Inflation, Its Types, Causes and Effects

Inflation

Inflation is a sustained increase in the general price level of goods and services in an economy over time. When the general price level increases purchasing power of money decreases and each unit of money buys fewer goods and services. Thus, money losses its value.

Prof. Coulborn defines inflation as “too much money chasing too few goods.”

Prof Samuelson and Nordhaus defines inflation as “inflation is a rise in general level of prices.”

Types of Inflation

Inflation is usually categorized based on the following.

• On the basis of Causes
• On the basis of Rate
• On the basis of Coverage
• On the basis of Occurrence
• On the basis of Government Reaction

On the Basis of Causes

1. Demand-Pull Inflation: It is also known as Excess Demand Inflation takes place when aggregate demand for goods or services exceeds to its aggregate supply.
2. Cost-Push Inflation: It occurs when cost of producing goods and services are increasing. It is also known as “New Inflation theory”. It is caused by supply–side factors such as higher wage push, profit push and higher costs of raw material.
3. Structural Inflation: This type of inflation often experienced in developing countries which is caused by structural rigidities such as agricultural backwardness, resource constraints, foreign exchange restrictions, physical infrastructural restrictions etc.
4. Scarcity Inflation: This occurs due to hoarding and speculation by traders and black marketers so as to create an artificial shortage of essential goods like food grains, kerosene oil etc.

On the Basis of Rate

1. Creeping inflation: It is also called mild or low inflation. It is the type of inflation in which prices increase at the rate of 2% to 3% per annum.
2. Walking inflation: It is also called trotting or moderate inflation. This type of inflation occurs when prices increase by single digit at the rate of 3% to 10% per annum.
3. Running inflation: This type of inflation occurs when prices rise by more than 10% per annum.
4. Galloping Inflation: It is also known as Jumping inflation which occurs when prices rise by double or triple digits at the rate of  20% to 1000% per annum.
5. Hyperinflation: This type of inflation occurs when prices increase by four digits at the rate of more than 1000% per annum. Examples of hyperinflation are Germany in 1923, Hungry in 1946, Zimbabwe in 2008, Venezuela in 2020.

On the Basis of Coverage

1. Comprehensive Inflation: When the prices of all commodities rise throughout the economy it is known as Comprehensive Inflation also known Economy Wide Inflation.
2. Sporadic Inflation: When prices of only few commodities in few regions rise, it is known as Sporadic Inflation. It is sectoral in nature. For example, rise in food prices due to bad monsoon.

On the Basis of Occurrence

1. War-Time Inflation: When inflation that takes place during the period of a war-like situation then it is known as War-Time inflation.
2. Post-War Inflation: Inflation that takes place soon after a war is known as Post-War Inflation.
3. Peace-Time Inflation: It is due to huge government expenditure or spending on capital projects of a long period.

On the Basis of Govt. Reaction

1. Open Inflation: When government does not attempt to restrict inflation, it is known as Open Inflation.
2. Suppressed Inflation: When government prevents price rise through price controls, rationing, etc., it is known as Suppressed Inflation. It is also referred as Repressed Inflation.

Effects of Inflation

Negative Effect of Inflation

1. Fixed Income Group: When inflation increases the purchasing power of the fixed income and low-income groups reduce.
2. Impact on inequality: During inflation profits of businessmen increases due to increase in prices of the products and real income of the fixed income group decreases which increases the income inequality among the people of various classes.
3. Impact on Investment: During inflation prices of raw material and factor services increases which increase the cost of firms which further lead to increase the prices of goods.  Thus, inflation is followed by more inflation.
4. Impact on lenders: Inflation has also negative impacts on lenders of the money because during inflation money loses its value. Thus, they receive an amount having lower purchasing power.
5. Impact on savings: During inflation savings of the common people are reduced because to maintain the previous living standard they must increase their consumption.
6. Impact on Balance of Payments: During inflation, the prices of export items also increase, and imports become relatively cheaper. Hence, the demand for exports in the foreign markets fall which leads to a fall in balance of payments.

Positive Effect of Inflation

1. Higher Profits: Inflation, usually, benefits the producers of products. They experience better profits since they can sell their products at higher prices.
2. Increase in Production: Once the producers receive higher profits, they create more goods and services. Hence, inflation leads to an increase in production of products/services.
3. More Employment and Income: Since production increases, there is an increased demand for the various factors of production, including manpower. Therefore, employment and income increases during inflation.
4. Shareholders can earn a good income: If a company earns higher profits, which is possible during inflation, it can declare dividends to its shareholders. Thus, the shareholders can experience a rise in their dividend income during inflationary periods.
5. Benefits to borrowers: During inflation purchasing power of money decreases. Thus, the real value of the money that the borrower returns is actually less than that of the money borrowed.

Causes of Inflation

1. Shareholders can earn a good income: If a company earns higher profits, which is possible during inflation, it can declare dividends to its shareholders. Thus, the shareholders can experience a rise in their dividend income during inflationary periods.
2. Benefits to borrowers: During inflation purchasing power of money decreases. Thus, the real value of the money that the borrower returns is actually less than that of the money borrowed.
3. Exchange rates: Exchange rate movements can also influence inflation outcomes in two ways. ‌Cost-push channel, when the exchange rate increases i.e., domestic currency depreciates foreign goods services becomes relatively expensive, consumers and firms pay more for consumer goods and raw material which increase the cost of living and cost of production. ‌Demand-pull channel, when domestic currency depreciates exports become relatively cheaper which increases aggregate demand for goods and services.
4. Inflation expectations: Inflation expectations also affect current inflation. For example, if firms expect future inflation to be higher, they may raise the prices of their goods and services at a faster rate. Similarly, if workers expect future inflation to be higher, they may demand higher wages to maintain the purchasing power. These behaviors are sometimes called ‘inflation psychology’. Thus, inflation leads to further inflation, or we can say inflation feeds on itself.

Remedial Measures

Demand Side Policies

Demand-Side Policies focus on managing aggregate demand in the economy. The primary goal is to reduce demand-pull inflation. These include.

Monetary Measures

• Increase in Bank Rate: When Central Bank increases bank rate, commercial banks also increase interest rate which discourage borrowing and spending.
• Open Market Operations: During inflation Central Bank sells government securities which decrease the money supply in the economy, it reduces the price level.
• Raising Required Reserve Ratio: Increase in reserve ratio reduces the commercial bank’s ability to advance loans, it also decreases money supply.

Fiscal Measures

• Increase in Taxes: Governments can increase taxes to reduce disposable income and spending, which can help to lower demand-pull inflation.
• Decrease in Government Spending: Governments can reduce spending to decrease aggregate demand and inflationary pressures in the economy.

Direct Measures

• Increase in Voluntary Savings: Government may appeal to the people to increase their savings by cutting off their consumption. This would also result in lower aggregate demand.
• Deferred Pay Scheme: In this scheme a part of workers income is credited to their saving accounts which they can withdraw when the inflation were over.

Supply Side Policies

Supply-Side Policies aim to increase the productive capacity of the economy. These policies are more effective in controlling cost-push inflation. These include.

1. Investment in Infrastructure: Improvement in infrastructure, such as transportation, communication, and utilities, can increase productivity and reduce production costs.
2. Deregulation and Subsidies: Removing unnecessary regulations and barriers and giving subsidies can lead to greater efficiency and lower costs for businesses.
3. Education and Training: Investing in human capital though education and training can increase workers productivity which increase the ability of firms to increase their production.
4. Wage Price Controls: Government can regulate firms not to increase wages and prices above a certain limit.

Exchange Rate Policy

Exchange Rate Appreciation: Governments can appreciate the value of their currency through monetary policy tools or interventions in the foreign exchange market. A stronger currency makes imports cheaper, reducing domestic demand for goods and services and thereby controlling inflation.

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