MODULE-4 INFLATION

• Inflation is generally defined as a process of persistent

and appreciable rise in the general level of prices.
• That is the availability of goods is less when compared
to the supply of money.
• It shows a state of disequilibrium between the
aggregate demand and aggregate supply at the existing
prices.
• Inflation refers to a situation of appreciable or
considerable rise in prices.
• The value of money varies inversely with price level.
Value of money =
 TYPES OF INFLATION
There are several types of inflation which are
classified on different basis . Based on the rate,
inflation can be classified as follows.
• Creeping Inflation: When the price rise is very
slow, that is less than 3% per annum, it is
called creeping inflation. It is mild inflation and
is considered as good for economic growth.
• Walking Inflation: When prices rise
moderately and the annual inflation rate is 3%
to 6%, it is called walking inflation. Inflation at
this rate is a warning signal for the
government.
• Running Inflation: When price rises rapidly
and the rate of increase is 10% to 20% per
annum, it is called running inflation. It requires
strong monetary and fiscal measures and it is
a dangerous situation.
• Galloping or Hyper Inflation: When price rises
between 20% to 100% per annum or even
more, it is called galloping inflation. Such a
situation brings total collapse of the monetary
system because of the continuous fall in the
purchasing power of money.
 Demand pull Inflation
• Demand pull inflation occurs when the
demand for goods and services exceeds the
supply available at existing prices, i.e., when
there is excess demand for goods and
services.
• This is a situation of disequilibrium which can
be corrected partly by increase in prices and
partly by increase in output up to full-
employment level, and entirely by increase in
prices beyond full employment level.
 Cost-push Inflation
• Cost push inflation refers to inflationary rise
in rises which arises due to increase in costs.
When the cost of producing a commodity
increases, the price of the commodity also
increases. Increase in the wages of labourers is
also a reason for cost push inflation.
 CAUSES OF INFLATION
• 1.Increase in money supply: Increase in money
supply represents an increase in purchasing
power with the people. Unless increase in
purchasing power is offset by increase in supply
of goods and services, it will exercise an upward
pressure on prices.
• 2.Deficit financing: Deficit financing is another
important cause of inflationary rise prices. In
India, deficit financing is taken to mean the
excess of the government expenditure over
current revenue and public borrowing.
• 3.Increase in public expenditure: Increase in
public expenditure may lead to increase in
prices by increasing the aggregate demand.
• 4.Increase in export demand: Export demand
is an important component of aggregate
demand. An increase export demand, there
for, results in and increased aggregate demand
• 5.Increase in population – Increase in population
means increased demand for most of the
consumer goods. It increases the aggregate
demand for goods and services and puts pressure
on the existing supply of goods and services.
• 6.Higher wage rates -Higher wage rates are
responsible for rise in prices in an important way.
Modern economies are characterized by the
presence of strong trade union. They are able to
pressurize the entrepreneurs to grand them
increase in money wages in excess of increase in
labour productivity
 `
• 7.Higher taxes :Another cause of rise in
prices is imposition of higher taxes,
mainly indirect taxes like excise duties,
sales tax, etc. Indirect taxes are largely
passed over by the producers to the
consumers by increasing the prices of
goods and services by the amount of
taxes.
• 8.Hoarding: Hoarding of commodities
especially by the traders for profiteering is
also responsible for rise in prices. During the
period of scarcity and rising prices,
traders ,merchants and even consumers
indulge in hoarding of commodities .This will
lead to increase in the price of commodities.
• 9.Higher administered prices: In India the prices
of commodities are determined by
Government .For example the prices of food
grains are determined by the government.
• So in order to protect the interest of the farmers
the Government may increase the price of
commodities. This will lead to inflation.
• 10.Supply shocks: Supply shocks in the form
of higher oil prices by the OPEC (Organization
of Petroleum Exporting Countries) are a major
factor for price rise in recent years.
• Petroleum prices are of crucial importance
because petroleum is used directly and
indirectly in almost all the sectors of the
economy.
 EFFECTS OF INFLATION
EFFECTS ON PRODUCTION

• Inflation affects the pattern of production:

During inflation profits rise sharply. Therefore,
business men, traders, and merchants are able
to indulge in luxuries.
• It leads to hoarding: The traders and
merchants indulge in hoarding in-order to
earn higher profits in future.
 EFFECTS ON DISTRIBUTION OF INCOME

• Debtors and Creditors: During the period of

inflation, debtors as a group stand to gain while
creditors tend to lose. Debtors benefit during
inflation.
• Profit earners: Entrepreneurs, traders, merchants,
etc…whose incomes are derived from profits tend to
benefit during inflation.
• Wage earners and salaried class: Wage earners and
salaried class tend to lose during inflation. Though in
the modern economies wages and salaries are linked
with the cost of living, even the labourers and
salaried class are likely to lose during inflation.
• Pensioners: Pensioners and similarly placed
fixed income groups suffer during inflation.
Retired people who survive on pensions are
likely to lose during inflation for two reasons.
• Farmers: Farmers as a group stand to gain
during inflation. Farmers like other producers,
tend to gain because the price of agricultural
products outpaces the increase in price of farm
inputs. Moreover, farmers are generally debtors.
• Adverse effect on savings: Inflation decreases

the saving capacity of the people which badly

affect the economic growth of country.

• Effect on public revenue: Inflation is likely to

have favorable effect on public revenue. The

government would get more revenue from taxes,

such as excise duties, sales tax, etc will also

increase.
• Confidence on the currency: A high rate of

inflation can undetermined the confidence of

people in the currency.

• When people lose confidence in the currency,

money cannot function as money. People will

not like to hold currency.

• Political instability: Continuous inflation in

many cases has shaken the foundations of

political system. It has become a major

political issue during many elections.

• History is full of instances when many

governments lost power because of persistent

rise in prices.
 MEASUREMENT OF INFLATION

• Inflation is measured by calculating the changes to price

index numbers (PINs) over a period of time. Rate of
inflation is the percentage rate of change in the price
index for a given period of time.
• Rate of inflation= × 100

• Where PINt=Price index for the year t

• PINt-1= Price index for the year t-1
• Price index measures the average change in the price of
goods and services over a period of time .It can be
consumer price index or whole sale price index.
 CONSUMER PRICE INDEX
• CPI is widely used to measure inflation. It is a measure of
consumer goods and services. It is based on the price of
shelter, clothing, fuel, transportation, medical care, and
other commodities purchased for day to day living.
• We construct the price index by giving weightage to each
price according to the economic importance of the
commodity. Each item is assigned a fixed weight
proportional to its relative importance in consumer’s
expenditure budget.
• Inflation occurs when there is an increase in general
increase in price level .The rate of change of price level is
measured by CPI.
• Rate of inflation for a given year=
 CONTROL OF INFLATION
• There are two methods to control inflation.
Monetary policy and Fiscal policy. The policy used
by Reserve Bank of India is monetary policy.
Fiscal policy tool is used by the Government.
• Monetary measures:
• These are the measures adopted by the central bank
of a country to control credit and money supply in the
economy.
• It can be classified as Quantitative measures and
Qualitative measures.
• Quantitative Measures: It aims at influencing
the overall availability of bank credit and its cost.
• 1.Open Market Operations: The RBI is in charge
of buying and selling of Government securities. If
there is an inflationary situation the RBI sells
securities to the public through commercial
banks. By doing so it will reduce the supply of
money in the economy.
• (Government Securities: These are bonds, notes
and other instruments sold by a government to
finance its borrowings .It is generally long-term
securities with the highest market ratings)
• 2.Repo rate: It is the rate at which RBI advances loan
to commercial banks. When there is an inflationary
situation RBI will increase will repo rate which in turn
increases the lending rate of commercial banks. This
will increase the cost of credit and people will prefer
fewer loans and thereby the total money supply is
regulated.
• 3.Reverse Repo rate: When the commercial banks
have excess money supply, they will advance to RBI,
for which the commercial banks will get interest from
RBI. This rate is known as reverse repo rate. The RBI
will increase the reverse repo if there is an increase in
money supply.
• 4.Cash Reserve Ratio: Every commercial bank
have to keep a portion of their deposits with
RBI as reserve and the remaining only they can
lend for loans. This is mandatory and is known
as Cash Reserve Ratio-CRR. If there is inflation
RBI will increase CRR thereby reducing the
lending capacity of commercial banks.
• 5. Statutory Liquidity Ratio: The commercial
banks have to keep a portion of their deposits
in gold and approved Government Securities.
This rate is determined by RBI. If there is
inflation RBI will increase the SLR.
• 6.Bank rate policy: The bank rate is the rate
at which RBI rediscount approved first class
bill of exchange. During inflation RBI raises
the bank rate due to which cost of borrowing
goes up. As a result commercial banks borrow
less money from RBI and thereby the flow of
money from commercial banks to public
reduces.
 QUALITATIVE OR SELECTIVE CREDIT
CONTROL MEASURES
Under this method, extension of credit to essential
purposes is encouraged .It ensures that credit is
being extended to deserving economic sectors.
• Margin requirements: Margin means proportion
of the value of the security against which loan is
not given. In other words ‘Margin ‘refers to the
difference between market value of securities
and the amount of loan granted against these
securities. For productive purposes margin
requirements will be less.
• Publicity : RBI informs all the scheduled
banks about the nation's economic needs
and the procedures to be followed in order to
cater to them. It may issue warning to the
people and commercial banks, substantiating
its views by facts, figures and statements,
through the media of publicity.
• Moral Suasion: These are the informal request by
the central bank to commercial banks to contract
credit in times of inflation and expand credit in times
of deflation. The central bank issues periodical
letters to commercial banks and discussions are held
with authorities of commercial banks in this respect.
• Direct action : Under Banking Regulations Act, the
RBI is empowered to initiate direction action against
those commercial banks which ignore its advice, in
such cases RBI can impose restriction on sanctioning
of loans.
• Control of bank advances: This is also used as
selective control method. The Reserve Bank
has fixed from time to time maximum limits
for some kinds of loans and advances.
 FISCAL POLICY
1) Public expenditure: Public expenditure, i.e., expenditure
by the government is an important component of
aggregate demand. In order to control inflation it is
essential that government expenditure must be reduced.
a) Taxation: The major plank of anti-inflationary fiscal
policy is to increase the tax burden by increasing the tax
rate and by imposing new taxes. Direct taxes can be used
for this purpose.
b) Public borrowing: Public borrowing, i.e., borrowing by
the government from public, can also be used in controlling
inflation. Public borrowing enables the government to
meet its expenditure and thereby reduces the need for
deficit financing.
2.Price control and rationing: A direct measure to
control inflation is to introduce price controls and
rationing of essential goods. Under price control
policy, the government fixes the maximum price at
which certain commodities could be sold.
• 3.Increasing the availability of goods: The basic
solution to the problem of inflation is to increase
the availability of goods in the economy.
Production should be increased.
Domestic production of essential goods may be
supplemented by imports of these goods so as to
reduce shortages and reduce inflationary pressures
 QUESTIONS
• 1. What is inflation? How inflation does affect the various section of
the society?
• 2. Explain how RBI controls inflation?
•3. a) What are causes of inflation in an economy ?
• b) How does a central bank controls inflation. ?
• 4. What are the quantitative methods of credit control?
• 5. a) What is inflation? What adjustments can be made in CRR and
SLR to bring down level of inflation?
• 6. Consider there is an inflationary situation in the economy. What
changes would you make to the following parameters?
a) Repo rate b) Reverse repo rate c)Cash reserve ratio
d)Statutory Liquidity Ratio e)Bank rate
• 7. What is deflation? What are the various methods to control
deflation?