Inflation – Types, Causes, Effects,

Indicators –
1. Inflation
 Inflation is a quantitative measure of the rate at which the average
price level of a basket of selected goods and services in an
economy increases over a period of time.
 It is the rise in the general level of prices in a period where the
same money buys less than it did in previous periods.
 Usually shown as a percentage, inflation indicates a decrease in
the purchasing power of a nation’s currency.
Rate of Inflation = (Price Level in year N – Price level in year N-1) * 100
                    Price level in year (N-1)
2. Deflation
 Deflation is the general decline in prices for goods and
services occurring when the inflation rate falls below 0% i.e.
inflation rate becomes negative. Deflation happens naturally when
the money supply of an economy is fixed. In times of deflation, the
purchasing power of currency and wages are higher than they
otherwise would have been. 
 Deflation is caused by a number of factors but is largely attributed
to two:
 A decline in aggregate demand and increased productivity. A
decline in aggregate demand typically results in subsequent lower
prices of the goods & services. 
 Causes of this shift include reduced government spending, stock
market failure, consumer desire to increase savings, and tightening
monetary policies (higher interest rates).
3. Reasons for inflation:
 Demand-pull inflation: It is caused by an increase in the demand
for the goods and services which in turn increases their prices this
is also known as too much money chasing too few goods. If
demand grows faster than supply, prices will increase. This has
been stated by the Keynesian school of economics.
 Measure: Import of goods is a short-term measure and as a long-
term measure government should increase the production to
match the demand.
 Cost-push inflation: This is caused when the cost of production
goes up. The need to increase prices and maintain their profit
 margins results in the price increase. This includes things such as
wages taxes and increased cost of natural resources or imports.
 Measure: Government should cut down taxes and reduce duties
like excise and custom on inputs as a short-term measure and in
the long-term measure better production process should be
adopted.
 Monetary inflation: When there is an oversupply of money in the
economy the value of the money reduces and fewer goods can be
bought with the same money. So, if there is too much supply of the
money price of the commodity increases and results in inflation.
This is stated by the monetarist school of economics.
 Measure: In the short term a tighter monetary policy may be
preferred and as a long-term measure better production practice
can resolve the issue.

4. Types of inflation
Depending upon the range and severity there are several types of inflation.
1. Low inflation is slow and unpredictable lines are also called
creeping inflation it takes place in a longer. And the ranges limited
to a single digit.
2. Galloping inflation: it is a double-digit of triple-digit referring to a
very high inflation Latin American countries such as Argentina Chile
Brazil add saturates of inflation.
3. Hyperinflation: it is large and accelerating which have the annual
rates in a million or a trillion not only range is very large the
increase happens in a very short span of time like overnight. some
examples are Germany after first World War in the 1920s.Such a
situation in Stu loss of confidence in the domestic currency and
people opt for other forms of money like gold.
4. Bottleneck inflation: play falls drastically well the demand
remains the same this occurs reasons maybe supply-side accidents
hazards or miss management. Also called structural inflation.
5. Core inflation: It shows the price rise in all goods and services
excluding energy and food articles .it was the first time used in the
year 2001.
5. Effects of inflation:
Effects of inflation are both at the micro and macro levels. Various players the
economy are affected in varied ways.
1. Lenders suffer and borrowers benefit when the inflation
rises and vice versa when the inflation falls.
 2. Higher price levels reduce the purchasing power of the
money in the short run but in the long run income levels also
increase.
3. As money loses value with increase in inflation holding physical
currency reduces its value. Rising inflation depletes the saving
rate in an economy.
4. With the rise in inflation consumption levels decreases (high
prices) and investment expenditure increases (lower cost of
finance).
5. The taxpayer pays higher taxes because of increased
income and crossing their respective slabs of Direct tax and
increased prices in case of indirect tax.
6. The currency of the economy depreciates and loses its exchange
value.
7. Exports increase due to currency depreciation and gain
competitive prices in the world market.
8. Import decrease as foreign goods become costlier.
9. Employment increases in the short run but becomes neutral or
negative in the long run.
10.The nominal value of the wages increases while the real value
decreases and there is a negative impact on purchasing power.

6. Indicators of inflation:
The two most common indicators to measure inflation are wholesale price
index and consumer price index.
1. Wholesale price index:
 It is the price of a representative basket (697 items) of wholesale
goods of 3 categories. manufacturing primary articles fuel and
power. services are not included in WPI.
 The data is released by the office of economic advisor,
department of industrial policy and promotion, ministry of
Commerce.
 The base year for measuring WPI is 2011-12. The current series is
the 7th revision of the base year.
2. Consumer price index:
 CPI measures the changes in the price level of a basket of
consumer goods and services or just by households
  It includes food and beverages housing fuel and light clothing and
footwear pan, tobacco and intoxicants.
 CPI is released in 3 categories. CPI rural, CPI urban, CPI combined
 Central statistics office, ministry of statistics and program
implementation release the data.
 Monetary policy takes note of CPI for inflation data.
3. Headline inflation
Headline inflation is a measure of the total inflation within an economy including
commodities such as food and energy prices which are more volatile my core
inflation is calculated from CPI minus the volatile food and energy components.
headline inflation may not present an accurate picture of open economies
inflationary trend.
7. Related terms
1. Stagflation is high unemployment and economic stagnation along
with high rates of inflation. When the inflation rate is high the
economic growth rate slows down, and unemployment remains
constantly high and results in stagflation.
2. Reflation: To achieve higher levels of economic growth and reduce
unemployment governments often go for stimulating the economy
by increasing public expenditure, tax cuts, lower interest rate etc.
Here fiscal deficit rises due to Stimulus, wages increase but there is
no improvement in employment.
3. Phillips curve: Phillips curve explains the relationship between
inflation and unemployment in an economy according to the curve
there is an inverse relationship between inflation and
unemployment.
4. Inflation targeting the announcement of an official target range
by the central bank for inflation is known as inflation targeting. it
started in 2015 after the agreement on monetary policy framework
according to its CPI -C inflation to be below 6% by 2016 January and
4% plus or minus 2% going forward.

Sample Questions
Q. What is the Opposite of the term Deflation?
1. Stagflation
2. Inflation
3. Reflation
4. Disinflation
Answer: Inflation
Q. Who benefits from the increase in inflation?
1. Borrowers
2. Lenders
 3. None
4. Importers
Answer: Borrowers (Real interest rates decrease)
Q. Phillips curve is a measure of?
1. Stagnation and inflation
2. Higher wages and inflation
3. Unemployment and inflation
4. Higher wages and stagnation
Answer: Unemployment and inflation (There is an inverse relationship
between unemployment and inflation in a Phillips Curve)
Q. Fiscal Deficit is also known as?
4. Deflationary Gap
5. Inflationary Gap
6. Reflation
7. Primary Deficit
Answer: Inflationary Gap (Deflationary Gap is the Fiscal surplus) 

What is Inflation?

Inflation is a rise in the general level of prices of goods and services in an

economy over a period of time.

When the general price level rises, each unit of currency buys fewer goods and
services. Therefore, inflation also reflects an erosion of purchasing power of
money.

According to Crowther, “Inflation is State in which the Value of Money is Falling

and the Prices are rising.”

In Economics, the word ‘inflation’ refers to General rise in Prices Measured

against a Standard Level of Purchasing Power.

Here are several variations on inflation used popularly to indicate specific

meanings.

 Deflation is when the general level of prices is falling. It is the opposite of

inflation. Also referred to as Disinflation. The lack of inflation may be an
indication that the economy is weakening.
 Hyperinflation is unusually rapid inflation in very short span of time. In
extreme cases, this can lead to the breakdown of a nation’s monetary
system with complete loss of confidence in the domestic currency. One of
 the earlier examples of hyperinflation occurred in Germany in early 1920s
after the First World War, when prices rose 2,500% in one month.
 Stagflation is the combination of high unemployment with high inflation.
This happened in industrialized countries during the 1970s, when a bad
economy was combined with OPEC raising oil prices led to low growth.

Inflation is all about prices going up, but for healthy economy wages should be
rising as well. The question shouldn’t be whether inflation is rising, but whether
it’s rising at a quicker pace than your wages, if the answer is a Yes only then
inflation is problematic.

Finally, inflation is a sign that an economy is growing. The RBI considers the

range of 4-5 % as comfort zone of inflation in India.

 Impact or Effect of Inflation:

 Inflation affects the pattern of production, a shift in production pattern

takes place from consumer goods to luxury goods.
 On Investment: Inflation discourages entrepreneurs in investing as the
risk involved in the future production would be very high with less hope
for returns. Uncertainty about the future purchasing power of money
discourages investment and savings.
 Inflation also results in black marketing. Sellers may stock up the goods to
be sold in the future, anticipating further price rise.
 The effect of inflation is felt on distribution of income and wealth and on
production.
 People with fixed income group are the worst sufferers of inflation. Those
living off a fixed-income, such as retirees, see a decline in their purchasing
power and, consequently, their standard of living.
  The entire economy must absorb repricing costs (“menu costs”) as price
lists, labels, menus and more have to be updated.
 If the inflation rate is greater than that of other countries, domestic
products become less competitive.
 They add inefficiencies in the market, and make it difficult for companies
to budget or plan long-term.
 On Exchange rate and trade: There can also be negative impacts to trade
from an increased instability in currency exchange prices caused by
unpredictable inflation.
 On Taxes: Higher income tax rates on taxpayers. Government incurs high
fiscal deficit due to decreased value of tax collections.
 On Export and balance of trade: Inflation rate in the economy is higher
than rates in other countries; this will increase imports and reduce
exports, leading to a deficit in the balance of trade.

Causes of Inflation:

There is no one cause that’s universally agreed upon, but at least two theories
are generally accepted while the debate still goes on:

1. Demand-Pull Inflation – This theory can be summarized as “too much

money chasing too few goods”. It is a mismatch between demand and
supply , if demand is growing faster than supply, prices will increase. This
usually occurs in growing economies as more people gain purchasing
power while the supply is not able to catch up to growing demand. When
the government of a country print money in excess, prices increase to
keep up with the increase in currency, leading to inflation.
2. Cost-Push Inflation – When production costs go up, there is an increase
in prices to maintain profit margins. Increased costs can include things
such as wages, taxes, or increased costs of imports.
3. Demand pull vs Cost Push Inflation• If demand pull inflation is present in
the economy, the government must bear the cost of excessive spending
and monetary authorities are to be blamed for “cheap money policy”• On
the contrary, if cost push is the real cause for inflation then the trade
union are to blamed for excessive wage claim, industries for acceding
them and business firms for marking- up profits aggressively.

Measurement of Inflation
Inflation is measured by calculating the percentage rate of change of a price
index, which is called the inflation rate. 
Inflation is often measured either in terms of Wholesale Price Index or in terms
of Consumer Price Index.

 Wholesale Price Index(WPI) : The Wholesale Price Index is an indicator

designed to measure the changes in the price levels of commodities that
flow into the wholesale trade intermediaries. The index is a vital guide in
 economic analysis and

policy formulation. It is a basis for price

adjustments in business contracts and projects. It is also intended to
serve as an additional source of information for comparisons on the
international front.

 Consumer Price Index (CPI) : Consumer price index is specific to

particular group in the population. It shows the cost of living of the group.
It is based on the changes in the retail prices of goods or services. Based
on their incomes, consumer spends money on these particular set of
goods and services. There are different consumer price indices. Each
index tracks the changes in the retail prices for different set of consumers.

Measures to control inflation:

Effective policies to control inflation need to focus on the underlying causes of

inflation in the economy. There are two broad ways in which governments try to
control inflation. These are-

1. Fiscal measures.                                                                                  

2.  2. Monetary measures
 Monetary Policy:  Monetary policy can control the growth of demand
through an increase in interest rates and a contraction in the real money
supply. For example, in the late 1980s, interest rates went up to 15%
because of the excessive growth in the economy and contributed to the
recession of the early 1990s.
 Monetary measures of controlling the inflation can be either quantitative
or qualitative. Bank rate policy, open market operations and variable
reserve ratio are the quantitative measures of credit control, by which
inflation can be brought down. Qualitative control measures involve
selective credit control measures.
 Bank rate policy is used as the main instrument of monetary control
during the period of inflation. When the central bank raises the bank rate,
it is said to have adopted a dear money policy. The increase in bank rate
increases the cost of borrowing which reduces commercial banks
borrowing from the central bank. Consequently, the flow of money from
the commercial banks to the public gets reduced. Therefore, inflation is
controlled to the extent it is caused by the bank credit.
 Cash Reserve Ratio (CRR) : To control inflation, the central bank raises
the CRR which reduces the lending capacity of the commercial banks.
Consequently, flow of money from commercial banks to public decreases.
In the process, it halts the rise in prices to the extent it is caused by banks
credits to the public.
 Open Market Operations: Open market operations refer to sale and
purchase of government securities and bonds by the central bank. To
control inflation, central bank sells the government securities to the public
through the banks. This results in transfer of a part of bank deposits to
central bank account and reduces credit creation capacity of the
commercial banks.
 Fiscal Policy:
  Higher direct taxes (causing a fall in disposable income).
  Lower Government spending.
 A reduction in the amount the government sector borrows each year .
 Direct wage controls – incomes policies Incomes policies (or direct wage
controls) set limits on the rate of growth of wages and have the potential
to reduce cost inflation.
 Government can curb it’s expenditure to bring the inflation in control.
 The government can also take some protectionist measures (such as
banning the export of essential items such as pulses, cereals and oils to
support the domestic consumption, encourage imports by lowering duties
on import items etc.