What is Inflation?

In economics, inflation (or less frequently, price inflation) is a general rise in an

economy’s price level over time. When the general price level rises, each unit of
currency buys fewer goods and services; consequently, inflation reflects a
reduction in the purchasing power per unit of money – a loss of real value in the
medium of exchange and a unit of account within the economy.
The different types of inflation in an economy can be explained as follows:
Causes of Inflation
There is no one cause of inflation in the economy. Economists have
hypothesized a few theories, that in some combination may cause the overall
inflation in a given economy.
1. Demand-Pull Theory: As per this theory, inflation is caused due to the
general increase in the demand for goods and services. So, when demand
outgrows the supply, the prices will increase.
Causes of Demand-Pull Inflation:
● A growing economy or increase in the supply of money – When
consumers feel confident, they spend more and take on more debt. This
leads to a steady increase in demand, which means higher prices.
● Asset inflation or increase in Forex reserves– A sudden rise in exports
forces a depreciation of the currencies involved.
● Government spending or Deficit financing by the government – When the
government spends more freely, prices go up.
● Due to fiscal stimulus.
● Increased borrowing.
● Depreciation of rupee.
● Low unemployment rate.

Effects of Demand-Pull Inflation:

● Shortage in supply
● Increase in the prices of goods (inflation).
● The overall increase in the cost of living.

2.Cost-Push Theory: As the production costs of goods and services increase,

then the companies are forced to increase the prices of the goods and
services. This causes inflation in the economy.
This type of inflation is caused due to various reasons such as:
● Increase in price of inputs
● Hoarding and Speculation of commodities
● Defective Supply chain
● Increase in indirect taxes
● Depreciation of Currency
● Crude oil price fluctuation
● Defective food supply chain
 ● Low growth of Agricultural sector
● Food Inflation
● Interest rates increased by RBI
Cost pull inflation is considered bad among the two types of inflation. Because
the National Income is reduced along with the reduction in supply in the Cost-
push type of inflation.
3. Monetary Inflation Theory: According to this theory, the increase in prices is
due to the excessive supply of money in the market. This causes the value of
money to drop, and the prices go up.c
4. Built-in Inflation
This type of inflation involves a high demand for wages by the workers which
the firms address by increasing the cost of goods and services for the customers.
Classification of Inflation or type of inflation
Now, let us take a look at the classification of inflation in an economy. Some of
the most prominent classifications of inflation is as follows,
1] Creeping Inflation
Creeping inflation also known as mild inflation is as the name suggests a very
slow rise in the prices of goods and services. If the prices increase by 3% or less
annually, then such inflation is creeping inflation. Such inflation is not harmful
to the economy. In fact, as per the Federal Reserve, a 2% inflation rate is
desirable. It is necessary for the economic growth of a country.
2] Walking Inflation
In this case, the inflation rate falls between 3% to 10%. Such inflation can be
harmful to the economy. The economic growth of the country is too accelerated
to sustain. Consumers start stocking goods fearing the prices will rise further.
This causes excess demand and the prices increase further.
3] Galloping Inflation
When creeping and walking inflation are left unchecked, the rate of inflation
will rise above 10%. This is galloping inflation. The currency of the country
will lose value in the global economy. The salaries and income of common
people will not be able to keep up with the ever-increasing prices of
commodities. This will lead to the general instability of the economy and the
country as a whole.
4] Hyperinflation
Next in the classification of inflation is hyperinflation. This when the inflation
is completely out of control. No measures taken by the monetary authorities can
control the prices. The rate of inflation can be 50% on a monthly basis. This is
the last stage of inflation. A real-world example is that of Venezuela, where the
IMF has predicted prices rose 13,000% in 2018.

Effects of Inflation on the economy

Here are some of the most prominent effects of inflation on the economy –
Effects on production
The rise in prices of goods and services stimulates its production. As producers
are happy to get high profits, they utilize all resources to produce more.
However, after reaching the stage of total employment, production stops at a
certain point as all resources are fully used. This gives rise to the cornering and
hoarding of commodities. Although, these effects are not always seen. Whereas,
even after increasing prices, production comes to a still position. This condition
is referred to as stagflation.

Effects on employment and income

Another significant impact of inflation is seen on income and employment. As
production and spending increase, the national income also increases. Also, it
gives rise to employment opportunities as there is a higher need for workers.
However, the income of the people falls because of the massive fall in
the purchasing power of money.
Effects on business and trade
Because of factors like high income, enormous spending, and more outstanding
production, internal trade increases in the condition of inflation; however, some
firms expand their business to attain higher profits. During inflation, the prices
and the wages of the workers stop at a point, rising inequality in the economy.
Effects of government finance
During hyperinflation, the government revenue increases as they get revenue
in different forms. These include tax, sales tax, excise duties, and so on.
However, the government is expected to spend more; as a result, public
expenditure boosts. But the rise in prices reduces the burden of public debt.
Effects on growth
On the one hand, where mild inflation contributes to economic
growth, hyperinflation can negatively affect the development of an economy.
In developing countries like India, benign inflation is the ideal condition.
Conclusion
With this, we end the topic—short notes on the Effects of Inflation. Inflation is
a crucial topic that majorly deals with the increase in the prices of an economy
throughout a specified time. Every time the prices in an economy increase,
every currency unit buys comparatively lesser goods and services.
There are majorly three types of inflation which show different effects on
various sectors of life. Its effects are primarily seen in the Distribution of
Income and Wealth, Production, Income and Employment, Business and Trade,
Government Finance, and, lastly, the economy’s overall growth. It is believed
that in developing countries like India, mild inflation is the ideal condition.
Measures to Control Inflation
The government takes different measures to control inflation of different types
as explained below:
1.Monetary Measures
One of the commonly used measures to control inflation is controlling the
money supply in the economy. If the Government decreases the supply of
money, then the demand will fall, leading to a fall in prices.
2.Fiscal Policy Measures to Control Inflation
Apart from the monetary measures, the Government also uses fiscal measures to
control inflation. A country’s fiscal policy has two essential components –
Government revenue and expenditure.
Therefore, the Government can change the tax rates to increase its revenue or
manage its expenditure better.
Typically, when the aggregate demand exceeds the aggregate supply, an
inflationary gap arises. Therefore, the Government can take these fiscal
measures to control inflation:
1. Take steps to decrease the overall Government expenditure and
transfer payments
2. Increase the rate of taxes causing individuals to decrease their total
expenditure, leading to a decrease in demand and a drop in the money
supply in the economy.
The government can also use a combination of the two to obtain a reasonable
control over inflation.
3.Cost-Push Inflation Control
In order to control cost-push inflation, the Government uses direct control
measures. These include steps like freezing the wages of workers, putting upper
limits on the prices of important inputs like electricity, coal, steel, etc.
While these steps can control the extent of inflation, it is not a good ploy for the
long-term. At the end of the day, identifying the cause of inflation is the best
way to control it.
Some other measures to control inflation
These are:
● Increasing imports to augment the supplies of commodities in the
domestic market
● Increasing domestic production, etc.

Difference Between Inflation and Deflation

Inflation and deflation are two commonly used terms in Macroeconomics.
These two phenomena are experienced by almost every country in the world. It
can be said that inflation and deflation are two sides of the same coin.
Inflation is referred to as the situation when the price level of goods and
services rises, which leads to a decrease in the purchasing power in the
economy or in other words decreases the buying power of the money.
Inflation is characterized by two conditions, (1) there is always a steady or
sustained rise in the prices of goods and services, which is not seasonal and has
a tendency of continuing for a long time (2) the impact is felt across most of the
sectors of the economy.
Deflation is the exact opposite of inflation. In this condition, the price level of
goods and services decrease exponentially which results in an increase of the
buying power of the money. In other words, in case of deflation, the people in
an economy are able to purchase more quantities of products with limited
amounts of money.
Let us look at some of the points of difference between inflation and deflation.
Inflation Deflation

Definition

Inflation is defined as the increase in the Deflation is termed as the decrease in price
price levels of goods and services in an levels of goods and services in an economy
economy

Impact on demand

Demand for products and services increase Demand for products and services decrease
in inflation in deflation.

Impact on National Income

No impact on national income National income declines as a result of

deflation

Consequences seen

Distribution of income is not equal as a There is a rise in level of unemployment in

result of inflation the nation as a result of deflation

Is it beneficial?

Moderate levels of inflation is considered Calculated based on only the amount that is
good for the economy availed

Impact on Purchasing Power of Money

Decreases the purchasing power of money Increases the purchasing power of money
What is Deflation?
Deflation is a decrease in the general price level of goods and services. Put
another way, deflation is negative inflation. When it occurs, the value
of currency grows over time. Thus, more goods and services can be purchased
for the same amount of money.

Causes of Deflation
Economists determine the two major causes of deflation in an economy as (1) a
fall in aggregate demand and (2) an increase in aggregate supply.
The fall in aggregate demand triggers a decline in the prices of goods and
services. Some factors leading to a decline in aggregate demand are:
1. Fall in the money supply
A central bank may use a tighter monetary policy by increasing interest rates.
Thus, people, instead of spending their money immediately, prefer to save more
of it. In addition, increasing interest rates lead to higher borrowing costs, which
also discourages spending in the economy.
3. Decline in confidence
Negative events in the economy, such as recession, may also cause a fall in
aggregate demand. For example, during a recession, people can become more
pessimistic about the future of the economy. Subsequently, they prefer to
increase their savings and reduce current spending.
An increase in aggregate supply is another trigger for deflation. Subsequently,
producers will face fiercer competition and be forced to lower prices. The
growth in aggregate supply can be caused by the following factors:
4. Lower production costs
A decline in price for key production inputs (e.g., oil) will lower production
costs. Producers will be able to increase production output, which will lead to
an oversupply in the economy. If demand remains unchanged, producers will
need to lower their prices on goods to keep people buying them.
5. Technological advances
Advances in technology or the rapid application of new technologies in
production can cause an increase in aggregate supply. Technological advances
will allow producers to lower costs. Thus, the prices of products will likely go
down.
Effects of Deflation
Frequently, deflation occurs during recessions. It is considered an adverse
economic event and can cause many negative effects on the economy,
including:
Increase in unemployment
During deflation, the unemployment rate will rise. Since price levels are
decreasing, producers tend to cut their costs by laying off their employees.
Increase in the real value of debt
Deflation is associated with an increase in interest rates, which will cause an
increase in the real value of debt. As a result, consumers are likely to defer their
spending.
Deflation spiral
This is a situation where decreasing price levels trigger a chain reaction that
leads to lower production, lower wages, decreased demand, and even lower
price levels. During a recession, the deflation spiral is a significant economic
challenge because it further worsens the economic situation.
Trade cycle

Trade cycles refer to regular fluctuations in the level of national income. It is

a well-observed economic phenomenon, though it often occurs on a generally
upward growth path and has a variable time span, typically of three years. In
trade cycles, there are upward swings and then downward swings in business.
The four important features of Trade Cycle are (i) Recovery, (ii) Boom, (iii)
Recession, and (iv) Depression!
(1) Recovery:
In the early period of recovery, entrepreneurs increase the level of investment
which in turn increases employment and income. Employment increases
purchasing power and this leads to an increase in demand for consumer goods.
(2) Boom:
The rate of investment increases still further. Owing to the spread of a wave of
optimism in business, the level of production increases and the boom gathers
momentum. More investment is possible only through credit creation. During a
period of boom, the economy surpasses the level of full employment and enters
a stage of over full employment.
(3) Recession:
The orders for raw materials are reduced on the onset of a recession. The rate of
investment in producers’ goods industries and housing construction declines.
Liquidity preference rises in society and owing to a contraction of money
supply, the prices falls. A wave of pessimism spreads in business and those
markets which were sometime before sellers markets become buyer’s markets
now.
(4) Depression:
The main feature of a depression is a general fall in economic activity.
Production, employment and income decline. The prices fall and the main factor
responsible for it is, a fall in the purchasing power.
________________________________________________________