INFLATION

Unit -3 , HML351
MEANING OF INFLATION
• Inflation is when the prices of goods and services persistently increase over a
period of time. Inflation is a sustained increase in the overall price level in the
economy, which reduces the purchasing power of a Rupee. On the other hand,
inflation rate is the percentage increase in the overall price level from one period
to the next.

• Inflation is a process of rising prices (and not a state of high prices) showing a
state of disequilibrium between the aggregate supply and the aggregate demand at
the current level of prices. In other words, prices rise due to an increase in money
supply compared to the supply of goods. (QUANTITY THEORY OF MONEY
APPROACH)

• [Note: Any rise in price level should not be taken to mean inflation, as prices in a dynamic economy do rise
on account of various factors.]
Keynes Point of View: Inflation and Unemployment
nexus
• Keynes does not agree with the quantity theory approach that it is the volume of
money that is responsible for price rise. According to Keynes, inflation is caused
by an excess of effective demand.
• Keynes introduced a new concept called the inflationary gap.
 The inflationary gap shows a situation in the economy when anticipated expenditures (demand) exceed the
available output (supply) at base prices or at the pre-inflation prices.

 In other words, when on account of increased investment expenditure or government expenditure or both,
money income rises, but due to limitations of the capacity to produce, the supply of goods and services does
not increase in the same proportion, an inflationary gap emerges, giving rise in prices.

 Keynes believed that this inflationary gap has to be lowered by reducing the excess purchasing power with
the help of appropriate tax measures, or voluntary or compulsory saving by the people.
SALIENT FEATURES OF INFLATION
1) Inflation is always accompanied by rise in prices and it is, in fact, uninterrupted increase in prices.

2) Inflation is essentially an economic phenomenon as it originates within the economic system md is fed by the
action and interaction of economic forces.

3) Inflation is a dynamic process which can be observed more or less over a long period.

4) A cyclical movement should not be confused with inflation.

5) Inflation is a monetary phenomenon as it.is generally caused by excessive money suppIy.(QUANTITY

THEORY APPROACH VIEWPOINT)

6) Pure inflation start after full-employment.(When effective demand is more than effective supply.) –KEYNES
VIEWPOINT
TYPES OF INFLATION
• 1. Demand-Pull Inflation 2. Cost-Push Inflation
#Demand Pull Inflation:

• Demand Pull Inflation is mainly due to increase in Aggregate demand. The increase in Aggregate demand
mainly comes from either increase in Government Expenditure (Expansionary Fiscal Policy) or by an
increase in expenditure from Households and Firms.
The root cause of demand pull inflations is- Aggregate demand > Aggregate Supply. This means that the firms
in the economy are not capable of producing the goods and services demanded by the households in the present
time period. The shortages of goods and services due to increase in demand fuels inflation.
• Economy is at full employment level ----- Government pursues expansionary fiscal policy -Since
economy is already at Full Employment level, so Aggregate Supply can’t be increased further -- AD rises
(through income rise)---- Prices rises due to inflationary gap
• #2.Cost Push Inflation/Supply Shock Inflation: It occurs when the cost of
production increases. Increase in prices of the inputs (labour, raw materials, etc.)
increases the price of the product.

• Cost-push inflation happens when the cost of factors of production or inputs

within the economy goes up, and nothing can easily be substituted for it.

• Cost-push inflation often happens when outside suppliers of a key product or

service increase their costs, and the importing economy is forced to pay higher
prices.
• Therefore, It is caused mainly by three factors : i) an increase in wage rate, ii) an
increase in profit margin, or iii) an increase in material costs.
• Stated in terms of the aggregate demand and aggregate supply
functions, the cost-push inflation emerges in the economy due to the
pressure of various factors that shift the aggregate supply function
upward.
#3Built-in Inflation:
• Expectation of future inflations results in Built-in Inflation. A rise in
prices results in higher wages to afford the increased cost of living.
• Therefore, high wages result in increased cost of production, which in
turn has an impact on product pricing. The circle hence continues.
• It occurs when workers expect their salaries or wages to increase when
prices of goods and services increase to help maintain their living
costs.
• Because of certain principles of macroeconomics, such as what is
known as the price-wage spiral, this inflation never went away.
Instead, built-in inflation becomes an expected part of the economy.
• However, built-in inflation doesn’t happen on its own. It can either be
influenced by demand-pull inflation or cost-push inflation.
• The triangle model is employed by new Keynesian economics and
given its name by Robert J. Gordon (1988). The model views inflation
as having three root causes: built-in inflation, demand-pull inflation,
and cost-push inflation.
CONTROL OF INFLATION

• Control of inflation should involve monetary and fiscal steps aiming at

reducing the level of aggregate demand so as to equate it with the full
employment output in the economy. The level of investment or
consumption or both may be curtailed by increasing the number and
the rates of direct and indirect taxes and by raising the rate of interest.
• The-measures for controlling inflation can be divided into three broad categories :
i) monetary measures, 2) fiscal measures, and 3) direct controls and other
measures.

• 1) Monetary measures : The central bank of the country can curb inflation by
restricting the supply of money and credit with the help of three important
measures available to it. They are bank rate policy, open market operations, and
varying the reserve requirements of the member banks. Monetary measures,
however, are not very effective in underdeveloped countries which lack a well
developed and integrated money market.
• Monetary policy is, however, subject to limitations and it alone cannot succeed in curbing
the difficult problem of inflation.

• 2)Fiscal Measures- Government should try to mop up, through taxation, as much
purchasing power as possible without adverse effects in incentives to enterprises and
investment. For this,

Devising a suitable tax policy directed towards restricting demand without discouraging
production is a fiscal measure which can control inflation. Private savings have a strong dis-
inflationary effect. The government should take measures to promote private savings. The
government should avoid paying back any of its past loans during inflationary periods so as
to prevent an increase in the circulation of money.
• Keynes suggested a programme of compulsory saving like deferred pay or forced
savings to control inflation.

• Deferred pay implies that a part of the pay of the workers is credited to their
savings account and would not be available for spending so long as the inflation
lasts. Such compulsory saving schemes are expedient during wartime or during
post-war hyperinflation, but are not practicable in peace time, particularly in
democratic societies.
3.Direct controls : Many countries have adopted direct measures to
control inflation. These include price control and rationing of essential
commodities. Rationing and price control, however, have not been very
effective in underdeveloped countries because of lack of competent and
honest machinery to administer such measures. These have often led to
the disappearance of goods in the market giving scope for black
marketing, bribery and corruption.
Classification based on the Degree of Price Rise
• On the basis of the rapidity with which prices increase, inflation may be divided into
four types : 1) creeping inflation, 2) walking inflation, 3) running inflation and 4)
jumping or galloping or hyperinflation.
• Creeping inflation is the most mild form of inflation and some economists do not
consider it to be dangerous for the economy. In fact, some economists consider it to
be an important instrument of economic development. It is argued that it keeps the
national economy free from the effects of stagnation. However, some economists
believe that mild inflation may ultimately become hyperinflation.
• In the case of walking inflation, the rise in prices becomes more marked as
compared with the situation obtained under creeping inflation. In fact, it is a danger
signal of the occurrence of running and jumping inflation under which the rise in
prices takes place at a faster rate.
• In hyper or galloping inflation, prices rise every moment, and there is no limit to the
height to which the prices might rise.
Hyperinflation is an indication of the highest degree of abnormality in the monetary
system of a country. Under the conditions of such an inflation, all assets having a
fixed income lose their real value.
Conclusion
Inflation is easy to control in its initial stages. Beyond a stage, it starts
feeding on itself and the inflationary problem assumes such dimensions
that it becomes very difficult to control.