Inflation

Economics

Inflation is the sustained rise in the general price level of goods and services in an economy over a period of time, leading to a decline in the purchasing power of money.Inflation is a rise in the general level of prices of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services. Therefore, inflation also reflects an erosion of purchasing power of money. According to Crowther, “Inflation is State in which the Value of Money is Falling and the Prices are rising.”

Terms:-

Deflation

It is when the general level of prices is falling. It is the opposite of inflation. The lack of inflation may be an indication that the economy is weakening.

Disinflation

It is slower rate of inflation. It means that there is still rise in prices but overall rate is slow.

Hyperinflation

It is unusually rapid inflation in very short span of time. In extreme cases, this can lead to the breakdown of a nation’s monetary system with complete loss of confidence in the domestic currency.

Stagflation

It is the combination of high unemployment with high inflation. This happened in industrialized countries during the 1970s, when a bad economy was combined with raising oil prices led to low growth.

Skewflation

It means that some sectors are facing inflation while other sectors of economy do not. For example food prices may rise due to increase in prices of onion and tomatoes, whereas prices of other commodities remain same.

Head Line Inflation

It is a measure of total inflation in an economy. In India, Consumer Price Index Combined (CPI -C) represents Headline Inflation.

Core Inflation

Core Inflation is Headline Inflation minus the food and fuel inflation. Core Inflation is also known as underlying inflation. It is a reflection of longterm inflationary trend in the economy.

Reflation

It is a fiscal or monetary policy enacted after a period of economic slowdown or contraction. Here the goal is to expand output, stimulate spending and curb the effects of deflation. Reflation policies can include reducing taxes, changing the money supply and lowering interest rates.

Philips Curve

It is a curve which provides relationship between inflation and unemployment. As per the Philips curve, there is inverse relationship between Inflation and Unemployment. The underlying logic behind the Phillips curve is that wages are quite inflexible in a market economy so unemployment is bound to shoot up whenever workers refuse to accept lower wages.

Base Effect

The base effect refers to the impact of the rise in price level (last year’s inflation) in the previous year over the corresponding rise in price levels in the current year (current inflation). When a change in the index in the base period has a considerable effect on the measured inflation, this is called base effect of inflation.

Types of Inflation

1. Demand-Pull Inflation

When price rise because aggregate demand in an economy is greater than the aggregate supply of goods and services. This rise in demand is such that it cannot be met by currently available supply of output. Demand for goods and services exceeds available supply. Thus, there is a situation where too much money chasing few goods and services. This rise in demand will lead to a rise in price levels resulting in Demand-Pull Inflation.

2. Cost Pull Inflation

When price rise because aggregate supply in an economy declines or is lower than the aggregate demand of goods and services. This decline in aggregate supply is majorly due to rise in production cost.

3. Structural Factors

It means that inflation is due to structural factors. For example under developed transportation sector will increase logistic cost and will result in overall increase in prices of commodities.

Measurement of Inflation

Inflation is measured by calculating the percentage rate of change of a price index, which is called the inflation rate. Inflation is often measured either in terms of Wholesale Price Index or in terms of Consumer Price Index.

Wholesale Price Index:

The Wholesale Price Index is an indicator designed to measure the changes in the price levels of commodities that flow into the wholesale trade intermediaries. It is a basis for price adjustments in business contracts and projects. It is also intended to serve as an additional source of information for comparisons on the international front. Published by the Office of Economic Adviser, Ministry of Commerce and Industry. WPI does not capture changes in the prices of services, which CPI does. WPI, tracks inflation at the producer level and CPI captures changes in prices levels at the consumer level.

Consumer Price Index:

It shows the cost of living of the group. It is based on the changes in the retail prices of goods or services. Based on their incomes, consumer spends money on these articular set of goods and services. There are different consumer price indices. Each index racks the changes in the retail prices for different set of consumers.

Four types of CPI are as follows:

CPI for Industrial Workers (IW).
CPI for Agricultural Labourer (AL).
CPI for Rural Labourer (RL).
CPI (Rural/Urban/Combined).

Of these, the first three are compiled by the Labour Bureau in the Ministry of Labour and Employment. Fourth is compiled by the Central Statistical Organisation (CSO) in the Ministry of Statistics and Programme Implementation.

GDP Deflator

It is a measure of general price inflation. It is calculated by dividing nominal GDP by real GDP and then multiplying by 100. Nominal GDP is the market value of goods and services produced in an economy, unadjusted for inflation (It is the GDP measured at current prices). Real GDP is nominal GDP, adjusted for inflation to reflect changes in real output (It is the GDP measured at constant prices). GDP Deflator = (GDP at Current Prices/GDP at constant Price) * 100 GDP deflator is much broader measure of inflation than CPI and WPI. GDP deflator reflects the prices of all domestically produced goods and services in the economy whereas, other measures like CPI and WPI are based on a limited basket of goods and services, thereby not representing the entire economy. Further, WPI does not include services whereas, GDP deflator includes Services. GDP deflator also includes the prices of investment goods, government services and exports, and excludes the price of imports.

Effects of Inflation

On Investment: Inflation discourages entrepreneurs in investing as the risk involved in the future production would be very high with less hope for returns. Inflation also results in black marketing. Sellers may stock up the goods to be sold in the future, anticipating further price rise. Those living off a fixed-income, such as retirees, see a decline in their purchasing power and, consequently, their standard of living. If the inflation rate is greater than that of other countries, domestic products become less competitive. On Exchange rate and trade: There can also be negative impacts to trade from an increased instability in currency exchange prices caused by unpredictable inflation. On Taxes: Higher income tax rates on taxpayers. Government incurs high fiscal deficit due to decreased value of tax collections. On Export and balance of trade: Inflation rate in the economy is higher than rates in other countries then this will increase imports and reduce exports, leading to a deficit in the balance of trade.

Measures to control inflation

Fiscal policy by Government involves manipulation in tax/subsidy rate to control Inflation Monetary policy can control the growth of demand through an increase in interest rates and a contraction in the real money supply. Monetary measures of controlling the inflation can be either quantitative or qualitative. Bank rate policy, open market operations and variable reserve ratio are the quantitative measures of credit control, by which inflation can be brought down. Qualitative control measures involve selective credit control measures.

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Subject: Economics

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