What is Inflation?
Inflation refers to a persistent and appreciable rise in the general price level. It is a situation of continuously rising prices of commodities and factors of production resulted from the excess money supply.
Different economists defined it in different ways. Some economists like Crowther, Gardner Ackley, Harry Johnson regarded inflation as a phenomenon of rising prices. According to Crowther, “inflation is a state in which the value of money is falling, i.e. the prices are rising.”
But economists like Friedman, Coulborn, Kemmerer regarded inflation as a monetary phenomenon. Coulbron defines it as “too much money chasing too few goods.” According to Friedman “inflation is always and everywhere a monetary phenomenon.”
Keynes defined, “Inflation as a phenomenon of full employment.” In his view, rising prices in all situations cannot be termed inflation. According to him, inflation starts only after full employment. In a situation of unemployment, when an increase in money supply and rising price level are accompanied by an expansion of output and employment, inflation does not occur.
Sometimes due to bottlenecks in the economy, an increase in the money supply may cause costs and prices to rise more than the expansion of employment and output, but the termed such a rise in prices as semi inflation. Once the full employment level is reached, the entire increase in money supply is reflected by rising prices, a case of pure inflation. Such inflation possesses a real threat to the economy and is to be worried about
For all practical purposes, Emile James defined inflation, “as a self-perpetuating and irreversible upward movement of the price level, caused by an excess demand overcapacity of supply.”
The excess demand may be the demand for investment as well as for consumer goods. The phrase ‘capacity of supply’ in the definition stresses that any increase in demand constitutes a call for an increase in production. If the excess demand is met by the increase in production there will be no inflation.
It can come about only if expansion in production or supply is held back by some obstacles. In this sense, the term inflation is also applicable to an economy where a rise in the price level may not lead to increased output beyond a certain stage due to the existence of bottlenecks, even though the stage of full employment is not attained. In short, apart from price rises, the existence of excess demand over supply is regarded as an essential condition for inflation.
Demand-pull inflation occurs when the aggregate demand for goods and services exceeds the aggregate supply available at existing prices, i.e. when there is excess demand for goods and services. It is mainly caused by demand-raising factors such as an increase in money supply, public expenditure, export and population, and a decrease in the tax rate, etc. It is mainly characterized by rising in output, income, and employment with the rise in price level up to full employment and an increase in only price level after full employment.
It occurs when aggregate demand exceeds aggregate supply due to cost-raising factors (or supply reducing factors) such as an increase in wage-cost, increase in profit margin, supply shock, etc. It is mainly characterized by a fall in output, income, and employment with the rise in the price level. It can be classified as:
Wage-push Inflation: It occurs when aggregate demand exceeds aggregate supply due to an increase in wage cost. It is attributed to the exercise of monopoly power of labor unions to get money wages enhanced above the competitive labor market wage rate or Productivity of labor.
Profit-push Inflation: A series of increases in the profit margins will lead to an increase in the cost of production and thereby prices resulting in an inflationary rise in price. It is called profit-push inflation.
Supply Shock Inflation: Supply shock inflation is a sudden, unexpected disturbance in the supply position of some major commodities or key industrial inputs. It occurs generally due to a sudden rise in the prices of high weightage items in the price index number, e.g. food prices due to crop failure, and prices of some key industrial inputs like coal, steel, cement, basic chemicals, and petroleum products.
Various economists have justified from their empirical research that demand-pull and cost-push forces operate simultaneously and interdependently in an inflationary process. Thus, inflation is mixed rather than demand-pull and cost-push when price level changes reflect upward shifts in both aggregate demand and supply fluctuations.
Effects of Inflation
Effects of inflations are as follows:
Effects on Production: While a mild degree of inflation activates the economy by increasing investment, production, and employment, a high degree of inflation has effects of inflation various adverse effects on production. The main adverse on production are:
- Reduction in Production
- Changes in the pattern of production
- Misallocation of resources
- Encourages sepculation
- Fall in quality of product
- Reduction in saving
- Hinders foreign capitals
Effects on the Distribution of Income: Inflation leads to inequitable and arbitrary redistribution of income and wealth in society. It results in all sections of society in the same way. During inflation, a section of the society may gain while another section may lose. An advantage accruing to one group of people may be at the cost of the other groups. These effects are to the:
- Debtors and creditors
- Profit earners
- Wage-earners and salaried class
- Pensioners and fixed income groups
Adverse Effect on Savings: It is likely to have an adverse effect on savings. Inflation wipes out saving completely. The real value of accumulated cash savings evaporates. Small savers, who put their savings in the form of bank deposits and government securities find the real value of their investment falling by large magnitude during the period of rising prices. This reduces the motivation for savings.
Effects on the Balance of Payments: It generally has an adverse effect on the balance of payments. If the rate of inflation in the country is higher than in other countries, the competitiveness of the country’s products in the world market would decrease. Our exportables would become relatively expensive in the world market lending to fall in exports. On the other hand, our importables would become relatively cheaper and this would increase our imports. Thus, demand for the country’s exports would decrease, and demand for its imports would increase. This would adversely affect the balance of payments.
Effects on Public Revenue: It is likely to have a favorable effect on public revenue. The Government would get more revenue from taxes during inflation. As prices rise, the revenue earned from indirect taxes, such as excise duties, sales tax, etc. will also increase. Moreover, revenue from direct taxes, such as income tax, will rise at a faster rate than the growth of money incomes due to the progressive tax system in most countries.
Social and Moral Degradation: Periods of hyper-inflation are often associated with social and moral degradation. It has led to thefts, robberies, and widespread corruption. It is the period during which a small type of crime thrives. Corruption breeds during inflation not only among businessmen but also among government officials and politicians.
Political Instability: Continuous inflation in many cases has shaken the foundations of the political system. It has become a major political issue during many elections. History is full of instances when many governments lost power because of the persistent rise in prices. For example, Nazi Revolution in German Was the outcome of the hyper-inflation of 1923. To conclude, it has serious economic, social and political consequences.
Control of Inflation
In view of the serious consequences of inflation, it is essential that it must be effectively controlled before it assumes such a serious proportion that it threatens the very existence of the economic and political system of the country. The main measures to control it are discussed below:
Monetary policy aims at controlling the supply of money by influencing in availability and cost of bank money or bank credit. The central bank in every country is entrusted with the task of enforcing the monetary policy. It is essential to adopt a restrictive or dear monetary policy to combat inflation. Restrictive monetary policy is characterized by reducing the availability of bank credit and increasing the cost of credit. Two types of instruments can be adopted to implement anti-inflationary and restrictive monetary policy, which are discussed below:
Quantitative Measures: Quantitative measures aim at influencing the overall availability of bank credit and its cost. Open market operations, bank rate, and legal reserve ratio are the main quantitative credit control measures.
Selective Credit Control Measures: Selective credit control measures aim at influencing the purpose for which bank credit is made available and thereby affect the direction of credit.
Fiscal policy also can be used to control inflation. Fiscal policy is the policy of government expenditure and government revenue. Contractionary fiscal policy can be used to reduce the aggregate demand and thereby control demand-pull inflation. Contractionary fiscal policy is the policy of reducing government expenditure and increasing government revenue. The main tools of fiscal policy are:
Public Expenditure: Public expenditure, i.e. expenditure by the government is an important component of aggregate demand. In order to control inflation, it is essential that government expenditure should be reduced.
Taxation: The major plank of anti-inflationary fiscal Policy is to increase the tax burden by increasing the tax rate and by imposing new taxes.
Public borrowing: Public borrowing helps in reducing the amount of purchasing power and thereby total demand in the economy. However, if people give loans to the government out of their savings rather than by curtailing their expenditure, the total demand may not fall.
In order to curb cost-push inflation, there is a need for adopting an appropriate income policy. The primary objective of income policy is to ensure that wages, salaries, and other incomes should increase in tune with an increase in productivity. This would mean that higher incomes do not result in an increase in cost per unit and thereby prices.
However, it is difficult to implement such a policy particularly with regard to wage income in view of the pressure of the trade unions. Trade unions normally pressurize entrepreneurs for the increase in wage rates to compensate for the increase in the cost of living.
Price Control and Rationing: A direct measure to control inflation is to introduce price controls and rationing of essential goods. Under price control policy, the government fixes the maximum price at which certain commodities could be sold.
Increasing the Availability of Goods: The basic solution to the problem of inflation is to increase the availability of goods in the economy.
Indexation: It is defined as a mechanism at which wages, prices, and contracts are partly or wholly compensated for changes in the general price level.