services

Used by only a few countries including India Used by 157 countries

  GDP Deflator:

The GDP deflator, also called implicit price deflator, is a measure of inflation. Is the ratio of
the value of goods and services an economy produces in a particular year at current prices to
that of prices that prevailed during the base year.

 Real GDP Vs. Nominal GDP

GDP deflator measures the difference between real GDP and Nominal GDP. Nominal GDP
differs from real GDP as the former does not include inflation but later includes.

Nominal GDP reflects the raw numbers in current dollars unadjusted for inflation.

Real GDP adjusts the number by fixing the currency value, thus eliminating any distortion
caused by inflation or deflation.

The formula to find the GDP deflator:

(Nominal GDP/ Real GDP)*100

Measures to Check Inflation

Inflation can be controlled by different measures. Inflation is controlled to idea (Zero rate of
inflation is never preferred). For a developing country like India, desired rate of inflation is 3-
4 per cent.

It is not easy to control inflation by using a specific measure or an instrument. The prime
objective of any measure to check inflation is to reduce the flow of money supply in the
economy or reduce the liquidity in the market. Following are the three categories of
measures:

A. Fiscal Measures: The government uses fiscal measures to control inflatyion. The two
main components of fiscal policy are government revenue and Government
expenditure. Under fiscal policy, the government controls inflation and in the
following ways:
 By reducing private spending i.e., when the Government reduces private
spending by increasing taxes, individuals decrease their total expenditure and
the money supply in the economy is reduced.
 By reducing non developmental government expenditure.
 By avoiding deficit financing as far as possible.

B. Monetary measures: These measures are taken by the RBI to check inflation by
controlling supply of money, and it consists of the following:
 By selling government securities through open market operations.
 By increasing Cash Reserve Ratio (CRR).
 By increasing Statutory Liquidity Ratio (SLR).
  By increasing Bank Rate.
 By increasing reserve repo rate & repo rate.

C. Administrative Measures:
 Prevention of black marketing & prevention of hoarding.
 Banning export of constrained materials.
 Suspending future trading etc.
 Facilitating supply of goods and services in case of demand-pull inflation.

Questions Module Bloom's Marks

Taxonomy
Levels

1. Why is inflation bad for the economy? Who I Economics 4 5

decides inflation rate in India?
2. What is GDP Deflator? What is the formula of I Economics 4 5
GDP deflator?
3. Why can’t the government just print more I Economics 4 5
money?
4. What are the differences between Deamd Pull I Economics 4 5
inflation and Cost Push Inflation?
5. Define the following term: Inflation, Deflation, I Economics 4 5
Dis-inflation, Reflation and Stagflation.
6. What might happen to industrialized food I Economics 5 10
production if oil prices rise sharply?
7.How does inflation affect my earning power or the I Economics 5 10
value of individual’s salary? How will inflation
affect individual’s loans?
8. How to measure inflation? Explain it. I Economics 5 10
9. What are the measures to control inflation? I Economics 5 10
10. What are the types of inflation by its I Economics 5 10
Pace?