ECONOMICS PROJECT - INFLATION

1. Meaning of Inflation:
Inflation is often defined in terms of its supposed causes. Inflation exists when money supply exceeds
available goods and services. Or inflation is attributed to budget deficit financing. A deficit budget
may be financed by the additional money creation. But the situation of monetary expansion or budget
deficit may not cause price level to rise. Hence the difficulty of defining ‘inflation’.

It is not high prices but rising price level that constitute inflation. It constitutes, thus, an overall
increase in price level. It can, thus, be viewed as the devaluing of the worth of money. In other words,
inflation reduces the purchasing power of money. A unit of money now buys less. Inflation can also
be seen as a recurring phenomenon.

While measuring inflation, we take into account a large number of goods and services used by the
people of a country and then calculate average increase in the prices of those goods and services over
a period of time. A small rise in prices or a sudden rise in prices is not inflation since they may reflect
the short term workings of the market.

It is to be pointed out here that inflation is a state of disequilibrium when there occurs a sustained rise
in price level. It is inflation if the prices of most goods go up. Such rate of increases in prices may be
both slow and rapid. However, it is difficult to detect whether there is an upward trend in prices and
whether this trend is sustained. That is why inflation is difficult to define in an unambiguous sense.

As inflation is a state of rising prices, deflation may be defined as a state of falling prices but not fall
in prices. Deflation is, thus, the opposite of inflation, i.e., a rise in the value of money or purchasing
power of money. Disinflation is a slowing down of the rate of inflation.

2. Types of Inflation:

(i) Currency inflation:

This type of inflation is caused by the printing of currency notes.

(ii) Credit inflation:

Being profit-making institutions, commercial banks sanction more loans and advances to the public
than what the economy needs. Such credit expansion leads to a rise in price level.

(iii) Deficit-induced inflation:

The budget of the government reflects a deficit when expenditure exceeds revenue. To meet this gap,
the government may ask the central bank to print additional money. Since pumping of additional
money is required to meet the budget deficit, any price rise may the be called the deficit-induced
inflation.

(iv) Demand-pull inflation:

An increase in aggregate demand over the available output leads to a rise in the price level. Such
inflation is called demand-pull inflation

(v) Cost-push inflation:

Inflation in an economy may arise from the overall increase in the cost of production. This type of
inflation is known as cost-push inflation

B. On the Basis of Speed or Intensity:

(i) Creeping or Mild Inflation:
If the speed of upward thrust in prices is slow but small then we have creeping inflation. What speed
of annual price rise is a creeping one has not been stated by the economists. To some, a creeping or
mild inflation is one when annual price rise varies between 2 p.c. and 3 p.c. If a rate of price rise is
kept at this level, it is considered to be helpful for economic development. Others argue that if annual
price rise goes slightly beyond 3 p.c. mark, still then it is considered to be of no danger.

(ii) Walking Inflation:

If the rate of annual price increase lies between 3 p.c. and 4 p.c., then we have a situation of walking
inflation. When mild inflation is allowed to fan out, walking inflation appears. These two types of
inflation may be described as ‘moderate inflation’.

Often, one-digit inflation rate is called ‘moderate inflation’ which is not only predictable, but also
keep people’s faith on the monetary system of the country. Peoples’ confidence get lost once
moderately maintained rate of inflation goes out of control and the economy is then caught with the
galloping inflation.

(iii) Galloping and Hyperinflation:

Walking inflation may be converted into running inflation. Running inflation is dangerous. If it is not
controlled, it may ultimately be converted to galloping or hyperinflation. It is an extreme form of
inflation when an economy gets shattered.”Inflation in the double or triple digit range of 20, 100 or
200 p.c. a year is labelled “galloping inflation”.

(iv) Government’s Reaction to Inflation:

Inflationary situation may be open or suppressed. Because of anti-inflationary policies pursued by the
government, inflation may not be an embarrassing one. For instance, increase in income leads to an
increase in consumption spending which pulls the price level up.
If the consumption spending is countered by the government via price control and rationing device,
the inflationary situation may be called a suppressed one. Once the government curbs are lifted, the
suppressed inflation becomes open inflation. Open inflation may then result in hyperinflation.

EFFECTS OF INFLATION
People’s desires are inconsistent. When they act as buyers they want prices of goods and services to
remain stable but as sellers they expect the prices of goods and services should go up. Such a happy
outcome may arise for some individuals; “but, when this happens, others will be getting the worst of
both worlds.”

When price level goes up, there is both a gainer and a loser. To evaluate the consequence of inflation,
one must identify the nature of inflation which may be anticipated and unanticipated. If inflation is
anticipated, people can adjust with the new situation and costs of inflation to the society will be
smaller.

In reality, people cannot predict accurately future events or people often make mistakes in predicting
the course of inflation. In other words, inflation may be unanticipated when people fail to adjust
completely. This creates various problems.

One can study the effects of unanticipated inflation under the following:
1. Effects of Inflation on Distribution of Income and Wealth:
During inflation, usually people experience rise in incomes. But some people gain during inflation at
the expense of others. Some individuals gain because their money incomes rise more rapidly than the
prices and some lose because prices rise more rapidly than their incomes during inflation. Thus, it
redistributes income and wealth.

Though no conclusive evidence can be cited, it can be asserted that following categories of people are
affected by inflation differently:
o Creditors and debtors:
Borrowers gain and lenders lose during inflation because debts are fixed in rupee terms. When debts
are repaid their real value declines by the price level increase and, hence, creditors lose. An individual
may be interested in buying a house by taking loan of Rs. 7 lakh from an institution for 7 years.

The borrower now welcomes inflation since he will have to pay less in real terms than when it was
borrowed. Lender, in the process, loses since the rate of interest payable remains unaltered as per
agreement. Because of inflation, the borrower is given ‘dear’ rupees, but pays back ‘cheap’ rupees.
However, if in an inflation-ridden economy creditors chronically loose, it is wise not to advance loans
or to shut down business.
Never does it happen. Rather, the loan-giving institution makes adequate safeguard against the erosion
of real value. Above all, banks do not pay any interest on current account but charges interest on
loans.

o Bond and debenture-holders:

In an economy, there are some people who live on interest income—they suffer most. Bondholders
earn fixed interest income: These people suffer a reduction in real income when prices rise. In other
words, the value of one’s savings decline if the interest rate falls short of inflation rate. Similarly,
beneficiaries from life insurance programmes are also hit badly by inflation since real value of savings
deteriorate.

o Investors:
People who put their money in shares during inflation are expected to gain since the possibility of
earning of business profit brightens. Higher profit induces owners of firm to distribute profit among
investors or shareholders.

o Salaried people and wage-earners:

Anyone earning a fixed income is damaged by inflation. Sometimes, unionised worker succeeds in
raising wage rates of white-collar workers as a compensation against price rise. But wage rate changes
with a long time lag. In other words, wage rate increases always lag behind price increases. Naturally,
inflation results in a reduction in real purchasing power of fixed income-earners.

On the other hand, people earning flexible incomes may gain during inflation. The nominal incomes
of such people outstrip the general price rise. As a result, real incomes of this income group increase.

o Profit-earners, speculators and black marketers:

It is argued that profit-earners gain from inflation. Profit tends to rise during inflation. Seeing
inflation, businessmen raise the prices of their products. This results in a bigger profit. Profit margin,
however, may not be high when the rate of inflation climbs to a high level.

However, speculators dealing in business in essential commodities usually stand to gain by inflation.
Black marketers are also benefited by inflation.

Thus, there occurs a redistribution of income and wealth. It is said that rich becomes richer and poor
becomes poorer during inflation. However, no such hard and fast generalisation can be made. It is
clear that someone wins and someone loses during inflation.

These effects of inflation may persist if inflation is unanticipated. However, the redistributive burdens
of inflation on income and wealth are most likely to be minimal if inflation is anticipated by the
people. With anticipated inflation, people can build up their strategies to cope with inflation.
If the annual rate of inflation in an economy is anticipated correctly people will try to protect them
against losses resulting from inflation. Workers will demand 10 p.c. wage increase if inflation is
expected to rise by 10 p.c.

Similarly, a percentage of inflation premium will be demanded by creditors from debtors. Business
firms will also fix prices of their products in accordance with the anticipated price rise. Now if the en-
tire society “learn to live with inflation”, the redistributive effect of inflation will be minimal.

However, it is difficult to anticipate properly every episode of inflation. Further, even if it is

anticipated it cannot be perfect. In addition, adjustment with the new expected inflationary conditions
may not be possible for all categories of people. Thus, adverse redistributive effects are likely to
occur.

Finally, anticipated inflation may also be costly to the society. If people’s expectation regarding future
price rise become stronger they will hold less liquid money. Mere holding of cash balances during
inflation is unwise since its real value declines. That is why people use their money balances in
buying real estate, gold, jewellery, etc. Such investment is referred to as unproductive investment.
Thus, during inflation of anticipated variety, there occurs a diversion of resources from priority to
non-priority or unproductive sectors.

2. Effect on Production and Economic Growth:

Inflation may or may not result in higher output. Below the full employment stage, inflation has a
favourable effect on production. In general, profit is a rising function of the price level. An
inflationary situation gives an incentive to businessmen to raise prices of their products so as to earn
higher volume of profit. Rising price and rising profit encourage firms to make larger investments.

As a result, the multiplier effect of investment will come into operation resulting in a higher national
output. However, such a favourable effect of inflation will be temporary if wages and production costs
rise very rapidly.

Further, inflationary situation may be associated with the fall in output, particularly if inflation is of
the cost-push variety. Thus, there is no strict relationship between prices and output. An increase in
aggregate demand will increase both prices and output, but a supply shock will raise prices and lower
output.

Inflation may also lower down further production levels. It is commonly assumed that if inflationary
tendencies nurtured by experienced inflation persist in future, people will now save less and consume
more. Rising saving propensities will result in lower further outputs.
One may also argue that inflation creates an air of uncertainty in the minds of business community,
particularly when the rate of inflation fluctuates. In the midst of rising inflationary trend, firms cannot
accurately estimate their costs and revenues. That is, in a situation of unanticipated inflation, a great
deal of risk element exists.

It is because of uncertainty of expected inflation, investors become reluctant to invest in their business
and to make long-term commitments. Under the circumstance, business firms may be deterred in in-
vesting. This will adversely affect the growth performance of the economy.

However, slight dose of inflation is necessary for economic growth. Mild inflation has an encouraging
effect on national output. But it is difficult to make the price rise of a creeping variety. High rate of
inflation acts as a disincentive to long run economic growth. The way the hyperinflation affects
economic growth is summed up here. We know that hyper-inflation discourages savings.

A fall in savings means a lower rate of capital formation. A low rate of capital formation hinders
economic growth. Further, during excessive price rise, there occurs an increase in unproductive
investment in real estate, gold, jewellery, etc. Above all, speculative businesses flourish during
inflation resulting in artificial scarcities and, hence, further rise in prices.

Again, following hyperinflation, export earnings decline resulting in a wide imbalances in the balance
of payment account. Often galloping inflation results in a ‘flight’ of capital to foreign countries since
people lose confidence and faith over the monetary arrangements of the country, thereby resulting in a
scarcity of resources. Finally, real value of tax revenue also declines under the impact of hyperinfla-
tion. Government then experiences a shortfall in investible resources.

Thus economists and policymakers are unanimous regarding the dangers of high price rise. But the
consequences of hyperinflation are disastrous. In the past, some of the world economies (e.g.,
Germany after the First World War (1914-1918), Latin American countries in the 1980s) had been
greatly ravaged by hyperinflation.

- Pankhudi Narayan