Inflation

Inflation is the rate of increase in prices over a given period of time. Inflation is typically a broad measure, such as the overall increase in prices or the increase in the cost of living in a country. But it can also be more narrowly calculated—for certain goods, such as food, or for services, such as a haircut, for example. Whatever the context, inflation represents how much more expensive the relevant set of goods and/or services has become over a certain period, most commonly a year.


According to Milton Friedman, “inflation is always and everywhere a monetary phenomenon and can be produced only by increase in the value of money than in output.”


Types of Inflation –

Broadly inflation can be divided into (on the basis of cause): -


1. Demand Pull Inflation – it is caused by an increase in the aggregate demand for goods and services whereas, the aggregate supply is not increasing. It is a situation where too much money is chasing too few goods.


2. Cost Push Inflation – any increase in the cost of production of industry, either because of increase in the price of raw materials or increase in wages of labourers, brings cost push inflation. This is generally caused by wage increase enforced by labour union. This type of inflation is characterised by lack of aggregate demand, unemployment, unused resources and excess capacity.


Inflation is also divided on the basis of speed, at rate which prices increase – 


1. Creeping Inflation (Mild or Low Inflation): A gradual increase in prices, usually less than 3% annually, which is considered manageable and may positively stimulate demand and investment.


2. Walking Inflation (Trotting Inflation): Prices increase at a moderate pace, generally around 3% to 10% per year. If unchecked, it can lead to economic overheating.


3. Galloping Inflation (Hopping or Running Inflation): This inflation occurs when prices increase rapidly at double—or triple-digit annual rates, between 10% and 50%. It disrupts economic stability and can severely affect consumer purchasing power.


4. Hyperinflation: An extreme form of inflation where prices rise over 50% monthly. Hyperinflation can decimate a currency’s value.


Causes of Inflation –

Inflation arises from demand-pull factors, cost-push factors, supply shocks, increased money supply, wage-price spirals, inflation expectations, and certain fiscal policies. These elements collectively drive price increases, impacting purchasing power.


1. Demand-Pull Factors: When demand for goods and services exceeds supply, prices increase. This often happens when there is an influx of cash or credit in the economy, stimulating purchasing beyond the economy’s capacity.


2. Cost-Push Factors: Rising production costs can also cause inflation. When the costs of inputs like raw materials and labour increase, companies pass these costs on to consumers through higher prices.


3. Supply Shocks: Sudden disruptions to supply, such as natural disasters, conflicts, or pandemics, can significantly reduce the availability of critical goods.

For example, supply chain issues during COVID-19 led to price spikes across sectors.


4. Increased Money Supply: A significant increase in the money supply can drive inflation, as more cash circulating in the economy fuels higher demand. With too much money chasing too few goods, prices tend to rise.


5. Wage-Price Spirals: When workers demand higher wages to cope with rising prices, businesses often raise prices to cover these increased labour costs. This cycle, known as the wage-price spiral, can fuel sustained inflation.


6. Inflation Expectations: When people expect inflation to persist, they may demand higher wages and buy goods now to avoid future price increases, reinforcing inflation. Central banks aim to keep these expectations stable to control inflation.


7. Fiscal Policies: Government policies like tax cuts or increased public spending can raise overall demand, leading to inflation if the economy is already operating at full capacity and supply cannot keep pace.


Effects of Inflation –

Effects of inflation on production: -


  1. If affects the volume of production very badly.
  2. It brings about a fall in the quality of the commodity.
  3. It causes miss-allocation of resources.
  4. It brings hoarding and black marketing into existence.
  5. It increases speculation.


Effects of inflation on Distribution of Income and Wealth: -

  1. Debtors gain because of the fall in the value of money.
  2. Creditors lose during the period of price hike.
  3. Regular salary earners are hit hard.
  4. Businessmen gain in times of inflation.
  5. Agricultural landlords loose during price rise.
  6. People who have invested in shares and stocks gain at times of inflation.
  7. Landless agricultural labourers loose.


Other effects of Inflation: -

  1. Expenditure of govt. will increase due to rise in prices.
  2. Govt. can collect the higher amount of tax as a result of increase in the income of people.
  3. Balance of Payment (BOP) is adversely affected.
  4. Inflation lowers the Foreign Exchange Rate.
  5. Monetary system of the country can collapse during inflation.
  6. Social evils like black marketing, adulteration, corruption emerges during inflation.


Deflation

It is the state wherein the value of money is rising, i.e., prices are falling. It refers to a persistent fall in price and a corresponding rise in the value of money.

It is said to be caused when prices are falling more than proportionately to the output of goods and services in the economy as a result of decrease in money supply.


Causes of Deflation –

Causes of deflation are as follows: -


  1. Deflation is caused when volume of production increases faster than the volume of money income in the country.
  2. It is caused when the total demand for goods and services is less than their total supply.
  3. Over production in agricultural and industrial sector leads to deflation.
  4. A reduction in national income, bank credit and investment brings about deflation.


Effects of Deflation:

Deflation leads to following effects: -


1. Reduced Spending and Investment – When prices are falling, consumers may postpone purchases, anticipating even lower prices in the future. This can significantly decrease demand for goods and services. Businesses may also postpone investments and expansion plans due to the uncertainty and decreased demand caused by deflation. This can lead to slower economic growth.


2. Increased Debt Burden – Deflation increases the real value of debt, making it more difficult for individuals and businesses to repay loans. Debtors must use a larger portion of their income or revenue to service the same amount of debt. As debt becomes harder to manage, the risk of defaults and bankruptcies increases, potentially destabilizing the financial system.


3. Economic Slowdown and Unemployment – With decreased demand, businesses may reduce production, leading to lower output and potentially job losses. As companies cut costs and production, they may lay off employees, increasing the unemployment rate.


4. Lower Business Profits and Revenue – Deflation means lower prices for goods and services, which can lead to lower revenue and profits for businesses. Businesses may face pressure to cut wages or reduce salaries to offset the impact of lower prices.


5. Potential for Recession or Depression – If deflationary pressures persist, the economy can experience a significant contraction, potentially leading to a recession or even a depression. Deflation can erode consumer and business confidence, further exacerbating the economic slowdown.


In conclusion, while lower prices might seem beneficial in the short term, deflation can have severe consequences for an economy, including reduced spending, increased debt burdens, economic slowdown, and potentially devastating recessions or depressions.