Inflation
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Inflation is defined as a sustained increase in the general price level in an economy. It occurs when there is too much money chasing too few goods, as explained by Coulborn. There are different types of inflation classified by speed, from creeping inflation of around 2% annual price increases up to hyperinflation with no limit to price growth. The main causes are an increase in the money supply or credit in an economy. Inflation can be addressed through monetary policy measures like raising interest rates, or fiscal policy steps like increasing taxes and reducing government spending.
Inflation
- 1. INFLATION “Inflation” in simplest manner can be defined as a chronic and sustained rise in prices caused by an increase in money supply. In other wards, it is a substantial rise in general price level, which causes the decline in purchasing power of money . According to Crowther, Inflation is a “state in which the value of money is falling i.e. the prices are rising”. According to Coulborn, Inflation is a situation where “too much money chasing too few goods”. However, every rise in prices is not leading to the inflation. If a rise in price raises the profit margins of the producer and induces larger volume of production, this would be beneficial to the economy because after some point of time prices will be falling as a result of increased production. 1
- 2. Hence, there are two types of rise in prices: • Rise in prices accompanied by increase in production. • Rise in prices which does not increase production. It is the second type of rise in prices which leads to the inflationary situation in the economy. Causes of Inflation: (1) Increase in Money Supply: when the supply of money in a country increases it is likely to lead rise in price level. The Central bank of the country might print more currency notes and put them into circulation to tide over its budgetary deficits. As this increased, money supply comes into the hands of the public and they spends more of it. This leads to an increase in the aggregate demand 2 and creates inflation in the country.
- 3. (2) Increase in the Volume of Credit: the supply of money in the market also includes the amount of credit created by the banks. Any undue expansion in the bank credit will set in inflationary pressure, while a credit contraction causes depression in the economy. Very often inflation is result of expansion in bank credit. Classification of Inflation on the basis of Speed: (1) Creeping inflation: it is the mildest form of inflation and generally regarded as conducive to economic development because it keeps the economy away from the stagnation. Under the creeping inflation, prices rise about 2 percent annually. (2) Walking Inflation: under walking inflation, prices rise about 5 percent annually. 3
- 4. (3) Running Inflation: under the running inflation, prices rise about 10 percent annually. (4) Galloping Inflation or Hyper Inflation: under this inflation price rises every moment and there is no upper limit to the price rise. Example: Hyper inflation in Germany after the First World War and in China after the Second World War. The type of inflation can better be explained by the help of a graphical representation given below: 4
- 5. Graphical Representation: D 200 C 150 B 100 A 50 0 25 35 40 42 Year 0 to A = Creeping Inflation (2%) A to B = Walking Inflation (5%) B to C = Running Inflation(10%) C to D = Galloping Inflation/Hyper Inflation (>10%) 5
- 6. Theories of Inflation: (1) Demand-Pull-Inflation : Demand-pull-inflation occurs when the aggregate demand in the market exceeds the volume of output available at the market, which occurs due to the rise in general price level. Thus, the demand-pull-inflation may be defined as the situation where the aggregate demand exceeds the economy’s ability to supply the goods and services at the current prices. (2) Cost-Push-Inflation: On the other hand, CostCost-Push-Inflation push-inflation occurs when the price rise because of the increase in factor prices without a proportionate increase in their productivity. When trade unions get a rise in wages, when the cost of raw materials goes up, the cost of production will be bound to rise and there by leading to a rise in the price level. 6
- 7. Inflationary Gap: Keynes in guide entitled “How to Pay for the War, 1940”, explained inflation in terms of inflationary gap. According to him, inflationary gap occurs when, at full employment level, aggregate demand exceeds aggregate supply. This suggests that due to increase in investment and govt. expenditure, the money income increases but the production does not increase due to the limitations of the productive capacity. As a result inflationary gap comes to exist causing the prices to rise. The price continues to rise so log as the inflationary gap exist. So, According to K.K. Kurihara, Inflationary gap is an excess of anticipated expenditure over the availability of output. 7
- 8. Basically, the important cases of inflationary gap are those associated with the govt. expenses on war and war preparations. Hypothetical Example: Let us take the example of War time economy. Demand Side 1. Total Money Income 2. Minus Taxes Supply Side Rs.1000Cr. 1. GNP (pre-inflation prices) Rs.800Cr. Rs.100Cr. 2. Minus War Expenditure Rs.200Cr. 3. Total Disposable Income Rs.900Cr 4 Minus Saving Rs.100Cr. 5. Net Disposable Income 3. Available Output for Civilian Consumption Rs.600Cr. Rs.800Cr. Inflationary Gap = Demand – Supply i.e. 800Cr. – 600Cr. = 200Cr. 200Cr 8
- 9. This can also be represented by the help of a figure: Y=C+I+G Exp. Y=C’+I’+G’ E1 Y=C+I+G E G O Y0 Y1 Income 9
- 10. The above figure shows the graphic representation of inflationary gap. Where 450 or Y=C+I+G is the equilibrium line which shows the equality of total income and total expenditure. C+I+G curve represents total expenditure comprising private consumption (C), private investment (I) and govt. expenditure (G). The initial equilibrium of the economy is at point E0 which represents full employment income OY0. When expenditure increases from C+I+G to C’+I’+G’, the new equilibrium will be at E1 representing higher money income OY1. The Available output (real Income) is OY0 or E0Y0 which is less than the money income E1Y1 or OY1 by the vertical distance E1G. 10
- 11. Control of Inflation: Broadly, the measures against inflation can be divided into: (1) Monetary Measures (2) Fiscal measures Monetary Measures: This is adopted by the monetary authority or the central bank of a country to influence the supply of money and credit by changing interest rate structure and availability of credit. (a) Increasing Bank rate: Bank rate is the rate at which the central bank lends money to the commercial banks. An increase in the bank rate will increase the rate of interest charged by commercial banks, which in turn, discourages borrowings by business man and consumers. This will reduce money supply with public and thus controls the inflation. 11
- 12. (2) Higher Reserve Ratio: An increase in the minimum reserve ratio means that the member banks are required to keep larger reserves with the central bank. This reduces the deposit of the banks and thus limits their power to create credit. So, restrictions on credit creation will control the inflation. (3) Consumer Credit Control: In developed and developing Control countries, most of the consumer durable goods, such as, T.V., Fridge, motorcycles etc. are purchased by the consumers on installment credit. During inflation, loan facilities for installment buying are reduced to minimum to check the consumption spending. This is done by: (a) Raising initial payment (b) Covering large number of goods on this category (c) Reducing length of payment period. 12
- 13. Fiscal Measures: Fiscal measures are the budgetary measures of the government relating to taxes, public expenditure etc. The major anti-inflationary budgetary measures are: (a) Increase in both direct and indirect taxes. (b) Reduction in public expenditure (c) Increasing public borrowings etc. 13