Lecture 04

Inflation
Introduction:- In the mid 20th centaury, inflation was considered to be state of
affairs in which there was excess demand for commodities in the economy. A widely
used phrase for excess demand.
Inflation is a condition in which “too much money is chasing too few goods”
Meaning:- It means a process of rising prices.
(i) Paish describes inflation “ a condition in which money income is rising faster
than the flow of goods and services on which to spend it, which implies faster
than real national income”
(ii) Crowther defines “ inflation is a state in which the value of money falls and
price level persistently rises.
(iii) Prof.Ackly defines “ Inflation is a persistent and appreciable rise in general
value of average prices.
(iv) Hicks defines “ Inflation in terms of a continuous rise in prices.
(v) Johnson defines “Inflation as a sustained rise in prices
(vi) Brooman defines “Inflation as a continuing increase in the general price level.
(vii) Prof Pigou defines “ Inflation takes place when price level expands more in
proportion to output.
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 Different Categories of Inflation
Creeping Inflation:- This form of inflation is marked by a very slow rate of
increase in prices by producers. If it is controlled, lead to favorable effects on
production and employment conditions.
In this type of inflation, prices rise less than 3% yearly.
Walking Inflation:- When the velocity of price increases, and shows an
upward trend, is referred to as walking inflation. In this type of inflation,
prices rise in the intermediate range of more than 3 to 6 percent per year.
Running Inflation:- When the sustained rise in prices is about 10% per
annum, it is known as running inflation.
Hyper Inflation:- The term hyper means “excess “ of and thus, it indicates an
alarming rate of increase in prices. The value of money declines considerably
and people loose faith in the currency of their country. An increase in prices
more than 3% annually to be considered as hyper inflation.
Money supply is the main culprit in hyper inflation.

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 Causes of Inflation
(a) On t he basis of Monetary Factors:-
(b)Political Conditions Basis
(c) International Trade Basis
In times of a depression, the authorities inject more money into the
economy, so as to revive the business conditions. As the level of full
employment is approached, increasing money supply trends to generate
rising prices.
(d) On the basis of Monetary Factors
(i) During Depression in Economy
(ii) Deficit Financing:- In developing countries, the authorities are generally
called upon to spend in excess of their revenue proceeds for development
purposes. This deficit of expenditure over revenue is financed usually by
printing of currency notes or borrowing from the central Bank. Such
increase in money supply results in increased purchasing power in the
hands of people thus inducing inflation

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(b) Political Conditions Basis
(i) Inflation During War Time:- History has shown that all modern wars have
brought inflation. The government has to undertake heavy expenditures of
defense equipment and general provisions for armed forces. As a result
imposing heavy taxes to meet government spending for an inflation purpose.
It pushes up prices and creates inflation.
(ii) Inflation after War:- The government undertakes rehabilitation and
construction activity after a war which result in increase in expenditure. These
forces, contribute to inflation.
(c ) International Trade Basis:-
(iii) Increase in Demand of Exportable Goods:- When the pressure of demand on
exported items from international market high, there are shortages in the
domestic economy. It fuels inflation.
(iv) Increase in process of Imported Inputs:- Every country requires new
technology for its development. The developing countries do not have such
technology . Therefore, they import from the advanced countries. Any
increase in the price of imported goods, which rise the cost of production and
leads to raise price. Such type of trend creates inflation
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 Measures For Controlling Inflation

(i) Monetary Measures (ii) Fiscal Measures (iii) Non Monetary Measures

(i) Monetary Measures:- It consists of measures in which the Central Bank

controls and regulates money by controlling the volumes of credit in a country
Central Bank Measures
(a) Bank Rate Policy:-The central Bank raises the bank rate for commercial banks which
induces the deposits.
(b) Bank Rate:- It is a discount rate set by Central Bank of every country in giving out loans
to commercial banks through bills of exchange.
(c) Open Market Operation:- It sells government securities to the public or to the banks
themselves. It also sells securities to the people in general at low rate in the open
market. Thus people withdraw their cash from the commercial Banks
(d) To Change Reserve Ratio:-The commercial banks are required to keep minimum cash
in relation to the volume of their deposits and the central Bank has the power to
change ratio from time to time. Hence, Cash ratio can be raised.

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(ii) Fiscal Measures:- The following measures are taken by the
government through fiscal policy to control inflation.
(a) To reduce government expenditure Specially non-developmental
(b) Increasing Taxes on the Private Sector
(c ) Increasing Saving
(d) Public Debt Management is to reduce the supply of money

(iii) Non Monetary Measures

(a) To Increase Output
(b)To Control Money Wages
(c) Price Control
(d)Rationing

Definition of Interest Rate

It is the rate at which commercial banks provide loan to the people in

general

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 Types of Inflation
(i) Demand Pull Inflation
(ii) Cost Push Inflation
(i) Demand Pull Inflation:- It represents a situation whereby the pressure of
aggregate demand for goods and services exceeds the available supply of
output. Aggregate demand is the sum of consumers spending on current
goods and services and also government spending. The level of output is
constant at full employment. Accordingly, the price level rises due to
increase in AD is known as Demand Pull Inflation.
Factors
I. Increase in Marginal Propensity to consume
II. Increase in level of income
III. Expansion of domestic investment activity caused by an increase in the
MEC or decline in the rate of interest
IV. Expansion of Credit by Banks
V. Expansion of Government Expenditure
VI. Increased inflow of foreign capital Or Remittances from residents
settled Abroad
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 Demand Pull Inflation is shown in the Form of Diagram
Y
In diagram, the horizontal axis represents C
the real national income or output and P2

vertical Axis represent the general price D2

P1
level. At point A supply curve AS is D1
constant at the level of full employment. P0
S D0
The demand curves are represented by X
0 Y
DoDo, D1D1 and DD2. AS shown in the
diagram, when the aggregate demand
curve moves upward from D0Do to D1D1
and D2D2, the price line moves upward
from P0 to P1 to P2.

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Cost Push Inflation
In an economy, price level rises due to increase in cost of
production is known as cost push inflation. The important feature
of this type of inflation is this that on one side the level of output
and employment decreases and on the other side the price level
rises. In this type of inflation, unemployment and inflation go side
by side. It is said that whenever the inflation is accompanied by
unemployment it is accorded as Stagflation.

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 Forms of Cost Push Inflation
(i) Wage Push Inflation:- Now a days, he trade unions are very strong,.
They are well informed about rise in price level, wage agreements,
changes in fiscal and monetary policies. As a result, they force to
increase their wages. This puts a burden on the cost of production of the
firms. Hence it leads to increase price level and generates inflation.
(ii) Profit Push Inflation:- The market power of large business houses
has increased tremendously in recent years. The nature of modern
technology adopted by them results in lower production costs. This
group has monopoly over certain goods and they raise the margin of
profit.
Thus, profit push inflation is called administered price theory of inflation
or price pull inflation or Seller’s Inflation or market power inflation

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 Factors of Cost Push Inflation
(i) Key Inputs
When the prices of some vital inputs such as coal, steel, gas and
petroleum increase due to domestic and international market conditions,
the price level rises, resulting in cost push inflation.
Example:- In 1973, the price of oil increased in the international market

(ii) Increase in Indirect Taxes:

An other cause of restriction in AS is the increase in indirect taxes by
Central ,State and local governments. When indirect taxes are increase,
they raise costs and prices and reduce output and employment.

(iii) External Factors

Restriction on AS may also cause by external factors such as rise in the

world prices of food grains and crude oil prices and required input for
development. In all theses cases, domestic price level is raised by outside
forces.
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 Stagflation:-
Stagflation is a new term which has been added to economic literature in
the 1970s. The word “Stagflation” is the combination of “Stag” plus
“flatiron” taking stag from stagnation and flatiron from inflation
Since they take place simultaneously. This process is known as stagflation.
It is a situation where both unemployment and the rate of inflation are
high as compared to the accepted standard.
Stagflation of the economy means that with an increase in the level of
investment in a country the real national income practically remains the
same because at the same time the rate of growth of population is
increasing and so is the money supply, hence the goods and services keep
on increasing which eventually leads to inflation. Thus situation is known
as stagflation.
Stagflation is explained by Diagram

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 Diagram of Stagflation

Y D S’
In diagram employment is measured on the
horizontal axis and the price level on the P’ E’
S
vertical axis. The initial equilibrium is at E where E
the demand curve DD intersects. Supply curve P
SS and the employment level is ON. When S’
S
Aggregate Supply (AS) is reduced to any of the D
factors, the supply curve SS shifts to the left at
0 N’ N X
S’S’. The new equilibrium is at E’ where S’S’
intercepts DD curve. Now the price level rises
from OP to OP’ and the level of employment
declines from ON to ON’.

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Causes of Stagflation
I. Restrictions in the Aggregate Supply
II. Increase in Indirect Taxes by Central ,States and Local Governments
III. External Factors
IV. Rise in World Prices (a) Oil (b) Input (c ) Food Grains

Measures
(1) Minimum Wages should not be increased
(2) Tax Based Income Policies
(3) Induced Income Policies
(a) To Link the increasing money wages to productivity increase
(b) Prices should be reduced in those industries having above average
productivity growth
(c ) Stable Prices of industries which produce the national average rage
(4) Reduce personal business Taxes
It prevents the price level from rising

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 Effects of Inflation

I. Effects on income:- Inflation redistributes real purchasing power of

the consumers. Example:- Fixed income group, pensioners, rent
earners and salary group.
II. Effects on Wealth:- All financial assets fixed value such as bank
deposits, public sector bonds, life insurance services, retirement
funds, their value decrease due to inflation.
III. Effects on Economic Stability:- When there is a state of hyper
inflation in an economy and government is forced to adopt
restrictive policy measures. Such policy depress the economy.
IV. Effects on Economic Growth:- Inflation has a positive impact on the
growth rate of the GNP. Example:- In developing countries, inflation
is sometimes considered essential for achieving a high rate of
economic growth

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