Inflation & Deflation

16.1 Inflation

“Inflation is a state of economy where value of money is declining and the prices are increasing.” Under inflation, general price level increases above normal price level.

Debtor gains in inflation because he has to pay lower amount in terms of money value under inflationary condition. Under inflation, money value reduces. Saver, creditor, pension holder are badly effected under inflation. [Q:55]

Increase in GDP, rise in employment level, increase in the real income bring inflation. Because these things increase the money supply in market, brings more demand.

Inflation Status in India

-         The maximum inflation at 13.9 was recorded for the year 1966-67

-         As per April 2007, Inflation rate was 6.3%.

-         Consumer price index is used for  measurement of inflation.

Types of inflation

i.      Demand-Pull Inflation: In a market there is interaction between the flow of money and flow of goods and services. When more money chases relatively less quantity of goods and services the excess of demand relative to supply pushes up the prices of goods and services. Such inflation, as a result of increased money expenditure, is called demand-pull inflation.

ii.    Cost-push Inflation: It is caused by a rise in the cost of factors of production. In fact, demand-pull inflation is responsible for cost-push inflation, because, when the demand-pull inflation sets in, there is a rising demand for the factors of production, which increase their prices. The cost-pull inflation may also cause due to rise in the wages or due to rise in profit margin.

iii.   Stagflation: It is the combined effect of ‘Demand pull inflation’ and ‘Cost pull inflation’. Stagflation = Stagnation + Inflation. In this case, there is low rate of growth, which results in economic stagnation. On the other hand, the general price level continuously rises.

In developed countries, the growth rate may be low, because their industries have already matured. But their strong labour unions may force to enhance the wage rate continuously, which results into stagflation.

v.     Suppressed inflation: When the government imposes physical and monetary controls to check open inflation, it is known as suppressed inflation.

vi.   Galloping inflation : If Mild inflation is not controlled and it is allowed to go on, it is called galloping inflation.  

vii.  Hyper inflation. : If price line goes to a uncontrollable stage, it is called hyper inflation. [Q:38]

Effects of Inflation

Inflation causes a number of problems in our economy. Some of its adverse effect are:

i.      Adverse effect on production: Due to the economic recession caused by inflation in many sectors of the Indian economy, the prices of important articles of consumption rise causing fall in demand. In line with fall in demand, production too reduces.

ii.    Adverse effect on distribution of income: The producers, traders and speculators always gain enormously through ever-rising profit margins and through illegal gains and windfall profits, due to hoardings, speculation and black marketing. The people living on past savings, fixed interest and rental income and old-age pensioners become victim of depreciation in the buying power of the rupee.

iii.   Resistance to development: Due to price rise, government expenditure plans based on earlier price levels cannot the target. Consequently, economic development suffers.

16.2 Causes of Inflation in India

Some of significant causes of inflation in India are:

i.      Excessive population growth: Fast increase in the population brings inflation in the country. When the population of a country increase rapidly, but the supply of the goods do not increase in the same proportion, then it raises the general price level. Due to explosive population growth, there will be scarcity of essential goods. Demand will exceed the supply level. Consequently,  price level of essential goods will increase causing inflation. India is suffering from overpopulation. Government has failed is tackle this population growth. So, inflation has now become one of the greatest economic problem of India.

ii.    Increase in public expenditure: Increase in public expenditure increases the purchasing power of the people. If public expenditure rises without simultaneous increase in supply of goods, this will promote inflation in the country. In recent year, government has increased its public expenditure in its budget for country’s development. Increase in public expenditure is also the reason behind recent inflationary economic condition.

iii.   Irregular agricultural growth: Most of the industries of our country depend on agricultural (e.g. cotton, jute, sugarcane, tea, tobacco, etc.). The failure of crop leads to failure of industries to produce the common goods. So, failure of agricultural due to drought etc. increases not only the price of food article but also the general price level. So, agricultural failure brings inflation to Indian economy.

iv.   Deficit financing: When the government spends more than what it expects to collect as revenue; it takes the help of deficit financing. Under the deficit financing, the government issues more currency in the market or borrows the funds from foreign governments or international agencies. It results in more money in the market and increases the price level.

v.     Imposition of high rate of indirect tax: Another source of inflation is higher taxes, especially indirect tax like sales tax, excise etc. imposed by the government. Such taxes increases the selling price of the commodities. Thus higher indirect taxes increase the commodity prices in the market. Indirect taxes are great source of revenue to the government. Government often resorts to higher indirect taxes to meet its expenditure.

16.4 Measures for controlling inflation

Inflation is a situation, which takes place either due to a increase in the buying power of the people or due to the excessive money in circulation. Therefore, it can be regulated either by regulating the purchasing power of the people or by decreasing the money in circulation.

Measures to regulate the inflation

a.     Monetary Measure: Monetary measures are taken by the central bank of the country (such as RBI in India) to control the money supply in the economy. Such measures directly hit the inflationary effects. Generally, the central bank takes the following steps to regulate the money supply:

-         Bank rate

-         Open market operations

-         Cash Reserve Ratio

-         SLR

-         Credit ceiling

-         variable margin requirement

-         Variable interest rate

-         regulation of consumer credit

-         Moral suasion

If RBI increases bank rate, commercial Bank’s credit creation capacity reduces By reducing the bank credit in the market. Government decreases the supply of money in the market. Change in Cash Reserve Ratio (CRR) also reduces the credit creation capacity of commercial banks. Open market operations is also another measure to reduce the money in circulation. These measures reduce the money supply in the market.

b.    Fiscal Measure: Fiscal measures are also very effective for controlling the inflationary economic conditions. Fiscal measures are a part of the budgetary operations of a government.

Following measures are normally  taken for controlling the inflation situation.

i.      Anti inflation taxation policy: The government, as an anti-inflationary measure, may increase the rate of existing taxes and impose new taxes on the commodities and services, so as to leave lesser money with the public to purchase goods and services. Increase in direct tax rate also decreases the money supply.

ii.    Public Borrowings: Public borrowing is also another measure to decrease inflation. Under this measure, the government borrows the money from public. The main object of public borrowings is to take away the public from excessive purchasing power. Thus, during the period of inflation, the government should increase the public borrowings to reduce the purchasing power of the public. Public borrowings reduces the money supply in the market.

c.     Other Measure:

i.      Wage Policy: Restrictive wages policy should be taken to reduce the inflationary pressure in the economy. The wage-increase should be linked with the increase in productivity. If this criterion is followed, higher prices will not increase the unit cost and unit price. Under inflationary condition, high wages rate increases the inflation.

ii.    Price Control & Rationing: It is a direct method to control price level. The main aim of price control is to determine the maximum limit beyond which the price of a particular commodity not be allowed to rise. Generally, when inflation goes to a such an extent that monetary measures and fiscal measures cannot effectively control the inflation, government uses restrictive pricing policy by fixing maximum price for a particular commodity. Government adopts these measures for controlling inflation in  public interest because in case of inflation poor people are badly affected due to inflation.

16.5 Deflation

Deflation is a state in which the prices are falling and thus the value of money is increasing. Deflation is just the opposite of inflation.

Effects of Deflation

During deflation, there is a fall in the national income of the economy and there is a large scale unemployment in the economy. Massive unemployment and all around gloom pervade the economy. The government, generally, has to take initiative by increasing public expenditure and other investment expenditure to increase employment level and to take the economy out of deflationary situation.

Inflation Vs. Deflation

Inflation disturbs of income between different groups of people in an in-equitable manner; the rich gain at the expenses of the poor. Deflation, on the other hand, reduces national income through a fall in production on account of unemployment. It renders the whole country poor including the petty wage-earners who may suffer due to unemployment.

Inflation demoralizes people, it encourages speculative hoarding and profiteering. Deflation also has a social cost because of unemployment of the people.

Both are thus evils but deflation is considered to be the bigger evil probably because inflation is easier to control than deflation. Also, deflation inflicts greater injury on the economy, the effect of which is long lasting, Economic stabilization with full or near full employment is, therefore, the ideal which a country should try to achieve.

In regard to government expenditure, it should be restricted during the period of inflation. But, normally, governments fail to keep a check on expenditure, can be stepped up. This will help employment by a revival of demand of goods.

Public debt should be so managed that supply of money in the country is controlled. During inflation, government should not pay back the past loans. They can be renewed. Further, it should, through surplus budgets, cancel the debts which it owes to the bank.