Inflation

Inflation may be defined as ‘a sustained upward trend in the general level of

prices’ and not the price of only one or two goods. G. Ackley defined inflation
as ‘a persistent and appreciable rise in the general level or average of prices’.
In other words, inflation is a state of rising prices, but not high prices.

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.

Types of Inflation:

1. Cost-Push Inflation:
Cost-push inflation occurs when we experience rising prices due to higher costs
of production and higher costs of raw materials. Cost-push inflation is
determined by supply-side factors, such as higher wages and higher oil prices.
Cost-push inflation is different to demand-pull inflation which occurs when
aggregate demand grows faster than aggregate supply.
Cost-push inflation can lead to lower economic growth and often causes a fall
in living standards, though it often proves to be temporary.

Diagram Showing Cost-Push Inflation

Short-run aggregate supply curve shifts to the left, causing a higher price level
and lower real GDP.

Causes of Cost-Push Inflation:

 Higher Price of Commodities. A rise in the price of oil would lead to

higher petrol prices and higher transport costs. All firms would see some
rise in costs. As the most important commodity, higher oil prices often
lead to cost-push inflation (e.g. 1970s, 2008, 2010-11)
 Imported Inflation. Devaluation will increase the domestic price of
imports. Therefore, after devaluation, we often get an increase in
inflation due to rising cost of imports.
 Higher Wages. Wages are one of the main costs facing firms. Rising
wages will push up prices as firms have to pay higher costs (higher
wages may also cause rising demand)
 Higher Taxes. Higher VAT and Excise duties will increase the prices of
goods. This price increase will be a temporary increase.
 Profit-push inflation. If firms gain increased monopoly power, they are
in a position to push up prices to make more profit.
 Higher Food Prices. In western economies, food is a smaller percentage
of overall spending, but in developing countries, it plays a bigger role.
(food inflation)

2. Demand-pull Inflation: Demand-pull inflation is a period of inflation

which arises from rapid growth in aggregate demand. It occurs when
economic growth is too fast.
If the aggregate demand (AD) rises faster than the productive capacity (LRAS),
then the firms will respond by putting up prices, creating inflation.

How demand-pull inflation occurs

If aggregate demand is rising at 4%, but productive capacity is only rising at

2.5%; firms will see demand outstripping supply. Therefore, they respond by
increasing prices.

Also, as firms produce more, they employ more workers, creating a rise in
employment and fall in unemployment. This increased demand for workers
puts upward pressure on wages, leading to wage-push inflation. Higher wages
increase the disposable income of workers leading to a rise in consumer
spending.

Causes of demand-pull inflation

 Lower interest rates. A cut in interest rates causes a rise in consumer

spending and higher investment. This boost to demand causes a rise in
AD and inflationary pressures.
 The rise in house prices. Rising house prices create a positive wealth
effect and boost consumer spending. This leads to economic growth.
 Rising real wages. For example, unions bargaining for higher wage rates.
 Devaluation. A depreciation of the exchange rate which makes exports
more competitive in overseas markets leading to an injection of fresh
demand into the circular flow and a rise in national income and demand
for factor resources – there may also be a positive multiplier effect on
the level of demand and output arising from the initial boost to export
sales.
 Higher demand from a government (fiscal) stimulus e.g. via a reduction
in direct or indirect taxation or higher government spending and
borrowing. If direct taxes are reduced, consumers will have more
disposable income causing demand to rise. Higher government spending
and increased borrowing feeds through directly into extra demand in the
circular flow.
 Monetary stimulus to the economy: A fall in interest rates may
stimulate too much demand – for example in raising demand for loans
or in causing rise in house price inflation.
 Faster economic growth in other countries – providing a boost to
exports overseas.
 Types of Inflation by Rate of Increase

 Creeping inflation (1-4%)

 When the rate of inflation slowly increases over time. For example, the
inflation rate rises from 2% to 3%, to 4% a year. Creeping inflation may
not be immediately noticeable, but if the creeping rate of inflation
continues, it can become an increasing problem.

 Walking inflation (2-10%)

 When inflation is in single digits – less than 10%. At this rate – inflation is
not a major problem, but when it rises over 4%, Central Banks will be
increasingly concerned. Walking inflation may simply be referred to as
moderate inflation.

 Running inflation (10-20%)

 When inflation starts to rise at a significant rate. It is usually defined as a
rate between 10% and 20% a year. At this rate, inflation is imposing
significant costs on the economy and could easily start to creep higher.

 Galloping inflation (20%-1000%)

 This is an inflation rate of between 20% up to 1000%. At this rapid rate
of price increases, inflation is a serious problem and will be challenging
to bring under control. Some definitions of galloping inflation may be
between 20% and 100%. There is no universally agreed definition, but
hyperinflation usually implies over 1,000% a year.

 Hyperinflation (> 1000%)

 This is reserved for extreme forms of inflation – usually over 1,000%
though there is no specific definition. Hyperinflation usually involves
prices changing so fast, that it becomes a daily occurrence, and under
hyperinflation, the value of money will rapidly decline.
 Effects of Inflation

Effects on business

A rise in inflation is likely to mean a rise in the cost of raw materials. Also,
workers are likely to demand higher wages to cope with the higher cost of
living. This rise in prices can also cause greater volatility and uncertainty. With
firms uncertain about future costs, they may hold back from making
investment decisions. Firms generally prefer a low and stable inflation rate.

Also, with an inflation rate, firms may expect rising interest rates, which will
increase cost of borrowing – another reason to hold back on investment.

With higher inflation, firms may face menu costs (the cost of changing and
updating prices). However, with modern technology this cost has diminished in
importance – as it is easier for firms to update prices automatically.

Effects on consumers

With rising prices, consumers may be more inclined to try and purchase more
quickly before prices rise further. With rising prices, it can create more
confusion over which prices are good value. It could lead to costs of consumers
looking around different shops comparing prices (this is known as shoe leather
costs). However, for moderate rises in inflation, this is unlikely to be too
serious. Also, the internet and price comparison sites can make it easier to
compare prices.
Effect on Central Bank and interest rates

Most Central Banks have an inflation target of around 2%. Therefore, if

inflation rises above the target, they may feel the need to increase interest
rates. Higher interest rates will increase borrowing costs and slow down the
rate of investment and economic growth. Lower economic growth will lead to
lower demand-pull inflation (though there can be time-lags).

However, it is possible, that Central Banks respond to higher inflation by

keeping interest rates the same. If inflation was due to cost-push factors and
economic growth was low – the Bank may feel it would be inappropriate to
raise interest rates.

Effect on savers

For savers with cash under the bed or receiving fixed interest payments, a
higher inflation rate could reduce the real value of their savings. For example,
if bond holders buy government bonds with interest rate of 3% and anticipated
inflation of 2% – then they expect a real interest rate of 1%. However, if
inflation rises to 7% and their interest rate stays at 3%, their effective real
interest rate is 4% – in this case, their savings reduce in value.

Effect on workers

Higher inflation will raise the cost of living. The impact on workers depends on
what happens to nominal wages. For example, if inflation is caused by rising
demand and falling unemployment, firms are likely to raise wages to keep
attracting workers. In this case, workers’ real wages will continue to rise.

Effect on the exchange rate

If inflation in India rises faster than her international competitors, the Indian
goods will become relatively uncompetitive leading to lower demand for Indian
goods and for Rupee. This will cause depreciation in the exchange rate.

Effect on economic growth

The effect on economic growth is uncertain. Sometimes inflation is caused by a

rapid rate of economic growth. However, if growth is above the long-run trend
rate – this may not be sustainable – especially if interest rates rise. Therefore,
higher inflation may be a sign the economic cycle is getting close to the end of
the boom period and may be followed by a recession.

NATURE OF INFLATION IN A DEVELOPING ECONOMY

Developing countries in their bid to raise the standards of living of their people
through development plans have often found themselves in the grip of
inflation. But the nature of inflation in under-developed and developing
economies is quite different from that found in advanced or developed
countries.

In advanced countries true inflation starts after the level of full-employment is

attained. But in developing countries like India huge unemployment and
inflation exist side by side. In other words, in developing countries, serious
inflation is in evidence long before the level of full-employment is reached.

This is so because the nature of unemployment in developing countries differs

from that which prevails in developed countries during times of depression. In
order to get the economy out of depression, governments in advanced
countries take various steps to increase the level of investment. The additional
investment expenditure leads to an increase in effective demand depending
upon the magnitude of the multiplier. But this increase in investment and
effective demand does not generate serious inflationary pressures because of
the elastic nature of the supply curve of output. Instead, increase in
investment and effective demand helps a great deal in removing depression
and unemployment which are caused by the lack of effective
demand. This is the case of developed economies. In advanced countries,
during depression, there is a lot of excess capacity in the system so that an
increase in output presents no difficult problems. Thus, the supply of output
can be increased easily so as to match increase in effective demand; there
need be no inflationary pressures.

The situation in developing countries is, however different. Here an increase in

investment does create additional demand but a corresponding increase in the
supply of output cannot be taken for granted. Unemployment in developing
economics is not due to the lack of effective demand but due to the dearth of
real capital. In these countries, level of national income can be increased and
the unemployment can be removed by accumulating more real capital. But
increase in the rate of capital formation requires stepping up the level of
investment.

Now, developing countries, under their development plans, are making huge
investment expenditure to increase the rate of capital formation and thus to
obtain rapid economic growth. This huge investment expenditure leads to a
sharp increase in prices.

Another approach to inflation in emerging countries and why it tends to be

higher is that many of these countries are experiencing rapid economic growth
contrasted with slower growth in advanced economies.

Fast growth can lead to excess demand and a positive output gap thereby
causing demand-pull inflation. It also brings about cost-push inflation for
example because of rising global demand for raw materials.

A second reason why inflation in developing countries is higher is because

many of these countries have volatile exchange rates and do not necessarily
have a well-established central bank to operate monetary policy.

Therefore, if a fast-growing country has a large current account deficit, this can
lead to a large depreciation in their exchange rate. One effect of this is a big
jump in the prices of essential imports such as foodstuffs and energy.