Chapter 3.

Inflation and Deflation

Aim
To familiarise the students with the knowledge of
Inflation and Deflation
Instructional Objectives
After completing this chapter, you should be able to:

Explain the concept of Inflation

Explain the different types of inflation

Explain the concept of Deflation

Enumerate the causes of Deflation

Explain the concept of
Inflation
3.1.1 Inflation
Meaning

• Inflation is a monetary phenomenon of persistent increase in price.

• Inflation may be defined as a situation where prices of all goods and

services are rising continuously and constantly, or the value of money is
falling continuously and constantly.

• According to Crowther, “inflation is a state in which the value of money

is falling that is, prices are rising”.

• According to Gardner Ackley, “inflation is a persistent and appreciable

rise in the general level or average of prices”.

• According to Pigou, inflation exists, “when money income is expanding

relative to the output of work done by the productive agents for which it
is the payment”.
3.1.1 Inflation
Causes

Inflation is caused by one or more of the following factors:

Increase in money supply:
• When there is excess money supply in comparison to aggregate
demand, the price level increases.
• According to Milton Friedman, “Inflation can be produced only by a
more rapid increase in the quantity of money than output”.

Increase in aggregate demand

• The excess aggregate demand could be due to increasing government
expenditure, investment by business sector and consumption demand
from the household sector.

Wars
• Wars are responsible for inflation. During wars, the needs of the
military are first met. Consequently, the supply of goods for the civilians
is reduced.
3.1.1 Inflation
Causes
Deficit Financing : When the government adopts deficit financing, that is, if the
government spends more than its revenues, it results in the printing of more
currency notes.

Increase in disposable income: When taxes are lowered or national income

increases or savings decrease than disposable income of the people increases.

Black money: Aggregate demand increases due improper declaration of income

to evade taxes and increasing corruption.

Excessive investment by the government

• When the government of a country spends an enormous amount of money on
the projects, it takes a long time to yield results.
• There will be a rise in the income of the people without corresponding
supply of goods.
Taxes: Taxes like excise duties levied by the government will result in a rise in
prices.
3.1.1 Inflation
Causes

Natural Calamities: Natural calamities like floods, droughts, earthquakes, etc. will
badly affect the normal productive activities in the country and cause the scarcity of
certain products.

Price rise in other countries: When price rises in other countries, more goods may
be exported to other countries, to get higher prices.

Cheap monetary policies: Cheap monetary policy increases the borrower’s money
income (money supply increases), which in turn increases the aggregate demand.
Hoarding of goods: Hoarding of goods by producers and traders will create artificial
insufficiency of the goods. This artificial scarcity of goods will push up the prices.

Structural Bottlenecks in production: Structural bottlenecks and market

imperfections can be used to explain the inflation in India and developing countries of
Latin America. The three types of structural bottlenecks: Agricultural bottlenecks,
Government budget constraint or resource constraint, Foreign exchange
bottleneck.
3.1.1 Inflation
Causes
Repayment of public debt: Public money supply increases when the
government pays off its internal debt. This in turn increases aggregate
demand and therefore increase in prices.

Increase in wage cost: If there is an increase in the wage of labourers

without a corresponding increase in the productivity of labour, the
costs of goods go up. The rise in the cost of goods pushes up the prices.

Effect
Effect on balance of Effect on holding of
payments currency

Effect on investment
pattern
3.1.1 Inflation
Effect
• Effect on Debtors
• Effect on creditors
• Effect on wage earners
Effects on
• Effect on fixed income groups
redistribution of • Effect on Investors
income • Effect on small savers
• Effect on producers
• Effect on agriculturists
• Effect on the government

• Misallocation of resources due to shift in

the focus of production
• Reduction in quality standards
Effects on Production • Change in transaction patterns
• Creation of artificial scarcities
• Creates speculation
• Less production
3.1.1 Inflation
Calculation

• Consumer Price Index (CPI), Wholesale Price Index (WPI) and Gross
Domestic Product (GDP) deflator are the indices which are mostly used
in the calculation of the rate of inflation.

Consumer Price Index (CPI)

• It is determined by taking the retail prices of a fixed basket of goods and
services.
• This percentage change in the CPI is the percentage change in price
levels. It is also known as the inflation rate.
• CPI is the weighted average of retail prices of a few consumer goods and
services.
• Laspeyre’s index is used to calculate the consumer price index and is
𝑄𝑖0 𝑃𝑖𝑡
given by: CPI = X100
𝑄𝑖0 𝑃𝑖0
3.1.1 Inflation
Calculation

Wholesale price index (WPI)

• This means that it includes the wholesale prices of raw materials, capital
goods and prices of consumer goods and services. Prices of services like
transport and education are not used in the calculation of WPI.
• Laspeyre’s index is used to calculate the wholesale price index and is given by
𝑄𝑖0 𝑃𝑖𝑡
• WPI= X100
𝑄𝑖0 𝑃𝑖0

GDP Deflator
• Nominal GDP is the aggregate output measured at the current prices, and real
GDP is the aggregate output measured at constant base year prices.
• The GDP deflator is a price index which represents the change in the GDP in
comparison to the base year.
• It can be calculated by dividing the nominal GDP by the real GDP.
GDP Deflator = (Nominal GDP/Real GDP) * 100
Self Assessment Questions
1. Which of the following causes in increasing the borrower’s money income, that in
turn increases the aggregate demand.

A. Cheap Monetary Policies C. Prices changes in other countries

B. Deficit Financing D. Black Money

2. Inflation is a monetary phenomenon of ______________.

A. Increase in goods C. Increase in Price

B. Decrease in Price D. Increase in value of money
Short Answer Questions

What is Inflation?

What is nominal GDP and real GDP?

Explain the different types of
inflation
3.1.2 Types of Inflation
On the basis of causes

Currency Inflation

Credit Inflation

Deficit-induced inflation

Demand Pull Inflation

Cost push inflation

3.1.2 Types of Inflation
Demand-pull V/s Cash push inflation
Demand pull inflation:
• It occurs when the demand for goods and services outstrips the supply. As
the demand increases, sellers start selling out of the product which
frustrates the potential customers.

• in Figure, an increase in demand shifts the aggregate demand curve to the

right from AD1 to AD2. This increases the price levels and the real GDP.

• But, the increase in aggregate demand does not cause an equal increase in
the aggregate supply. This creates a demand supply imbalance and leads to
an increase in inflation.

• Demand-pull inflation is often described as involving “too much money

spent chasing too few goods”, since its only money which is spent on goods
and services that can cause inflation.
3.1.2 Types of Inflation
• There are various circumstances which can cause demand-pull inflation. The
following are the causes of demand pull inflation:

Growing Expectation of Discretionary

Strong Brand
economy inflation fiscal policy

Cost push inflation:

• Cost-push inflation is a phenomenon where a shortage in the supply of labour,
capital and raw materials drives up the prices.
• Cost-push inflation can occur only if the demand for an end product or service
is inelastic that is, there is a high demand for the product even if its price goes
up. Example: Petrol.
• If the demand is elastic, then people do not have to pay higher prices. Instead,
they will just simply buy less of the product.
• A fall or left shift in the Aggregate Supply is a cause of Cost-Push Inflation. It
can occur due to an increase in the cost of production or due to decrease in the
volume of production. A collaboration of cost push and demand pull inflation
results in the Wage Price Spiral.
3.1.2 Types of Inflation
Causes of Cost Push Inflation

Rising oil prices

Increase in prices of agricultural products

Import price shock

Increase in wages
3.1.2 Types of Inflation

On the basis of speed and intensity

Creeping/Mild Inflation

Walking Inflation

Galloping and Hyperinflation

Self Assessment Questions
3. Inflation arising out continuous aggregate demand for goods without a decline in
cost of production is called ___________________.

A. Currency Inflation C. Credit Inflation

B. Deficit reduced Inflation D. Demand pull Inflation

4. In Running Inflation the price increases __________ per annum.

A. 3-7% C. 3%
B. 10-20% D. 30%
Short Answer Questions

What is Deficit Budget?

What are the causes of Demand pull inflation ?

Explain the concept of
Deflation
3.1.3 Deflation
Meaning

• It is “a state in which the value of money is rising that is prices are

falling.”

• In simple terms, Deflation is associated with falling prices,

unemployment and rising value of money.

• According to Crowther, “Deflation is that state of the economy

where the value of money is rising or the prices are falling.”

• According to A.C. Pigou, “Deflation is that state of falling prices

which occurs at the time when the output of goods and services
increases more rapidly than the volume of money income in the
economy.”
 3.1.3 Deflation
Causes

• The prices of all goods and services are affected heavily by a change in supply and demand, which means that if demand
drops in relation to supply, prices will also have to drop accordingly.

• A change in the supply and demand of a nation’s currency also plays an instrumental role in setting up the prices of
goods and services of the country.

• The following are the causes which play the largest role in deflation:

Change in Structure of Increased Decrease in Currency

Austerity Measures Deflationary Spiral
Capital Markets Productivity Supply

Reduced Business Wage cutbacks and Changes in Customer Reduced Stake in

Reduced Credit
Revenues layoffs Spending Investments
3.1.3 Deflation
Effects

Effect on output and Effect on traders and

employment producers

Effect on debtors Effects on creditors

Effects on wage-
Effects on consumers
earners

Effect on fixed income

Effect on investors
groups

Effect on balance of
Effects on savers Effect on government
payments position
3.1.3 Deflation
Control of deflation
Deflation can be controlled through a number of measures. The various
measures that can be undertaken for the control of deflation can be broadly
classified in to three categories.

• Cheap money policy

Monetary Measures • Open market purchases of securities
• Lowering of cash reserve ratio

• Reduction in taxation
• Deficit financing
Fiscal Measures • Public sector projects
• Price support

• Giving subsidies
• Increasing exports
Other Measures • Creation of employment
• Encouraging production
3.1.3 Deflation
Comparison between inflation and deflation
• According to the Keynes, “Inflation is unjust; deflation is inexpedient. Of
the two, deflation is worse.”
Deflation is more harmful than inflation for the following reasons:
• Inflation increases the inequality of income distribution. Deflation, on the
other hand, reduces the national income, employment and output.

• Inflation occurs under full employment level or at full capacity output. But
deflation is always supplemented by unemployment.

• Inflation may, sometimes, become beneficial. For instance, inflation

accompanied by employment is beneficial. But deflation is always harmful,
as it is always supplemented by unemployment.

• Except hyper-inflation, all other types of inflation can be held in check

through fiscal, monetary and direct meaures. But it is very difficult to
control deflation.
Self Assessment Questions

5. Deflation occurs when output of _____________increases at a faster than __________.

A. Money income, Goods and Services C. Goods and Services, Money Income
B. Rising Price, money income D. falling price, falling money income

6. “Open market purchases of securities” is the factor that comes under ___________
measures.
A. Monetary measures C. Fiscal measures
B. Other measures D. National measures
Short Answer Questions

What is Deflation According to Crowther?

What are the fiscal measures in control of deflation?

Activity:
Online Activity
Duration: 30 Minutes

Description

Prepare report for recent trends in inflation.

(Hint: refer latest economic survey of India).

Prepare and evaluate your points and give a 30 minute presentation for the same.
Long Answer Questions
1. Describe the effects of inflation.

2. List the various types of inflation.

3. Explain Deflation and its causes.

4. Enumerate the measures to control deflation.

Summary
 Inflation is defined as a situation when prices of all goods and services are rising
continuously and constantly,
 Inflation is a sustained increase in the price level of goods and services in an economy,
as measured by some broad index like Consumer price index over a period of time.
Inflation has its worst effect on the people who are fixed-wage earners.
 The main causes of inflation are either the excess aggregate demand or cost push
factors
 Printing of more currency notes lead to currency inflation
 Inflation has a regressive effect on lower-income families of the society.
 When the expenditure exceeds the revenue, the budget is known as the deficit. To fill
this difference, the government may want the central bank to print additional currency.
This supply of money in an economy leads to the deficit- induced inflation.
 Inflation arising out of too much of demand for goods as against the supply of goods at
the full employment level is called demand pull inflation.
Summary
 Cost push inflation is caused by wage increases enforced by trade unions and profit
increases by entrepreneurs.
 Cost push inflation is a phenomenon where a shortage of supply of labour, capital and
raw materials drives up the prices.
 Creeping inflation refers to situation where there is very mild rise in prices.
 Walking inflation is a situation where the rate of price is faster, generally, three times
faster, then that in creeping inflation.
 Galloping inflation is refers to a situation where the price level rises very rapidly.
 Deflation refers to a situation when prices of all goods and services are falling
continuously and constantly.
 Deflation is usually associated with unemployment, which is only corrected after
wages drop significantly.
References

Weblinks
1. Inflation. Retrieved 26 Oct, 2016 from
http://www.livemint.com/Sun ayapp/nWV9n2mle4QboagcYO5XSK/The-roots-of-
inflation-in-India.html

2. Impact of Inflation. Retrieved 26 Oct, 2016 from

http://www.rediff.com/money/special/special-how-inflation-impacts-indias-aam-
aadmi/20150708.htm

3. Deflation. Retrieved 26 Oct, 2016 from

http://www.economist.com/blogs/economist-explains/2015/01/economist-explains-4
References (Cont.)
Books

1. Berlatsky, N. (2013). Inflation. Detroit, MI: Greenhaven Press.

2. Farrell, C. (2004). Deflation: What Happens When Prices Fall. New York: Harper
Business.

3. Marthinsen, J.E. (2014).Global Economy-Demystifying International

Macroeconomics. NY, Cengage Learning
THANK YOU