Inflation: Definition, Types, Impacts and Control

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. This implies that:

• The purchasing power of money gets eroded.
• There is a loss in real value of money as medium of exchange and unit account in the economy.

Inflation has good as well as bad impacts for economy.

Adverse Impacts of Inflation

• Inflation causes decrease in the real value of money and other monetary items over time.
• Inflation causes uncertainty over future; this may discourage investment and savings
• High inflation may lead to shortages of goods if consumers begin hoarding out of concern that prices will increase in the future.

Favorable impacts of Inflation

• Inflation ensures that the central banks adjust the interest rates.
• Inflation encourages non-monetary investment.

Monetary versus Non-monetary Investments

In accounting, the monetary investments are all those investments which are to be settled in cash. Some examples include Trade receivable and payables; Cash dividends recognized as liability; Investment in debt securities etc.

The examples of non-monetary investments include Prepaid amount for some goods or services; Investments in equity instruments; Inventory or other fixed assets; Goodwill, patent, trademarks and other intangible assets.

In general, the monetary authorities / central banks are vested with the task of keeping the inflation rate low. They do this job by setting of interest rates, through open market operations, and through the setting of banking reserve requirements.

Reasons of Inflation

Several reasons of inflation are as follows.

Increase in Money Supply

The most important reason of inflation is excessive growth of the money supply. A long sustained period of inflation is caused by money supply growing faster than the rate of economic growth. When there is more money in the system, too much money chases too few goods. That is why the RBI takes tight policy measures to reduce money in the system.

Increased Effective Demand

Another important reason for inflation is increased effective demand for goods and services. When there is an increased demand, the people tend to offer higher price for same good or commodity.

Decreased Effective Supply or aggregate output

Negative changes in available supplies such as during scarcities cause inflation. If there is a decrease in aggregate level of output, the money available in the economy will chase for goods / services which are now less available now. This may lead to inflation.

Types of Inflation

There are three major types of inflation, which is also known as Triangle Model.

Demand Pull Inflation

• Demand-pull inflation is caused by increases in aggregate demand due to increased private and government spending, etc.
• Demand-pull inflation is constructive to a faster rate of economic growth since the excess demand and favourable market conditions will stimulate investment and expansion. Demand-pull theory states that the rate of inflation accelerates whenever aggregate demand is increased beyond the ability of the economy to produce (its potential output). Hence, any factor that increases aggregate demand can cause inflation. However, in the long run, aggregate demand can be held above productive capacity only by increasing the quantity of money in circulation faster than the real growth rate of the economy.

Cost Push Inflation

• Cost-push inflation, also called “supply shock inflation,” is caused by a drop in aggregate supply (potential output). This may be due to natural disasters, or increased prices of inputs. For example, a sudden decrease in the supply of oil, leading to increased oil prices, can cause cost-push inflation.
• Producers for whom oil is a part of their costs could then pass this on to consumers in the form of increased prices.

Built in Inflation

• Built-in inflation is induced by adaptive expectations, and is often linked to the “price/wage spiral”. It involves workers trying to keep their wages up with prices (above the rate of inflation), and firms passing these higher labor costs on to their customers as higher prices, leading to a ‘vicious circle’. Built-in inflation reflects events in the past, and so might be seen as hangover inflation.

Measures to Contain Inflation

RBI takes monetary measures while the Government takes fiscal measures to contain inflation.

Monetary Measures

As part of the monetary policy review, the RBI takes suitable measures to moderate demand to levels consistent with the capacity of the economy to maintain its growth without provoking price rise. It is generally agreed that high rates of inflation is caused by an excessive growth of the money supply.

The RBI controls the money supply by its monetary policy via which it alters the interest rates and alters the banking reserve requirements to bring the inflation in its comfort zone {which is around 5%}. The key policy rates are Repo Rate, Reverse Repo Rate, Marginal Standing Facility and the key banking reserve requirements are SLR and CRR. When these rates are altered, the movements are passed on other prevailing interest rates in the economy which ultimately influences the borrowing costs for firms and households. For example, when the interest rates go down, it becomes cheaper to borrow, so households are more willing to buy goods and services and firms are in a better position to purchase items to expand their businesses, such as property and equipment.

Fiscal Measures

The government can take the following Fiscal Measures to contain inflation:

• Reducing Import Duties
• Allowing imports of the commodities which are scarce in market.
• Removing levy obligations in case of sugar
• Banning exports of commodities such rice and oils.
• Imposing minimum export prices.
• Suspending or banning the futures trading is come commodities.
• Raising the stock limit of some commodities.
• Making available the commodities via various organizations such as NAFED and NCCF.

Headline Inflation versus Core Inflation

Headline inflation reflects prices of all the tradeables within an economy including those commodities or items that experience sudden inflationary spikes such as food or energy. On the other hand, Core Inflation is a measure which excludes transitory or temporary price volatility as in the case of some commodities such as food items, energy products etc.

Since headline inflation includes everything, it may not present an accurate picture of the current state of the economy. On the other hand, the core inflation shows long term trends and is focused by Central Banks because it reflects the demand side pressure in the economy. It is also used as tool for framing long-term policy. In recent years, due to the these reasons, RBI has inclined from headline to core inflation which shows a more correct trend in inflation.

Impact of Inflation on Rich versus Poor

In inflation, too much money chases too few goods. It affects poor more than rich and distributes income in favour of rich. Thus, inflation leads to more inequality in the society, helps rich get richer and poor get poorer. Thus, Inflation is regressive in nature and hits lower class more. Inflation hits the savings and also makes people think to earn more by speculation.