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.

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.

The second measure of inflation is the Producer Price Index, or the PPI. While the CPI

indicates the change in the purchasing power of a consumer, the PPI measures the change

in the purchasing power of the producers of those goods. The PPI measures how much

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producers of products are getting on the wholesale level, i.e. the price at which a good is

sold to other businesses before the good is sold to a consumer. The PPI actually combines

a series of smaller indices that cross many industries and measure the prices for three

types of goods: crude, intermediate and finished. Generally, the markets are most

concerned with the finished goods because these are a strong indicator of what will

happen with future CPI reports. The CPI is a more popular measure of inflation than the

PPI, but investors watch both closely.

Subsequently, when either the prices of goods or services or the supply of money rises;

this is considered as inflation. Depending on the characteristics and the intensity of

inflation, there are several types, namely.

Creeping inflation

Trotting inflation

Galloping inflation

Hyper inflation

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.

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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.

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.

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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

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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.

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Methods of 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 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

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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 a

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

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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.

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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

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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 corrections through periodic adjustments in money

incomes of the people and in the values of financial assets such as savings deposits,

which are held by them in relation to the degrees of price rise. Basically, if the annual

price were to rise to 20%, the money incomes and values of financial assets are enhanced

by 20%, under the system of indexing.

Indexing also saves the government from public wrath due to severe inflation persisting

over a long period. Critics, however, do not favour indexing, as it does not cure inflation

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but rather it encourages living with inflation. Therefore, it is a highly discretionary

method.

In general, monetary and fiscal controls may be used to repress excess demand but direct

controls can be more useful when they are applied to specific scarcity areas. As a result,

anti-inflationary policies should involve varied programmes and cannot exclusively

depend on a particular type of measure only.

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Other monetary phenomena

In Keynes’ view, rising prices in all situations cannot be termed as inflation. In a

condition of under-employment, when an increase in money supply and rising prices are

accompanied by the expansion of output and employment, but when1here are bottlenecks

in the economy, an increase in money supply may cause cost and prices to rise more than

the expansion of output and employment. This may be termed as “semi-inflation” or

“reflation” till the ceiling of full employment is reached. Once full employment level is

reached, the entire increase in money supply is reflected simply by the rising prices - the

real inflation.

Incidentally, Keynes mentions the following four related terms while discussing the

concept of inflation:

Deflation

Disinflation

Reflation

Stagflation

Deflation

It is a condition of falling prices accompanied by a decreasing level of employment,

output and income. Deflation is just the opposite of inflation. Deflation occurs when the

total expenditure of the community is not equal to the existing prices. Consequently, the

supply of money decreases and as a result prices fall. Deflation can also be brought about

by direct contractions in spending, either in the form of a reduction in government

spending, personal spending or investment spending. Deflation has often had the side

effect of increasing unemployment in an economy, since the process often leads to a

lower level of demand in the economy.  However, each and every fall in price cannot be

called deflation. The process of reversing inflation without either creating unemployment

or reducing output is called disinflation and not deflation. Therefore, some perceive

deflation as an underemployment phenomenon.

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Disinflation

When prices are falling due to anti-inflationary measures adopted by the authorities, with

no corresponding decline in the existing level of employment, output and income, the

result of this is disinflation. When acute inflation burdens an economy, disinflation is

implemented as a cure. Disinflation is said to take place when deliberate attempts are

made to curtail expenditure of all sorts to lower prices and money incomes for the benefit

of the community.

Reflation

Reflation is a situation of rising prices, which is deliberately undertaken to relieve a

depression. Reflation is a means of motivating the economy to produce. This is achieved

by increasing the supply of money or in some instances reducing taxes, which is the

opposite of disinflation. Governments can use economic policies such as reducing taxes,

changing the supply of money or adjusting the interest rates; which in turn motivates the

country to increase their output. The situation is described as semi-inflation or reflation.

Stagflation

Stagflation is a stagnant economy that is combined with inflation. Basically, when prices

are increasing the economy is deceasing. Some economists believe that there are two

main reasons for stagflation. Firstly, stagflation can occur when an economy is slowed by

an unfavourable supply, such as an increase in the price of oil in an oil importing country,

which tends to raise prices at the same time that it slows the economy by making

production less profitable. In the 1970's inflation and recession occurred in different

economies at the same time. Basically, what happened was that there was plenty of

liquidity in the system and people were spending money as quickly as they got it because

prices were going up quickly. This gave rise to the second reason for stagflation.

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