Inflation can be defined as the persistent increase in the price

level of goods and services in an economy over a period of time.

Some of the important definitions of inflation are:
In the words of Samuleson-Nordhaus, “Inflation is a rise in
the general level of prices.”

According to Coulborn, inflation can be defined as, “too much

money chasing too few goods.”

According to Parkin and Bade, “Inflation is an upward

movement in the average level of prices. Its opposite is
deflation, a downward movement in the average level
of prices. The boundary between inflation and
deflation is price stability.”

In the words of Peterson, “The word inflation in the

broadest possible sense refers to any increase in the
general price-level which is sustained and non-
seasonal in character.”

According to Johnson, “Inflation is an increase in the

quantity of money faster than real national output is
expanding.”

By studying the above definitions, it is clearly understood that if

the rise in prices exceeds the rise in output, the situation is
called inflationary situation. Inflation can take place due to
various reasons. One of the major reason is a rapid increase in
money supply which leads to a decrease in interest rate. A
detailed explanation on how money supply and interest rate
leads to inflation is given in the subsequent sections. Apart
from this, the following are some other causes of inflation:
  Increase in demand because of rise in individual and
aggregate disposable income on consumption and
investment goods, rise in exports, and rise in population.
 No rise in output in response to increase in demand due to
lack of capital equipment, factors of production, decrease
in imports due to restrictive policies, and emergence of
drought, famine or any other natural calamity.

CHARACTERISTICS OF INFLATION
Inflation is desirable in a country at moderate levels. However,
there is no universally acceptable limit of inflation. Depending
on the contribution, a country decides the acceptable limit of
inflation. The concept of inflation can be understood by
studying its characteristics, which are given as follows:
 Inflation is followed by price rise.
 The cause behind inflation is increase in money supply.
Thus, it is a monetary phenomenon.
 Due to interaction among various economic forces,
inflation is also an economic phenomenon. Inflation
occurs in a dynamic environment over a period of time.
 Inflation is always scarcity oriented and occurs in
disequilibrium state of economy.
 The rise in prices in inflation cannot be reversed.
 Inflation is persistent in nature

Types of Inflation
The types of inflation have been classified on the basis of their
varying nature. Generally, the basis of its classification is the
rate of speed, cause, government reaction, and employment
levels.

I. On the basis of speed

The different types of inflation on the basis of speed are

explained below:
  Creeping/Mild inflation
When the rise in price level is less than 3 percent per annum, it
is termed as creeping or mild inflation. The price of goods and
services rise moderately and it is usually considered helpful for
the development of the economy. However, some economists
consider it as a signal towards the rising prices.

 Walking inflation
A sustainable rise in price level within the range of 3 percent to
6 percent or less than 10 percent is called as walking inflation.
It occurs when mild inflation is not considered or is let to fan
out by the government.

Both creeping inflation and walking inflation are one digit

figures and are considered as moderate inflation in the
economy.

 Running inflation
When the rise in prices increase rapidly at a rate of 10 percent
or 20 percent per annum is known as running inflation. As the
inflation rate crosses two-digit figure, economic problems arise.
Running inflation adversely affects the poor and middle class
families and households in the economy.
 Hyperinflation

Hyperinflation or galloping inflation is a rise in price level by 50

percent or more annually. It occurs when running inflation is
left uncontrolled in the economy. When the economy faces
hyperinflation, the preference of people shift from money to the
traditional barter system.

For instance, between 2007 and 2009, Zimbabwe faced severe

economic problems due to political changes and harsh climatic
conditions. As a solution to this, the leaders of the country
printed billions of money, which led the country into
hyperinflation. The rate of inflation reached 79 billion% per
month.
II. On the basis of employment level

 Semi-inflation
The rise in general price level below the level of full
employment is termed as semi-inflation. According to Keynes,
general prices do not rise as long as there are unemployed
resources in the economy. However, when aggregate
expenditure increases by a large portion, costs for some
resources may rise eventually leading to increase in price. This
phenomena is known as semi-inflation.

 Pure inflation
The inflation that occurs when the economy is at full
employment level is known as pure inflation. As Keynes states,
at full employment levels, output cannot be increased any
further. Due to this, price level rises in relation to the rise in
demand for commodities. This is termed as pure inflation.

III. On the basis of government reaction

 Open inflation
When the government has no control over the price rise and
there are no barriers to price rise, it is termed as open inflation.
In this case, markets for commodities or factors or production
are allowed to function freely with no intervention from the
central authority.

 Suppressed inflation
When the government makes efforts to check the price rise
through price control mechanisms, it is called as suppressed
inflation. The government imposes various physical and
monetary controls in order to suppress the extensive increase in
price levels. Although control over price rise helps to keep
inflation under check, it leads to price rise in uncontrolled
resources, consequently resulting in diversion of productive
resources. It may also lead to economic problems like hoarding
of goods, black marketing, corruption, and so on.

IV. On the basis of cause

 Demand pull inflation

The rise in price due to excess demand for goods and
commodities in comparison to their supply is termed as
demand pull inflation. Classical economists state that the
reason behind the rise in demand is because of the increased
supply of money.

 Cost push inflation

The rise in the price level as a result of increase in the cost
involved in the production of goods and services in known as
cost push inflation. Cost of production may be caused due to
the rise in price of raw materials, wages of workers, and so on.

For instance, the cost bread that costs $1 has risen to $1.5 in a
month. This may have occurred because of the increase in the
price of wheat or because of the higher wages demanded by
workers in a baking company.

 Deficit-induced inflation
An economy faces deficit balance when its expenditures exceed
revenue. In order to meet the gap, the government prints more
money through central bank. So, any price rise in the economy
due to the government’s effort to level of the deficit balance is
called as deficit-induced inflation.

 Credit inflation
When financial institutions and commercial banks provide
more loan to the public with a view to earn more profit, the
amount of money in the economy exceeds more than what is
required. The expansion of credit leads to rise in price level and
is termed as credit inflation.
IMPORTANT CONCEPTS
Demand Pull Inflation
This is when the aggregate demand in an economy exceeds the
aggregate supply. This increase in the aggregate demand might
occur due to an increase in the money supply or income or the
level of public expenditure.

This concept is associated with full employment when altering

the supply is not possible. Take a look at the graph below:

In the graph above, SS is the aggregate supply curve and DD is

the aggregate demand curve. Further,

 Op is the equilibrium price

  Oq is the equilibrium output
Exogenous causes shift the demand curve to the right to D1D1. 
Therefore, at the current price (Op), the demand increases by
qq2. However, the supply is Oq.

Hence, the excess demand for qq2 puts pressure on the

price, increasing it to Op1. Therefore, there is a new equilibrium
at this price, where demand equals supply. As you can see, the
excess demand is eliminated as follows:

 The price rises which leads to a fall in demand and a rise in

supply.

Cost-Push Inflation
Supply can also cause inflationary pressure. If the aggregate
demand remains unchanged but the aggregate supply falls due to
exogenous causes, then the price level increases. Take a look at
the graph below:

 
In the graph above, the equilibrium price is Op and the
equilibrium output is Oq. If the aggregate supply falls, then the
supply curve SS shifts left to reach S1S1.

Now, at the price Op, the demand is Oq but the supply is

Oq2 which is lesser than Oq. Therefore, the prices are pushed
high till a new equilibrium is reached at Op1.

At this point, there is no excess demand. Hence, you can see that
inflation is a self-limiting phenomenon.

Effects of INFLATION
a. Effects of Inflation on Production

Inflation has the following effects on production activities:

 Inflation may or may not result in an increase in production

 As long as the economy does not reach the full employment
stage, inflation has a favourable effect on production
 Usually, as the price level increases, profits increase too
 During inflation, businessmen tend to raise the prices of
their products to earn better profits
 However, if the wages and production costs start rising
rapidly, then this favourable effect of inflation does not last
long
 If the inflation in an economy is of the cost-push type, then
the inflationary situation usually leads to a fall in production
 There is no direct correlation between prices and output
b. Effects of Inflation on the Distribution of Wealth
Inflation has the following effects on the distribution of wealth:

 Usually, during inflation, most people experience a rise in

their income levels
 Some people might gain at the cost of others. As the sellers
will be able to sell the goods at a higher rate to its customers
due to inflation.
 A certain set of people gain because their money income
rises faster than the prices
 A different set of people lose because prices rise faster than
their incomes during inflation

c. Effects of Inflation on Different Categories of People

Inflation affects different categories of people.

Debtors and Creditors

 During inflation, borrowers tend to gain. Hence, lenders

tend to lose.
 Borrowers gain because they repay less in real terms as
compared to when they had borrowed the money
 Lenders lose because when they receive repayment of
their debts, the real value of their money declines by the
amount of increase in the price levels
 In other terms, a borrower receives ‘dear rupees’ but pays
back ‘cheap rupees’.
Bond and Debenture Holders

 Debenture and Bond Holders earn fixed income on their

investments
 Therefore, when the price levels rise, they suffer a reduction
in real income
 Beneficiaries of life insurance programs also suffer badly
because the real value of their savings deteriorates

Investors
During inflation, businesses have an opportunity to earn good
profits. Therefore, people who invest in shares during inflation
tend to gain. As the businesses earn higher profits, they usually
distribute the profit among investor and shareholders too.

Salaried People and Wage-earners

During inflation, people earning a fixed income face a lot of
damage because the rate of increase in wages is always behind
the rate of increase in prices.

Therefore, inflation results in a drop in the real purchasing

power of people earning a fixed income. Hence, people earning a
flexible income tend to gain during inflationary periods.

Profit Earners, Speculators, and Black Marketeers

 During inflation, the profit-earners gain

 Businessmen also raise the prices of their products and earn
bigger profits
 Speculators gain by inflation, especially when the prices of
factors of production increase too
 Black marketeers tend to gain since the price of products
increases with time
Various Causes of Inflation

Primary Causes
In an economy, when the demand for a commodity exceeds its
supply, then the excess demand pushes the price up. On the other
hand, when the factor prices increase, the cost of production rises too.
This leads to an increase in the price level as well.

Increase in Public Spending

In any modern economy, Government spending is an
important element of the total spending. It is also an important
determinant of aggregate demand.

Usually, in lesser developed economies, the Govt. spending increases

which invariably creates inflationary pressure on the economy.

Deficit Financing of Government Spending
There are times when the spending of Government increases beyond
what taxation can finance. Therefore, in order to incur the extra
expenditure, the Government resorts to deficit financing.

For example, it prints more money and spends it. This, in turn, adds
to inflationary pressure.

Increased Velocity of Circulation

In an economy, the total use of money = the money supply by the
Government x the velocity of circulation of money.
When an economy is going through a booming phase, people tend to
spend money at a faster rate increasing the velocity of circulation of
money.

Population Growth
As the population grows, it increases the total demand in the market.
Further, excessive demand creates inflation.

Hoarding
Hoarders are people or entities who stockpile commodities and do
not release them to the market. Therefore, there is an artificially
created demand excess in the economy. This also leads to inflation.

Genuine Shortage
It is possible that at certain times, the factors of production are short
in supply. This affects production. Therefore, supply is less than the
demand, leading to an increase in prices and inflation.

Exports
In an economy, the total production must fulfill the domestic as well
as foreign demand. If it fails to meet these demands, then exports
create inflation in the domestic economy.

Trade Unions
Trade union work in favor of the employees. As the prices increase,
these unions demand an increase in wages for workers. This
invariably increases the cost of production and leads to a further
increase in prices.

Tax Reduction
While taxes are known to increase with time,
sometimes, Governments reduce taxes to gain popularity among
people. The people are happy because they have more money in their
hands.

However, if the rate of production does not increase with a

corresponding rate, then the excess cash in hand leads to inflation.

The imposition of Indirect Taxes

Taxes are the primary source of revenue for a Government.
Sometimes, Governments impose indirect taxes like excise duty,
VAT, etc. on businesses.

As these indirect taxes increase the total cost for the manufacturers
and/or sellers, they increase the price of the product to have a
minimal impact on their profits.

Price-rise in the International Markets
Some products require to import commodities or factors of
production from the international markets like the United States. If
these markets raise prices of these commodities or factors of
production, then the overall production cost in India increases too.
This leads to inflation in the domestic market.

Non-economic Reasons
There are several non-economic factors which can cause inflation in
an economy. For example, if there is a flood, then crops are
destroyed. This reduces the supply of agricultural products leading to
an increase in the prices of the commodities.

Investment in Gold, Real estate, stocks, mutual funds, and other

assets are some of the ways to deal with Inflation.
Methods to Control Inflation
The different measures used for controlling inflation are
shown in Figure-5:

The different measures (as shown in Figure-5) used for controlling

inflation are explained below.

1. Monetary Measures:
The government of a country takes several measures and formulates
policies to control economic activities. Monetary policy is one of the
most commonly used measures taken by the government to control
inflation.

In monetary policy, the central bank increases rate of interest on

borrowings for commercial banks. As a result, commercial banks
increase their rate of interests on credit for the public. In such a
situation, individuals prefer to save money instead of investing in
new ventures.

This would reduce money supply in the market, which, in turn,

controls inflation. Apart from this, the central bank reduces the
credit creation capacity of commercial banks to control inflation.

The monetary policy of a country involves the following:

(a) Rise in Bank Rate:
Refers to one of the most widely used measure taken by the central
bank to control inflation.

The bank rate is the rate at which the commercial bank gets a
rediscount on loans and advances by the central bank. The increase
in the bank rate results in the rise of rate of interest on loans for the
public. This leads to the reduction in total spending of individuals.
The main reasons for reduction in total expenditure of
individuals are as follows;
(i) Making the borrowing of money costlier:
Refers to the fact that with the rise in the bank rate by the central
bank increases the interest rate on loans and advances by
commercial banks. This makes the borrowing of money expensive
for general public.

Consequently, individuals postpone their investment plans and wait

for fall in interest rates in future. The reduction in investments
results in the decreases in the total spending and helps in
controlling inflation.

(ii) Creating adverse situations for businesses:

Implies that increase in bank rate has a psychological impact on
some of the businesspersons. They consider this situation adverse
for carrying out their business activities. Therefore, they reduce
their spending and investment.

(iii) Increasing the propensity to save:

Refers to one of the most important reason for reduction in total
expenditure of individuals. It is a well-known fact that individuals
generally prefer to save money in inflationary conditions. As a
result, the total expenditure of individuals on consumption and
investment decreases.

(b) Direct Control on Credit Creation:

Constitutes the major part of monetary policy.

The central bank directly reduces the credit control

capacity of commercial banks by using the following
methods:
(i) Performing Open Market Operations (OMO):
Refers to one of the important method used by the central bank to
reduce the credit creation capacity of commercial banks. The central
bank issues government securities to commercial banks and certain
private businesses.
In this way, the cash with commercial banks would be spent on
purchasing government securities. As a result, commercial bank
would reduce credit supply for the general public.

(ii) Changing Reserve Ratios:

Involves increase or decrease in reserve ratios by the central bank to
reduce the credit creation capacity of commercial banks. For
example, when the central bank needs to reduce the credit creation
capacity of commercial banks, it increases Cash Reserve Ratio
(CRR). As a result, commercial banks need to keep a large amount
of cash as reserve from their total deposits with the central bank.
This would further reduce the lending capacity of commercial
banks. Consequently, the investment by individuals in an economy
would also reduce.

2. Fiscal Measures:
Apart from monetary policy, the government also uses fiscal
measures to control inflation. The two main components of fiscal
policy are government revenue and government expenditure. In
fiscal policy, the government controls inflation either by reducing
private spending or by decreasing government expenditure, or by
using both.

It reduces private spending by increasing taxes on private

businesses. When private spending is more, the government
reduces its expenditure to control inflation. However, in present
scenario, reducing government expenditure is not possible because
there may be certain on-going projects for social welfare that cannot
be postponed.

Besides this, the government expenditures are essential for other

areas, such as defense, health, education, and law and order. In
such a case, reducing private spending is more preferable rather
than decreasing government expenditure. When the government
reduces private spending by increasing taxes, individuals decrease
their total expenditure.

For example, if direct taxes on profits increase, the total disposable

income would reduce. As a result, the total spending of individuals
decreases, which, in turn, reduces money supply in the market.
Therefore, at the time of inflation, the government reduces its
expenditure and increases taxes for dropping private spending.

3. Price Control:
Another method for ceasing inflation is preventing any further rise
in the prices of goods and services. In this method, inflation is
suppressed by price control, but cannot be controlled for the long
term. In such a case, the basic inflationary pressure in the economy
is not exhibited in the form of rise in prices for a short time. Such
inflation is termed as suppressed inflation.

The historical evidences have shown that price control alone cannot
control inflation, but only reduces the extent of inflation. For
example, at the time of wars, the government of different countries
imposed price controls to prevent any further rise in the prices.
However, prices remain at peak in different economies. This was
because of the reason that inflation was persistent in different
economies, which caused sharp rise in prices. Therefore, it can be
said inflation cannot be ceased unless its cause is determined.