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Dinesh Basnet (117) Ritesh Mishra


In economics, 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.
Consequently, inflation also reflects an erosion in the purchasing power of money – a loss of real value in
the internal medium of exchange and unit of account in the economy. A chief measure of price inflation is
the inflation rate, the annualized percentage change in a general price index (normally the Consumer
Price Index) over time.

Inflation's effects on an economy are various and can be simultaneously positive and negative. Negative
effects of inflation include a decrease in the real value of money and other monetary items over time,
uncertainty over future inflation may discourage investment and savings, and high inflation may lead to
shortages of goods if consumers begin hoarding out of concern that prices will increase in the future.
Positive effects include ensuring central banks can adjust nominal interest rates (intended to mitigate
recessions), and encouraging investment in non-monetary capital projects.

Economists generally agree that high rates of inflation and hyperinflation are caused by an excessive
growth of the money supply.Views on which factors determine low to moderate rates of inflation are
more varied. Low or moderate inflation may be attributed to fluctuations in real demand for goods and
services, or changes in available supplies such as during scarcities, as well as to growth in the money
supply. However, the consensus view is that a long sustained period of inflation is caused by money
supply growing faster than the rate of economic growth.

Today, most mainstream economists favor a low, steady rate of inflation. Low (as opposed to zero or
negative) inflation may reduce the severity of economic recessions by enabling the labor market to adjust
more quickly in a downturn, and reduce the risk that a liquidity trap prevents monetary policy from
stabilizing the economy. The task of keeping the rate of inflation low and stable is usually given to
monetary authorities. Generally, these monetary authorities are the central banks that control the size of
the money supply through the setting of interest rates, through open market operations, and through the
setting of banking reserve requirements.


 According to Crowther, “Inflation is a state of generally rising prices and falling value of
 According to Shapiro, “Inflation is a persistent and appreciable rise in the general level of prices.”
 According to Pigou, “By inflation exists when money income is expanding more than the amount
of goods and services.”

Broadly speaking from the definitions of inflation as given above, we imply three main schools of
thought regarding the nature of inflation.
1. Demand-pull phenomenon
2. Cost-push phenomenon
3. Structural phenomenon


Inflation is usually estimated by calculating the inflation rate of a price index, usually the Consumer Price
Index. The Consu.mer Price Index measures prices of a selection of goods and services purchased by a
"typical consumer". The inflation rate is the percentage rate of change of a price index over time.

For instance, in January 2007, the U.S. Consumer Price Index was 202.416, and in January 2008 it was
211.080. The formula for calculating the annual percentage rate inflation in the CPI over the course of
2007 is

The resulting inflation rate for the CPI in this one year period is 4.28%, meaning the general level of
prices for typical U.S. consumers rose by approximately four percent in 2007.


Inflation can be classified on various basis. Some of the classifications are discussed as under:

Open Inflation:

When government does not attempt to restrict inflation, it is known as Open Inflation. In a free market
economy, where prices are allowed to take its own course, open inflation occurs.

Suppressed Inflation:

When government prevents price rise through price controls, rationing, etc., it is known as Suppressed
Inflation. It is also referred as Repressed Inflation. However, when government controls are removed,
Suppressed inflation becomes Open Inflation. Suppressed Inflation leads to corruption, black marketing,
artificial scarcity, etc.

Creeping Inflation:

When prices are gently rising, it is referred as Creeping Inflation. It is the mildest form of inflation and
also known as a Mild Inflation or Low Inflation. According to R.P. Kent, when prices rise by not more
than (up to) 3% per annum (year), it is called Creeping Inflation.
Chronic Inflation:

If creeping inflation persist (continues to increase) for a longer period of time then it is often called as
Chronic or Secular Inflation. Chronic Creeping Inflation can be either Continuous (which remains
consistent without any downward movement) or Intermittent (which occurs at regular intervals). It is
called chronic because if an inflation rate continues to grow for a longer period without any downturn,
then it possibly leads to Hyperinflation.

Walking Inflation:

When the rate of rising prices is more than the Creeping Inflation, it is known as Walking Inflation. When
prices rise by more than 3% but less than 10% per annum (i.e. between 3% and 10% per annum), it is
called as Walking Inflation. According to some economists, walking inflation must be taken seriously as
it gives a cautionary signal for the occurrence of running inflation. Furthermore, if walking inflation is not
checked in due time it can eventually result in Galloping inflation.

Moderate Inflation:

Prof. Samuelson clubbed together concept of Crepping and Walking inflation into Moderate Inflation.
When prices rise by less than 10% per annum (single digit inflation rate), it is known as Moderate
Inflation. According to Prof. Samuelson, it is a stable inflation and not a serious economic problem.

Running Inflation:

A rapid acceleration in the rate of rising prices is referred as Running Inflation. When prices rise by more
than 10% per annum, running inflation occurs. Though economists have not suggested a fixed range for
measuring running inflation, we may consider price rise between 10% to 20% per annum (double digit
inflation rate) as a running inflation.

Galloping Inflation:

According to Prof. Samuelson, if prices rise by double or triple digit inflation rates like 30% or 400% or
999% per annum, then the situation can be termed as Galloping Inflation. When prices rise by more than
20% but less than 1000% per annum (i.e. between 20% to 1000% per annum), galloping inflation occurs.
It is also referred as Jumping inflation. India has been witnessing galloping inflation since the second five
year plan period.

Hyper Inflation:

Hyperinflation refers to a situation where the prices rise at an alarming high rate. The prices rise so fast
that it becomes very difficult to measure its magnitude. However, in quantitative terms, when prices rise
above 1000% per annum (quadruple or four digit inflation rate), it is termed as Hyperinflation. During a
worst case scenario of hyperinflation, value of national currency (money) of an affected country reduces
almost to zero. Paper money becomes worthless and people start trading either in gold and silver or
sometimes even use the old barter system of commerce. Two worst examples of hyperinflation recorded
in world history are of those experienced by Hungary in year 1946 and Zimbabwe during 2004-2009
under Robert Mugabe's regime.

1. Quantity theory of money

Excessive money supply growth can also be a cause of inflation. The quantity theory of money explains
why this happens.

The classical economist’s view of inflation revolved around this theory, and this theory was in turn
derived from the Fisher Equation of Exchange. This equation says that:



M is the amount of money in circulation

V is the velocity of circulation of that money

P is the average price level, and

T is the number of transactions taking place

The equation is in fact an identity/truism. It says that the amount of the money stock times the rate at
which it is used for transactions will be equal to the number of those transactions times the price of each
transaction. It will always be true, as it simply says that National Income will be equal to National
Expenditure and basic macroeconomics tells us that this is true anyway. So nothing stunning there!
However, what makes it important is what classical economists predicted from it.

Classical economists suggested that V would be relatively stable and T would always tend to full
employment. Therefore they came to the conclusion that:


In other words increases in the money supply would lead to inflation. The message was simple; control
the money supply to control inflation.
2. Demand pull Inflation

Demand-pull inflation happens when the level of aggregate demand grows faster than the underlying
level of supply. This may be easier to imagine, if you think of supply as the level of capacity. If our
capacity to produce is growing at 3%, and the level of demand grows at the same rate or slower then we
don't have a problem. We can produce all we need. However, if our capacity grows at 3%, but demand
grows faster, then we have a problem. In effect we have 'too much money chasing too few goods', and we
can't manage to produce all we need. Something has to give, and it is prices that are forced up, therefore
causing inflation. We can see all this in the diagram below. As the aggregate demand curve shifts to the
right, the price level rises - inflation.

There are a variety of possible reasons for the increased aggregate demand, and to look at these in more
detail we need to look at the components of aggregate demand. Aggregate demand is made up of all
spending in the economy. It is:

AD = C + I + G + (X-M) 
where C is consumer expenditure, I is investment, G is government expenditure, X is exports and M is

An increase in aggregate demand could therefore be because consumers are spending more, perhaps
because interest rates have fallen, taxes have been cut or simply because there is a greater level of
consumer confidence. It could be because firms are investing more in the expectation of future economic
growth. It could be that the government is boosting spending on defence, health, and education and so on.
Or it could be because there is a boom in UK exports to overseas. Whatever it is, it will be inflationary if
demand grows faster than supply.

It would be nice to stop at that point and claim we have understood demand-pull inflation, but it's not that
simple. As you'll have spotted by now, economists are not specialists in simple solutions! There are
differences between economists about the causes of demand changes, and as if that weren't enough, there
are also differences on the effects these changes have.
The effect of a shift in aggregate demand depends on the shape of the aggregate supply curve, and this is
where economists particularly differ. There are two particular views; Keynesian and Classical. Few
economists would fall totally into one camp or the other, but the main differences are given below.

Classical economists

Classical economists have a fundamental belief in free markets - a 'laissez-faire' economy. They believe
that left to itself, the economy will find its own full-employment equilibrium. In other words, there is no
point in the government trying to manipulate the economy to get full-employment, it will make its own
way there in the long run. The key to this is in the way they assume the labour market works. If the
economy is below full-employment, then the following will happen:

Unemployment (a surplus of labour)   wages fall   more labour is employed  full-employment is


This process happens automatically thanks to the market mechanism, so there is no need for the
government to intervene in the long run. This means that the long run aggregate supply curve will be

Any attempt by the government to boost aggregate demand in the long run using reflationary policies will
simply be inflationary as it will shift the AD curve straight up a vertical AS curve.

In the short run they acknowledge that the AS curve will be upward sloping because of diminishing
returns, but any reflationary policy will still be stoking up inflation for the future.
In this diagram we can see that the reflationary policy did shift aggregate demand to the right, which
increased real output in the short run, but in the long run the increase in prices wiped this out and there
was no overall increase in the real level of output.

Keynesian economists

Keynesian economists, not surprisingly, subscribe to the views of John Maynard Keynes, a famous
economist of the twentieth century. They have a different view of the workings of the labour market, and
would argue that it doesn't work perfectly. They believe that wages are 'sticky downwards'. This means
that any unemployment may not lead to wages falling. This in turn means that the unemployed do not get
re-employed. Getting rid of unemployment therefore means the government intervening to boost demand
enough to get those people employed again.

They argue that the long run and short run AS curves will be the same and that to reduce unemployment,
the government must use reflationary policies to boost the level of demand.
The difference between Classical and Keynesian policy can be summed up therefore in their approach.
The Classical economists argue for 'laissez-faire' or non-intervention, whereas Keynesians argue for
active intervention.

Talk to a Classical economist, and they will advise

'Don't just do something, sit there!'

while a Keynesian will advise

'Don't just sit there, do something!'

3.Cost Push Inflation

If costs rise too fast, companies will need to put prices up to maintain their margins. This will cause
inflation. Cost-push inflation happens when costs increase independently of aggregate demand. It is
important to look at why costs have increased, as quite often costs are increasing simply due to the
economy booming. When costs increase for this reason it is generally just a symptom of demand-pull
inflation and not cost-push inflation. For example, if wages are increasing because of a rapid expansion in
demand, then they are simply reacting to market pressures. This is demand-pull inflation causing cost

However, if wages rise because of greater trade union power pushing through larger wage claims - this is
cost-push inflation. Cost-push inflation is shown on the diagram below. The aggregate supply curve shifts
left because of the cost increase, therefore pushing prices up.

So why might costs get pushed up, causing inflation? There are a number of possible sources of rising

If trade unions gain more power, they may be able to push wages up independently of consumer demand.
Firms then face higher costs and are forced to increase their prices to pay the higher claims and maintain
their profitability.


If firms gain more power and are able to push up prices independently of demand to make more profit,
then this is considered to be cost-push inflation. This is most likely when markets become more
concentrated and move towards monopoly or perhaps oligopoly.

Imported inflation

We now work in a very global economy and many firms import a significant proportion of their raw
materials or semi-finished products. If the cost of these increases for reasons out of our control, then once
again firms will be forced to increase prices to pay the higher raw material costs. This could happen for
several reasons:

 Exchange rate changes - if there is a depreciation in the exchange rate, then our exports will
become cheaper abroad, but our imports will appear to be more expensive. Firms will be paying more for
their overseas raw materials.
 Commodity price changes - if there are price increases on world commodity markets, firms will
be faced with higher costs if they use these as raw materials. Important markets would include the oil
market and metals markets.
 External shocks - this could be either for natural reasons or because a particular group or country
has gained more economic power. An example of the first was the Kobe earthquake in Japan, which
disrupted world production of semi-conductors for a while. An example of the second was when OPEC
forced up the price of oil four-fold in the early 1970s.

Exhaustion of natural resources

As resources run out, their price will inevitably gradually rise. This will increase firms' costs and may
push up prices until they find an alternative source of raw materials (if they can). This has happened with
fish stocks. Over-fishing has put many types of fish and fish-based products under extreme pressure,
forcing their price up. In many countries equivalent problems have been caused by erosion of land when
forests have been cleared. The land quickly becomes useless for agriculture.


Changes in indirect taxes (taxes on expenditure) increase the cost of living and push up the prices of
products in the shops. An example would be when the level of VAT was increased from 8% to 15% in the
1979 Budget. Many saw this as a one off change in prices rather than triggering inflation in its true sense,
i.e. a general increase in the price level. The RPIY measure of inflation takes out the effect of indirect tax
changes to get a clearer picture of the true level of inflation.
4. Price expectations and inflation

there is a definite link between people's price expectations and the level of inflation, but there is a lot of
debate among economists on the exact nature of the link. Expectations can be an important determinant of
inflation, and this has increasingly been recognised by economists and policy-makers in recent years. As a
result, a lot of research has been done in this area. The trouble with economics is that the more work that
is done, the more muddled the picture can become. This is certainly true with expectations and there is
considerable disagreement between economists on what determines people's expectations.

Some years ago, research was done to see how many times the word 'recession' appeared in newspapers
and the press to see if there was any relationship between the expectation of a slowdown and it actually
happening. The results suggested that there did indeed appear to be some relationship between the two.
The idea was that as people began to expect a slowdown they would adjust their behaviour to
accommodate this and thus help to bring about the very problem they had feared! Further information on
this idea can be gained by looking at The Economist who maintain an 'R-word index'.

One of the main reasons expectations are important is because people take account of them in their wage
claims. If inflation is expected then people will include that in their claim to ensure that they get a real
wage increase. This increases firms' costs and so can in itself cause inflation.

If people believe that increases in the money supply will simply cause inflation, then any increase will
simply lead to inflation and no real increase in output or employment. This is because they will simply
anticipate the effects. This is essentially the monetarist position on expectations. The most extreme
version of this is rational expectations. The rational expectations school assume that people will look
simply at the present situation and take no account of the past. This means that they will instantly
anticipate the impact of any changes. The government therefore have no chance at all of getting away
with subtle changes to try to boost demand, as people will simply anticipate the inflationary impact, and
the changes will be useless.

The Keynesian position is that if people expect any expansion in demand to lead to an increase in output
and employment, then it will. This happens because firms will take on more people in anticipation of an
increased level of demand for their product.


There is often considered to be a trade-off between unemployment and inflation. The Phillips curve
shows this relationship.
The Phillips Curve is a relationship between unemployment and inflation discovered by Professor
A.W.Phillips. The relationship was based on observations he made of unemployment and changes in
wage levels from 1861 to 1957. He found that there appeared to be a trade-off between unemployment
and inflation, so that any attempt by governments to reduce unemployment was likely to lead to increased
inflation. This relationship was seen by Keynesians as a justification of their policies. However, in the
1970s the curve appeared to break down as the economy suffered from unemployment and inflation rising
together (stagflation).

The curve sloped down from left to right and seemed to offer policy makers with a simple choice - you
have to accept inflation or unemployment. You can't lower both. Or, of course, accept a level of inflation
and unemployment that seemed to be acceptable!

The existence of rising inflation and rising unemployment caused the government many problems and
economists struggled to explain the situation. One of the most convincing explanations came from Milton
Friedman - a monetarist economist. He developed a variation on the original Phillips Curve called the
expectations-augmented Phillips Curve.

Expectations-Augmented Phillips Curve

The Phillips Curve showed a trade-off between unemployment and inflation. However, the problem that
emerged with it in the 1970s was its total inability to explain unemployment and inflation going up
together - stagflation. According to the Phillips curve they weren't supposed to do that, but throughout the
1970s they did. Friedman then put his mind to whether this could be adapted to show why stagflation was
occurring, and the explanation he came up with was to include the role of expectations in the Phillips
Curve - hence the name 'expectations-augmented'. Once again the supreme logic of economics comes to
the fore!

Friedman argued that there were a series of different Phillips curves for each level of expected inflation.
If people expected inflation to occur then they would anticipate and expect a correspondingly higher wage
rise. Friedman was therefore assuming no 'money illusion' - people would anticipate inflation and
account for it. We therefore got the situation shown below:

Say the economy starts at point U with expected inflation at 0%, and the government decide that they
want to lower the level of unemployment because it is too high. They therefore decide to boost demand
by 5%. The attempt to reduce unemployment would primarily be through boosting aggregate demand
(AD) in some way. In the short run, the increase in AD would lead to a rise in national income and
subsequently we might expect unemployment to fall. This is represented by a movement along the Philips
curve to point V.

However, the adjustment period would also mean that there would be shortages in the economy which
would 'pull' prices up. The increase in these prices leads people to seek wage demands that give them a
'real' increase, i.e. is above inflation. Since inflation has risen people could reasonably be expected to
build an anticipated inflation rate into their wage demands. If these wage demands were granted (and in
the days of powerful trade unions and without the emphasis on global competition as there is now this
was very likely), the result would be increased costs for businesses. The increased costs caused the AS
curve to shift to the left and the economy would be at point W.

Firms would push up prices to maintain their profit margins or shed labour in response to the additional
demand and higher costs and the net result would be that the economy would be back to the
unemployment level it started with (U) but with a higher level of inflation (5%). (Note how we have used
the framework of AS/AD to explain the Phillips Curve - this shows how closely related the two things
are!) The increase in demand for goods and services will fairly soon begin to lead to inflation, and so any
increase in employment will quickly be wiped out as people realise that there hasn't been a real increase
in demand.

So having moved along the Phillips curve from U to V, the firms now begin to lay people off once again
and unemployment moves back to W. Next time around the firms and consumers are ready for this, and
anticipate the inflation.
If the government insist on trying again to reduce the unemployment the economy will do the same thing
(W to X to Y), but this time at a higher level of inflation. In future wage negotiations they may not push
just for a 5% increase in wages but 5% +! They might think that given that inflation had risen by 5% last
year it might rise by 8% next and so put in for a wage rise of 11% to ensure they get a real pay increase
plus cover themselves for any anticipated inflation.

Any attempt to reduce unemployment below the level U will simply be inflationary. For this reason the
rate U is often known as the Natural Rate of Unemployment.


In view of the serious repercussions of inflation on the economy following measures are taken to control

1. Monetary measures
2. fiscal measures
3. Other measures.
1. Monetary Measures

Monetary measures aim at reducing money incomes.

(a) Credit Control.

One of the important monetary measures is monetary policy. The central bank of the country adopts
a number of methods to control the quantity and quality of credit. For this purpose, it raises the bank
rates, sells securities in the open market, raises the reserve ratio, and adopts a number of selective
credit control measures, such as raising margin requirements and regulating consumer credit.
Monetary policy may not be effective in controlling inflation, if inflation is due to cost-push factors.
Monetary policy can only be helpful in controlling inflation due to demand-pull factors.

(b) Demonetization of Currency.

However, one of the monetary measures is to demonetize currency of higher denominations. Such a
measure is usually adopted when there is abundance of black money in the country.

(c) Issue of New Currency.

The most extreme monetary measure is the issue of new currency in place of the old currency. Under
this system, one new note is exchanged for a number of notes of the old currency. The value of bank
deposits is also fixed accordingly. Such a measure is adopted when there is an excessive issue of
notes and there is hyperinflation in the country. It is very effective measure. But is inequitable for its
hurts the small depositors the most.

2. Fiscal Measures
Monetary policy alone is incapable of controlling inflation. It should, therefore, be supplemented by
fiscal measures. Fiscal measures are highly effective for controlling government expenditure,
personal consumption expenditure, and private and public investment. The principal fiscal measures
are the following:
(a) Reduction in Unnecessary Expenditure.

The government should reduce unnecessary expenditure on non-development activities in order to

curb inflation. This will also put a check on private expenditure which is dependent upon
government demand for goods and services. But it is not easy to cut government expenditure.
Though economy measures are always welcome but it becomes difficult to distinguish between
essential and non-essential expenditure. Therefore, this measure should be supplemented by taxation.

(b) Increase in Taxes.

To cut personal consumption expenditure, the rates of personal, corporate and commodity taxes
should be raised and even new taxes should be levied, but the rates of taxes should not be so high as
to discourage saving, investment and production. Rather, the tax system should provide larger
incentives to those who save, invest and produce more. Further, to bring more revenue into the tax-
net, the government should penalize the tax evaders by imposing heavy fines. Such measures are
bound to be effective in controlling inflation. To increase the supply of goods within the country, the
government should reduce import duties and increase export duties.

(c) Increase in Savings.

Another measure is to increase savings on the part of the people. This will tend to reduce disposable
income with the people, and hence personal consumption expenditure. But due to the rising cost of living,
people are not in a position to save much voluntarily. Keynes, therefore, advocated compulsory savings or
what he called `deferred payment' where the saver gets his money back after some years. For this purpose,
the government should float public loans carrying high rates of interest, start saving schemes with prize
money, or lottery for long periods, etc. It should also introduce compulsory provident fund, provident
fund-cum-pension schemes, etc. compulsorily. All such measures to increase savings are likely to be
effective in controlling inflation.

(d) Surplus Budgets.

An important measure is to adopt anti-inflationary budgetary policy. For this purpose, the
government should give up deficit financing and instead have surplus budgets. It means collecting
more in revenues and spending less.

(e) Public Debt.

At the same time, it should stop repayment of public debt and postpone it to some future date till
inflationary pressures are controlled within the economy. Instead, the government should borrow
more to reduce money supply with the public.
Like the monetary measures, fiscal measures alone cannot help in controlling inflation. They should
be supplemented by monetary, non-monetary and non fiscal measures.

3. Other Measures

The other types of measures are those which aim at increasing aggregate supply and reducing aggregate
demand directly.

(a) To Increase Production.

The following measures should be adopted to increase production:

(i) One of the foremost measures to control inflation is to increase the production of essential
consumer goods like food, clothing, kerosene oil, sugar, vegetable oils, etc.
(ii) If there is need, raw materials for such products may be imported on preferential basis to
increase the production of essential commodities.
(iii) Efforts should also be made to increase productivity. For this purpose, industrial peace should be
maintained through agreements with trade unions, binding them not to resort to strikes for some
(iv) The policy of rationalization of industries should be adopted as a long-term measure.
Rationalization increases productivity and production of industries through the use of brain,
brawn and bullion.

(v) All possible help in the form of latest technology, raw materials, financial help, subsidies, etc.
should be provided to different consumer goods sectors to increase production.

(b) Rational Wage Policy.

Another important measure is to adopt a rational wage and income policy. Under hyperinflation, there is
a wage-price spiral. To control this, the government should freeze wages, incomes, profits, dividends,
bonus, etc. But such a drastic measure can only be adopted for a short period and by antagonizing both
workers and industrialists. Therefore, the best course is to link increase in wages to increase in
productivity. This will have a dual effect. It will control wage and at the same time increase productivity,
and hence production of goods in the economy.

(c) Price Control.

Price control and rationing is another measure of direct control to check inflation. Price control means
fixing an upper limit for the prices of essential consumer goods. They are the maximum prices fixed by
law and anybody charging more than these prices is punished by law. But it is difficult to administer
price control.

(d) Rationing.

Rationing aims at distributing consumption of scarce goods so as to make them available to a large
number of consumers. It is applied to essential consumer goods such as wheat, rice, sugar, kerosene oil,
etc. It is meant to stabilize the prices of necessaries and assure distributive justice. But it is very
inconvenient for consumers because it leads to queues, artificial shortages, corruption and black
marketing. Keynes did not favour rationing for it "involves a great deal of waste, both of resources and of

Conclusion. From the various monetary, fiscal and other measures discussed above, it becomes clear that
to control inflation, the government should adopt all measures simultaneously. Inflation is like a hydra-
headed monster which should be fought by using all the weapons at the command of the government.


DR.Raj Kumar, Prof. Kuldip Gupta


Joseph G. Nellis & David Parker

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