43

H A P T E R

eztiseeious

Inflation: Nature and CauIses

Meaning
between quantity of money and price level in h
Having discussed the relationship the
now in a position to explain the
nature and causes of inflation
previous chapter, we are
To be more correct, inflation is a persistent rico in iBy
inflation we mean a general rise in prices. in the
general price level rather than a once-for-all rise in it. On the other hand, deflation sents
persistently failing prices. These days all the economies of the world, underdeveloped as well
as developed, suffer from intlation. Intlation or persistentuy rising prices is a major problem in
world today. Rate of inflation during the seventies and eighties was very high as compared to
the rates of inflation experienced earlier during peace periods. Since the late nineties, rate of
inflation in several countries (including India) has declined. However, in some countries, it still
remain very high.
Causes of Infiation
Let us understand how the inflation originates or what causes it. Depending upon the
specific causes, four types of inflation have been distinguished: (1) Demand-pull inflation
(2) Excessive growth in money supply (3) Cost-push inflation, (4) Structural inflation. An
important cause of inflation is the excessive growth of money supply in the economy. We will
explain this cause in Monetarist Theory ofInflation. We will explain and discuss below these iour
types of infation. At the end of this discussion, we will explain how inflation in the developing
countries like India can be explained.
DEMAND-PULL INFLATION
This represents a situation where the basic
factor at work is the increase in aggregate aen
for
output either from the government or the entrepreneurs or the resulti

households.
thatthe pressure of demand is such that it cannot be met by the currently available suppl
output. If, for example, in a situation of full employment, the government expenditure or Keynes vate
investment goes up, this is bound nomy. Keynes
to generate an
explained inflation arises when there occurs
that inflationary pressures in tne
which com
to exist when
aggregate demand
an
inflationary gap
'gap in the economy
output
Basically, intlation is caused by a exceeds aggregate supply at full employment
pply at empioyi levvel of
and services situation whereby the of mand
and forgoods
for 90
exceeds the available supply of output pressure aggrega ces rulingat
rices ruling
(both being counted at ue
1022
 and Causes

ton:Nature
Miatio
he ginningof Deriod). In such
situation,
a
the rise in
1023
this imbalance
etween aggregate demand price level is the natural
and consequence.
NoK

force
rk. As we know
at
work.
aggregate demand issupply may be the result of more than
the sum of
sumergoods and services, government consumers' spending on
emplated by the spending onTheconsumer goods and services
gne

e n t being contemplated
in distributing
and entrepreneurs.
ordinary functioning of
and net

to the cost of
spernding
income in such a
manner that
an
economy
u ti s e q u i v a l e r

producing total output aggregate demand for

Ouput
vever, the governmenent, the entrepreneurs or the including profits and taxes. At times,
than would thus accrue to households may attempt to secure a
t of uo in the share of output usedthem. If other sectors are not prepared to larger
by any one sector, all of the acquiesce
of the national
more
output than sectors together will be
When aggregate demand production
to get
tying has provided. This is the basic
cause
f o ri n f l a t i o n
for all
governimen, e
xDenditure-exceeds the supply of goodspurposes--consumption,
at current
investment and
prices, there is rise in
ohrate
ilustr the above point, let us assume that
a
prices.
the government adopts expansionary
t under which it increases its
expenditure on
iscal
reby borrowing from Reserve Bank of India
extra expenditure
education, health, defence and finances
will lead to increase in aggregate demand
s purpose. This
which prints new notes for
utput does not increase or increases
(C + I + G). If
aggregate supply
by a relatively less amount in the short this will
domand-pull inflation in the economy, that is, general rise in price level fromrun,one period
to another

f the government is insistent on securing additional resources, it will get them in one way or
nther-by issuing currency or by borrowing from the central bank or from commercial banks.
father sectors, particularly the active sectorsentrepreneurs and wage earners--are unwilling
th contract their investment or consumption by the amount of these additional resources used
hur the government, an inflationary process will be initiated. Similarly, an inflationary process will
be initiated if entrepreneurs wish to use more ot national output than the ordinary functioning
ofthe economy provides (through savings out of profits and savings lent to them or invested by
the public) while other sectors do not wilingly reduce their demands for resources to the extent
that entrepreneurs want to use them more.
Itis important to note that Keynes in his booklet How to Pay for the War published during
the Second World War explained
indlation in terms of excess demand
Y
for goods relative to the
aggregate AS
sSupply of their output. His notion
of the
inflationary gap which he put
torward in his booklet represented P4
excess of aggregate demand over
tull-employment output. This in
lationary gap, according to him,
eads to the rise in prices. Thus ADg4
2
Neynes explained inflation in terms P ADa
demand-pull
ne
forces. Theretore, AD2
theory of demand-pull inflation is
SOCiated with the name of Keynes. AD
nce beyond full-employment level X
aggregate supply, output cannot Y Ya YF
CTease in
demand thisresponse
results to increase n
in rise in prices
Aggregate Demand and Supply
Demand-Pull Inflation
under the Fig. 45.1.
pressure of excess demand.
 1024 Managerial Economics
demand and supply curves. COnet
Demand-pull inflation can be illustrated with aggregate nsider
ig. 45.1 in which aggregate demand and aggregate supply are measured along the X-axis
upward
-
and
general price level along the Y-axis. Curve AS represents the aggregate supply which rises un
eached, aggegate
in the beginning but when full-employment level of aggregate supply OV, is reached, aggro
Supply curve AS takes a vertical shape. This is because after the level of hull employment
of output cannot be increased. When aggregate demand curve is AD,, the equilibrium isSupply
at ilese
less
nan full-employment level where price level OP, is determined. Now, if the aggregate denand
and
ihcreases to AD,, price level rises to OP, due to the emergence of excess of demand at prico

level OP. It will be noticed that here the rise in price level has also brought about increase inin
about increase
demand further
increases to AD
aggregate output supplied from OY, to OY,. If the aggregate But since the
the price level rises to OP, under the pressure of more demand. aggregate supply
curve is yet sloping upward, increase in aggregate demand from AD, to AD, has caused the
increase in output from OY, to OY If aggregate demand further increases, say to AD only
price level rises to OP, with output remaining constant at YF. OY, is the full-employment level
of output and aggregate supply curve is perfectly inelastic at Yr

Demand-Pull Inflation and Wage Price Spiral

If the total claims on output exceed the available supply of output, prices will rise. The rise
in prices provides the necessary mechanism whereby the real resources being currently used
by inactive sectors are reduced so that they should be used by the more active sectors. If, for
example, the initiative for the inflationary pressure comes from the government demand for more
resources, the only way that the government can have more resources is by the consumers and
private entrepreneurs having less of them (assuming that all the resources are fully employed
already). If they are not wiling to reduce their claims on resources voluntarily, the prices will
rise and the result will be that the value of spending by these sectors will be reduced and to that
extent resources will be made available for use by the government.
But that will not be the end of the story. A rise in prices reduces the real consumption of the
wage earners. They will, therefore, press for higher money wages to compensate them for the
higher cost of living. Now, an increase in wages, if granted, will raise the prime cost of production
and, therefore, entrepreneurs will be tempted to raise the prices. This adds fuel to the inflation-
ary fire. A further rise in prices raises the cost of living still further and the workers ask for still
higher wages. In this way, wages and prices chase each other and the process of inflationary
rise in prices gathers momentum. If unchecked, this may lead to
hyper-inflation which signifies
a state of affairs where wages and
prices chase each other at a very quick speed.
MONETARIST THEORY OF INFLATION
We have explained above the Keynesian theory of
demand-pull inflation. t is important
to note that both the original quantity theorists and the
modern monetarists, prominent
arnong whom is Milton Friedman, also explain inflation in terms of excess demand for goods
and services. But there is an important difference between
the monetarist view of demat
pull inflation and the Keynesian view of it. Keynes explained inflation as arising out
sector forces. In his model of inflation excess demand comes into or
being as a result O
tonomous increase in expenditure on investment or
consumption, that is, the increase m as
gregate expenditure or demand occurs independent of any increase in the supply of money
 other hand, mon
onetarists explai
n t h e

prices
on account of
on.
explain the
the inc
ease in ergence of excess
e itn
tiationi sa l u always and eve
everyuwhere a
ernand and the 1025
quantitymonetary
rapid increase in the oply in the
of
phenomenon.. and oconomy. To quote Fried
a m o r e

hat wh
Test

an
holdsthat
when money supply money than in
e
F r i e d m

ofrealmoney balances with increased outpuit.

is
h d can
be producerd iedman
rder
Supply

CS
to restore the
public
in the
Dubdin

onity
1re on
the
equilibriurn, over the econoriy, then there
goods demand for
a n d u i l

1 s i n ge x p e n d

and services. the ernergøs a

TEASin
the excess
cnKCes

supply Thus, public will reduce money This disturbs

for ads and
of real
services. It theremonetary according to the
rmoney
Friedman and other balarncesby
is no balances results
demand

ate ads to excess de

proportionate increasein thein increase inmodern
oney supply leads
demand
hole argument can be for goods and
rices.The
presented in the services. This causes output, then estr agge
MkPY> AD1following P scheme inflation o risein
of money a
stands for quantity of
money and P for the price level.
Therefore,M1epreents
s hbalances
rea
Ystands for na ome and k for the
YHence
alances. Hen kY represents demand fo ratio of income which
cash balances people want to keep in
AD Te esents aggregate emand for or
dem (i.e., demand for money cash
of consumption demand (C) and aggregate expenditure on goods and
s
composed
investment demand . services which
phove
In the scheme it will be seen that when the
ossSupply of real cash balances. supply of money (M) is
2s This is expressed
by M> increased, it cre-
leads to() the rise (1) in aggregate kPY. This
al money alances excess suppiy of
ETegate demand (AD) leads to (- the rise (T)
demand (AD). Then increase ()in
in prices (P).
Ciodman's monetarist theory of inflation can be better
explained with quantity equation
MV LL Wriing in percentage form which is uritten as below
taking Vor kas constant

AP AM AY
(2)
P MS Y
AMS
is the rate of inflation,
MS
i s the rate of growthofmoneysupply andis the rate
AP
goth of output. Thus, according to equation (2), rate ofinflation is determined by
4MS with velocity of circula-
hof money supply and rate of growth ofoutput
M
claim that inflation is pre
constant. Friedman
and other monetarists
and output are
remaining
which implies that changes in velocity
monetary phenomenon
disturbance in the equilibrium,
increases, it
causes
reaction of the people
us follows that when money
ey supply monetarists, the
s kPY. Accord Friedman and other so as to bring
money sup-
ACcording to services
on goods and
excess money supply
O spend the EKCeSS
E
March 1-17.
1968,
American Economic Review,
Monerery Polcy,
 Manageriai Economics
in aggregate dem-
1026 to the
increase

This leads to the incro

will lead
demand for money. constant, e An
Ply n equilibrium with the k remaining
services which,
Or e x p e n d i t u r e
on goods and
fur-
nominal national
income (PY). They AS
national income or
ther argue that the real for
Yin the demand
aggregate output (i.e., sta-
stated above) remains
money function
in the long run
ble at full employment level
due to the flexibility of wages.
Therefore,
Friedman and his followers
P
according to
(modern monetarists), in the long
run, the Po
income (PY)
increase in nominal national
in money AD, (M)
brought about by the expansion
supply and resultant increase aggregate
in AD, (M)
increase
demand will cause a proportional
in the price level. However, in the
short YY X
believe that the National lncome
run, like Keynesians, they
economy may be working at
less than full
in
employment, that is, in the short run there may Fig. 45.2. The
Effect of expansion money supply in
inio price rise and
prevailexcess and unemployment of
capacity the shot run is split up
increase in Real National Income: Fried
labour so that expansion in money supply and
man's Monetarist Approach.
consequent increase in nominal income partly
induces expansion in real income (Y) and
what extent price level increases
results in rise in the price level as shown in Fig. 45.2. To
partly It will be seen from Fig. 45.2 that
the of supply or aggregate output.
depends upon elasticity in aggregate demand
to M, and resultant increase
effect of increase in money supply from M,
into the rise in price level (from P, to
curve for and services from AD, to AD, is split up
goods
aggregate output (from Y, to Y,).
P) and the increase in real income
or
modern quantity theorists believe that in the
It should be noted that Friedman and other
not prevail due to recessionary
short run full-employment of labour and other resources, may
of increase in output. But they emphasise
conditions and, therefore, they admit the possibilities
the growth in output, the result is excess
that when the growth in money supply is greater than
inflation.
demand for goods and services which causes rise in prices or demand-pull
in terms of excess
It follows from above that both Friedman and Keynesians explain inflation
excess demand
demand for goods and services. Whereas Keynesians explain the emergence of
due to the increase in autonomous expenditure, independent of any increase in money supply.
Friedman explains that inflation is caused by proportionately greater increase in money suppy
than the increase in aggregate output. In both views inflation is of demand-pull variety.

Money and Sustained Intation

tne
Many economists believe in the monetarist view of inflation. Increase in money shits
aggregate demand curve to the iight and if the economy is operating at full capacity (i.e. alon
will
the verticai part of the aggregate supply curve), the upward shift in aggregate demand curve w
cause price level to rise. A big drawback of this approach is that it assumes that supply of oup
jate
does not increase suficiently to counter this effect of expansion in money supply on aggregalu
rice
demand. In this context there is a need to distinguish between a one-time increase in the pr
level and sustained inflation which occurs when the general price level continues to e ver a
a
long period is believed by most of the economists that whatever be the itial
of time. It generally inil
cause of intlation (demand-pull, cost-push or inflationary expectations), for the price to
 MMZMON,

eggte demand ntle

S u s t a n e d
rising, period

erefore
inflation
i n t i a n .

is
ter
period,i must be
considered
level to continue rising
lev

iffthe as accommodated
mePrely nonetetary phenormena
price

ntinues shifting the

the the 1027
money
tly to match aggregate pansion
r

the increasedemand supply

p l yc o n t

raon in
i p r e a s e
s u t f i c i e n

rernains
curve to the constant. enon. It is not
incese in psi
in The
Sustained
inflation be bettercan
aggregate right, if
dernarnd, aggrerpte nofe
as nt
sing taxes. TThis leads to the understood when price level will supply doe, TE
will cause rise in increase in Governrnent rrstinue,
yithout
maining c o n s t a n t ,
a
aggregate increases, fisir
rises. The price level. demand its,
the
ce
. nnlu of igher price level raises the is irnportant to which, uggrexgte
level: It
entenditure
uposes. With
money remaining demand know what supply
rate to
nerest
rise. The rise in for
interest rate constant, the reaterrmoney to rie frr vhe happpts
wants to prevent theifall in
country
the
crowds out
e
private dernand for rmoney trersattits
the Cenitralase
fa
AD M 2p he interest constant. But this
private investment, itinvestrnent.If
the price level expansion the rmoney an
o heep
wll
and will cause in
money supply
expand
through its effect on. suppl
a t ed e m
to rise
ossible pricelevel will further if increase in more
This further rise in
ag
ome nterestrate. And d the again
Central Bank, if it is cause supply
greater demand for of outgut is not
igher
private investment does not decline, it
uate
that
investmen committed to keep the money leading tu
n in so
Ads or inflation. This will further interest rate constanit
money suppl a process could expand the money
cause
lead to supply which. will
period after period. Thehyper
p into inflation which represents
pice riseFietant level,
tinuous rise in price le
onal income: come countries when the Central Bank or
ion in some
rapid and
historical
experience shows this hyperinfia-
a

roach. and more money either to finance the Government of these countries kept purnping
in mo
persistent budget deficit of the
rice level inceRses oar
afteryea Ot to prevent the interest rate to rise.
However, as
government year
mentioned above, hyperinflation
from Fig 452ba isupts the payment system and people s loss of
redibility the currency. This leads to a de
of
a0orpnado
aggregate demand Crisis in the economy. If hyper inflation is to be avoided, then the
of process
ce level(fromP.b money supply must be halted. rapid expansion in

nflationary xpectations
believe that in t Inflationary expectations are an important cause of inflation. The expectations of future prices
due to recessionay pay a significant role in decision-making by firms regarding price and output. If a firm expects
But theyempha that its rival firms will raise their prices, it may also raise its own price in anticipation. Suppose
inlation has been occurring at a rate of 8 per cent per annum in the past, a will this
resultisia exexces
i, the result
the its
expect
by 8 per cent. If every
firm
inflation. aion rate to continue in future too and therefore it will raise priceone will raise its prices
expects that other firm will raise their prices by 8 per
cent, every
ofexes by per cent. As a result, inflation rate of about 8 per cent will occur. This is how inilationary
ferns
m lead
ON "Expectations can

inflation. Elaborating this, Case and Fairwrite, have been rising and
on
Scause
toan dhat makes it difficult to stop an inflationary spiral. If prices on the basis ofpast
ha if they form their
expectations
are adaptive, that is, is slowing Therefore
pectations if demand
pricgingbehaviour-that firm may continue raising prices
the intiau
break the
even

inflationary
expectations.
check inflation, teps should be taken to
to break

COST-PUSH INFLATION aggregate

demand,
increase in
increase
there is no of any
We c ualise situations where
though even
i n c r e a s e in
costs
independent

generate
cost-push
eS if there is which

may still rise. This may

may happen
1S
in costs
increases

gregate
u t o n o m o u s

demand. Three such

ion have been uggested. They are:
Chacafio, Edion 002
Ware-psh inflation
 Managerial Economics
1028
2. Profit push inflation such as rise in crude oil nriee
ices.
especially energy inpufs
materials,
Increase
It may
3. in prices
be noted thatr arise
w
in prices of raw materials, especially of energy inputs (petroli.. low
iurn
shocks. We discuss these hol
have a cost push
effect are also called supply
which
products)
the growth of powertul trade union is e- w
It has been suggested that
Wage-Push Inflation. countries. When trade unin
in the industrialized ions
of inflation, especially
sponsible for the spread
either o n grounds
of a prior rise in productivit
which are not justifiable
a w a

push for higher wages in a situation of high demand

cost-push effect. The employers
or of cost of living they produce
a
claims because they hoDe to
to concede to these wage a g er

and employment are more agreeable

c o n s u m e r s in the
form of hike in prices. If this happens u o
in costs to the
pass on these rises
tur

result of cost-push eftect of higher wages

have cost-push inflation. It may be noted that as a
to the left and, given
the aggregate demand curve, this
supply curve of output shifts
aggregate
results in higher price of output.
without any increase in
increase in wages of labour
Profit-Push Inflation. Besides the
inflation. This is the increase
its productivity. there is another
factor responsible for cost-push
conditions and as
in the profit margin by the
firms working under monopolistic or oligopolistic
the cause of cost-
a result charging higher prices
from the consumers. In the former case when e rt

called wage-push inflation and in the latter case when

push inflation is the rise in wages it is
it is called profit-push inflation. The
the cause of cost-push inflation is the rise in profit margins,
increase in profit margins also produces a cost-push effect and results in shift in the aggregate

supply curve to the left.

Rise in Raw material Prices Oil Price Shock. In addition to the rise in wage rate of
or
increase
labour and increase in profit margins, in the seventies the other supply-shocks causing
in marginal cost of production became more prominent in bringing about cost-push inflation. OSS

During the seventies, rise in prices ofraw materials, especially energy inputs
(hike in crude oil ore
price made by OPEC resulting in rise in prices of petroleum products). The sharp rise in worid
oil prices during 1973-75 and again in 1979-80 produced significant supply shocks resulting in

cost-push infation.
The cost-push inflation can also be illustrated with the aggregate demand and supply curves.
Consider Fig. 45.3, where aggregate supply and demand are measured along the X-axis and

price level along the Y-axis. AD is the aggregate demand curve and AS, and AS, curves are
aggregate supply curves. Now, when wages in-
crease, and as a result cost of production rises, AS
the aggregate supply curve would shift upward
to the left. As will be seen in Fig. 45.3 when AS
there is an upward shift in the aggregate supply
Curve frorm AS, to
AS, due to the rise in wages, E
price level rises from OP, to OP, Thus, in this
ase when aggregate demand
8
remains the
curve
siarne, price level rises due to rise
wages which
has caused leftward shift in the
An importunt
supply curve.
feature of cost-push inflation is AD
that this causes not
only rise in price level but X
brings about a fall in
aggregate outpul. Thus in Y
Y2
Fig. 45.3 when price level rises from Aggregate output
OP to OP
aggregate output falls from OY, to OY, Fig. 45.3. Cost-Push Inflation
 I n d i r e c t

Effect of
E f e c

Increase in oil
ct of oil price shocks a
a i n e c te f f e c
prices or other
ocks and increase
upply shocks which in other raw material
1029
o f SuchS u
cause further
rise in rate material prices,prices. In addition
raw
atesupply curve
drawn
ho WOrkers willassuming given price of inflation. It there are indirect
the
occurs.
revise their level expectations may be noted that
prices or oil price price
shock price level of expectations. over time.
Whenna
a e
m a t e r i a l

r t h ew o r k e r s
revise upward their Now,
output has risen as when due to increase
decline and thereforeexpectations result
of price a
u ratep/willa uill level. With this, of cost-push
less labour the
will be expected
Thus, in Fig. 45.3with the increase
supplied a given money
at
Thus. in
ahift to expected price level,
r a t e .

to the lett as a result of

th
shift
this indirect
l
tTd
further

level. As result of this indirect

p r i c el e v e l a aggregate supply curve
effect through the 9STegate Curve
cur
effect, the price level upward vevision of ex
will rise above P,in Fig. 45.3
between Demand-Pull and Cost-Push
lation in the economy is Inflation.
interaction

ny economists think
Manty and cost-push
ull factors. The inflation maygenerally caused by the interaction of
be started in the
or by
demand pull factors both work and the first instance
either by
pus
N e rt i m e .
Thus, according to
interact
Machlup. "there cannot be a thing as to cause sustained infiation
cost push inflation because
an crease in purchas-
aithout
and demand, cost
n gp o w e

will lead to unem-

inCreases LAS
and depression, not
oloyment
Likewise, Cairn-
inflation
y
"there is no need AS
gOSS writes,
that demand and
pretend
o P
do not interact AS
ast inflation
or that excess demand does

notaggrevate wage inflation, P

ofcourse it does."
AD
We will explain this inter AD
action, fust with inflationary
proces starts with cost push
actor and then secondly when
>X
niation begin with shift in ag-
Y, Y
9egate demand. In both cases Aggregate Output
dte of infiation over time is the and Demand-Pull
Inflation
Interaction of Cost-Push
2utof interaction of demand- Fig. 45.4.
ul and
cost-push factors. aggregate curve AD demand and
45.4 where to begin with and output
consider the Figure and determine
price level P,
egate supply curve AS intersed at
point E
Economics and
Review of
Infiation' in
Demand-Pul
and
Mach up. *Another View of Cost-Push
Unwin, 19/6.
Saistics
S s Voi, Vo 42. 1960
Trade, George
Allen and
AVec Cairncros Iniemational

be",
Growth and
 1030 Managerial Economics
level Y. Further suppose that Y, is the full capacity (i.e., full-employment) level of output and
therefore long-run aggregate supply curve LAS is vertical at Y, level of output. Suppose there i
increase in oil prices which causes shifts in aggregate supply curve to the left from AS to AS, As a
result, price level rises to P, but output falls from Y, to Y,. With decline in output unemployment
will also increase. This is a cost-push inflation which has caused a recessionary conditions in the
economy. The Government and Central Bank are likely to adopt expansionary monetary and
fiscal policies in order to avoid recession. Consequent to the adoption of expansionary policies.
(for example, increase in money supply or increase in Government expenditure or reduction
in taxes), aggregate demand curve will shift to the right, say to AD, which intersects AS, curve
and LAS curve at point E,. Though as a result of this accommodatary policy while output level
has increased to the original full-capacity level Y price level has further risen to P level. This
later rise in price level from P, to P, is the result of demand-pull Inflation. It is thus clear that both
cost-push and demand -pull inflation interact to cause inflation in the economy.
2. Let us now explain inflationary process which starts with demand-pull inflation in the first
instance. Consider Figure 45.5. where to begin with aggregate demand curve AD,and aggregate
supply curve AS, intersect at E, and determine level of price Pand aggregate output Yo. Assume
long-run aggregate supply curve LAS also passes through point E, so that equilibrium level of
output Y, also represents full-employment level of output (that is, at Y, only natural unemploy
ment exists) and price level P also represents long-run equilibrium price level
Now suppose due to increase in Government expenditure financed by creation of new
money aggregate demand curve shifts from AD, to AD,.The new aggregate demand curve AD
intersects the short-run aggregate supply curve AS, at point E,. As a result, in the short run
price level rises to P, and output to Y,. It may be recalled, short-run aggregate supply curve
is drawn assuming a given expected price level by the workers which is usually the price level
prevailing in the last few years which is here taken to be Pa. Now that as a result of increase

LAS AS
E2 ASo

AD

AD

Yo X
Aggregate output
Fig, 45.5. Inleruction betwen Demand-Pull and Cost-Push fhation
 : N a t u r ea n d auses
ntetion. 1031
n
mand price
level has actually risen to
te demand price
a T E g a t ed e m a r

P,, workers' real wages would decline.

e 1n orderto to restore their real wages,
order
they would demand higher money wages. When
Thenetore,

for
f o r higher wages are conceded to,
d e m a n d
hie

short-run aggregate supply curve will shift to

ir deeh
their this left
With this leftward shift in the aggregate supply curve, price level will rise further. In this
theh ice spiral will go on operating until short-run aggregate supply curve shifts to the
a yw a g e - p r i c e

a together with
together with aggregate demand curve AD, determine a long-run equilibriumn at
jel
elAS
AS, and
ull be seen that both demand-pull inflation and cost-push inflation have operated
lt will
oointE. raise price level from P,toP
ther to
onclude, demand-pull inflation and cost-push inflation are intertwined and operate
To c o n c l u d e ,
of inflation over time. It is difficult to say in actual practice what part
determine rate of
to
gether
ion
inflation
due tto demand-pull factors and what due to cost-push factors, though,
is due
as seen
theoretically speaking, we can distinguish between demand-pull and cost-pushinflation.
theoretically speak

STRUCTURALISTTHEORY OF INFLATION
inflation known as structuralist inflation which
there is another important theory of
Rut
in a slightly different way. The structuralists argue
inflation in the developing-countries
nlains finance it are the
investment expenditure and the expansion of money supply to
hat increase in ultimate factors responsible for inflation in the developing
countries.
and not the
anly proximate as to why aggregate output,
espe-
should go deeper into the question match
According to them,
o n e countries to
sufticiently in the developing
has not been increasing and money
cally of foodgrains, about by the increase in
investment expenditure,
demand brought financed by voluntary
the increase in investment expenditure
has not been fully
supply. Further, they argue
why
has been done.
excessive deficit financing devel-
and as a result of inflation in the
savings forward as an explanation
inflation has been put Myrdal and Streeten
Structural theory of economists,
The well-known countries in terms
of Latin America. developing
oping countries especially inflation in these this
theory have analysed Nixon have generalised
no have proposed this Kirkpatrick and
e c o n o m i e s . Recently developing countries.
features of their
inflation prevailing in all
Sructural explanation of demand-
a n aggregative
CTural theory of inflation
as highly
the
correct to apply there is a
argued that it is not According to them,
and Streeten have developing
countries.
between consumption
ydal inflation in the possibilities
explaining
n o d e l for
substitution
them where sectors of the economy

structure in between
different
explained
a l a n c e d inteqrated flows of
resources

not be reasonably
inter-sectoral them c a n that
production and
uction and
s o that
the
i n f l a t i o n in
this
connection it is noteworthy

are not smooth and quick

price
re supply. In need for
distinguishing

aggregate the
nterms
terms demand and
aggregate also felt
Economics
has sector?

Prof.V.N. Pandit
manufacturing

School of in the economies

of Delhi from that
it theory of
intlation that as
aviourin
sector
naviour in the Indian ag dlan
agricultural

of
structural
s
sttr
ruuc
cttu
urra
alll
lyy
u
unnd
deer
rdde
evve
ello
oppe
edd

rigidies
structural
exponents
India a r e
Thus, it has been a: r g u e d by the
A
Am e r i c a
and and
of the d
developing
imperfections

evelonien
of Latin market
ewell as highly unries existence
of
4 highlu g m e n t e d
due to the Penguin
Books.
conditions
1968,
Nations, r e c e s s i o n a r y

Poverty of to
into the
response

in
G.Myrdal, Asian Drama,
The aY
An
N
Enquiry
andfiscal
policies
adopted

fachMillan. 1(ol 22, 1978

 Managerial Economics
1032 and rigidies is that whereas
as in some
The result of these structural imbalances relative demand
ofvarious types. we tind shortages
of supply to
under-utilisation of resources
of these developing and excess
countries, capacity exist due to lack of demand A hersto
sectors
countries make the aggregate do
structural features of the developing
structuralists. these
to them. They therefore argue
for analysing disacand
of inflation inapplicable e
supp model imbalances to explain inflation
in the developing countria
demand-supply
bottlenecks which generate the sectoral imbalancoe
and sectoral
sectoral constraints or and
mention various
Therefore, to explain the origin and propagation of inflation in tho de
lead to rise in prices. these bottlenecks or imbalances of various hma
countries. the forces which generate
veloping
economic development need to be analysed. A study of these bottlenecks i
in the process
of countries. These bottlenecks are of
essential for explaining inflation in the developing
therefore
which make supply of agricultural products inelastic.
three types: (1) Agricultural bottlenecks
Government budget constraint, and (3) foreign exchange bottleneck
resources constraint or
2 structural bottlenecks cause inflation in
the developing countries.
Let us explain briefty how these
the developing
first and foremost bottlenecks faced by
Agricultural Bottlenecks. The
tood grains to increase adequately. Of
countries relate to agriculture
and they prevent supply of
in land ownership, defective land tanure
mention of the structural factors are disparities
special
agricultural production in response increasing
to
which act as disincentives for raising
system
incomes, growth in population and urbanisa-
demand for them arising from increase people's
in
backward agricultural technology also hampers
agricultural growth. Thus,
tion. Besides, use of
removed so that agricultural output
these bottlenecks have to be
in order to control inflation,
meet the increasing demand
for it in the process of economic development.
grows rapidky to
Constraint. Another important bottleneck
Resources Gap or Government's Budget economic development.
mentioned by structuralists relate to
the lack of resources for financing
Government to industrialise
efforts are being made by the
In the developing countries planned sector investment in various
resources to finance public
economies. This requires large
their
amount of resources were used
for investment in basic
industries. For example, in India, huge structure of these
sector. But socio-economic and political
heavy industries started in the public
Government to raise enough resources through
coun tries is such that it
is not possible for the for
surplus generation in the public sector enterprises
taxation, borrowing from the public, has been
economic development. Revenue raising from taxation
investment in the projects of ad-
scale tax evasion, inefficient and cormupt tax
relatively very small due to low tax base, large
excessive deficit financing
has been forced to resort to
ministration. Consequenty, the government supply relative
which has caused excessive growth in money
(that is, Creation of new currency) inflation in the developing
and has therefore resulted in
to increase in output year after year inftlation, it is not
of supply is the proximate cause of
Countries. Though rapid growth money
For proper explanation
the proper and adequate explanation
of inflation in these economies.
forces which has
and enquire into the operation of structural
of inflation one should go deeper economies. Besides, resources
caused ecessive growth in money supply
in these developing of
voluntary savings and under-development tne
9ap in the private sector due to inadequate has createa
from the banking system which
capital market have led to their larger borrowings
it. This has greatly countributed to
the growth of money supplyin ne
eessive bank credit for Nixon write,
and has caused rise in prices. Thus, Kirkpatrick and
developing countries which allowed the inflationary spidu
in the
supply of money was a permissive factor zive
nCrease a system of the structural rigidities wnicng
tO manifest itself and become cumulative-it
was
itselt.
rise to the inflationary pressures rather than the cause ofinflation

LDC's in N. Gemmel (ed.), Srvey

ApaiK arnd F., Nizon, Inflation and Stabilisation policy in
Development Economics, 1987 Basil, Blackwell.
 Naure

Foreign Exchang nge

Bottleneck. The other
1033
ave to encounter is
ertaken.Industriadeveln
zUnres
the
shortage of foreivimpratant ytienery. viih the
velopment.

veloping countries ambitiousenchare ton éesdrfrg

industrialisation re
Tequires financirg
progarmme of needen
India, even heavy irnports of capital
i
npors
os
todgains have been ods, indusrialisaticni
as iin
cases, as
sdnSs
ome
is beirsg
enentizl rau mateiis
are being made.
e. On account
e g escale.

countrieshas been
of all these imported. Besides, irnports oh ol on
apidly inceasing. On the imports, import
ng
onsimposed byby the developing other hand, due erpenditre ch the deve
countries, to lack o erport
ports of the developed countries has relatively lkw surphss,
iroports,
urting the developing
imports the been
shuggish. competitivenes
As a result of
of enprts, the
ard
countries have been shuggish enprts
and shortage foreign enchange which at
of fo
times facing balarce of
parymert diffioil
the eprice level in two ways. First, due has assumed
crisis
to
in short-supply could not be increasedforeign echange shortae
proportions This has
9merican countries as well
which
as in India and
led
the rise in their
to drurmestir.availability
hortage prices. essdy,
zchange through encouraging exports Pakistan, to solve the problern
shortage thro of
ral currencies hadito be made. But and
this devaluation reducing imports devaluation in toreig
the na
aterials which further raised the prices ot caused rise in prices of
imported
due to cascading effect.gods
other goods as well
rought aboutcost-push inflation in their
Dhusical Infrastructural Bottlenecks. econormies This

er's such as lack of infrastructural facilitiesFurther, the structuralists

ie., lack of
point out various bot
dsin the way of adequate gouth in output. At power, transport and fuel which
r e infrastructural inputs which are
present in India, there is
acute shortage of
hampering POvth of output.
Sluggish growth of output
nthe one hand, and excessive growth of
money supply on the other have
zed stogfiation, that is inflation which exists caused what is now
along with stagnation or slow economic
Acconding to the structuralist school of thought, the aboue gowth
sted the social, political and economic
in bottlenecks and constraints are
structure of these countries.
road-based strategy of development which aims to Therefore, in its view a
al changes in these economies is
bring about social, institutional and struc-
needed to bring about economic
Further, many structuralists argue for giving higher gowth without inflation.
priority agriculture in the strategy of devel-
to
ment if price stability is to be ensured. Thus, we see that
structuralist view is geatly relevant
7 explaining inflation in the developing countries and for the adoption of measures to control
Ltus further elaborate the causes of inflation in the developing countries.
INFLATION IN DEVELOPING COUNTRIES: DEMAND-PULL OR
COST-PUSH INFLATION
t e question arises as to which theory of inflation can explain infiation in develop-
aties. Of course, the rise in prices has come about as a resut of excess of aggregate
v e r aggregate supply. In other words, inflation in the developing countries is
emand-pull
s been variety. However, how this excess demand for goods and services
caused
2used is
is issue
issu at dispute. In our view both the Keynesian and Friedman's views
relevant Oto explain
explai the emergence of excess demand for goods. To promote rapid
successive
hunge investment expenditure has
been made India in in
ment
a had been financed by rais-
plans. If this increase in investment expenditure
resouces
ertakin Ough taxation, Government borrowings
from the public, profits of public
have been matched by increase
thenthe incTease in investment expenditure would
ease in
matter of fact, a
with the result that demand for goods had not arisen. As a
encess
 Managerial conomics
1034
been tinanced by deficit
finanet
exYINditun has
ase in private in.
investment
în
n deal of increase the c n r a l bank.
Besicdes, the incrrase private investment
of new money by
hrogh creating finacad
a l s been
xpenditre has
expansion of AS
extent by
to a
credit or
god
demand deposits by
the
E ASo
commercial
banks. This incnease

in investmment
for pro-
expenditure
e o n o m i c gouth has
been
E
moting
possble by the expansion in
made
uhich as emphasized
money supp.
by Friedman and other
monetarists. P AD
causes prices to rise through
aeating
exes demand tor goods and ser- AD
vices. Thus, it is hard to distinguish
uhether it is increase in investment X
expenditure as such or expansion
National Output or Real National Income
in money supply to finance it which
has caused demand-pull inflation Fig. 45.6. Aise in General Price Level as a Result of Joint
in the face of slow growth of output impact of Demand-Pull and Cost-Push Factors
of goods. especialy foodgrains and
other essential consumer goods. Indeed, both have played a part in causing inflationary situ
ation in india.
economy? To think that
What has caused the inflationary pressures in India's developing
deficits and huge growth
only demand-pull factors or excess demand generated by huge budget
inflation facing the Indian economy would
in money supply are responsible for the problem of
not be fully correct. As of fact, both types of factors, namely, demand-pull and cost
a matter
which crossed the two-digit figure in some
push factors have operated to cause inflation in India,
Government expenditure without corresponding increase in
years. As a result of rapid growth in
the crea-
mobilisation of resources, the Government has resorted to heavy deficit financing (i.e.,
tion of new money). This has further created the conditions of excess demand in the economy
which have led to the rise in general price level. Besides, the increase in petroleum prices, many
times during the last few years, the hike in administered prices of steel, cement, coal, fertilizers,
increase in indirect taxes on several commodities, increase in railway fares and freights
have all
led to the cost-push inflation or what is also called supply-side inflation.
Now, when due to the demand pull inflation, the general price-level rises, the demand for
rise in wages and dearness allowance are made by the working classes and have
to oe
conceded to in view of the rising cost of living. The rise in wages and dearness allowance of
they
tne
workers raises the cost of production. The increases in cost of production due higher wages and
dearness allowance also cause the aggregate supply curve shift to the left and brings aboutcost
push or supply side inflation. Thus there has been persistent rise in prices under the combined
mpact of demand-pull factors caused by the large budget deficits and cost-push factors due to
the hike in administrated prices of petroleum, steel, cement, coal etc., and increase in indirect
taxes on commodities such sugar, cloth,
as
cooking
gas, soaps, cold-drink, etc.
Let us illustrate graphically how the operation of the various demand-pull and cost-pus
tactors resulting in
persistent rise in general price level. Consider Fig. 45.6, where
aggregate demand curve and AD,Tepr
and the
AS, the aggregate supply curve and the two intersect at po E
price level Pis determined. With huge budget deficits and large expansion in moey
 and Cause
:
Nature
nfiation

s u p p l yg e n e r a ;
anditions
ating condition of excess
demand cause
cunve t o A D , . oneral price level rises
1 The. upward 1035
ce
increase cost
in co of
to
P, shift in the
E.Nou, t h e
by increase in production brought
caused hr corresponding
about
to the newaggregate demand

mand-pull aggregate demand or by rise by .either

e r inden
equilibrium point
m price

ced by inflation
this the price evel in the irst
tirst i n e t i s e in
in independently
wages and dearness
of the rise
level furth
moves from further rises to
instance, allowances
aggregate supply curve shifts
price
equilibrium
E, to
E, and then to P,under the
influence of to the
The
st-push factors has been
d-pull and cost
E,. This process of cost push factors.
Indian economy. going on year after year and is joint operation of
he Indian
dema

t rise in prices in the

udget deficits have to beTherefore, to check and moderate responsible
persistent

not only the budç for the

production by drastically
event the increase in cost of
proce

cut but this inflationary

preve

and indirect taxes. avoiding the frequentalsohikesteps should be taken to

and ina tarist in
administered price
Is Monetarist
Theory Valid Explanation of
a
naney or Friedman modern monetarist Infation. Does the classical
thed
vieuw not true that inflation in India is a theory of inflation appy to India quite
itiis quantity
In o u r
e money supply in the past has contributed purely monetary well
gTowth
to the inflationphenomenon, though rapid
erience shows that despite
relatively higher growth in money in India. However, recent
rateoffinflation
ina remainedata low level.
It will be seen from Table 45.1supply during the last 8 years
that whereas rate
moneysupply has been
money supply quite of growth
high (it has varied from 14 per cent a year to 21 per cent
ate of inflation has been relatively
low. This shows that a year.
Even after adjusting for rate of growth money
in
not
ho cAuse of inflation.
GDP
supply alone is
1995-2007 there still remains a large gap between money supplygrowth rate
growth and rate of inflation.
during the period
Taking the Indian time series data of whole sale price index number and the money supply, when
uhole sale price index number data was regressed on money supply and GDP
(i.e.,
Qutput), the coefficient of money supply was found to be around 0.5 and of aggregateaggregate
output to
be around 0.45. This shows there is one-to-one relationship between money supply and price
no
level and further that the growth of output (i.e., supply side factor, also plays an important role in
determing inflation in India's growing economy; this disproves strict quantity theory of mone)

Table 45.1 Growth in Money Supply and Rate of Infation in India (1995-2005)
Year Growth in Rate of inflation Rate of Inflation Growth rate
based on WPI based on CPI in GDP
Money Supply M,
4.4 8.9 6.5
1955-96 13.6
10.0 4.8
1996-97 16.2 5.4
8.3 7.8
1997-98 18.0 4.5
8.9 7.3
1998-99 19.4 5.3
6.1
6.5 4.8
1999-2000 14.6 2.5 4.4
2000-2001 16.8 4.9
5.2 5.8
2001-2002 14.1 1.6 4.0
4.1
2002-2003 14.8 6.5
3.5
8.5
2003-2004 16.8 4.6
4.2
7.5
2004-2005 5.1 9.2
12.3 5.0
9.4
2005-2006 17.0 4.1 6.9
9.3
2006-2007? 21.1 6.7 6.2 6.7
2007-08 21.4 4.7 9.1 8.
2008-09 19.3 8.1 12.4 9.3
2009-10 16.8
3.8 10.4 2
2010-11 16.0
9.6 8.4
5.0
2011-12 15.6
8.9 10.0
2012-13 11.2
7.6
 1036 agerial Economics
INFLATIONAND INTEREST RATE:THE FISHER EFFET
Interest rate is an important macroeconomic variable as it dermines savina anainves
ment in the economy that play an important rate in the determination of national income
employment. Through its effect on saving and investment, interest links the present u and
future. Itis therefore important to understand the relation between interest rate and inflatie
understand the relation between interest rate and inflation, it is necessary to know the distinch
between nominal interest rate and real interest rate. Nominal interest rate is the stated interoet
érest
rate which a bank provides to its depositors on the saving account and the fixed deposits
of
different maturity periods. Nominal interest is also the agreed nominal rate at which the lenders
lend money to the borrowers. If your bank gives you 8 per cent interest rate on the fixed deposit
of one year, then 8 per cent is the nominal interest rate.
posit
On the other hand, real interest rate means how fast the purchasing power of your depog
its in the bank increases over a year. The rate of increase in purchasing power of your moneu
deposits over time depends not only on the nominal interest rate but also on the inflation rate
that takes place over time. For example, if nominal interest rate on a fixed deposit for a year is
8 per cent and inflation rate in the year is 5 per cent, then5 per cent of purchasing power
nominal interest rate has been wiped out by infaltion. Therefore, in this case 8 per cent minus
5 per cent, that is, 3 per cent is the increase in purchasing power of your deposits and therefore
represents the real rate of interest.
Thus real interest rate can be obtained from nominal interest rate by adjusting for inflation
rate that takes place in a year. Thus relationship among the real rate of interest, nominal rate of
inflation rate can stated as under
interest and be
Real interest rate=nominal interest rate - inflation rate.

If we denote real interest rate by r, nominal interest rate by i and inflation rate by n, then
r=i-T ...)
Fisher Equation and Effect
An important principle of Classical theory is that money is neutral, that is, it does not affect
the real variables. Changes in money supply determine only the changes in price level or rate
of inflation in the economy. This principle has an important application in the determination of
relation between nominal interest rate, real interest rate and inflation rate.
Rearranging the equation (i) we have
Nominal interest rate = real interest rate + rate of inflation
In symbolic terms,
i =r + T . (i)
The above equation (2) shows that change in nominal interest rate (i) can occur due to
the reasons: (1) changes in real interest rate, and (2) changes in rate ofinflation. The relation
ship between nominal interest rate, real interest rate and inflation rate described in equation
2), namely, nominal interest rate is the sum of real interest rate and inflation rate is called Fisher
Equation after the economist. Irving Fisher (1867- 1947) who first of all stated this
The
relation.
viewing nominal interest rate as the sum of real interest rate and inflation rate is quie
usetul entirely different forces determine the real interest rate and the inflation state whic
as

together determine the nominal interest rate. As has been studied ssical
earlier, according to
clas
theory, real interest rate is determined by
saving and investment (or, according to neo-classi
theory, demand for and supply of loanable
funds), rate of inflation is detemined by rae owth
of money supply. According to Classical
of money theory, rate of inflation is determined by rate orgh wth
supply. Growth of many supply does not influence real interest rate. As a of
mat
 Uses
fact, reali
erest rate 1037
sical principle of is a
real
Fisher monetary variabl and. stated above. according to the important
as

change in i Effect. An
neutrali
rality, changes in clas
inflation
o important
n rate whient
2ank of a country
money supply do not affect the real variables.

since nominal
which
increases macroeconom
in macroeconomic issue is how nominal interest rate adjusts
turn i
rOh ofof money supply. When Cent to
rate will raise interest money determined by growth
rate is the sumsupphy the economy, it will monyto
py in the cause rate of inflation to rise.
nominal inteSum real interest rate and rate of inflation.of inflafi0
the
for-one of econouy
inal interestadjustment nterest rate, Teal interest rate
of
rise in intilation
rate to nominal interes rate to remaining unchanged. In fact there
Suppose your fixed changes
on
den in nfiation changes in inflation rate. Adjustment of
inflationrare in the inflation rate
rate is called
Fisher effect. Let us take an example.
economuie Eayear your e
bank pays you 8 per cent. Further
r Cent per
annum. Writing them in suppose
Fisher equation we have

Now, if as a result of 8 3 +5
per hen given the higher
annum, the growth of money supply
real interest
cent. This is because rate as sup rate ofinflation rises to 6 per cen
3 per ent,
cent nominal interest rate will rise to 9
p

If follows rom above 9 3+6

nominal interest rate adjusts to
a t e of inflation,
the higher change in
will be the nominal interest rate. rate of inflation. The higner
The historical experience shows that nominal
Sociated in recentyears. Chile and Brazel interest rate and rate of inflation are
losely
rs Chile experienced an annual have experienced high rates of infation. In recent
years

razil inflation rate of around 30

of 45 per cent. Braz experienced
a still per cent with nominal interest
intere rate were about 45 per cent higher inflation rateand
a rate
in it inflation rate and nominal
per month.

EFFECTS OF INFLATION
Inflation is a very unpopular happening in an
economy. Opinion surveys conduced in India.
he U.S.A. and other countries
reveal that infilation is the most important concern of the
as it badly affects their
standard living. The political fortunes of many political leaders people
of
(Prime
Ministers and Presidents) and Governments in lIndia and abroad have been
determined by how
far they have succeeded in tackling the problem of inflation. So much so that some American
Dresidental candidates called 'inflation as enemy number one'. Same is the case in India where
inflation is the most hotly debated issue during the general elections for the Parliament and
Assemblies. A high rate of intilation makes the life of the poor very miserable. It is, therefore.
described as anti-poor. It redistributes income and wealth in favour of some and greatly harms
others. By making the rich richer and the poor poorer, it militates against social justice. Besides,
inilation lowers national output and employment and impedes long-un economic growth.
Specially in developing countries like India. We shall discuss below all these effects of inflation.
Anticipated and Unanticipated Infation
and unanticipated inílation is of crucial im-
Ine ditference between anticipated inflation redistributive effect, depend on whether it is
Ce as the effects of inflation, especially its then people take steps to make suitable
ated or not. If rate of inflation is anticipated,effects which inflation could bring to them.
adverse
ra
Fo Sn their contracts to avoid the the rate of inflation in a particular year to be equal
example, if a
10per cent worker
correctly anticipates
month, he can enter
into contractwith
and if his present wage rate is 5000 per
empl his money wage per month
cent rise in prices
employer that to con
t year hjat to compensate
ext
for the 10 per
he gets 5500 per month. In this way
he
year be rais
Ed 10
by cent so that next year
per
1038
has been able to prevent the erosion of his real income with the
Managerial Economic
automatic revision of hisis money
wage depending on the anticipated rate of inflation. m

Take another example. You lendR 10,000 to a person at a rate of 10 per

After a vear you will receive 11,000. But if it is cent per an
anticipated that during the year
there
annum.
8 per cent rate of inflation, then 8 per cent
of your income
that would occur so that you will get only 2 per cent real rate
will be offset by the rise
in:
of interest. Therefore, in prices
receive 10 per cent real rate of interest, in view of 8
per cent anticipated inflation rate
order
demand 18 per cent nominal rate of interest. you ms
must
Cost of Unanticipated Infiation. Unanticipated inflation has a more substantial and
t as compared to the cost of anticipated infllation rate. The significant effect of harmful ef.
inflation is that it arbitrarily re-distributes wealth among individuals. unanticipated
Consider the value
fixed in nominal terms. Between 1995 and 2006, of assets
price level in India rose by about 100
cent. This implies that those who held claims on assets Der
fixed in nominal terms in 1996, their
real value in terms of purchasing power would have declined
significantly. Thus, a person
who
bought government bound of 10 years maturely with a face value of 1000
nominal interest rate in 1996 will find that 1000 he bearing per cent
8
gets bank in 2006 has far less value than
when he purchased the bond in 1996.
Similarly, unanticipated inflation harms the individuals, who retire on
rupee terms. After some years of inflation, the real value or
pensions fixed in
nal pension will greatly decline and will therefore purchasing power the fixed nomi-
of
reduce his standard of living in his old
Thus inflation hurts individuals with fixed age.
pensions. Workers and the private firms often agree
on fixed nominal
pension payable to the workers after retirement. Workers are greatly harmed
when inflation is higher than
anticipated. Likewise, higher than anticipated inflation rate hurts
the creditors who give loans to the others and
get back the principal amount after the stipulated
period. Thus inflation redistributes wealth in favour of debtors. On the other effects of
unanticipated inflation are unavoidable because in this case you do not know hand, what would be
the rise in the price level. That is,
unanticipated inflation catches you by surprise.
Effects of Inflation in General
In what follows we shall examine the
effects of inflation in general, especially unanticipated.
The effects of inflation can be divided into three
1. Effect on real income;
categories:
2. Effect on distribution of income and
wealth;
3. Effect on output; and
4. Effect on long-run economic growth.
Inffation Erodes Real Incomes of the People. To examine
the effect of inflation it is
important to note the difference between money income and real income. It is the change in
the general price level that creates the crucial difference
between the two. Money income or
what is also called nominal income means the inconme such as
in terms of rupees. On the other hand, real income wages, interest, rent received
implies the amount of and services
goods
which you can buy. In other words, real income means the
lf your money or nominal income increases at a purchasing power of your income
lower rate than the rate of rise in the general
price level (i.e., the rate of inflation), you will be able to buy less
real income will decline. Real income will rise goods and services, that is, you
only if nominal income rises faster than the rate o
inflation. For illustration, take the case of workers who enter
into contract with their employer a
an agreed wage rate
of 5000 per month for the period, say 5 years. Now, suppose the rate
inflation is 10 per cent per annum. This means after a 000
year, with
workers will be able to buy less goods and services. That their money wage
rate of
and
is, real income will decrease a
therefore their standard of living will fall.
 niathon
her example. Suppose you deposit your saving of 7 100
notn ate in a saving
receive 105. However,account
of interest. After a year you will which
if during that
a T i e s5 p e r

has been 12 per cent,

inflation you will be a
ee of
o
il be negative as, with I2 per cent rate loser in real terms. In fact your real
t+incomewill
Merest
services than what you can purchase with
of inflation, 105 after a year will buy
s g o o d sa n d

100 today.
The above nOt w o examples clearly show that
inflation reduces the
The adversely affects real income of the people. purchasing power of money
Distribution of Income and Wealth
a n at.hereby

E H e c to n D i s t r i

ant effect of inflation in that it redistributes income and wealth in favour of some
A ni m p o r

f others. Inflatio
of others. Inflation adversely affects those who receive relatively fixed incomes and
athe
t
the usinessmen, producers, traders and others who enjoy flexible incomes. Inflation brings
benetfits

for the
for the
producers and traders. Thus, all do not lose as a result of inflation, rather
pated profits
wuindfall We examine below how intlation redistributes income and wealth and thereby
from it. We
aSses egain
people.and benefits others.
mssome
paiors and Debtors. Unanticipated inflation harms creditors and benefits debtors and
hen
edistributes income in favour of the latter. As explained above, value of money de-
awho in this way
to inflation. For creditors (including financial institutions such as banks and insurance
cinesdue t

han nanjes) who enter into agreement with the borrowers to provide loans at fixed nominal rate
at the
intorest, the real value of money in terms of goods and services which they will receive
ofinte
would be much less if during the period prices rise sharply. Thus, the debtors
xed in nd
end of
of the
the period
period would

nomi because they would return the loan-money when its real value has declined
horrowers gain
r

the unexpected rapid rate of inflation.

Ggreatly due to fixed incomes stand to lose from inflation. Workers
Those who get
agmee Fixed Income Groups. inflation.
Amed salaried people who earn fixed wages and salaries are hit hard by unanticipated
and wages or salaries fixed
in
hurts often enter into contract with the employers regarding
These people of their nominal incomes fals greatly
ulated intlation occurs, the purchasing power
nominal terms. When there are
ects of levels of living. Thus, when inflation persists for some years
ld be causing a decline in their be mentioned that now-a-days
workers and
and salaries. It may
demands for revision of wages them for the rise in cost off living
dearness alowances to compensate
other salaried people get neutralise the rise in price
dearness allowances do not fully
due to inflation. However, these
Dated. scales.
also demand revision of wages and pay
level and therefore they who get income in fixed
nomi-
in the category of the people
Pensioners. They also come
monthly pension of Rs. 2000, the real
in 1984 with the
nal ferms. For the people who retired as compared to
1984 as
been reduced to one third
in Oct. 1998 would this period. It may also be
ue ot their pension 300 in the price level during
also
e has been more than per cent rise some
dearness allowance is
of the pensioners, are only party
in order to reduce the hardship value of their pension
Unat on the real
effects of inflation
e d on pension. But and traders,
offset in this way. Businessmen,
that is, entrepreneurs
and Traders. of goods produced
by entre-
: Producers the prices
SShen inflation, behind the rise in
stand to inflation.. During periods of because wages lag
PRenens gain by the cost of
production b u s i n e s s m e n . The
value of the
preneur rise relatively ely faster than increases the
profits of increases
and traders
prices of goods.
Consequent
ently, inflation
by the
entrepreneurs

mventori or stocks of goods and materials kept in their profits.

increase
adversely affects
due to rise in about an
iniation also
prices of goods which bringsand Debentures.

demand deposits,
sav-

Wealth Holder of Cash, Bonds of cash money,

olders
hole
the form These wealth
wealth holders who hold thei heir wealth in
bonds and
debentures.

ng and fixed ieposits and interest-bearing

 Managerlal Economics

1040
real value ot their wealth. Saving and

reduces the value is fixed in tterms of money.

by inflation as inflation
care severely hurt bonds assets
whose
and debentures present
fixed-value money
assets such as savind
demand deposits,
The rise in prices reduces the purchasing
ower ofthese fixed nominal rate of interest.
debentures which bear a
and time deposits, bonds and them. Consequently, it has boonn
interest earned by
reduces the real rate of of money
convert ther nodings
Inflation, therefore
inflation people try to
observed thatduring periods of rapid avoid the l o s
due toinflation, It
so as to
and physical property rates of intlation thenomi
and near money into goods
and all expect equal
if inflation is anticipated real rate of interest. Thus, if
ay
diso
oe noted that so as to obtain targeted
nal rates of interest are adjusted upward rate of inflation is equal
to 10 per cent and anticipate
creditors want real rate of interest equal at 18 per cent. This is known
fixed
nominal rate of interest
to 8 per cent, they will try to have rate of interest IS equal
to the real rate of
that market or nominal
as Fisher effect which states the anticipated rate
and rate of time preference) plus
(based on productivity of capital to prevent
nterest what is called inflation premium
Thus nominal rate of inflation includes
of inflation.
the erosion of purchasing power due to intlation. as to whether
There is a good deal of uncertainty and also disagreement
Effect o n Output.
The effect of inflation on output
infiation will adversely or favourably affect national output.
factors. Further, the
depends on whether it has been caused by
demand-pull or cost-push
aIso moderate or very rapid or whether it is
ettect of inflation on output depends on whether it is
effects of inflation in each of these cases.
anticipated or unanticipated. Let us examine the likely
number of economists favoured
Demand-pull Inflation and Output. Till recently large
a
a mild or modest inflation and they argued that rising prices are caused by increase in aggregate
demand which are accompanied by expansion in output. Indeed, according to them, rising
of labour and other
prices create a tonic effect on the level of investment and employment
resources by raising the marginal efticiency of capital (i.e., expected rate of profits). We know
the level of output and employment depend on aggregate demand, given the aggregate supply
curve. For instance, in Fig. 45.1, aggregate supply curve slopes upward up to ful-employment
aggregate output level Y,and beyond it,it becomes vertical. If in Fig. 45.1 in the beginning ag
gregate demand curve is AD, and in equilibrium aggregate output is OY, and price level is P"
the economy. The level of aggregate output Y, is far below the full-employment level of output
Y Now, if aggregate demand increases to AD, the price level level rises to P, and output rises
to Y Even if aggregate demand further increases upto AD aggregate output increases to Yp
and is accompanied by rise in the price level to P. Thus, in until the full-employment output Y
is reached, increase in aggregate demand causes moderate inflation and also raises aggregate
output and employment. It is only when aggregate demand increases beyond ful-employment
output that it leads to a higher rate of inflation without affecting output. Thus, so far as economy
finds itself in in equilibrium betore full-employment in view of the
rising aggregate supply
AS, moderate inflation has to be tolerated if higher levels of output and employment are curve to be
achieved. Therefore, some economists have argued that there exists
trade-off between output and
inflation or between employment and Some
intlation. inflation has to be
higher output (and therefore less unemployment). However, this viewpoint accepted
if you want
has been criticised in
recent years and it has been asserted that any trade-off
between rate of inflation and output (or
unemployment) is only a
short-run phenomenon and there is no
such trade-off in the long run
Cost-Push Inflation and Output. But, as seen above, the
years have thrown up another type of inflation which is economic events in rece
the effective inflation which is caused by lettward shift in the generally described as cost-pus
aggregate supply curve due to Tise
 Inflation : Nature and
Causess 1041
e s of crucial inputs such as petroleum oil, of labour etc. In the cost-push intlatton,
wages
c e level is associated witha fall in aggregate
eary years of 1970s and again in 1979-80 when output as will be seen from Fig. 49.d. I
tne
oil price shock given by OPEC
Costpusn intlation, prices rose but at the same
time
CTeated
SUcn a
sruation
has been described output fell and unemployment went
static or loweroutput and higher
as stagflation which implies occurrence of inflauou th
w
hTom tne above it is clear unemployment.
that there is
put. nauon may necessary relationship between
no

To quote
come about
with either inflation and ou
higher or a lower level of output and
a
samuelson, "Today, macroeconomists believe that there is no necessaryemploym
betweer pices
and output.
ut a supply shock
put, but An increase in
agareoate demand will increase both prices relatios
and
shifting up aggregate supply curve out
will raise prices and lower output."
EFFECTS OF INFLATION ON LONG-RUN
Some bconomists have ECONOMIC GROWTH
argued that inflation
the long-run economic growth. In of
creeping or mild variety has a tonic
a
onn
their support they aive the eftect
cOuntries in the
ghteenth and Nineteenth example of today's industralised
Centuries when the rate of growth of output had
heen more rapia during long periods of inflation
witnessed in these countries. The driving
in the process of economic growth,
according to them. has been high
force
hu inflation. They argue that wages lag behind the rise in profit margins created
general price level and thus creating
higher profit margins tor businessmen and industrialists. This tends to increase the profit share
in national income. The businessmen and industrialists who receive
profits as income belong to
the upper incomee brackets whose propensity to save is higher as compared to the workers. As
a result, savings g0 up whicH ensures higher rate of investment. With greater rate of investment
more accumulation ot capital is made possible More rapid capital accumulation generates a
higher rate of long-run economic growth
Looking at the probiem from an alternatrve angle. with wages lagging behind rise in prices,
inflation causes a large shif of resources away from the production of consumer goods for the
wage earners to the production ot capital goods The higher rate of expansion in capital stock
raises the growth of productive capacity of the economy productivity of labour. This generates
rapid economic growth
Fconomic Growth
Bad Eftect of Inffation on

from encouraging savings and generating

However, it is now widely recognised that, far
There
inflation slows down the rate of capital accumulation.
higher 1ate of economic growth, thas First, as seen above, when due to rapid inflation value
for
are several reasons responsibe
will not like to keep money with
themselves and will, therefore,
of money is declining. people demand
down heavily. This raises their consumption
be eager to spend it betore its value goes erode the
Besides. people find that the rapid inflation will
and therefore lowers their saving rise in prices
therm to save. Thus, inflation or rapid
eal value of their savings. This discourages
the rise in prices, a relatively greater
SerTes as a disincentive to save
Further, as a consequence of level of living and
on consumption
to maintain their
is
the people spent to save, it
t of the income of saved Thus, not only
does inflation reduce the willingness
l i t l e is left to be
also slashes their ability to save investrnent in gold, jewel-
unproductive form of add to
Sec i,fiatNCAT?Or prices lead to
rising forms wealth do not
of
kn These unproductive economic
C o n s t r u c t i o n of
houses etc.
useless from the viewpoint of
ale,
te procductive and are quite type.
of the e c o n o m y is of unproductive
Capacity investment but much of this
h Thus. ERAton may lead to
more
1992
McGra-Hill.

t editior,
 1042 Managerial Economics
In this way economic surplus is frittered away in unproductive investment.

Thirclly, a highly undesirable consequence of inflation, especialy in developing countries,

that it accentuates the problem of poverty in these countries which is agamist inctusive grouth i
is
is often said inflation is enemy number one of the poor people. Due to ising prices poor people
are not able to meet their basic needs and maintain minimum subsistence level of consumption
Thus inflation sends many people to live below the poverty line with the result that the number
of people living below the poverty line increases. Besides, due to intlation. consumption of a
large number of poor people is reduced much below what may be regarded as productive con-
sumption, that is, essential consumption required to maintain health and proctuctrve etficiency
India, rapid inflation in recent years is as much responsible for the mounting number of people
below the poverty line as the lack of employment opportunities.
Fourthly, inflation adversely affects balance of payments and thereby hampers economic
growth, especially in the developing countries. When prices of domestic goods rise due to infla-

they cannot compete abroad and as a consequence exports

of a country are discouraged
tion,the
On other hand, when domestic prices rise relatively to prices of foreign goods, imports of
foreign goods increase. Thus, falling exports and rising imports create disequilibrium in the bal-
ance of payments which may, in the long run, result, in a foreign exchange crisis. The shortage
of foreign exchange prevents the country to import even essential materials and capital goods
needed for industrial growth of the economy. The Indian experience during 1988-92 when
reserves declined to abysmally low level
and created an economic crisis in the
foreign exchange
country, shows the validity of this argument.
or not moderate or mild inflation
There is agreement among economists whether
no
ensures higher rate of capital
accumulation and economic
encourages saving and therefore
that a very rapid inflation o r what is often called
growth. However, there is complete unanimity
economic growth. However, barring the special
hyperinflation discourages saving and hinders inflation depends on whether
or not saving is encouraged by
case of hyperinflation, whether
countries such as
sufficient evidence in the industrialised
there exists wage lag. While there is before the
about the existence of wage lag in the period
the U.S.A. Great Britain, France etc.,
there is no solid evidence of it. In the present wages quickly
World War I1, in the period after this that the
the prices. Indeed, there is evidence in some developed countries
catch up with rising has gone up during the post
in national income has declined and that of wages
share of profits economic growth depends
"To the extent that rate of long-run
World War II period. Therefore,
accumulation, a major basis for
the conclusion that inflation promotes
on the rate of capital inflation as they
is undermined given that wages no longer lag during
rapid economic growth
apparently did in time of past."10
that in the developing countries like
India where labour is mostly
be noted
However, it may there is a lack of informa
trade unions of labour are not strong and further
unorganised and during periods of inflation. This itself
will cause
lagging behind prices should
tion which c a u s e s wages and other business incomes which
of national income going to profits
greater proportion businessmen are prone to make unproductive
rate. However, in India, whose prices
e n s u r e higher saving real estate and palatial houses
activities, gold, jewellery,
investment in speculative not only counter-productive
of inflation. Such kind of investment is
rise rapidly during periods tne
in
accentuates inequalities
to social justice as it further
but is repugnant
and anti-growth
distribution of income
and wealth. disastrous con
are full of
prices as a goal of monetary policy
above that rising as a desirabe
It follows from the people and therefore cannot be recommended
the economy and
sequences for
Analysis, Fouth Edition, 1978, p.443.
Shanire. M a c r o e c o n o m i c
 90 h e economic
which will shake the 1043
confidenceing prices often get out of hand and
of the
hyperinflafion might set in
people in the monetary and fiscal
Measures MEASURES TO system of the country.
to
Control cONTROL INFLATION
As has been explained Demand-Pull Demand
goods and services relative above,
to their inflation occurs due to the
called demand-pull supply of output at the emergence of excess
this intlation. inflation. Various fiscal and prevailing prices. Inflationdenanna
inflation whichweis discuss below the monetary
caused by excess efficacy of the various measures can be adopted to typ
of this
1. Fiscal
Policy: aggregatedemand.
policy measures to check cne
Reducing
The budget deals with Fiscal Deficit denand-pu
how a
enue raised by the Government raises its revenue and
Government through
less than the expenditure it spends it. If the total
taxation, fees, surpluses from
incurs
defence, civil administration and on
buying goods and services to meet public undertakings rev-
various welfare and its is
fiscal deficit. It may be noted
here that the requirements
developmental activities, there ernerges a
of

Budget, (2) Capital Budget. In the budget the government has two
of
taxes, interests, fees, revenue parts: (1) Keverue
surpluses from public budget on the receipts side revenue raised
consumption expenditure by the undertakings are given and on the througn
of defence, civil
administration,
government on
goods and services required toexpenditure sIde
and exports, and interest education and health services, subsidies on
meet the needs

In
payments on the loans
taken
food, fertilizers
items. the capital budget, the by it in the
previous
main years are
from the Banks and other financial items of receipts are market borrowings by the important
government
National Savings Schemes etc.). Theinstitutions, foreign aid, small savings (i.e., Provident Fund.
defence, funding of important items of expenditure in the
public enterprises for capital budget are
developmental
infrastructure projects and loans to states and union purposes, especially those relating to
territories.
Fiscal deficit can be financed in two
ways. First,
bank (RBI in case of India) against its own borrowing by the government from thje central
securities. This leads to the creation of more
supply and therefore gives rise to inflationary money
pressures in the economy. For some
this was called deficit financing which was years ago.
held to be the main cause of
of fiscal deficit. However, in recentdemand-pull
in India. Now, we call it monetisation inflation
India is financed mainly through years fiscal deficit in
borrowing by the Government through sale of its bonds which
are generally purchased by banks, insurance companies, mutual funds and
increase in government expenditure made corporate firms. The
possible by borrowing without being matched by extra
taxation causes aggregate demand to increase. The net increase in
Government expenditure
leads to multiple increase in aggregate demand through Government
expenditure multiplier.
In the opinion of many economists, the expansion in aggregate expenditure caused by fiscal
deficit leads to the excess aggregate demand and inflationary pressures in the
economy, espe-
Cially when aggregate supply of output is inelastic. To some extent increase in aggregate demand
may not generate demand-pull inflation because if the aggregate output increases, especialy of
essential consumer goods such as foodgrains, cloth, the extra demand arising out of increase in
expenditure would be matched by extra supply of output.
But when increase in expenditure occurs and the economy is already utilising its production
inflation. Therefore, to tackle the
apacity fully or working near to it, this leads to demand-pull In its recommendation for
PODlem of demand-pull inflation fiscal deficit should be reduced. has
has suggested that fiscal deficit must be reduced to 3 per cent of GDP if inflation
I M
to be
kept under check.
 Managerial Economcs
1044
mobilise more
resources through taxes, hnl
lo reduce fiscal deficit the Government can
for raising resources tnrough taxation. In bol.
indirect. In India there is a lot of scope
airect
and number of unnecessary exemptions whi
personal and corporate income taxes, there are large
a
been found that though there is 33 per cent
lower the effective rate of income tax. Thus it has
exemptions which have outlived their utilih,
tax on coIporate income but because of several
abOut 24 per cent. Ihus with withdrawal
rate of corporate income tax in India is only
etfective in revenue of the Government. Besides
of these exemptions can lead to significant increase
tax evasion which occurs on a large scale
improving efticiency of tax-collecting administration
revenue for the Government. On
in India and generate a lot of black money can yield large
the other hand, it can reduce fiscal deficit by curtailing its wasteful and inessential expenditure.

subsidies to the non-poor people. In India, it is often argued that there is a large scope
especially
tor pruning down non-plan expenditure on defence, police and general administration and on
subsidies being provided on food, fertilizers and fuel oil. Though it is easy to suggest cutting
down of Government expenditure, it is difficult to implement it in practic However, in our
view, there is a large-scale ineficiency in resource use and also a lot of corruption involved in
spending by the Government expenditure which can be curtailed to a good extent. Thus,
both by greater resource mobilisation on the one hand and pruning down of wasteful and ines-
sential Government expenditure on the other, the fiscal deficit can be reduced.

2. Monetary Policy to Control Inflation: Monetary Tightening

Monetary policy refers to the adoption of suitable policy regarding interest rate and the avail
ability of credit. Monetary policy is important measure for reducing aggregate demand tocontrol
inflation. As an instrument of demand management, monetary policy can work in two ways.
First, it can affect the cost of credit and second, it can influence the credit availability for private
business firms. Let us first consider the cost of credit. The higher the rate of interest, the greater
the cost of borrowing from the banks by the business firms. As anti-inflationary measure, the rate
of interest has to be raised to discourage businessmen to borrow more so that less bank credit
is created. In the fitties and early sixties, the cheap credit policy (i.e., lower interest rates) was
recommended on the ground that lower rate of interest will promote more private investment
which is an important factor determining economic growth. Keeping in view this consideration,
cheap money policy was adopted in India upto 1972 and accordingly bank rate was kept low.
The dear money policy (that is, higher interest rate policy has been often used in India to
curb the inflationary pressures in the Indian economy. In India, bank rate has not been
generally
used to check inflation. Instruments like repo rate and reverse repo rate have often been used to
manage aggregate demand. Rep0 rate is the interest rate at which Reserve Bank of India lends
funds to the commercial bankfor a short period. To curb inflation repo rate is raised. Hike in
repo
rate raises the cost of funds for the banks which will, if
they do not have excess reserves, raise
their lending rates. The higher lending rates will lower the
demand for bank credit for investment
and for purchases of cars (auto loans and housing (housing loans). Under these circumstances
to mobilise funds banks raise their deposit rates. The higher rate of
interest on saving ana
fixed deposits will induce more savings by the households and
help in cutting down aggregate
consumption expenditure. Besides, higher rates of interest will
inventories and consumer durables and will help in discourage
more investment
in repo rate will lead to the decline in credit
reducing aggregate demand. However, rise
growth if monetary transmission mechanism
This will happen only if banks are short of
liquid funds. If the banks have excess
work
with them they would not raise their lending rates when
the RBI raises
liquid reserve
monetary transmission mechanism to work liquidity with the banks repo rate. Therefore,can o
must be curtailed. This
 be done by the RBI
by
sale of Government raising Ps
Cash Reserve
ve ratio (CRR) and by open market operation
n
through
securities.
Itis noteworthy that a
recent in the credit
availability
availabit
than cost monetary theory emphasizes that it is the changes
bility ratherthan
of
of reg
regulating aggregatedenmand credit (ie.
(ie. rate
rate of interest) that is a more effective instrument
of egulating aggregate demand. There are
reduced. Firstly, it is throunh1here
o
are several methods by which credit availability can be
reduced.
Firsty. it is several me
reduce
through
the availability of open market operations that the central bank of country can
a
credit in the onomy.
Bank
Bank sells Government securities. economy. Und
Under open market operations, the Reserve
Those, especially banks,
nks, who buy
buy these
these securities will make
payment or them in terms of cash reserves. securies w
end money to the business firms will be With their reduced cash reserves, their
curtailed. This will tend
capaiy
or loanable tunds by the banks which in to reduce the
supPPy OT
turn would tend to reduce
However, în India open market aggregate demand
of credit control to fight against operations do not play a significant role as an
inflationary instrument
situation. This is because market for Government
securities is narTow as well as captive.
General public do not buy more than a fraction of
ment secuities. It is the institutions such as commercial Govern-
which required by law to invest a certain
are banks, LIC, GIC and Provident unds

securities. However, the RBI can reduce the proportionwith the funds in buying Government
of their
liquidity banks by selling Government
securities to them through open market operations
In India. it is the Cash Reserve Ratio (CRR)
which can be effectively used to curb intla-
ion. By law banks have to keep a certain proportion of cash
deposits. This is called cash reserve ratio. To reduce liquidity with the banks andagainst
money as reserves their
thereby to
contract credit availability Reserve Bank can raise this ratio. In recent
years to squeeze credit for
checking inflation, cash reserve ratio in India has been raised from time to time.
Another instrument with Reserve Bank of India for affecting credit availability is the
Statutory Liquidity Ratio (SLR). According to statutory liquidity ratio, in addition to CRR,
banks have to keep a certain minimum proportion of their deposits in the form of specified
iquid assets. And the most important specified liquid asset for this purpose is the Government
securities. To mop up extra liquid assets with banks which may lead to undue expansion in credit
availability for the business class, the Reserve Bank has often raised statutory liquidity ratio.
Limitations of Tight Monetary Policy
However, tight monetary policy for controlling inflation is not without its limitations. First,
monetary transmission mechanism may be weak and raising of short-term interest rates by the
RBI may not actually lead to the restriction of bank credit. First, the banks may have surplus
iquidity (i.e., cash reserves) with them and therefore they may not follow tight monetary policy
and raise their lending rates. As a result, supply of credit by banks will not be restricted. Secondly,
I the economic environment is such that boom conditions prevail in the economy and aggregate
lend-
Cemand for products is quite high, demand for credit may not be much affected by higher
is determined more by marginal efficiency
g rates. As emphasized by J.M. Keynes investment
rather than rate of interest. Thirdly, at present in India
capital (that is, expected rate of return) markets (i.e., external com-
Corp
Orate firms are more easily able to borrow from foreign capital
interest in the US, European zone and Japan
of
borrowing. ECB) especially when rates
are e unless this debt-capital inflow (ie. ECB) is checked RB>'s monetary
xtremely low. Therefore,
control inflation in the economy.
ymay not be effective to check the supply ofcreditto
demand is quite high, the
irdly, when the stock market prices are rising and aggregate
 1046 Managerial Economics
corporate sector is able to raise funds itself more easily from the capital market. This will
offset the
impact of tight monetary policy of the RBI to control inflation. Fourthly, if
internal quate
funds are available with the
corporate firms as a result of retained profit
earnings bythe
companies they can use them to finance their expansion plans and thereby add to the aggrecato
expenditure or demand. This will also nllifty the tight monetary policy of the RBl to curb
infation
t noted that in recent years to control inflation the Reserve Bank of India raised its
may be
repo rate 13 times from March 2010 to Nov. 2011 (from 4.75% in March 2010 to 8.50% in Nov
2011) but inflation as measured by the WPI remained at an it was

per
elevated level. estimated at
cent YoY) in September 2011, 9.73% in Oct. 2011 and 9.11 per cent in Nov. 2011.
Ater Nov. 2011, WPI infiation declined because of dip in food inflation due partly to the base
effect and partly to easing of
supply position of some food articles. Thus tight monetary policy
tailed to check inflation despite 3.75 per centage points increase in repo rate. The RBl explained
talilure of its tight monetary policy to curb inflation by pointing out to large fiscal defjict of the
Government in 2011-12. Due to large fiscal deficit, aggregate demand was increasing which
was feeding inflation in the Indian economy. According to the RBI, unless fiscal deficit is brought
down by the Government, tight monetary policy alone will not succeed in checking inflation.
Besides, the RBI blamed supply-side factors responsible for food inflation which has contributed
to overall rise in WPI inflation.
Lasty if inflation in the economy has originated from the supply-side factors, for example,
if production of foodgrains and other essential food articles such as milk, vegitables, fruits etc.
in a year declines or does not increase adequately to meet the growing demand for them due
to certain supply-side bottlenecks, this will cause the demand supply imbalances leading to the
rise in inflation. Such supply-side inflation cannot be checked by raising interest rates under
the tight monetary policy. This happened in 2009-10 when due to the shortage of monsoon
rainfall, drop in agricultural production was expected, inflationary pressures emerged in the
Indian economy raising food-inflation to around 20 per cent in December 2009. This food
inflation continued to prevail at double digit level till November 2010. Tight monetary policy
which is aimed at management of aggregate demand rather than augmentation of supply is
ineffective in tackling this supply-side inflation as in case of food inflation in 2010. Likewise, in
2010-11 and 2011-12 shortage of protein-based food products such as pulses, milk, fruits and
vegetables, eggs, meat and fish, contributed a good deal to the persistence of food inflation. It
is only after Oct. 2011 when there was a drop in food-inflation, that headline WPI inflation also
declined. Similarly, supply-side inflation arises when prices of petroleum products rise which is
passed on to the domestic consumers and cannot be tackled with use of tight monetary policy.
In addition to fuel, if output growth in core industries such as steel, cement, coal declined as
they did during 2011-12 in India they create supply-side botlenecks in various industries lead-
ing to supply-side inflation.
Now to control food inflation what is required to take long-term measures to augment supply of
foodgrains and other food articles by raising agricultural productivity by undertaking appropriate
technological changes and land-reform measures. In the short run to control food inflation what
is needed is to release food stocks through public distribution system (PDS) which should be
properly monitorad to check black-market. Besides, to control rise in food prices in the short run
release of food stocks for sale in the open market should be made. However, this
pre-suppose
enough food stocks with the Government. Further, to check food-inflation foodgrains, pulses,
oilseeds and other feed articles in shor-supply can be imported.

It may however be noted that when inflationary expectations arise as a result of emergence
nfetion
Nature and Causes
Nature

supply ot some essential commodities

af 1047
sof of goods in short
good there is tendency on the
3rd
stocks
supply for
speculative purposes. To discourage part of traders to
of goods in short supply monetary such speculative
hoardin
policy
plained below, selective credit controls of
beexplained
of hgih interest
rates can be
helpful. Besides
hoarding of foodgrains, oil-seeds and monetary policycy can also
also be
be used
used to check
to check
other essential
selective Credit Controls commodities.
aortant anti-inflationary measure in
odit cOontrol described above are known India is the use of
selective credit controls. The meth-
ant to control the cost and as
quantitative or general methods as they
mear

availability of credit in
aerse repo rate, open market operations and general. Thus, bank rate policy, repo
vailability of credit for all
ract the avail. variation in cash reserves ratio
purposes. On the other hand, selective expand or
meant regulate Jiow of credit Jor particular or
are mear to the credit controls
oral credit controls seek to regulate the total
Genera
specific purposes, Whereas the
the high powered money) and the cost of available quantity of credit (through changes
n.
ho distribution or allocation of credit betweencredit, the selective credit control seeks to change
its various uses. These
o also known as Qualitative Credit
are selective credit controls
Controls, The selective credit controls have both the
nositive and negative aspects. In its positive
aspect,
fow of credit to some particular sectors considered measures are taken to stimulate the greater
snall and marginal farmers, small artisans,
as
important. Thus, in India, agriculture,
small-scale industries are the
greater flow of bank credit has been sought to be priority sectors to which
is negative aspect, several measures
are taken to
encouraged by Reserve Bank of India. In
the
activities or sectors which are regarded as restrict the credit flowing into some
undesirable or harmful from the social specific
The selective credit controls of
point view.
generally used in
lending by banks against the stocks of India was changes in the minimum margin for
specific goods kept or against other types of securities.
In India, in the
past the selective credit controls were used the
speculative hoarding of essential commodities so as to check theby Reserve Bank to prevent
ies. The selective credit rise in prices of these commodi-
controls in India were used in case of
oils, cotton, sugar, gur and Khandsari.
It may be noted that the
foodgrains, oilseeds, vegetable
power to vary the minimum Reserve Bank of India has the
While lending advances to
margin requirements against the security of stocks of
businessmen, the commercial banks leave a commodities.
stock kept as
security to be financed by the businessmen from their own margin of the value of
equal to the remaining amount of the value of the sources and lend
stock. This
money
of the stock left minimum requirement of the value
to be financed by the
borrowers themselves is known as
margin fixed for a stock of
particular commodity is 60 per cent. In this case,margin. Suppose the
can borrow the businessmen
up to the value of 40 per cent of the stock of
per cent of the that commodity and the remaining 60
value of stock will be financed by he
5ank raises the businessman himself. Now, if the Reserve
per cent of the
margin to 70 per cent, then he can
borrow from the bank to the extent of 3
value of the stock of that commodity. This
or holding the stock of the commodity by the businessman.will lead to the contraction of credit
If the businessmen are
tinance the holding of 10 per cent extra stock of the not able to
he market and thus raising market supply of the commodity, they will be forced to sell that
things remaining the same. commodity. This will lower the prices, other
ome conditions are necessary for the successful
modities. First, they should be accompanied by operations of selective credit controls of
Use the
clever businessmen can obtain general credit control measures. This is be-
credit from the banks by
offering other securities and use
 Managerlal Economlca
1048
stocks of sensitive commoclities
the speculative holdings of the
the tnds sO obtaned to finance the rise in prices of sensi
controls ane to succeed in preventing
Thewtonw, if the selective credit cHedit controls aimed at reclucin
be accompanied by general ing
five commodities, they have to above that end-USe or purpose of all

the capacity of banks to lend noney. It

also tollows from
and crecdit advanced accorcdingly selectiua
if
by the banks
endit ought to be taken into account
controls have been in operation
In India the selective credit
controls to be ettective,
endit ane
But in recent years, the RBI has
to check the rise in prices of sensitive commodities,
sinee 195
intlation in India.
control measunes to check
stopped uising selective cnedit
the extent to which the funds
The succeSS of the selective credit controls
also depends upon
the unregulated money market)
hom non-bank sourmes (i.e., tom their own
funds and also from
purpose is reduced, the
is available to the businessmen. When the
bank crelit for a particular
markets for specula-
funds borrow from non-regulated money
businessmen can use their own or
of black money
the businessmen have large quantities
five holding of inventories. In India today other sensitive
with them which thev generally use for speculative
holling of foodgrains and
of selective control of credit to
commodities and in this way succeed in defeating the purpose
contain intlation.
Supply-side Inflation in India
to be wid-
certain commodities was found
n of India, demand-supply imbalances in
case
swings in their prices. Barning a
ening in recent years (2008-09, 2009-10) causing significant
bulk of its food demand through domestic
few edible oils and pulses, India has so far met the
resorted to imports, though generally
poduction. For wheat and sugar, India has occasionally
it is an exporter of these commodities.
the domestic supply and the deficit
In the of edible oils, the demand has far outstripped
case
around 35 per cent of the total consumption.
is met through imports, the share of imports being
demand in dependence on imports to the
resulting
Pulses production has also lagged behind the
commodities like crude oil, where the import depend-
extent of 14-15 per cent. In the case of
domestic prices
ence is more than 80 per cent,
while full pass through of international prices to
it will contribute to price stability by alleviating the
has implications for inflation in the short-run,
situation (that is, they will help in reducing fiscal deficit). The deregulation
pressure on the fiscal
to improve the fiscal situation could also promote
of petroleum products besides contributing
energy efficiency and
conservation.

food items in recent

The increase in inflation in India in certain commodities, especially
account of structural factors, which has created supply-side
bottlenecks. As
years has been on
lower than the overall growth in population the net
the growth in food production has been
which gets partly reflected in sustained increase in prices.
availability of food has come down,
inclusive growth, the resultant increase in income of
Moreover as the economy exhibits stronger
to shitt in the pattern of demand and consumption of food
the population at large would lead
could increase which would exert pressure on prices of these
items like pulses, milk and sugar
behind the growing demand.
products for which supply response may lag
Tackling Supply-side Inflation
The identification of sources of inflation is important for the conduct of monetary policy
Tightening of monetary policy in the face of demand pressures could yield desirable results b
reducing money supply or bank credit which will reduce the level of aggregate demand. How
ever, when the inflationary pressures are dominated by adverse supply shocks, monetarypo
could be less effective in containing price pressures. Supply shocks, however, generally tend
alter relative prices, and in certain conditions, relative price trends could necessitate monetaly
Dolicy actions, as had been the case for India in the last quarter of 2009-10.