CONTENTS

PARTICULARS PAGE NUMBER

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Inflation
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How inflation is measured? •

Causes of inflation •

Effect of inflation
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Methods to control
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1. INFLATION

Inflation can be defined as a rise in the general price level and therefore a fall

in the value of money. Inflation occurs when the amount of buying power is

higher than the output of goods and services. Inflation also occurs when the

amount of money exceeds the amount of goods and services available. As to

whether the fall in the value of money will affect the functions of money

depends on the degree of the fall. Basically, refers to an increase in the

supply of currency or credit relative to the availability of goods and services,

resulting in higher prices.

Therefore, inflation can be measured in terms of percentages. The

percentage increase in the price index, as a rate per cent per unit of time,

which is usually in years. The two basic price indexes are used when

measuring inflation, the producer price index (PPI) and the consumer price

index (CPI) which is also known as the cost of living index number.
2. HOW INFLATION IS MEASURED?

Inflation is normally given as a percentage and generally in years or in some

instances quarterly and is derived from the Consumer Price Index (CPI).

However, there are two main indices used to measure inflation. The first is the

Consumer Price Index, or the CPI. The CPI is a measure of the price of a set

group of goods and services. The "bundle," as the group is known, contains

items such as food, clothing, gasoline, and even computers. The amount of

inflation is measured by the change in the cost of the bundle: if it costs 5%

more to purchase the bundle than it did one year before, there has been a 5%

annual rate of inflation over that period based on the CPI. You will also often

hear about the "Core Rate" or the "Core CPI." There are certain items in the

bundle used to measure the CPI that are extremely volatile, such as gasoline

prices. By eliminating the items that can significantly affect the cost of the

bundle (in either direction) on a month-to-month basis, the Core rate is

thought to be a better indicator of real inflation, the slow, but steady increase

in the price of goods and services.

When there is a general rise in prices at very low rates, which is usually

between 2-4 percent annually, this is known as creeping inflation.

Whereas, trotting inflation occurs when the percentage has risen from 5 to

almost percent. At this level it is a warning signal for most governments to

take measures to avoid exceeding double- digit figures.

Another type of inflation is the galloping inflation, where the rate of inflation is

increasing at a noticeable speed and at a remarkable rate, usually from 10-20

percent.

However, when the inflation rate rises to over 20% it is generally considered

as hyper inflation and at this stage it is almost uncontrollable because it

increases more rapidly in such a little time frame.

The main difference between the galloping and hyper inflation, is

that hyperinflation occurs when prices rise at any moment and

there is no level to which the prices might rise.

During World War II certain countries experienced a hyperinflation, where the

price index rose from 1 to over 1,000,000,000 in Germany during January

1922 to November 1923.

3. CAUSES OF INFLATION

Inflation comes in different forms and those at are familiar with the economic

matters would observe that there are trends in the way that prices are moving

gradual and irregular in relation to aggregate sections of the economy. This

suggest that there is more than one factor that causes inflation and as

different sections of the economy develop it gives rise to different types

inflationary periods. The main causes of inflation are:

− Demand-pull Inflation

− Cost push Inflation

− Monetary inflation

− Structural inflation

− Imported inflation

DEMAND-PULL INFLATION

Demand-pull inflation occurs when the consumers, businesses or the

governments’ demand for goods and services exceed the supply; therefore

the cost of the item rises, unless supply is perfectly elastic. Because we do

not live in a perfect market supply is somewhat inelastic and the supply of

goods and services can only be increased if the factors of production are

increased.

The increase in demand is created from in increase in other areas, such as

the supply of money, the increase of wages which would then give rise in

disposable income, and once the consumers have more disposal income this

would lead to aggregate spending. As a

result of the aggregate spending there would also be an increase in demand

for exports and possible hoarding and profiteering from producers. The

excessive demand, the prices of final goods and services would be forced to

increase and this increase gives rise to inflation.

COST-PUSH INFLATION

Cost-push inflation is caused by an increase in production costs. It is

generally caused by an increase in wages or an increase in the profit margins

of the entrepreneurs.

When wages are increased, this causes the business owner to in turn

increase the price of final goods and services which would be passed onto the

consumers and the same consumers are also the employees. As a result of

the increase in prices for final goods and services the employees realise that

their income is insufficient to meet their standard of living because the basic

cost of living has increased. The trade unions then act as the mediator for the

employees and negotiate better wages and conditions of employment. If the

negotiations are successful and the employees are given the requested wage

increase this would further affect the prices of goods and services and

invariably affected.

On the other hand, when firms attempt to increase their profit margins by

making the prices more responsive to supply of a good or service instead of

the demand for that said good or service. This is usually done regardless to

the state of the economy. This can be seen in monopolistic economies where

the firm is the only

supplier or by entrepreneurs that are seeking a larger profit for their own self

interests.

MONETARY INFLATION

Monetary inflation occurs when there is an excessive supply of money. It is

understood that the government increases the money supply faster than the

quantity of goods increases, which results in inflation. Interestingly as the

supply of goods increase the money supply has to increase or else prices

actually go down.

When a dollar is worth less because the supply of dollars has increased, all

businesses are forced to raise prices just to get the same value for their

products.

STRUCTURAL INFLATION

Planned inflation that is caused by a government's monetary policy is called

structural inflation. This type of inflation is not caused by the excess of

demand or supply but is built into an economy due to the government’s

monetary policy.

In developed countries they are characterized by a lack of adequate

resources like capital, foreign exchange, land and infrastructure. Furthermore,

over-population with the majority depending on agriculture for their livelihood

means that there is a fragmentation of the land holdings. There are other

institutional factors like land-ownership, technological backwardness and low

rate of investment in agriculture. These features are typical of the developing

economies. For example, in developing country where

the majority of the population live in the rural areas and depend on agriculture

and the government implements a new industry, some people get

employment outside the agricultural sector and settle down in urban areas.

Because there might be an unequal distribution of land ownership and

tenancy, technological backwardness and low rates of investments in

agriculture inclusive of inadequate growth of the domestic supply of food

which corresponds with an increase in demand arising from increasing

urbanization and population prices increase.

Food being the key wage-good, an increase in its price tends to raise other

prices as well. Therefore, some economists consider food prices to be the

major factor, which leads to inflation in the developing economies.

IMPORTED INFLATION

Another type of inflation is imported inflation. This occurs when the inflation of

goods and services from foreign countries that are experiencing inflation are

imported and the increase in prices for that imported good or service will

directly affect the cost of living. Another way imported inflation can add to our

inflation rate is when overseas firms increase their prices and we pay more for

our goods increasing our own inflation.

4. EFFECT OF INFLATION

Inflation can have positive and negative effects on an economy.

Negative effects of inflation include loss in stability in the real

value of money and other monetary items over time; uncertainty

about future inflation may discourage investment and saving, 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 a mitigation of economic recessions, and

debt relief by reducing the real level of debt.

Most effects of inflation are negative, and can hurt individuals and companies

alike, below are a list of negative and “positive” effects of inflation:

NEGATIVE EFFECTS ARE:

 Hoarding (people will try to get rid of cash before it is devalued, by

hoarding food and other commodities creating shortages of the hoarded

objects).

 Distortion of relative prices (usually the prices of goods go higher,

especially the prices of commodities).

 Increased risk - Higher uncertainties (uncertainties in business always

exist, but with inflation risks are very high, because of the instability of prices).

 Income diffusion effect (which is basically an operation of income

redistribution).

 Existing creditors will be hurt (because the value of the money they will

receive from their borrowers later will be lower than the money they gave

before).

 Fixed income recipients will be hurt (because while inflation increases,

their income doesn’t increase, and therefore their income will have less value

over time).

 Increased consumption ratio at the early stages of inflation (people will be

consuming more because money is more abundant and its value is not

lowered yet).

 Lowers national saving (when there is a high inflation, saving money would

mean watching your cash decrease in value

day after day, so people tend to spend the cash on

something else).
 Illusions of making profits (companies will think they were making profits

while in reality they’re losing money if they don’t take into consideration the

inflation rate when calculating profits).

 Causes an increase in tax bracket (people will be taxed a higher

percentage if their income increases following an inflation increase).

 Causes mal-investment (in inflation times, the data given about an

investment is often deceptive and unreliable, therefore causing losses in

investments).

 Causes business cycles (many companies will have to go out of business

because of the losses they incurred from inflation and its effects).

 Currency debasement (which lowers the value of a currency, and

sometimes cause a new currency to be born)

 Rising prices of imports (if the currency is debased, then it’s purchasing

power in the international market is lower).

"POSITIVE" EFFECTS OF INFLATION ARE:

 It can benefit the inflators (those responsible for the inflation)

 It be benefit early and first recipients of the inflated money

(because the negative effects of inflation are not there yet).

 It can benefit the cartels (it benefits big cartels, destroys

small sellers, and can cause price control set by the cartels

for their own benefits).

5. METHODS TO CONTROL

A high inflation rate is undesirable because it has negative consequences.

However, the remedy for such inflation depends on the cause. Therefore,

government must diagnose its causes before implementing policies.

MONETARY POLICY

Inflation is primarily a monetary phenomenon. Hence, the most logical

solution to check inflation is to check the flow of money supply by devising

appropriate monetary policy and carefully implementing such measures. To

control inflation, it is necessary to control total expenditures because under

conditions of full employment, increase in total expenditures will be reflected

in a general rise in prices, that is, inflation. Monetary policy is used to control

inflation and is based on the assumption that a rise in prices is due to excess

of monetary demand for goods and services by the consumers/households e

because easy bank credit is available to them. Monetary policy, thus, pertains

to banking and credit availability of loans to firms and households, interest

rates, public debt and its management, and the monetary standard. Monetary

management is aimed at the commercial banking systems, and through this

action, its effects are primarily felt in the economy as a whole. By directly

affecting the volume of cash reserves of the banks, can regulate the supply of

money and credit in the economy, thereby influencing the structure of interest

rates and the availability of credit. Both these, factors

A high inflation rate is undesirable because it has negative consequences.

However, the remedy for such inflation depends on the cause. Therefore,

government must diagnose its causes before implementing policies.

MONETARY POLICY

Inflation is primarily a monetary phenomenon. Hence, the most logical

solution to check inflation is to check the flow of money supply by devising

appropriate monetary policy and carefully implementing such measures. To

control inflation, it is necessary to control total expenditures because under

conditions of full employment, increase in total expenditures will be reflected

in a general rise in prices, that is, inflation. Monetary policy is used to control

inflation and is based on the assumption that a rise in prices is due to excess

of monetary demand for goods and services by the consumers/households e

because easy bank credit is available to them. Monetary policy, thus, pertains

to banking and credit availability of loans to firms and households, interest

rates, public debt and its management, and the monetary standard. Monetary

management is aimed at the commercial banking systems, and through this

action, its effects are primarily felt in the economy as a whole. By directly

affecting the volume of cash reserves of the banks, can regulate the supply of

money and credit in the economy, thereby influencing the structure of interest

rates and the availability of credit. Both these, factors

affect the components of aggregate demand and the flow of

expenditure in the economy.

The central bank’s monetary management methods, the devices for

decreasing or increasing the supply of money and credit for monetary stability

is called monetary policy. Central banks generally use the three quantitative

measures to control the volume of credit in an economy, namely:

1. Raising bank rates

2. Open market operations and

3. Variable reserve ratio

However, there are various limitations on the effective working of the

quantitative measures of credit control adapted by the central banks and, to

that extent, monetary measures to control inflation are weakened. In fact, in

controlling inflation moderate monetary measures, by themselves, are

relatively ineffective. On the other hand, drastic monetary measures are not

good for the economic system because they may easily send the economy

into a decline.

In a developing economy there is always an increasing need for credit.

Growth requires credit expansion but to check inflation, there is need to

contract credit. In such an encounter, the best course is to resort to credit

control, restricting the flow of credit into the unproductive, inflation-infected

sectors and speculative activities, and diversifying the flow of credit towards

the most desirable needs of productive and growth-inducing sector.

It should be noted that the impression that the rate of spending can be

controlled rigorously by the contraction of credit or money supply is wrong in

the context of modern economic societies. In modern community, tangible,

wealth is typically represented by claims in the form of securities, bonds, etc.,

or near moneys, as they are called. Such near moneys are highly liquid

assets, and they are very close to being money. They increase the general

liquidity of the economy. In these circumstances, it is not so simple to control

the rate of spending or total outlays merely by controlling the quantity of

money. Thus, there is no immediate and direct relationship between money

supply and the price level, as is normally conceived by the traditional quantity

theories.

When there is inflation in an economy, monetary restraints can, in conjunction

with other measures, play a useful role in controlling inflation.

FISCAL MEASURES

Fiscal policy is another type of budgetary policy in relation to taxation, public

borrowing, and public expenditure. To curve the effects of inflation and

changes in the total expenditure, fiscal measures would have to be

implemented which involves an increase in taxation and decrease in

government spending. During inflationary periods the government is

supposed to counteract an increase in private spending. It can be cleared

noted that during a period of full employment inflation, the aggregate demand
in relation to the limited supply of goods and services is reduced to the extent

that government expenditures are shortened.

Along with public expenditure, governments must simultaneously increase

taxes that would effectively reduce private expenditure, in an effect to

minimise inflationary pressures. It is known that when more taxes are

imposed, the size of the disposable income diminishes, also the magnitude of

the inflationary gap in regards to the availability of the supply of goods and

services.

In some instances, tax policy has been directed towards restricting demand

without restricting level of production. For example, excise duties or sales tax

on various commodities may take away the buying power from the consumer

goods market without discouraging the level of production. However, some

economists point out that this is not a correct way of combating inflation

because it may lead to a regressive status within the economy.

As a result, this may lead to a further rise in prices of goods and services, and

inflation can spread from one sector of the economy to another and from one

type of goods and services to another.

Therefore, a reduction in public expenditure, and an increase in taxes

produces a cash surplus in the budget. Keynes, however, suggested a

programme of compulsory savings, such as deferred pay as an anti-

inflationary measure. Deferred pay indicates that the consumer defers a part

of his or her wages by buying savings bonds (which, of course, is a sort of

public borrowing), which are

redeemable after a particular period of time, this is sometimes called forced

savings.

Additionally, private savings have a strong disinflationary effect on the

economy and an increase in these is an important measure for controlling

inflation. Government policy should therefore, include devices for increasing

savings. A strong savings drive reduces the spendable income of the

consumers, without any harmful effects of any kind that are associated with

higher taxation.

Furthermore, the effects of a large deficit budget, which is mainly responsible

for inflation, can be partially offset by covering the deficit through public

borrowings. It should be noted that it is only government borrowing from non-

bank lenders that has a disinflationary effect. In addition, public debt may be

managed in such a way that the supply of money in the country may be

controlled. The government should avoid paying back any of its past loans

during inflationary periods, in order to prevent an increase in the circulation of

money. Anti-inflationary debt management also includes cancellation of public

debt held by the central bank out of a budgetary surplus.

Fiscal policy by itself may not be very effective in combating inflation;

therefore a combination of fiscal and monetary tools can work together in

achieving the desired outcome.

DIRECT MEASURES OF CONTROL

Direct controls refer to the regulatory measures undertaken to convert an

open inflation into a repressed one.

Such regulatory measures involve the use of direct control on prices and

rationing of scarce goods. The function of price control is a fix a legal ceiling,

beyond which prices of particular goods may not increase. When ceiling

prices are fixed and enforced, it means prices are not allowed to rise further

and so, inflation is suppressed.

Under price control, producers cannot raise the price beyond a specified level,

even though there may be a pressure of excessive demand forcing it up. For

example, during wartimes, price control was used to suppress inflation.

In times of the severe scarcity of certain goods, particularly, food grains,

government may have to enforce rationing, along with price control. The main

function of rationing is to divert consumption from those commodities whose

supply needs to be restricted for some special reasons; such as, to make the

commodity more available to a larger number of households. Therefore,

rationing becomes essential when necessities, such as food grains, are

relatively scarce. Rationing has the effect of limiting the variety of quantity of

goods available for the good cause of price stability and distributive

impartiality. However, according to Keynes, “rationing involves a great deal of

waste, both of resources and of employment.”

Another control measure that was suggested is the control of wages as it

often becomes necessary in order to stop a wage-price spiral. During

galloping inflation, it may be necessary to apply a wage-profit freeze. Ceilings

on wages and profits keep down disposable income and, therefore the total

effective demand for goods and services.

On the other hand, restrictions on imports may also help to increase supplies

of essential commodities and ease the inflationary pressure. However, this is

possible only to a limited extent, depending upon the balance of payments

situation. Similarly, exports may also be reduced in an effort to increase the

availability of the domestic supply of essential commodities so that inflation is

eased. But a country with a deficit balance of payments cannot dare to cut

exports and increase imports, because the remedy will be worse than the

disease itself.

In overpopulated countries like India, it is also essential to check the growth of

the population through an effective family planning programme, because this

will help in reducing the increasing pressure on the general demand for goods

and services. Again, the supply of real goods should be increased by

producing more. Without increasing production, inflation just cannot be

controlled.

Some economists have even suggested indexing in order to minimise certain

ill-effects of inflation. Indexing refers to monetary

Another control measure that was suggested is the control of wages as it

often becomes necessary in order to stop a wage-price spiral. During

galloping inflation, it may be necessary to apply a wage-profit freeze. Ceilings

on wages and profits keep down disposable income and, therefore the total

effective demand for goods and services.

On the other hand, restrictions on imports may also help to increase supplies

of essential commodities and ease the inflationary pressure. However, this is

possible only to a limited extent, depending upon the balance of payments

situation. Similarly, exports may also be reduced in an effort to increase the

availability of the domestic supply of essential commodities so that inflation is

eased. But a country with a deficit balance of payments cannot dare to cut

exports and increase imports, because the remedy will be worse than the

disease itself.

In overpopulated countries like India, it is also essential to check the growth of

the population through an effective family planning programme, because this

will help in reducing the increasing pressure on the general demand for goods

and services. Again, the supply of real goods should be increased by

producing more. Without increasing production, inflation just cannot be

controlled.

Some economists have even suggested indexing in order to minimise certain ill-effects of

inflation. Indexing refers to monetary