Inflation | Types of Inflation and Causes of inflation | Measures to Control Inflation

What is inflation? types of inflation, causes  of inflation, how to control inflation 

Meaning:

A continuing rise in the general price level over a period of time is called inflation, Conversely, a continuing fall in the general price level would be called deflation. Inflation is a situation of the economic process where prices rising within the economy and a decrease in the purchasing power of the currency.   

Inflation is measured in terms of a price index and price index is the average price of different goods and services during a given period of time in an economy. In India, we have the wholesale price index (WPI) and the consumer price index (CPI). Inflation is a rate of change in the price level of goods and services.

According to Keynes increases in money supply beyond the full employment level, output comes to an end to rise, and prices rise in proportion with the money supply.

Types of inflation: 

  1. Creeping inflation: When the price rate increases by less than three percent per annum, it is known as creeping inflation.
  2. Walking Inflation: When the inflation rate crosses the three percent but remains within single digits that are below 10 percent, it is known as walking inflation. Walking inflation affects the purchasing power of money. Walking inflation may be a sign for the government to manage it before it turns into double-digit.
  3. Running inflation:  When the inflation rate is in double digits, it is called running inflation. When prices start increasing by more than 10 percent per annum and the rate of inflation accelerates, money begins to flow away from productive activities into unproductive or speculative activities that lead to falling in the supply of goods and services in an economy.   Running inflation affects the poor and middle class, strong economic policy may control running inflation.
  4. Hyperinflation and Galloping inflation: When the rate of prices increases rapidly at double or triple-digit rates from 20 percent to 100 percent per annum it's known as a runaway or galloping inflation.  Both galloping and hyperinflation is a sign of the collapse of the economy and absolutely uncontrollable.  For example, In 2008, the inflation rate in Zimbabwe was 11.2 million percent. 

Causes of Demand-Pull inflation:

  • Demand-pull inflation is additionally called demand-side inflation, Demand-pull inflation takes place due to the increase in aggregate demand. Aggregate demand may increase due to the higher demand by various sectors of the economy such as firms, households, and the government.
According to Keynesians, aggregate demand may rise due to a rise in consumer demand or investment demand, or government expenditure to meet the civil and military requirements of the country.  Thus the aggregate demand comprises consumption, investment, and government expenditure.
  • When aggregate demand is rising but the available supply of goods is less either because resources are fully utilized or production cannot be increased in a short period rapidly to satisfy the increasing demand. As a result, prices may start increasing.
  • Repayment of Public Debt: debt is a common feature of modern government. When public debt rises people have more income at their disposal. Additional disposal income ends to lift the demand for goods and services.

  • Black Money: Social and economic evils like corruption, evasion, smuggling, and other illegal activities create black money and It affects demand and thus price level.
  • Increase in population: the scale of the population is one of the important determinants of demand. In developing countries like India where demand rises rapidly than supply because of the large population.

Causes of Demand-Pull inflation
  • In the above diagram, X-axis indicates aggregate demand, and the Y-axis indicates supply curves are measured at the general price level.
  • The aggregate supply curve AS increases upward initially and later becomes vertical when the full employment level of output is achieved at point OY. This is often because the availability of output can't be increased once the full employment level of output is achieved. 
  • When the aggregate demand curve is AD1, the equilibrium is less than the full employment level and the price level OP1 is determined. When aggregate demand increases to AD2, the price level rises to OP2 due to more demand at price level OP1. Since the economy is operating at less than the full employment level, the real sector of the economy responds to the rise in prices, and hence the output increases to OY2. 
  • When the aggregate demand further rises to AD3, the price
  • the level rises to OP3 followed by an increase in output to OYf. When the aggregate demand further rises to AD4, the aggregate supply doesn't respond to remain constant at OYf and only the price level rises to OP4. After the full employment level of output, the aggregate supply curve becomes perfectly inelastic and parallel to the Y-axis.

Cost-Push Inflation

  1. Cost-push inflation is also known as stagflation. Inflation need not necessarily flow from a rise in demand. Prices may rise even when demand doesn't increase. It's also possible that prices may increase even when the economy experiences a decline in demand. Here the most cause is a rise in cost.
  2. An increase within the prices of inputs including labour, an increase in the margin of profit by business firms, and a monopoly in the factor market may increase prices as they are in an exceedingly position to influence the supply price.
  3. Supply shocks like a decline in foodstuff supply because of monsoon failure, oil crisis experienced in the 1970s and thereafter due to crude oil cartel (OPEC), shortage due to natural calamities may affect the value of supply.
  4. Wage-push Inflation:  prices rise due to an increase in wages rate demanded by the Powerful trade unions, it's known as d wage-push inflation. Wages rate increases because of many factors like improvements in productivity or higher margin of profit. The higher wages rate burden shifted to consumption in the form of higher prices that leads to cost-push inflation.
  5. Profit-push Inflation: Firms operating under imperfect market conditions like monopoly, monopolistic, and oligopoly markets may increase their profit margins either autonomously or through collusion. When prices rise on due increase in profit margins, it is known as profit-push inflation.  Profit push inflation may lead to cost-push inflation if the products are used as inputs by other firms.
  6. Input Cost Inflation: cost of production may rise when input prices rise because of scarcity-natural or artificial. Natural calamities like drought or floods adversely affect the supplies of raw material.  Supply shocks leading to rising in input costs are an important cause of input-cost inflation. For example, the oil price shocks of the 1970s. The sharp rise in world oil prices during 1973-75 and in 1979-80 created supply shocks and cost-push inflation. Recent increases in the prices of crude oil also caused the inflation rate to go up.
    Cost Push Inflation
  • In the above fig.16.2, the initial price OP1 is determined by the interaction of demand (AD) and Supply (AS1) at point A, the output level Y1, which we may assume as full employment output.
  • Supply curves shift up to the left side because of the rise in cost.
  • The new supply curve AS2 intersects the demand curve at point B, which shows increasing-price P2.
  • As the supply curve shifts further to the left, price rises, and output falls. This rise in price is mainly because of the cost-push factor.

Measures to control inflation

There mainly three measure such as Monetary Measures, Fiscal measures, Other measures so let discuss in details:

Monetary Measures

  1. Credit Control: One of the important measures is monetary policy. The central bank adopts various methods to control the quantity and quality of credit in an economy. For this purpose, it increases the bank rates, sells the securities within the open market, increases the cash reserve ratio, and adopts various selective credit control measures, like increasing margin requirements and regulating line of credit.
  2. Bank rate policy: Bank rate charged by the Central Bank from commercial banks for rediscounting the bills of exchange or for loans. When the bank rate increases, the interest rate of the commercial banks will also increase. As a result, the borrower has to pay a high rate of interest and demand will be less. By changes in bank rates, RBI affects the rate of interest within the money market.
  3. Open Market Operations: When the Reserve Bank of India(RBI)  buys and sells securities n the open market is known as an open market operation.  RBI sells the security to the general public, to collect excess liquidity from the market. and on other hand, RBI purchases securities from the market to distribute liquidity in the market. It leads to credit creation.
  4. Cash Reserve Ratio: It means the proportion of the total deposit which commercial banks have to keep with the Central bank. When the CCR is increased, the cash reserve of commercial banks will reduce which successively will reduce the lending capacity of banks. This may result in a decrease in the volume of credit creation by the bank. This policy is adopted during inflation.
  5. Margin Requirement: A bank requires security against loan sanctioned like gold, a house. No bank gives loans 100 percent of security. For Example, a person presents a security of ₹ 2 lakh then he may be given a loan up to ₹175, 000 or less. This difference between the actual value and sectioned value is known as margin. central bank directs the commercial bank to keep a lower margin against loans towards agriculture etc.
  6. The ceiling on Credit: It means fixing a limit for the various types of loans given by commercial banks.
  7. Demonetization of currency: On 8 November 2016, the Government of India announced the demonetization of all ₹500 and ₹1,000 banknotes to control black money in the country.
  8. Issue of new currency: On 8 November 2016, the Government of India announced the issuance of new ₹500 and ₹2,000 banknotes in exchange for the demonetized banknotes. Such measures are adopted when there is an excessive issue of notes and there's hyperinflation in the economy. 

Fiscal measures

  1. Reduction in Expenditure: The government should reduce the unnecessary expenditure on non-development activities so as to regulate inflation.
  2. Increase in Taxes: The tax rate of personal, corporate, and commodity should be increased to cut personal consumption expenditure, but the rates of taxes should not be so high that discourage saving, investment, and production. The government should penalize the nonpayment by imposing heavy fines. Such a measure is effective in controlling inflation.
  3. Increase in Savings: Increasing savings will reduce personal consumption expenditure. According to Keynes, the saver gets his money back after some years. The government should increase the interest rate on public loans, saving schemes with prize money for long periods provident fund, pension schemes, etc. increases savings, which helps in effective controlling inflation.
  4. Surplus budget: It means collecting more revenue and spending less. The Government should quit deficit financing so as to have surplus budgets. 
  5. Public debt: The Government should stop repayment of debt and postpone it to a future date till inflationary pressure is controlled within the economy. 

Other measures

  1. To increase production: One of the important measures to regulate inflation is to increase the production of essential consumer goods such as clothing, sugar, vegetable oil, etc.
  2. Rational wages policy: Under hyperinflation, the government should freeze wages, income, profits, dividends bonuses, etc. for a short period to control inflation.
  3. Price control: It means fixing an upper limit for the prices of the essential commodities. 

  1. Explain the types of inflation based on rates and their impact on the economy.
  2. Explain the measures to control inflation
  3. Explain the concept of Cost-push inflation and the factors causing Cost-push inflation.
  4. Explain the demand and supply-side factors affecting inflation

Edited by: Imaduddin Khan (BMS, MA in Business Economics,M.Com)  

Reference: Manan Prakashan and M.L Jhingan microeconomics

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