WHAT IS INFLATION???

 Inflation is the state when the value of money is

falling and there is an upward rise in price level.
 Too much of money chasing, but very few goods.

 For example, if the inflation rate is 5% for a particular

item, it means that the demand is 5% more than the total
supply of that particular item.
Inflation occurs when the AVERAGE price level (that is,
prices in general) increases over time. This does NOT
mean that ALL prices increase the same, nor that ALL
prices necessarily increase. Some prices might increase a
lot, others a little, and still other prices decrease or remain
unchanged. Inflation results when the AVERAGE of these
assorted prices follows an upward trend.
Cost Push Inflation
Cost-push inflation occurs when businesses respond to rising production costs, by raising prices
in order to maintain their profit margins. Higher costs shift a firms supply curve upwards and
lead to an increase in price. There are many reasons why costs might rise:

Rising imported raw materials costs perhaps caused by inflation in countries that are heavily
dependent on exports of these commodities or alternative by a fall in the value of the rupee in the
foreign exchange markets which increases the $ price of imported inputs .

Rising labor costs - caused by wage increases which exceed any improvement in
productivity. This cause is important in those industries, which are labour-intensive. If labor
costs amount for example to 25% of a firms total costs then a 10% increase in the total wage bill
will cause the firms total costs to rise by 2.5%. Firms may decide not to pass these higher costs
onto their customers (they may be able to achieve some cost savings in other areas of the
business) but in the long run, wage inflation tends to move closely with general price inflation

Higher indirect taxes imposed by the government for example a rise in the specific duty on
alcohol and cigarettes, an increase in fuel duties or perhaps a rise in the standard rate of Value
Added Tax or an extension to the range of products to which VAT is applied. These taxes are
levied on producers who, depending on the price elasticity of demand and supply for their
products can opt to pass on the burden of the tax onto consumers. For example, if the
government was to choose to levy a new tax on aviation fuel, then this would contribute to a rise
in cost-push inflation.
Profit Push Inflation: In an economy in which so called administered prices abound there is
at least the possibility that these prices may be administered upward faster than cost in an
attempt to earn greater profits.
To the extent such a process is wide-spread profit-push inflation will result.” Profit-push
inflation is, therefore, also called administered-price theory of inflation or price-push inflation
or sellers’ inflation or market-power inflation
Demand Pull Inflation
Demand-pull inflation is likely when there is full employment of resources and short run aggregate
supply is inelastic. In these circumstances an increase in AD will lead to a general increase in prices.

Average Demand might rise for a number of reasons some of which occur together at the same
moment of the economic cycle

A depreciation of the exchange rate, which increases the price of imports and reduces the foreign
price of exports. If consumers buy fewer imports, while foreigners buy more exports, AD will
rise. If the economy is already at full employment, prices are pulled upwards.

A reduction in direct or indirect taxation. If direct taxes are reduced consumers have more
disposable income causing demand to rise. A reduction in indirect taxes will mean that a given
amount of income will now buy a greater real volume of goods and services. Both factors can take
aggregate demand and real GDP higher and beyond potential GDP.

The rapid growth of the money supply perhaps as a consequence of increased bank and building
society borrowing if interest rates are low and consumer confidence is high. Monetarist economists
believe that the root causes of inflation are monetary in particular when the monetary authorities
permit an excessive growth of the supply of money in circulation beyond that needed to finance the
volume of transactions produced in the economy.
Faster economic growth in other countries providing a boost to exports overseas.
Remember that export sales provide an extra flow of income and spending into the
circular flow. Exports are counted as an injection of AD.

Increase in Disposable Income:

When the disposable income of the people increases, it raises their demand for goods and
services. Disposable income may increase with the rise in national income or reduction
in taxes or reduction in the saving of the people.

Increase in Public Expenditure:

Government activities have been expanding much with the result that government
expenditure has also been increasing at a phenomenal rate, thereby raising aggregate
demand for goods and services.
 EFFECTS OF INFLATION
HARMFUL EFFECT

Increase in Cost of living:

The working class are hard hit. Wages do not rise at the rate pricing are rising. Those sections of
society who have fixed incomes, find difficulty in buying their daily needs.

Income inequalities increases:

When prices rises, businessmen and big landlords makes huge money, the distribution of income
among various classes of society become more unequal
The effects of inflation on different groups of society are discussed below:

(1) Debtors and Creditors:

During periods of rising prices, debtors gain and creditors lose. When prices rise, the value of
money falls. Though debtors return the same amount of money, but they pay less in terms of goods
and services. This is because the value of money is less than when they borrowed the money.
Thus the burden of the debt is reduced and debtors gain. On the other hand, creditors lose. Although
they get back the same amount of money which they lent, they receive less in real terms because the
value of money falls. Thus inflation brings about a redistribution of real wealth in favour of debtors
at the cost of creditors.
(2) Salaried Persons:
Salaried workers such as clerks, teachers, and other white collar persons lose when there is
inflation. The reason is that their salaries are slow to adjust when prices are rising.
(3) Wage Earners:
Wage earners may gain or lose depending upon the speed with which their wages adjust to rising
prices. If their unions are strong, they may get their wages linked to the cost of living index. In this
way, they may be able to protect themselves from the bad effects of inflation.
EFFECTS OF INFLATION ON PRODUCTION:

(1) Misallocation of Resources:

Inflation causes misallocation of resources when producers divert resources from the production
of essential to non-essential goods from which they expect higher profits.
(2) Reduction in Production:
Inflation adversely affects the volume of production because the expectation of rising prices along
with rising costs of inputs brings uncertainty. This reduces production.
(3) Fall in Quality:
Continuous rise in prices creates a seller’s market. In such a situation, producers produce and sell
sub-standard commodities in order to earn higher profits. They also indulge in adulteration of
commodities.
(4) Hoarding and Black-marketing:
To profit more from rising prices, producers hoard stocks of their commodities. Consequently, an
artificial scarcity of commodities is created in the market. Then the producers sell their products
in the black market which increase inflationary pressures.
(5) Reduction in Saving:
When prices rise rapidly, the propensity to save declines because more money is needed to buy
goods and services than before. Reduced saving adversely affects investment and capital
formation. As a result, production is hindered.
Inflation leads to a number of other effects which are discussed as under:
(1) Government:
Inflation affects the government in various ways. It helps the government in financing its activities through
inflationary finance. As the money income of the people increases, the government collects that in the form of
taxes on incomes and commodities. So the revenues of the government increase during rising prices.
(2) Balance of Payments:
Inflation involves the sacrificing of the advantages of international specialisation and division of labour. It
adversely affects the balance of payments of a country. When prices rise more rapidly in the home country than
in foreign countries, domestic products become costlier compared to foreign products. This tends to increase
imports and reduce exports, thereby making the balance of payments unfavourable for the country. This happens
only when the country follows a fixed exchange rate policy. But there is no adverse impact on the balance of
payments if the country is on the flexible exchange rate system.
(3) Exchange Rate:
When prices rise more rapidly in the home country than in foreign countries, it lowers the exchange rate in
relation to foreign currencies.
(4) Collapse of the Monetary System:
If hyperinflation persists and the value of money continues to fall many times in a day, it ultimately leads to the
collapse of the monetary system, as happened in Germany after World War I.
(5) Social. Inflation is socially harmful:
By widening the gulf between the rich and the poor, rising prices create discontentment among the masses.
Pressed by the rising cost of living, workers resort to strikes which lead to loss in production. Lured by profit,
people resort to hoarding, black-marketing, adulteration, manufacture of substandard commodities, speculation,
etc. Corruption spreads in every walk of life. All this reduces the efficiency of the economy.
(6) Political:
Rising prices also encourage agitations and protests by political parties opposed to the government. And if they
gather momentum and become unhandy they may bring the downfall of the government. Many governments
have been sacrificed at the alter of inflation
GOOD EFFECTS

Healthy effects of inflation on the economy are felt only when the inflation is of mild nature ( say 2%
per annum)

Increase in production:
When prices are rising slowly, the profits of the businessmen and industrialists are increasing slowly.
They try to produce more goods.

Increase in Employment:
Because of high prices of production, firms try to increase their production and employ more
labors.

Increase in investment: With the improvement of profits, investment activity is boosted. The
investors readily put their capital in Businesses

Increase in Economic Development: Low inflation is helpful for Economic Development. The
Government Increases resources by increasing money supply.

Innovations and Research are encouraged : When industry is expanded, business activities
accelerates. The producers allocate funds to research and innovations
 Measures to control inflation
1. Monetary measures- Classical economists are of the view that inflation can be checked by
controlling the supply of money. Some of the important monetary measures to check the
inflation are as under:
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
reserved 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 a very effective measure. But is inequitable for it hurts the small
depositors the most.
 2.Fiscal measures- Measures taken by the government to control inflation.

 Decrease in public expenditure- One of the main reasons of inflation is

excess public expenditure like building of roads ,bridges etc. Government
should drastically scale down its non essential expenditure.

 Delay in payment of old debts: Payment of old debts that fall due should be
postponed for sometime so that people may not acquire extra purchasing
power.

 Increase in taxes : Government should levy some new direct taxes and raise
rates of old taxes.

 Over valuation of money: To control the over valuation of money it is

essential to encourage imports and discourage exports
 Other measures
1 Increase in the production- One of the major causes of the inflation is the excess of
demand over supply ,so those goods should be produced more whose prices are likely to rise
rapidly .In order to increase production public sector should be expanded and private sector
should be given more incentives.
2 Proper commercial policy- Those goods which are in scarcity should be imported as much as
possible from other countries and their export should be discouraged.
3 Encouragement to savings –During inflation government should come out with attractive
saving schemes. It may issue 5 or 10 year bonds in order to attract savings.
4 Proper investment policy- Investment in those industries should be increased wherein more
production of goods can be generated over a short period of time Less investment should be made
in industries having long production period.
5 Marginal requirements- It is the difference between the value of security and loan advanced .
MEASURES OF INFLATION
 Inflation is measured by calculating the percentage
rate of change of a price index, which is called the
inflation rate.
 This rate is calculated by mainly two different price
indices:
 1. Wholesale price index
 2. Consumer price index
 WHOLESALE PRICE INDEX
 WPI is the index that is used to measure
the change in the average price level of
goods traded in wholesale market.
 India uses the WPI to calculate and then
decide the inflation rate in the economy.
 WPI does not properly measure the exact
price rise an end-consumer will experience
because, as the name suggests, it is at the
wholesale level.
CONSUMER PRICE INDEX
 CPI is a measure of a weighted average of
prices of a specified set of goods and
services purchased by consumers.

 It is a price index that tracks the prices of

a specified basket of consumer goods and
services, providing a measure of inflation.

 Most developed countries uses this index