Inflation

Introduction:
➢ Inflation - overall increase in prices goods and services.
➢ Inflation erodes the purchasing power of money, meaning that the
same amount of money buys fewer goods and services over time.
➢ It refers to the slow decline in the value of money, shown by a general
increase in prices for products and services over time.
➢ It indicates how much costlier a group of goods and services has
become during a specific time frame.
➢ The inflation rate is determined by the average price rise of a chosen
set of goods and services, which may include areas like food, housing,
transportation, and healthcare.
Definitions:
➢ “A persistent and appreciable rise in the general level of prices.”
➢ A sustained rise in prices may be of various magnitudes. Different names
have been given to inflation depending upon the rate of rise in prices.
➢ Creeping Inflation - Rise in prices is very slow (less than 3% per annum).
➢ Walking or Trotting Inflation - When prices rise moderately (less than
10% per annum).
➢ Running Inflation - when prices rise rapidly (10 to 20% per annum).
➢ Hyperinflation - When prices rise at double or triple-digit rate (more than
20% per annum).
➢ Hyperinflation is a situation when the rate of inflation becomes
immeasurable and absolutely uncontrollable. Such a situation brings a total
collapse of monetary system because of the continuous fall in the
purchasing power of money.
Inflationary Gap
➢ An inflationary gap arises when the demand for goods and services
exceeds the supply, even at full employment
➢ It signifies that aggregate demand for goods and services is
outpacing the economy's capacity to produce due to higher levels of
employment, increased trade activities, or elevated government
expenditure, leading to upward pressure on prices and inflation.
➢ An inflationary gap measures the difference between the current
level of real gross domestic product (GDP) and the GDP that would
exist if an economy was operating at full employment.
➢ Inflationary Gap = Actual GDP−Anticipated GDP​
Inflationary Gap (contd.)
➢ The inflationary gap can be illustrated as under;
Actual GDP Anticipated GDP
GDP at current Rs. 250 cr. GDP at pre-inflation prices Rs. 200 cr.
prices
Taxes Rs. 60 cr. Government expenditure Rs. 80 cr.
Disposable income Rs. 190 cr. Output available for consumption Rs. 120 cr.
at pre-inflation prices
Inflationary Gap = Rs. 190 cr. – Rs. 120 cr. = Rs. 70 cr.
Inflationary Gap (contd.)
➢ In reality, the entire disposable income of Rs. 190 cr. is not spent and
a part of it is saved.
➢ If, say, 20% of it (Rs. 38 cr.) is saved, then Rs. 152 cr. (Rs. 190 cr. -
Rs. 38 cr.) would be left to create demand for goods worth Rs. 120
crore.
➢ The actual inflationary gap would be Rs. 32 cr. (Rs. 152 cr. - Rs. 120
cr.) instead of Rs. 70 cr.

➢ Diagrammatic representation of inflationary gap

Inflationary Gap (contd.)
➢ Where Yf is the full employment level
of income, the 450 line represents
aggregate supply AS and C+I+G = AD
line is the desired level of consumption,
investment and government
expenditure.
➢ The economy’s aggregate demand
curve (C+I+G) = AD intersects the AS
line at point E at the income level OYO
which is greater than the full
employment income level OYf.
➢ The amount by which aggregate
demand (AYf) exceeds the aggregate
supply (BYf) at the full employment
income level is the inflationary gap
Inflationary Gap (contd.)
➢ The excess volume of total spending when resources are fully
employed creates inflationary pressure.
➢ Thus, inflationary gap leads to inflationary pressures in the economy
which are the result of excess aggregate demand.
➢ The inflationary gap can be wiped out by increasing taxes and
reducing expenditure (increasing saving).
Types of Inflation
➢ Demand-pull inflation - occurs when aggregate demand exceeds
aggregate supply, leading to higher prices.
➢ Cost-push inflation - happens when production costs increase,
pushing up prices.
Demand-Pull Inflation
➢ Demand-pull inflation occurs when aggregate demand for goods and
services exceeds aggregate supply in the economy.
➢ Demand-pull inflation causes upward pressure on prices due to
shortages in supply, a condition that economists describe as “too
much money chasing too few goods.”
➢ The increase in AD can arise from any positive changes in:
consumption, investment, government spending or net exports.
➢ While demand increases, the supply of goods and services available
for purchase may remain the same or drop either because resources
are fully utilized or production cannot be increased rapidly due to
varous bottlenecks in the production system.
Demand-Pull Inflation (contd.)
➢Given the original aggregate demand
curve, AD1, and short-run aggregate
supply curve, AS, price-level settles at
point P1. For every rise in any the
components of AD, AD curve shifts to
the right, AD2, AD3, and so on and
with it the price-level also rises.
➢The rise in price is in response to the
supply elasticity. Since aggregate
supply curve also rises in the short run,
price-level rises but not quite sharply.
But, beyond certain point, aggregate
supply curve is unable to respond to rise
in AD. AS curve is completely inelastic
price level rises more rapidly.
Cost-push Inflation
➢ The rising prices due to higher costs of production. It is also known
as New inflation.
➢ Cost-push inflation is determined by supply-side factors, such as;
✓ Higher wages (wage-push)
✓ Higher profit (profit-push)
✓ Rising food and energy prices
✓ Higher taxes
✓ Currency depreciation/devaluation
Cost-push Inflation (contd.)
➢ The supply curves AS1 and AS2 are
shown as increasing functions of the
price level up to the full employment
level of income Y1.
➢ Given the demand conditions as
represented by AD, the supply curve
AS1 shifts to AS2 in response to cost
increasing pressures as a result of rise
in, say, money wage.
➢ Consequently, the equilibrium position
shifts from E1 to E2 reflecting rise in
the price level from P1 to P2 and fall
in output, employment and income
from Y1 to Y2.
➢ Short-run aggregate supply curve
shifts to the left, causing a higher price
level and lower real GDP.
Causes of Inflation
➢ Factors Affecting Demand
✓ Increase in Money Supply
✓ Increase in Disposable Income
✓ Increase in Public Expenditure
✓ Increase in Consumer Spending
✓ Cheap Monetary Policy
✓ Deficit Financing
✓ Expansion of the Private Sector
✓ Black Money
✓ Repayment of Public Debt
✓ Increase in Export
Causes of Inflation (contd.)
➢ Factors Affecting Supply
✓ Shortage of factors of Production
✓ Industrial Disputes
✓ Natural Calamities
✓ Artificial Scarcity
✓ Increase in Exports
✓ Lop-sided Production
✓ Law of Diminishing Returns
✓ International Factors
Effects of Inflation
➢ Inflation affects different people differently because of the fall in the
value of money.
➢ When price rises or the value of money falls, some groups of the
society gain, some lose and some stand in-between.
➢ This is because the price movements in the case of different goods,
services, assets, etc. are not uniform. The prices of some goods and
services rise faster, some rise slowly and still some remain
unchanged.
Effects of Inflation (contd.)
➢ Effects on redistribution of Income and Wealth
Inflation brings about shifts in the distribution of real income from
those whose money incomes are relatively inflexible to those whose
money incomes are relatively flexible.
➢ Broadly, there are two economic groups in every society
✓ Fixed income group - The poor and middle classes suffer
because their wages and salaries are more or less fixed but the
prices of commodities continue to rise. They become more
impoverished.
✓ Flexible income group - Businessmen, industrialists, traders, real
estate holders, speculators, and others with variable incomes gain
during rising prices. They become richer.
Effects of Inflation (contd.)
➢ Effects on Production
When prices start rising production is encouraged as it provides
wind-fall profits. This tends to increase employment, production and
income till the full employment level. Inflation adversely affects
production after the level of full employment.
➢ Other Effects
✓ Government
✓ Social
✓ Political
Measures to control Inflation
➢ Monetary policy
Monetary policy is adopted by the nation's central bank to control the
overall money supply and promote economic growth. It is a powerful
tool to regulate macroeconomic variables such as inflation and
unemployment.
An expansionary monetary policy is used to overcome a recession or
a depression or a deflationary gap. When there is a fall in the
consumer demand for goods and services, and in business demand
for investment goods, a deflationary gap emerges. The central starts
an expansionary monetary policy that ease the credit market
conditions and leads to an upward shift in aggregate demand.
Monetary policy (contd.)
The central bank purchases government securities in the open
market, lowers the reserve requirements of member banks, lower the
discount rate and encourages consumer and business credit through
selective credit measures.
The monetary policy designed to curtail aggregate demand is called
restrictive (or dear) monetary policy. It is used to overcome an
inflationary gap.
➢ The instruments of monetary policy;
Credit control – The central bank of the country adopts a number of
methods to control the quantity and quality of credit. The various
tools to control credit are;
Instruments of monetary policy
➢ Repo Rate (Repurchasing Option):
The interest rate at which the central bank lends money to
commercial banks against government securities as collateral. It
serves as a short-term borrowing facility for commercial banks to
meet their liquidity needs. By adjusting this, the central bank
influences liquidity conditions in the banking system.
An increase in the repo rate makes borrowing more expensive for
commercial banks leading to tighter interbank liquidity and
potentially higher lending rates for consumers and businesses
thereby reduces the money supply.
A lower repo rate increases the availability of funds for commercial
banks, leading to looser interbank liquidity and potentially lower
lending rates.
Instruments of monetary policy (contd.)
➢ Bank Rates or Discount Rate:
It is the interest rate at which a country’s central bank lends money
to commercial banks or other financial institutions. It is typically
used to control the overall money supply in the economy and
influence borrowing costs.
When the central bank raises the bank rate, borrowing becomes more
expensive for commercial banks. Conversely, when the bank rate is
lowered, it encourages borrowing and stimulates economic activity.
Instruments of monetary policy (contd.)
➢ Difference between Repo Rate and Bank Rate
Feature Repo Rate Bank Rate
Collateral Requires collateral (government Does not require collateral
securities) (unsecured)
Purpose Short-term liquidity management Long-term economic control
Lending Banks borrow from RBI against Banks borrow from RBI
Mechanism government securities, with a without any security or
repurchase agreement agreement
Impact More immediate impact on short- Indirectly influences inflation
term interest rates, potentially by affecting long-term interest
influencing inflation expectations rates and economic activity
immediately over time
Instruments of monetary policy (contd.)
➢ Open market operations:
Sale and purchase of government securities in the money market by
the central bank. When prices are rising and there is need to control
them, the central bank sells securities to drain out the reserves of
commercial banks required for lending to business community. Thus,
investment is discouraged and the rise in prices is checked.
Contrariwise, when recessionary forces start in the economy, the
central bank buys securities. The reserves of commercial banks are
raised. They lend more. Investment, output, employment, income
and demand rise and fall in price is checked.
Instruments of monetary policy (contd.)
➢ Changes in reserve ratios:
Banks are required by law to keep a certain percentage of its total
deposits in the form of a reserve fund in its vault and also a certain
percentage with the central bank. When prices are rising, the central
bank raises the reserve ratio. Banks are required to keep more with
the central bank to reduce lending. Thus, volume of investment,
output and employment are adversely affected.
Opposite is the case when the reserve ratio is lowered, the reserves of
commercial banks are raised to improve lending and the economic
activity are favourably affected.
Instruments of monetary policy (contd.)
➢ Selective credit controls:
It used to influence the direction of credit flow in the economy,
rather than the overall volume of credit. It focuses on regulating
credit for specific purposes, sectors, or types of borrowers,
encouraging or discouraging lending in certain areas.
They usually take the form of changing margin requirements to
control speculative activities within the economy. When there is
brisk speculative activity in the economy or in particular sectors in
certain commodities, and prices start rising, the central bank raises
the margin requirement on them. The result is that the borrowers are
given less money in loans against specific securities.
Instruments of monetary policy (contd.)
➢ An expansionary monetary policy is used to overcome a recession or
a depression or a deflationary gap. When there is a fall in the
consumer demand for goods and services, and in business demand
for investment goods, a deflationary gap emerges. The central starts
an expansionary monetary policy that ease the credit market
conditions and leads to an upward shift in aggregate demand.
➢ The central bank purchases government securities in the open
market, lowers the reserve requirements of member banks, lower the
discount rate and encourages consumer and business credit through
selective credit measures.
➢ The monetary policy designed to curtail aggregate demand is called
restrictive (or dear) monetary policy. It is used to overcome an
inflationary gap.
Fiscal Policy
➢ It refers to the use of taxation and government expenditure by the
government to influence a country's economy, particularly
macroeconomic conditions like aggregate demand, employment,
output and prices. It is the government's tool for managing revenue
and spending to achieve specific economic goals.
➢ An increase in public expenditure during depression adds to the
aggregate demand for goods and services and leads to a large
increase in income via multiplier process.; while a reduction in taxes
has the effect of raising disposable income thereby increasing
consumption and investment expenditure of the people.
Fiscal Policy (contd.)
➢ A reduction of public expenditure during inflation reduces aggregate
demand, national income, employment, output and prices; while an
increase in taxes tends to reduce disposable income and thereby
reduces consumption and investment expenditures.
➢ The principal fiscal measures are;
✓ Reduction in unnecessary expenditure
✓ Increase in Taxes
✓ Increase in Savings
✓ Surplus Budgets (Revenue exceed Expenditure)/Deficit Budgets
✓ Public Borrowing