INFLATION [CHAPTER-23]

Definition and Understanding of Inflation

1. Basic Definition:
a. Inflation refers to a persistent and appreciable rise in the general price
level over a period of time.
b. This affects purchasing power, as the same amount of money buys fewer
goods and services over time.
2. Classical Definitions:
a. Pigou: Inflation is when money income expands faster than real income.
b. Coulborn: Inflation is "too much money chasing too few goods."
c. Crowther: Inflation is a state where the value of money falls, and prices rise.
3. Modern Definitions:
a. Modern economists focus on the persistent and appreciable rise rather
than sporadic price increases.
b. For example:
i. Ackley: “Inflation is a persistent and appreciable rise in the general
price level.”
ii. Samuelson: “Inflation denotes a rise in the general level of prices.”
4. Key Characteristics:
a. Continuous: A one-time price rise is not inflation unless it sustains over
time.
b. General: Inflation affects all goods and services broadly, not just a few
items.
c. Measured Effect: Must significantly alter the economic environment (e.g.,
affecting savings, investment, and consumption).
5. Desirability of Inflation:
a. Moderate inflation is essential for growth, but excessive inflation can
destabilize an economy.
b. Economists recommend inflation limits:
i. Developed Economies: 1–2% annually.
ii. Developing Economies: 4–6% annually.

Measuring Inflation

1. Methods:
 a. Price Index Numbers (PINs):
i. Formula: Rate of Inflation=PINt−PINt−1PINt−1×100\text{Rate of
Inflation} = \frac{\text{PIN}_t - \text{PIN}_{t-1}}{\text{PIN}_{t-1}}
\times 100
1. PINtPIN_t: Price Index Number in the current period.
2. PINt−1PIN_{t-1}: Price Index Number in the previous period.
ii. Two major PINs:
1. Wholesale Price Index (WPI): Measures price changes at the
wholesale level.
2. Consumer Price Index (CPI): Tracks price changes at the
consumer level (cost of living).
b. GNP Deflator:
i. Formula: GNP Deflator=Nominal GNPReal GNP×100\text{GNP
Deflator} = \frac{\text{Nominal GNP}}{\text{Real GNP}} \times 100
1. Nominal GNP: GNP measured at current prices.
2. Real GNP: GNP measured at constant (base-year) prices.
2. Comparison:
a. WPI is commonly used but offers a partial view as it focuses on wholesale
prices.
b. GNP Deflator provides a broader measure, capturing the entire economy's
price level.

Types of Inflation

A. Based on Rate of Increase

1. Moderate Inflation:
a. Prices rise slowly (1–10% annually).
b. Predictable and manageable.
c. Encourages investment and economic activity.
2. Galloping Inflation:
a. Prices rise at a rapid pace (20–200% annually).
b. Can destabilize the economy and erode confidence in the monetary system.
c. Example: Germany post-WWI (4100% in 1922).
3. Hyperinflation:
a. Prices increase exponentially (e.g., 50% per month or more).
b. Currency becomes almost worthless.
 c. Example: Zimbabwe (2000s), Germany (1923).

B. Other Classifications

1. Open Inflation:
a. Prices rise without government intervention.
b. Occurs in free markets.
2. Suppressed Inflation:
a. Governments control prices artificially using subsidies or rationing.
b. Hidden inflation emerges once controls are lifted.
3. Disinflation:
a. Reduction in the rate of inflation (e.g., from 10% to 5%).
4. Deflation:
a. A general decrease in prices below the base level.

Causes of Inflation

Demand-Pull Inflation:

• Definition: Inflation caused by excessive demand in the economy.

• Mechanism: Aggregate demand (consumption, investment, government spending)
exceeds aggregate supply.
• Examples:
o Increased government spending (e.g., infrastructure projects).
o Monetary expansion (e.g., lower interest rates leading to more loans).

Cost-Push Inflation:

• Definition: Inflation caused by rising production costs.

• Types:
o Wage-Push: Higher wages increase production costs.
o Profit-Push: Monopolistic firms raise prices to increase profits.
o Supply-Shock: Events like oil crises reduce supply, raising costs.
Structural Inflation:

• Definition: Persistent inflation in developing economies caused by bottlenecks in

supply, inadequate infrastructure, or food shortages.
• Examples:
o India's inflation due to food and energy constraints.

Effects of Inflation

1. On Income Distribution:
a. Winners:
i. Businesses: Profits often rise faster than wages.
ii. Borrowers: Loans become cheaper in real terms.
b. Losers:
i. Fixed-income groups (e.g., pensioners): Real value of income erodes.
ii. Wage earners in unorganized sectors: Wage increases often lag
behind prices.
2. On Wealth Distribution:
a. Wealthy individuals benefit as prices of assets like land, gold, and stocks
increase.
b. Holders of fixed-value assets (e.g., bank deposits) lose purchasing power.
3. On Economic Growth:
a. Moderate Inflation:
i. Promotes investment and saving.
ii. Encourages businesses to expand.
b. High Inflation:
i. Distorts pricing signals.
ii. Reduces long-term investment.
4. On Employment:
a. Moderate inflation stimulates job creation by encouraging business
expansion.
b. Galloping inflation creates uncertainty and job losses.
Policy Measures to Control Inflation

Monetary Policies:

1. Tools:
a. Interest Rates: Raising rates discourages borrowing and reduces demand.
b. Open Market Operations: Selling government bonds absorbs excess
liquidity.
c. Cash Reserve Ratio (CRR): Increasing CRR limits banks' ability to lend.
2. Advantages:
a. Quick to implement.
b. Effective in controlling demand-pull inflation.
3. Limitations:
a. Less effective in addressing cost-push inflation.
b. May slow down economic growth.

Fiscal Policies:

1. Tools:
a. Taxation: Higher taxes reduce disposable income and demand.
b. Government Spending: Reducing spending lowers aggregate demand.
2. Advantages:
a. Addresses underlying causes of inflation.
b. Targets specific sectors.
3. Limitations:
a. Politically challenging to implement.
b. May lead to unemployment if overdone.

Other Measures:

1. Price Controls:
a. Government sets price ceilings for essential goods.
b. Drawback: Can lead to shortages and black markets.
2. Indexation:
a. Wages and pensions are tied to inflation to protect purchasing power.
3. Supply-Side Policies:
 a. Increasing production capacity to match demand.
b. Investment in infrastructure and technology.

Inflation in India: Key Insights

1. Trends:
a. 1950s: Low inflation (~1.5%).
b. 1970s and 1990s: High inflation due to oil shocks and fiscal deficits.
c. Post-1990s: Economic reforms helped moderate inflation to 4–7%.
2. Structural Issues:
a. Food and energy shortages often drive inflation.
b. Government policies (e.g., subsidies, MSPs) influence price levels.

INFLATION[CHAPTER-24]

Understanding Inflation

• Definition: Inflation means a continuous rise in the general price level of goods and
services over time.
• Types:
o Creeping Inflation: Slow and gradual rise in prices (2-3% annually).
o Hyperinflation: Extremely rapid price increase (e.g., Germany, 1920s).
o Stagflation: High inflation with unemployment and stagnant growth.

Theories of Inflation

1. Classical Theory of Inflation

• Historical Background:
o Developed by economists like David Hume, Adam Smith, and Irving Fisher. Irving
Fisher systematized it as the Quantity Theory of Money in 1911.
 • Core Principle: Prices rise in direct proportion to the increase in money supply if the
economy is at full employment and output is fixed.
• Key Formula:
o MV=PTMV = PT
▪ MM: Money supply.
▪ VV: Velocity of money (how often money changes hands).
▪ PP: Price level.
▪ TT: Total output (real GDP).
o Rearranged: P=MVTP = \frac{MV}{T}.
▪ If MM increases while TT (output) stays constant, PP (prices) must rise.
• Mechanism:
o Central banks or governments increase money supply → People have more money
→ Demand for goods rises → Prices increase as supply remains constant.
• Criticism:
o Ignores time-lag and mechanisms of price rise.
o Assumes full employment and no idle resources.

2. Neo-Classical Theory

• Developed by: Cambridge School of Economists, including Alfred Marshall and A.C.
Pigou.
• Core Idea:
o Focus on demand for money, rather than just supply.
o Prices rise when people want to hold more money (MDMD) than is available.
• Key Equation:
o MD=kPQMD = kPQ, where:
▪ kk: Proportion of income held in cash.
▪ PP: Price level.
▪ QQ: Output or income.
o Rearranged: P=MDkQP = \frac{MD}{kQ}.
▪ If MDMD rises and k,Qk, Q stay constant, PP must increase.
• Criticism:
o Does not explain why MDMD changes without shifts in income or output.
o Limited applicability to real-world situations.
3. Keynesian Theory of Inflation

• Origin: John Maynard Keynes expanded on classical ideas in his 1940 book How to Pay for
the War.
• Key Concepts:
o Inflation arises when demand exceeds supply at full employment.
o Inflationary Gap:
▪ Difference between total spending (aggregate demand) and full
employment output.
▪ Causes: Increased government spending, consumer demand, or
investment.
o Keynesian Cross:
▪ Explains how excess spending leads to price rises.
▪ Example: If a government increases spending beyond the economy’s
capacity, demand outstrips supply, causing inflation.
• Important Distinction:
o Inflation occurs only when demand exceeds full employment capacity.
o Before full employment, price rise stimulates production rather than causing
inflation.

4. Monetarist View

• Core Idea: Inflation is caused solely by excessive money supply.

• Key Figure: Milton Friedman’s statement: "Inflation is always and everywhere a monetary
phenomenon."
• Key Points:
o No strict proportionality between money supply and prices due to short-term real
effects.
o Short-Term Effects:
▪ Increased money supply can boost employment and output temporarily.
o Long-Term Effects:
▪ Once the economy adjusts, extra money only raises prices, leaving output
unchanged.
o Criticizes Keynesian theory for ignoring money supply’s role in the long term.
5. Demand-Pull Inflation

• Definition: Caused by excess demand in the economy when aggregate demand rises
faster than aggregate supply.
• Causes:
o Increased consumer spending due to higher incomes or lower taxes.
o Increased government expenditure (e.g., infrastructure projects).
o Central bank expanding money supply through low-interest rates.
• IS-LM Framework:
o Monetary expansion shifts the LM curve, increasing demand and pushing prices
up.
• Real-World Examples:
o Germany’s hyperinflation in 1922-23 due to excessive money printing.
o Russia in the 1990s when printing rubles led to prices doubling monthly.

6. Cost-Push Inflation

• Definition: Inflation caused by increased production costs.

• Types:
o Wage-Push: Strong labor unions demand higher wages, increasing costs for
businesses.
o Profit-Push: Monopolies increase prices to boost profits.
o Supply-Shock: Sudden shortage of critical goods (e.g., oil crisis in 1970s).
• Mechanism:
o Higher costs → Businesses pass costs to consumers by raising prices.
o Example: A drought reduces wheat supply, making bread more expensive.
• Key Insight: Inflation can occur even during recessions due to cost pressures.

7. Structuralist Theory

• Focus: Explains inflation in less developed countries (LDCs).

• Key Causes:
o Food Scarcity: Low agricultural output and population growth create supply-
demand gaps.
o Resource Imbalance: Excess labor but insufficient capital leads to inefficiency.
 o Foreign Exchange Bottlenecks: Dependence on expensive imports causes trade
deficits.
o Infrastructure Problems: Poor transport, electricity, and logistics increase
production costs.
o Social and Political Factors: Corruption, hoarding, and inefficient governance
worsen inflation.

Policy Measures to Control Inflation

1. Monetary Policy

• Definition: Central bank adjusts money supply and interest rates to manage inflation.
• Tools:
o Bank Rate: Higher rates make loans expensive, reducing spending.
o Cash Reserve Ratio (CRR): Banks hold more reserves, leaving less money to
lend.
o Open Market Operations: Central bank sells bonds to absorb excess money.
• Effectiveness:
o Works best in developed economies with stable financial systems.
o Less effective in developing economies due to weak banking infrastructure.

2. Fiscal Policy

• Definition: Government adjusts taxes and spending to control demand.

• Tools:
o Increase Taxes: Reduces disposable income and spending.
o Cut Government Spending: Lowers aggregate demand.
• Limitations:
o Risk of unemployment and slowing economic growth.

3. Price and Wage Controls

• Definition: Government imposes caps on prices and wages.

 • Examples:
o Fixing maximum prices for essential goods (e.g., food, fuel).
o Wage freezes to control production costs.
• Drawbacks:
o Can lead to shortages and black markets.

4. Indexation

• Definition: Adjusting wages and contracts to inflation to maintain purchasing power.

• Example:
o Pensions linked to inflation indices to ensure retirees can afford basic goods.

Key Takeaways

• Inflation theories highlight causes (demand vs. supply factors) and their mechanisms.
• Structural factors in LDCs create unique inflation patterns requiring customized policies.
• Balancing inflation control and economic growth is critical to prevent unemployment and
stagnation.

INFLATION[CHAPTER-25]

1. Inflation: Definition and Nature

1. Meaning:
a. Inflation refers to a sustained rise in the general price level of goods and
services over a period of time, leading to a decline in the purchasing power of
money.
b. Persistent inflation creates distortions in economic decision-making, affecting
consumption, savings, and investment.
2. Characteristics:
a. General Rise in Prices: Affects most goods and services.
 b. Continuous Increase: One-time price increases are not inflation unless they
persist.
c. Impact on Economy: Moderate inflation can stimulate growth, while high inflation
causes economic instability.
3. Causes:
a. Excess Demand: Too much money chasing too few goods (Demand-Pull
Inflation).
b. Rising Costs: Increased production costs (Cost-Push Inflation).
c. Supply Bottlenecks: Constraints in the availability of essential resources.
4. Measurement:
a. Price Indexes:
i. Consumer Price Index (CPI): Measures retail price changes.
ii. Wholesale Price Index (WPI): Tracks wholesale-level price changes.
b. Formula: Inflation Rate=Price Indext−Price Indext−1Price
Indext−1×100\text{Inflation Rate} = \frac{\text{Price Index}_t - \text{Price
Index}_{t-1}}{\text{Price Index}_{t-1}} \times 100

2. Unemployment: Definition, Types, and Measurement

1. Definition:
a. Unemployment occurs when individuals willing and able to work at the
prevailing wage rates cannot find employment.
2. Key Concepts:
a. Labor Force: Includes employed and unemployed individuals actively seeking
work.
b. Unemployment Rate: Unemployment Rate=Unemployed IndividualsTotal
Labor Force×100\text{Unemployment Rate} = \frac{\text{Unemployed
Individuals}}{\text{Total Labor Force}} \times 100
3. Types of Unemployment:
a. Frictional Unemployment:
i. Temporary joblessness due to labor market transitions.
ii. Examples: Job changes, new graduates entering the market.
b. Structural Unemployment:
i. Caused by mismatches between workers' skills and job requirements.
ii. Examples: Decline in traditional industries and rise of technology-intensive
sectors.
c. Cyclical Unemployment:
 i. Linked to economic cycles (e.g., recessions).
ii. Okun’s Law: A 1% rise in unemployment reduces GDP by approximately
2.5%.
d. Natural Rate of Unemployment:
i. Represents unavoidable unemployment in a healthy economy due to
frictional and structural factors.
ii. Coined by Milton Friedman.
4. Measurement in India:
a. Usual Status: Unemployed for most of the year.
b. Weekly Status: Jobless at least one day in a week.
c. Daily Status: Jobless for part of a day during the survey.

3. The Phillips Curve: Relationship Between Inflation and Unemployment

1. Historical Context:
a. A.W. Phillips (1958) identified an inverse relationship between unemployment
and wage inflation in the UK economy (1861–1957).
2. Short-Run Phillips Curve (SRPC):
a. Shows a negative correlation between inflation and unemployment:
i. Lower unemployment → Higher inflation.
ii. Higher unemployment → Lower inflation.
b. Policymakers can trade-off between inflation and unemployment in the short
term by adjusting fiscal and monetary policies.
3. Long-Run Phillips Curve (LRPC):
a. Milton Friedman and Edmund Phelps argued that:
i. In the long run, inflation expectations adjust, and the curve becomes
vertical at the Natural Rate of Unemployment (NAIRU).
ii. Implication: No long-term trade-off exists between inflation and
unemployment.
iii. Policies aimed at reducing unemployment below NAIRU result in
stagflation.
4. Key Implications:
a. Short-term trade-offs exist but are unsustainable.
b. Long-term efforts to reduce unemployment below the natural rate accelerate
inflation without reducing unemployment.
4. Causes of Inflation

1. Demand-Pull Inflation:
a. Occurs when aggregate demand exceeds aggregate supply.
b. Causes:
i. Increased consumer and government spending.
ii. Expansionary monetary policies (e.g., low-interest rates).
iii. Rising exports due to favorable trade conditions.
c. Example: Rapid economic recovery post-recession.
2. Cost-Push Inflation:
a. Caused by rising input costs, such as labor, raw materials, or energy.
b. Factors:
i. Wage hikes exceeding productivity growth.
ii. Supply shocks (e.g., oil price surges in the 1970s).
c. Example: Rising food prices due to drought.
3. Structural Inflation:
a. Persistent inflation due to inefficiencies in supply chains, inadequate
infrastructure, or resource shortages.
b. Examples:
i. Agricultural dependence in developing countries.
ii. Energy constraints in industrial economies.

5. Policy Measures to Control Inflation

1. Monetary Policy:
a. Implemented by central banks to control money supply and credit.
b. Tools:
i. Interest Rate Adjustments: Raising rates to curb demand.
ii. Open Market Operations: Selling government bonds to reduce liquidity.
iii. Cash Reserve Ratio (CRR): Increasing reserves to limit banks’ lending
capacity.
2. Fiscal Policy:
a. Adjusting government spending and taxation.
b. Methods:
i. Reducing public expenditure.
ii. Increasing taxes to lower disposable incomes.
3. Direct Controls:
 a. Price Controls: Setting price caps on essential goods.
b. Rationing: Distributing scarce goods through government channels.
4. Supply-Side Measures:
a. Enhancing production efficiency.
b. Investing in infrastructure to reduce bottlenecks.

6. Policy Dilemma: Inflation vs. Unemployment

1. Trade-Off:
a. Controlling inflation often increases unemployment, and reducing unemployment
can increase inflation.
b. Example: 1980s US policies aimed at reducing inflation caused high
unemployment.
2. Cost of Disinflation:
a. Reducing inflation leads to:
i. Slower economic growth.
ii. Higher unemployment (short-run cost).
b. Empirical Estimate: A 1% reduction in inflation requires a 2% increase in
unemployment for one year.
3. Stagflation:
a. Occurs when high inflation coexists with high unemployment.
b. Typically results from supply-side shocks (e.g., oil crises).

7. Structural Reforms to Balance Inflation and Unemployment

1. Labor Market Reforms:

a. Improving flexibility to reduce structural unemployment.
b. Enhancing skill development and training programs.
2. Productivity Enhancement:
a. Investing in technology and infrastructure to boost production.
3. Balanced Policies:
a. Maintaining moderate inflation while promoting employment.
b. Avoiding excessive reliance on either monetary or fiscal policies.
8. Practical Implications

1. Real-World Evidence:
a. Post-2008 Financial Crisis:
i. Governments used monetary stimulus to reduce unemployment, causing
inflation risks.
b. India (2008–2014):
i. High inflation (~8%) coexisted with slowing growth (~4.6%).
2. Optimal Policies:
a. Accepting the natural rate of unemployment as unavoidable.
b. Focusing on long-term measures to reduce structural bottlenecks.