Inflation : An Overview

Inflation is a sustained increase in the general price level of goods and services in an economy over a period of time. When the general price level rises, each unit of money buys fewer goods and services.Inflation reflects a reduction in the purchasing power per unit of money.

Inflation occurs due to an imbalance between demand and supply of money, changes in production and distribution cost or increase in taxes on products. When economy experiences inflation, i.e. when the price level of goods and services rises, the value of currency reduces. This means now each unit of currency buys fewer goods and services.

It has its worst impact on consumers. High prices of day-to-day goods make it difficult for consumers to afford even the basic commodities in life. This leaves them with no choice but to ask for higher incomes. Hence the government tries to keep inflation under control.

Contrary to its negative effects, a moderate level of inflation characterizes a good economy. An inflation rate of 2 or 3% is beneficial for an economy as it encourages people to buy more and borrow more, because during times of lower inflation, the level of interest rate also remains low. Hence the government as well as the central bank always strive to achieve a limited level of inflation.

Many developing countries use changes in the Consumer Price Index (CPI) as their central measure of inflation. India  used WPI as the measure for inflation but now on basis of Urjit Patel recommendations, new CPI(combined) is declared as the new standard for measuring inflation ( April 2014).

There are several variations in inflation:

Deflation : When the general level of prices is falling. This is the opposite of inflation.

Hyperinflation : Unusually rapid inflation. In extreme cases, this can lead to the breakdown of a nation's monetary system. One of the most notable examples of hyperinflation occurred in Germany in 1923, when prices rose 2,500% in one month.

Stagflation : It is the combination of high unemployment and economic stagnation with inflation. This happened in industrialized countries during the 1970s, when a bad economy was combined with OPEC raising oil prices.In recent years, most developed countries have attempted to sustain an inflation rate of 2-3%.

Recession : A period of general economic decline; typically defined as a decline in GDP for two or more consecutive quarters.A recession is typically accompanied by a drop in the stock market, an increase in unemployment, and a decline in the housing market. A recession is generally considered less severe than a depression, and if a recession continues long enough it is often then classified as a depression.

Depression : A depression is a severe economic catastrophe in which real gross domestic product (GDP) falls by at least 10%. A depression is much more severe than a recession and the effects of a depression can last for years. It is known to cause calamities in banking, trade and manufacturing, as well as falling prices, very tight credit, low investment, rising bankruptcies and high unemployment.

Causes of inflation

Inflation is the result of two sets of factors :

Cost-Push Inflation 

Cost-push inflation basically means that prices have been "pushed up" or increased by increases in costs of any of the four factors of production (labor, capital, land or entrepreneurship).

(Aggregate supply is the total volume of goods and services produced by an economy at a given price level.)When there is a decrease in the aggregate supply of goods and services due to an increase in the cost of production, we have cost-push inflation.  As a result, the increased costs are passed on to consumers, causing a rise in the general price level (inflation). 

Demand Pull inflation

A situation where the demand for goods and services rises faster than the supply of goods and services. This excess demand increases the prices of the goods and services hence creating inflation.Can be simply said as “ Too much money chasing too few goods ”.Some factors that cause this demand pull inflations are excessive foreign investment,expansionary fiscal policy e.g increase in government expenditure), expansionary monetary policy( eg. Increase in money supply),easy access to credit , deficit financing and others.

Some of the most important measures that must be followed to control inflation are:

 1. Fiscal Policy: Reducing Fiscal Deficit 

2. Monetary Policy: Tightening Credit 

3. Supply Management through Imports 

4. Incomes Policy: Freezing Wages.

1. Fiscal Policy: Reducing Fiscal Deficit:

Fiscal policy means  how a Government raises its revenue and spends it. If the total revenue raised by the Government through taxation, fees, surpluses from public undertakings is less than the expenditure it incurs on buying goods and services to meet its requirements of defence, civil admin­istration and various welfare and developmental activities, there emerges a fiscal deficit in its budget.To check inflation the Government should try to reduce fiscal deficit. It can reduce fiscal deficit by curtailing its wasteful and inessential expenditure. In India, it is often argued that there is a large scope for scaling down non-plan expenditure on defence, police and General Administration and on subsidies being provided on food, fertilizers and exports.

2. Monetary Policy: Tightening Credit:

Monetary policy refers to the adoption of suitable policy regarding interest rate and the avail­ability of credit. Monetary policy is another important measure for reducing aggregate demand to control inflation. It affects the cost of credit through interest rate.The higher the rate of interest, the greater the cost of borrowing from the banks.Other tools of monetary policy like SLR, CRR, Repo rate ,Reverse Repo rate, open market opertions are use to control inflation in the economy by  draining the liquidity from the market.

3. Supply Management through Imports:

To check the rise in prices of food-grains, edible oils, sugar etc., the Government has often taken steps to increase imports of goods in short supply to enlarge their available supplies.When inflation is of the type of supply-side inflation, imports are increased.To increase imports of goods in short supply the Govern­ment reduces customs duties on them so that their imports become cheaper and help incontaining inflation.

4. Incomes Policy: Freezing Wages:

Another anti-inflationary measure is the avoidance of wage increases.When cost of living rises due to the initial rise in prices, workers demand  higher wages to compensate for the rise in cost of living.By freezing wages of the employee can helpful in controlling inflation.