Introduction:
Inflation is the menace of the modern economy. It is one of the primary persistent threats that will undermine or even destroy decades of economic growth if unleashed and not curbed. It is feared by central bankers globally and forces the execution of monetary policies that are inherently unpopular. It makes some people unfairly rich and impoverishes others.
Inflation historically has destroyed entire economies and changed the course of human history. Inflation was one of the forces that unravelled the Roman Empire two millennia ago and the empire of the Soviet Union two decades ago. The impact of severe inflation often extends far beyond the economy. In the most telling story in modern history, the horrific inflation triggered by the Weimer Republic in Germany at the end of World War I caused prices to rise to such stupendous levels that the exchange rate of the German Mark to the Dollar exceeded three trillion to one. The resulting economic devastation created a political black hole from which emerged the National Socialist Party and Adolf Hitler, who exploited the ruination to become Chancellor of Germany in January 1933. Venezuela as of 2018 is experiencing an inflation rate of above 1,000,000%. Zimbabwe is on the verge of entering hyperinflation again after 2008 with an inflation rate of 175%.
Inflation's mirror image, deflation, has less of a dark historical legacy but is nonetheless a serious economic problem. Deflation defined price behaviour during the Great Depression in the 1930s and has emerged as an economic problem in Japan in the current period.
Meaning:
Inflation is a rise in the general level of prices of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation reflects a reduction in the purchasing power per unit of money a loss of real value in the medium of exchange and a unit of account within the economy. Inflation is defined as a sustained increase in the general level of prices for goods and services. It is measured as an annual percentage increase. It could be defined as ‘a continuing rise in prices as measured by an index such as the consumer price index (CPI), wholesale consumer price index (WPI) or by the implicit price deflator for Gross National Product (GNP)’. Inflation is frequently described as a state where “too much money is chasing too few goods”. When there is inflation, the currency loses purchasing power. In the definition of inflation, two keywords must be borne in mind. The first, is aggregate or general, which implies that the rise in prices that constitutes inflation must cover the entire basket of goods in the economy as distinct from an isolated rise in the prices of a single commodity or group of commodities. Second, the rise in the aggregate level of prices must be continuous for inflation to be said to have occurred. The aggregate price level must show a tendency of a sustained and continuous rise over different time periods.
For example, the purchasing power of a given amount of rupee will be smaller over time when there is inflation in the economy. For instance, assuming that INR 1000 can purchase 4 shirts in the current period if the price of shirts doubles in the next period, the same INR 1000 can only afford 2 shirts.
Types of Inflation:
Broadly, inflation can be grouped into four types, according to its magnitude.
1. Creeping Inflation: This occurs when the rise in price is very slow. A sustained annual rise in prices of less than 3 per cent per annum falls under this category. Such an increase in prices is regarded as safe and essential for economic growth.
2. Walking Inflation: Walking inflation occurs when prices rise moderately and the annual inflation rate is a single digit. This occurs when the rate of rising prices is in the intermediate range of 3 to less than 10 per cent. Inflation of this rate is a warning signal for the government to control it before it turns into running inflation.
3. Running Inflation: When prices rise rapidly at the rate of 10 to 20 per cent per annum, it is called running inflation. This type of inflation has tremendous adverse effects on the poor and middle class. Its control requires strong monetary and fiscal measures.
4. Hyperinflation: Hyperinflation occurs when prices rise very fast at double or triple-digit rates. This could get to a situation where the inflation rate can no longer be measurable and absolutely uncontrollable. Prices could rise many times every day. Such a situation brings a total collapse of the monetary system because of the continuous fall in the purchasing power of money.
Causes of Inflation:
Basically, two causes of inflation have been identified, namely, demand-pull and cost-push.
Demand-pull Inflation:
Demand-pull inflation or excess demand inflation is the traditional and most common type of inflation. It takes place when aggregate demand is rising while the available supply of goods is becoming less. Goods may be in short supply either because resources are fully utilised or production cannot be increased rapidly to meet the increasing demand. As a result, prices begin to rise in response to a situation often described as "too much money chasing too few goods."
Demand-pull inflation is inflation that results from an initial increase in aggregate demand. Demand-pull inflation may begin with any factor that increases aggregate demand. Demand-pull inflation occurs when aggregate demand and output is growing at an unsustainable rate leading to increased pressure on scarce resources and a positive output gap. When there is excess demand in the economy, producers are able to raise prices and achieve bigger profit margins because they know that demand is running ahead of supply. Typically, demand-pull inflation becomes a threat when an economy has experienced a strong boom with GDP rising faster than the long-run trend growth of potential GDP. An increase in aggregate demand may be caused by the inability to meet the demand for goods and services because of the full utilisation of resources available to a country and the inability to meet the surge in demand at the current time period. A third possibility is an increase in exports thereby reducing the quantity of goods available in the domestic territory. Demand-pull inflation can be explained with the help of the diagram below.
The figure above illustrates the start of demand-pull inflation. The increase in aggregate demand raises the price level from 110 to 120. With no further increase in aggregate demand, in the long run, the price level rises to 130 and then stops. This process is a one-time change in the price level. For inflation to become established, the rightward shift in the AD curve needs to continue. Persistent increases in the quantity of money result in persistent rightward shifts in the AD curve, so monetary growth is necessary for demand-pull inflation. The United States experienced demand-pull inflation through the middle of the 1970s, by which time the inflation rate was almost 10 per cent per year.
Cost-push Inflation:
Cost-push inflation occurs when businesses respond to rising costs, by increasing their prices to protect profit margins. Cost-push inflation arises from anything that causes the conditions of supply to decrease. Some of these factors include a rise in the cost of production, an increase in government taxation and a decrease in the quantity of goods produced. Cost-push inflation is inflation that results from an initial increase in costs. Thus, cost-push inflation starts as the result of an increase in costs. An increase in the money wage rate, profit increases by employers and an increase in the money price of raw materials, such as oil are the main sources of cost-push inflation. Cost-push inflation can be explained with the help of the diagram below.
Cost-push inflation can be illustrated by an inward shift of the short-run aggregate supply curve. The fall in AS curve causes a contraction of GDP together with a rise in the level of prices. One of the risks of cost-push inflation is that it can lead to stagflation. The combination of a rising price level and decreasing GDP is called stagflation. If nothing else changes, in the long run, the money wage rate adjusts and the price level stops rising. There is a one-time increase in the price level. If in response to the short-run decline in GDP, the central bank increases the quantity of money, aggregate demand increases and the price level rises still higher. The rise in the price level created by the increase in aggregate demand invites another cost hike. If it occurs and aggregate demand increases again a cost-push inflation results. The United States experienced cost-push inflation in the late 1970s when OPEC hiked the price of oil higher and the Fed initially responded with an expansionary monetary policy.
Effects of Inflation:
1. Effects of Inflation on Business Community: Inflation is welcomed by entrepreneurs and businessmen because they stand to profit by rising prices. They find that the value of their inventories and stock of goods is rising in money terms. They also find that prices are rising faster than the costs of production, so that their profit is greatly enhanced.
2. Fixed Income Groups: Inflation hits wage-earners and salaried people very hard. Although wage-earners, by the grace of trade unions, can chase galloping prices, they seldom win the race. Since wages do not rise at the same rate and at the same time as the general price level, the cost of living index rises, and the real income of the wage earner decreases.
3. Farmers: Farmers usually gain during inflation, because they can get better prices for their harvest during inflation.
4. Investors: Those who invest in debentures and fixed-interest bearing securities, bonds, etc, lose during inflation. However, investors in equities benefit because more dividend is yielded on account of high profit made by joint-stock companies during inflation.
5. Inflation will lead to deterioration of gross domestic savings and less capital formation in the economy and less long term economic growth rate of the economy.
Measures to Control Inflation:
Inflation should be controlled in the beginning stage, otherwise, it will take the shape of hyper-inflation which will completely ruin the country. The different methods used to control inflation are known as anti-inflationary measures. Anti-inflationary measures are of four types: Monetary policy, Fiscal policy, Price control and rationing, and other methods.
1. Monetary Policy: It is the policy of the central bank of the country, which is the supreme monetary and banking authority in a country. The central bank may use such methods as the bank rate, open market operations, the reserve ratio and selective controls in order to control the credit creation operation of commercial banks and thus restrict the amounts of bank deposits in the country. This is known as a tight money policy. Monetary policy to control inflation is based on the assumption that a rise in prices is due to a larger demand for goods and services, which is the direct result of the expansion of bank credit.
2. Fiscal Policy: It is the policy of a government with regard to taxation, expenditure and public borrowing. It has a very important influence on business and economic activity. Taxes determine the size or the volume of disposable income in the hands of the public. The proper tax policy to control inflation will avoid tax cuts, introduce new taxes and raise the rates of existing taxes. The purpose is to reduce the volume of purchasing power in the hands of the public and thus reduces their demand. A precisely similar effect will be achieved if voluntary or compulsory savings are increased. Savings will reduce the current demand for goods and thus reduce the inflationary rise in prices.
During war times as well as during a period of development, it is absolutely impossible to reduce the planned expenditure. If the government has already taken up a scheme or a group of schemes, it is ruinous to give them up in the middle. Therefore, public expenditure cannot be used as an anti-inflationary measure. Lastly, public debt, i.e., the debt of the government 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 previous loans during inflation so as to prevent an increase in the circulation of money. Moreover, if the government manages to get a surplus budget, it should be used to cancel public debt held by the central bank.
3. Price Control and Rationing: This is the most important and effective method available during war and other critical times particularly because both monetary and fiscal policies are more or less useless during this period. Price control implies the establishment of legal upper limits beyond which prices of particular goods should not rise. The purpose of rationing, on the other hand, is to distribute the goods in short supply in an equitable manner among all people, irrespective of their wealth and social status. Price control and rationing generally go together.
4. Other Methods: Another important anti-inflationary device is to increase the supply of goods through either increased production or imports. Production may be increased by shifting factors of production from the production of less inflation-sensitive goods, which are in comparative abundance to the production of those goods which are in short supply and which are inflation-sensitive. Moreover, the shortage of goods internally may be relieved through imports of inflation-sensitive goods, either on credit or in exchange for the export of luxury goods and other non-essentials.
Additional notes:
Theories of demand-pull inflation: There are two principal theories about demand-pull inflation that of the monetarists and the Keynesians. Danish economist, Bent Hansen has also propounded a theory on demand-pull inflation.
The monetarist emphasises the role of money as the principal cause of demand-pull inflation. They contend that inflation is always a monetary phenomenon. Its earliest explanation is to be found in the simple quantity theory of money. The monetarists employ the familiar identity of Fisher's Equation of Exchange: MV=PQ where M is the money supply, V is the velocity of money, P is the price level, and Q is the level of real output. Assuming V and Q as constant, the price level (P) varies proportionately with the supply of money (M). With flexible wages, the economy was believed to operate at full employment level. The labour force, capital stock, and technology also changed only slowly over time. Consequently, the amount of money spent did not affect the level of real output so that a doubling of the quantity of money would result simply in doubling the price level. Until prices had risen by this proportion, individuals and firms would have excess cash which they would spend, leading to rising in price. So inflation proceeds at the same rate at which the money supply expands.
Keynes and his followers emphasise the increase in aggregate demand as the source of demand-pull inflation. There may be more than one source of demand. Consumers want more goods arid services for consumption purposes. Businessmen want more inputs for investment. Government demands more goods and services to meet the civil and military requirements of the country. Thus the 'aggregate demand comprises consumption, investment and government expenditures. When the value of aggregate demand exceeds the value of aggregate supply at the full employment level, the inflationary gap arises. The larger the gap between aggregate demand and aggregate supply, the more rapid the inflation. Given a constant average propensity to save, rising money incomes at the full employment level would lead to an excess of aggregate demand over aggregate supply and to a consequent inflationary gap. Thus Keynes used the notion of the inflationary gap to show an inflationary rise in prices.
The Danish economist Bent Hansen has presented an explicit dynamic excess demand model of inflation which incorporates two separate price levels, one for the goods market and the other for the factor (labour) market.
Cost-push Inflation:
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