UNIT 7 INFLATION: CONCEPT, TYPES

AND MEASUREMENT*
Structure
7.0 Objectives
7.1 Introduction
7.2 Measurement of Price Level
7.2.1 Definition of Index Number
7.2.2 Types of Index Numbers
7.3 Inflation Defined
7.4 Types of Inflation
7.4.1 Moderate Inflation
7.4.2 Galloping Inflation
7.4.3 Hyper-Inflation
7.4.4 Stagflation
7.4.5 Deflation
7.4.6 Core Inflation
7.5 Let Us Sum Up
7.6 Answers/ Hints to Check Your Progress Exercises

7.0 OBJECTIVES

After going through this unit you should be in a position to

 explain the concept of inflation;
 explain how inflation is measured;
 distinguish between various types of price indices to measure inflation; and
 identify the types of inflation;

7.1 INTRODUCTION

We come across the term inflation very often in newspapers. The reason why it
holds such importance is because of its adverse effects on an economy as well as
people. A question that could arise at this point is in what way does inflation
affect our everyday life? Let us illustrate with the help of a single household.
Inflation, in simple words, is a steady rise in the prices of various goods and
services. Given the level of the money income, a household consumes a group
of commodities at a given price level. With inflation, the price level goes up. So
with the same level of money income, the household could consume a smaller
amount of the commodities than it was consuming earlier. Alternately, to maintain
the earlier level of consumption this household now needs to have more money.

*
Dr. Gurleen Kaur, Assistant Professor, Sri Guru Govind Singh College of Commerce, University of
Delhi
For example, suppose the household has a monthly income of Rs.100, consumes Inflation: Concept, Types
and Measurement
the entire income on a single commodity A and does not save anything. If the
price of commodity A is assumed to be Rs. 4 then the household consumes 25
units of A in a month. Now suppose, the price of commodity A goes up from
Rs.4 to Rs.5. The household will be able to consume only 20 units of commodity
A.
To maintain the level of consumption at 25 units of A per month, the household
needs to have a monthly income of Rs. 125. Thus, we see that with inflation, one
unit of money purchases a smaller amount of goods than it was doing earlier. In
other words, with inflation, purchasing power of money goes down.

In the above example, consumption of the household comprises one commodity

only. But for a typical household, consumption involves a variety of goods and
services. As a result, increase in the price of one commodity need not affect
household consumption adversely if there is a decline in the price of some other
good. Therefore, to ascertain the effect of inflation we need to take into
account the change in the prices of all the goods consumed by the household.
To do that, we need to find the change in the general level of prices. Therefore,
before defining inflation we discuss the meaning of price level and the
changes in it.

7.2 MEASUREMENT OF PRICE LEVEL

We are familiar with the term ‘price’ of a product. What do we mean by the term
‘price level’? What is the difference between the two? And how do we measure
price level? These are some of the questions we try to answer in the present
section.

In simple terms price is defined as the rate at which goods and services are
exchanged for money. It is the amount of money received for selling or, paid for
buying, one unit of a commodity (or services) in an exchange economy.

The term price level is an aggregate concept. It relates to the price of a basket of
goods and services. See that we do not refer to the price of a single
commodity but to a group of goods and services taken as a whole. Therefore,
when we talk of a change in the price level it is always in reference to a group of
commodities. Since the prices of commodities differ, in order to measure a change
in the price level of a group of commodities, it is necessary to use index numbers.
More specifically, we have to use price index. Let us understand the idea of an
index number in an elementary form.

7.2.1 Definition of Index Number

An index number is a concept which enables us to compare the changes in a

group of distinct, but related, variables in two or more time periods. A price
index is used for comparing changes in the general level of prices of a group of
commodities. Generally a price index refers to changes in the prices obtained over
time. It is expressed by putting a particular period (called the ‘base period’)
equal to 100 and the price level for other periods are expressed relative to this
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 Inflation base. For example, when we say, the wholesale price index has gone up this
year with respect to last year, we are taking last year price level as the base or, the
reference point = 100. With respect to it we measure the change in the price level
this year.
The price relative of an individual item is the ratio of its current price to its
price in a base period. The simplest price index for a given commodity can be
expressed as

It,o = 100 (pt / po) … (7.1)

where pt and po denote prices in the current period ‘t’ and the base period
‘0’ respectively.

For instance, if price of a kilo of potato goes up from Rs. 8 in 2017 to Rs. 10
in 2018, then the price index in this case would be:

I2017,2018 = 100 (10/8) = 125 …(7.2)

This index shows a 25 per cent increase in the price of potato over the year. In
other words, you need 25 per cent more money to maintain your consumption of
potatoes at the same old level.

7.2.2 Types of Index Numbers

Index numbers could be of various types, depending upon its purpose and
methodology. So far as price index is concerned, there are two main types of price
indices, viz., Wholesale Price Index (WPI) and Consumer Price Index (CPI). Both
the price indices are different in terms of i) the goods and services included, ii)
the weights assigned to each category of goods and services, and iii) the prices
(whether wholesale or retail) taken into account.

As it is not possible to consider all goods and services (because of time and
resource constraints), the index numbers are estimated on the basis of a sample
survey. The numerical value of two price indices will be different depending upon
three factors, viz., (i) the commodities included in construction of the index, (ii)
the weights assigned to each commodity, and (iii) the base year of the price index.
Thus while comparing two price indices we should take into account the above
factors. We will discuss about index numbers in greater detail later in the course
‘Statistical Methods for Economics’.

Wholesale Price Index (WPI)

The WPI is the price of a representative basket of wholesale goods. This index
measures the changes in price of goods and services at the wholesale market. In
India the WPI is published by Office of the Economic Adviser, Department for
Promotion of Industry and Internal Trade, Ministry of Commerce and Industry,
Government of India.

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The data are collected at the first point of bulk sale in the domestic market. The Inflation: Concept, Types
prices used are ‘wholesale prices for primary articles, administered prices for fuel and Measurement
items and ex-factory prices for manufactured products’. One advantage of the
WPI is that it has a long history, dating back to January 1942, which makes it
useful for assessing long-term trends in inflation. The WPI also covers a broad
range of goods, from raw materials to finished manufactures. A major limitation
of the WPI is that it excludes the services sector which has a major contribution to
GDP.

Consumer Price Index (CPI)

Consumer Price Index measures changes over time in general price level of goods
and services that households acquire for consumption purposes. The CPI numbers
in India are widely used i) as a macroeconomic indicator of inflation, ii) as a tool
for inflation targeting by the RBI, iii) for monitoring price stability by the
government, iv) for indexation of dearness allowance to employees, and v) as
deflator for national accounts. The CPI is published by the Central Statistics
Office (CSO), Government of India. You might have come across the term
‘headline inflation’ in newspapers and various reports. It refers to inflation based
on the comprehensive consumer price index.

Check Your Progress 1

1) If a country is experiencing inflation, the change in the nominal national

product will (choose the correct alternative)
a) be falling faster than the rate of inflation
b) equal the change in the real national product
c) understate the value of national income
d) overstate the change in the real value of production

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2) Distinguish between wholesale price index and consumer price index.

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 Inflation
7.3 INFLATION DEFINED

With the background of prices and price level in view we go on to the

definition of inflation. We mentioned earlier that inflation is defined as a
persistent rise or, a tendency towards persistent rise in the general level of
prices. The adjective ‘persistence’ has to be taken note of. The reason is, if
price level goes up today but falls tomorrow then it may not imply inflation, but
only short-term fluctuations in prices. The term ‘general price level’ is also
important since, over a period of time, prices of some commodities may have
gone up while some others may have actually fallen. As a result, on the
whole, the average of these prices may remain constant or even go down.
Similarly if the price of a group of commodities, which constitute a small
fraction of the total value of output of the economy, would go up, then again it
might not be inflationary as such. That is, the effect of rise in prices of such
commodities might be too small so as to affect the average price level of all the
commodities. Thus we see that inflation is a macroeconomic phenomenon and is
not concerned with the rise in the price of a particular commodity, or, a small
group of commodities.

In Section 7.1, it was pointed out how inflation is likely to affect a household
with fixed money income. In many cases, however, some of the income classes
actually benefit from inflation or at the least may remain unaffected by it. We
will discuss the causes and effects of inflation in the next Unit.

7.4 TYPES OF INFLATION

On the basis of the severity of inflation or, the rate of acceleration in prices we
can divide inflation into three different types, viz., moderate, galloping and
hyper-inflation. Further, there are some other related concepts which we discuss
below.

7.4.1 Moderate Inflation

When the general price level increases slowly but steadily, it is known as
moderate inflation. In the case of India, the Monetary Policy Committee (MPC)
resorts to inflation targeting at a rate of 4 per cent per annum. The rate of
inflation as per targets should not be outside the range of 2 per cent to 6 per cent
per annum.

7.4.2 Galloping Inflation

Steady and fairly high rate of increases in the general price level is known as
galloping inflation. The rate of inflation runs into two digits (20 per cent, 40 per
cent, etc.) and sometimes even as high as three digits (i.e., 200 per cent).
Some Latin American countries like Brazil and Argentina had experienced
inflation rates of over 100 per cent in the 1970s.

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7.4.3 Hyper-Inflation Inflation: Concept, Types
and Measurement
Hyper-inflation is a situation where the rate of inflation is very high. Thus the
value of money gets eroded rapidly. In order to cope with such a situation,
households minimize their holdings of local currency. Generally it happens in an
economy which faces wars and their aftermath, socio-political upheavals or other
crisis. In these situations it is very difficult to impose tax on the residents by the
government, which leads to fiscal deficit and government has to finance it
primarily through money creation rather than imposing taxes or borrowings. In a
situation of hyper-inflation, certain functions of money such as ‘a store of value’
and ‘a medium of exchange’ are no more valid.

There have been several instances of hyperinflation in various countries. Brazil

had hyperinflation during the 1980s. A recent example of hyperinflation is
Zimbabwe during 2008-09, where prices almost doubled from one day to the next
day. The public used to spend money on food or whatever other commodities they
could, rather than holding on to money, as the value of money eroded rapidly.
According to some reports, it was impossible to estimate the rate of inflation in
2008 – it was around 79.6 billion per cent in November 2008. As a consequence,
the country abandoned its currency and allowed use of foreign currencies for
transaction in 2009.

7.4.4 Stagflation

The term stagflation (stagnation plus inflation) refers to the situation where an
economy grows very slowly or at zero rate (stagnant) and prices keep rising. The
side effects of stagflation are increase in unemployment- accompanied by a rise in
prices, or inflation. It raises economic dilemma as the actions designed to lower
inflation may worsen unemployment and vice versa. This happened during the
1970s, when crude oil prices rose dramatically, fuelling sharp inflation in
developed economies.

7.4.5 Deflation

Deflation is a situation where there is a consistent decline in price level. Here

again you have to notice the words ‘consistent’ and ‘price level’. Thus decline in
price of a single commodity cannot be terms as deflation. A situation of deflation
arises when aggregate demand is lower than aggregate supply. Thus, deflation
is characterized by a decrease in output, increase in unemployment, and general
slowing down of the economic activities. The Great Depression of 1930s is an
example of an acute deflation when prices crashed, unemployment increased to a
very high level, and GDP of the developed countries fell sharply. There are many
adverse effects of deflation. Deflation in a modern economy is bad because it
increases the real value of debt, and discourages production in the economy as
prices keep falling.

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 Inflation 7.4.6 Core inflation

The measurement of inflation after removing the transitory or temporary price

volatility is known as ‘core inflation’. If temporary price shocks are taken into
account, they may affect the estimated overall inflation numbers, which may not
match with the actual inflation number. To eliminate this possibility, core
inflation is considered to assess actual inflation by removing the temporary
shocks and volatility. In India core inflation is calculated on the basis of price
increase in manufactured products excluding food products. Thus it does not
include agricultural commodities, fuel and energy and food products.

Check Your Progress 2

1) A price index in years after the base year
a. is never 100.
b. is always greater than 100.
c. is always less than 100.
d. can be less than, greater than, or equal to 100.

2) The CPI in 2017 was 111.5 and in 2018 was 114.1. The inflation rate is
a. 2.3%
b. 2.6%
c. 112.8
d. Insufficient information

3) Briefly discuss the various types of inflation.

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7.5 LET US SUM UP

Inflation is a persistent rise in the price level. When there is a rise in the price
level, there is a decline in the purchasing power of money. For measuring change
in the price level we take the help of the price index. An index number is a device
for comparing the magnitude of a group of distinct, but related, variables in two
or more time periods. There are two important types of price indices, viz.,
wholesale price index and consumer price index.

96
Deflation is a persistent decline in the price level. Hyper-inflation is a situation of Inflation: Concept, Types
and Measurement
very high inflation, which could arise in the aftermath of wars or serious
economic crisis in an economy. The severity of most of the costs of inflation
enhances during hyperinflation. Stagflation is commonly referred to a situation of
stagnation in growth coupled with high inflation. Core inflation is an inflation
measure which excludes transitory or temporary price volatility as in the case of
some commodities such as food items, energy products, etc.

7.6 ANSWERS/ HINTS TO CHECK YOUR

PROGRESS EXERCISES

Check Your Progress 1

1) d
2) Refer to Sub-Section 7.2.2 and answer.

Check Your Progress 2

1) d
2) a
3) Refer to Section 7.4 and answer.

97
UNIT 8 CAUSES AND EFFECTS OF *
INFLATION
Structure

8.0 Objectives
8.1 Introduction
8.2 Causes of Inflation
8.2.1 Demand-Side Inflation
8.2.2 Supply-Side Inflation
8.2.3 Quantity Theory of Money
8.2.4 Structural Theory of Inflation
8.3 Effects of Inflation
8.3.1 Debtors and Creditors
8.3.2 Fixed Income Groups
8.3.3 Traders and Investors
8.3.4 Agriculturists
8.3.5 Government
8.4 Cost of Dis-inflation
8.5 Let Us Sum Up
8.6 Answers/ Hints to Check Your Progress Exercises

8.0 OBJECTIVES

After going through this Unit you will be in a position to

 explain the major causes of inflation;
 distinguish between demand pull inflation and cost push inflation;
 explain the quantity theory of money and structural theory of inflation;
and
 appreciate the effects of inflation on various sections of people.

8.1 INTRODUCTION

In the previous Unit we explained the concept and types of inflation. In this Unit
we look into the causes and effects of inflation. According to Nobel Laureate
Milton Friedman, “Inflation is always and everywhere a monetary phenomenon”.
By this he meant that inflation is always higher when money supply exceeds
economic growth for a period of time. Monetarists also regard inflation as “too
much money chasing too few goods”. Apart from money supply there are several

*
Dr. Gurleen Kaur, Assistant Professor, Sri Guru Govind Singh College of Commerce, University
of Delhi
other factors that cause inflation. Further, as we discuss below, inflation affects Causes and Effects of
various sections of society differently. Inflation

8.2 CAUSES OF INFLATION

The causes underlying inflation are generally ascribed to the source through
which inflation originates. You have learnt from microeconomics that price of a
commodity is determined at the level where supply equals demand. If demand
exceeds supply there is an increase in price. On the other hand, if supply exceeds
demand, price will go down. In either case the price adjustment takes place till
demand and supply are equal. However, the source of the change in one case
originates from the demand side while in the other case it originates from the
supply side. A similar process applies in the case of aggregate demand and
aggregate supply also. Depending upon the initial process, we classify inflation
into two types, viz., (i) demand-pull or demand-side inflation, and (ii) cost-push
or supply-side inflation.

8.2.1 Demand-Side Inflation

Factors which increase aggregate demand, while there is no increase in aggregate

supply, can cause demand-side or demand-pull inflation. According to the
Keynesian view, demand-pull inflation occurs when aggregate demand exceeds
aggregate supply at full employment level of output thereby attributing inflation
to the relationship between aggregate demand (C+I+G) and full employment
level of output. Increase in aggregate demand will take place if there is an
increase in (i) Consumption (could be due to increase in income, reduction in
saving, or reduction in tax rate), (ii) Investment (due to reduction in rate of
interest or optimism in business sentiments), and (iii) increase in government
expenditure. Remember that in the Keynesian framework aggregate supply curve
is horizontal, upward sloping, and then vertical based on the time period under
consideration (LRAS in Fig. 8.1). Let us assume that the current level of
aggregate demand is AD1. The equilibrium price level is P1 and the level of real
output is Y1. As you can observe from Fig. 8.1, at output level Y1, there is under-
utilisation of production capacity. In other words, the economy is operating
below the full employment level YFE. An increase in aggregate demand (from
AD1 to AD2) in this situation (for example, due to a rise in government
spending), will lead to an increase in real output (from Y1 to Y2). You should
note that there is no increase in prices in this situation as the supply curve is
infinitely elastic (horizontal part of the LRAS curve in Fig. 8.1).

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Inflation
Price LRAS
Level (p)

P4

P3
AD5
P2 AD4
P1
AD1 AD2
AD3

0
Y1 Y2 Y3 YFE Real output/Real
Income(Y)

Fig. 8.1 Demand-Pull Inflation

Further increase in government spending however would result in increases in

output and prices. A shift in the AD curve from AD2 to AD3 will increase real
output (from Y2 to Y3) but the price level will also rise (from P1 to P2). This is
because producers are not willing to supply more at the existing price P1; they are
willing to supply output Y3 only at a higher price, that is, P2. The result is similar
if AD increases from AD3 to AD4. At this stage, the economy is approaching the
full employment level of output (YFE); some production units have some spare
capacity but others are operating at full capacity. Under such a situation increase
in aggregate demand will result in price rise in some industries, and so a rise in
the average price level when AD rises. Further increase in AD (from AD4 to
AD5), when the economy is at full employment output, will result in price rise
without any increase in the level of output.

8.2.2 Supply-Side Inflation

Keynesian theory of cost-push inflation attributes the basic cause of inflation to

supply-side factors such as increase in wage rate or unexpected rise in raw
material prices. Cost-push inflation is usually regarded as wage inflation process
as wages constitute a substantial part of total costs of production. Powerful and
militant trade unions often bargain for higher wages. If increase in wage rate is
the same as the growth rate in productivity of labour, then average cost of
production does not increase. If trade unions succeed in negotiating a higher
wage increase, not matched by productivity growth, then cost of production
increases. Such a situation forces producers to increase prices of the goods and
services they produce. This kind of inflation is known as wage-push inflation. A
pre-requisite for wage-push inflation is unionization of labour.

The workers, faced with inflation in the economy, often demand a rise in wage
rate. The producers often comply with such demands. As the cost of production
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increases, the firms increase the price of the product. Further, the firms increase Causes and Effects of
the price of their products so that they can have higher profits. When the prices of Inflation
goods and services increase, workers demand higher wages to compensate for
price rise. In this process, a series of increase in wage rate leads to a series of
increase in prices. This sort of a situation leads to a wage-price spiral. A pre-
requisite for firms to increase prices is market imperfection. In a market with
many competitors, a firm would have limited scope for increasing prices.

Suppose AD is the aggregate demand curve and AS1 is the aggregate supply
curve. Thus, the economy operates at equilibrium output Y1 and equilibrium
price level P1 (see Fig. 8.2). Suppose there is a shift in the aggregate supply curve
from AS1 to AS2 due to increase in the cost of production. The shift in the AS
curve indicates that the supply of the same level of output can be made only at a
higher price. The new equilibrium point is E’ with equilibrium output Y2 and
equilibrium price level P2. Note that, in this case, there is a decline in output and
increase in price level.

Fig. 8. 2 Cost-Push Inflation

8.2.3 Quantity Theory of Money

The discussion above reflects the explanation offered by Keynesian economists.

The Monetarist view, however, is different from the Keynesian explanations. The
Monetarists use the 'Quantity Theory of Money' (discussed in another Unit of
this course) to explain the causes of inflation. Recall the ‘equation of exchange’
used in the Quantity Theory of Money

MV = PY
where

 M = quantity of money in circulation in the economy

 Y = real national income
 P = price level
 V = velocity of circulation, the speed at which money circulates in the
economy

The quantity theory of money is based on two assumptions, viz., (i) that money is
‘neutral’, and (ii) velocity of circulation (V) is constant for any given situation.
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Inflation The neutrality of money, based on the dichotomy of the market, implies that
changes in money supply do not affect the level of output. The monetarists argue
that output (Y) is a real variable, which is driven by real factors only. Aggregate
output (Y) is constant (AS curve is vertical) as there is full employment in the
economy. Full employment is maintained through flexibility in wage rate and
prices.

The Monetarists use the equation of exchange to simplify the explanation of how
monetary policy works. The two sides of the equation of exchange must always
be in balance. If V is constant and Y cannot be changed by an increase in M, then
the only part of the equation that can be changed by an increase in M is P. So, if
the Central Bank increases the money supply leading to a rise in M, the result has
to be a proportional increase in P. The observed long-run relationship between
money and prices supports the monetarist view that over expansion of money
supply could result in higher inflation, and that inflation can be prevented by
appropriate regulation of money supply.

8.2.4 Structural Theory of inflation

The structural theory of inflation, as developed by Myrdal, Streeten and several

other Latin American economists, attributes the phenomenon of inflation to
structural factors or structural rigidities, generally found in developing
economies. The structural theory refers to the resource gap (i.e., saving is less
than investment), food-shortages (resulting from dependence of agriculture on
rainfall), foreign exchange scarcity, and poor infrastructural facilities. All these
structural factors, according to the structural theory of inflation, are the real
causes of inflation in developing countries.

The structural theory came to the fore in the 1970s when the world was
confronted with a situation of rising prices coupled with high unemployment
(stagflation), something that demand-pull theories could not explain. It was
observed that the two oil price shocks in the 1970s, which were essentially
supply-side shocks (because they increased the cost of production), were capable
of producing such a situation. Structural economists, on their part, argue that in
developing countries, in addition to money, structural factors such as supply and
demand conditions also play an equally important role in determining price in the
economy. Financing public investment through money expansion increases
productive capacity and real output, while real output, at the same time, would
increase the demand for money. Further, the concern of the government to
maintain a desired level of real public expenditure leads to increase in nominal
expenditure of the government leading to rise in prices.

Although this strand of thought invited criticism, we should not deny that supply
of goods and services matters. Government intervention to increase productivity
for example by encouraging research and development, may well contribute in
combating inflation in the longer term.

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Check Your Progress 1 Causes and Effects of
Inflation
1) Match the following:
1. Inflation a. when inflation is due to excess demand
2. Hyper-inflation b. sustained increase in the price level
3. Demand-pull inflation c. inflation due to rise in production costs
4. Cost-push inflation d. an accelerating increase in the price level

2) An increase in oil prices, such as the oil shocks in the 1970s, lead to
_______, thereby causing _______.
a) a movement along the AS curve; cost-push inflation
b) a leftward shift in the AS curve; demand-pull inflation
c) a rightward shift in the AS curve; cost-push inflation
d) a leftward shift in the AS curve; cost-push inflation

3) Distinguish between demand-pull and cost-push inflation.

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8.3 EFFECTS OF INFLATION

Inflation reduces the value of money thereby leading to erosion of purchasing

power. If the nominal income of a person is increasing at a rate higher than the
rate of inflation, her real income (i.e., nominal income divided by price level)
will be increasing. On the other hand, if the nominal income of a person is
increasing at a rate lower than the inflation rate, her real income is declining.

Broadly, there are two economic groups in every society, the fixed income group
and the variable income group. The fixed income group usually suffers as their
real income declines with inflation. On the other hand, people with variable
income such as industrialists, traders, real estate holders, and speculators may
gain during rising prices. Generally speaking, which income group of the society
gains or losses from inflation depends on who anticipates inflation and who does
not. Those who correctly anticipate inflation can adjust their present earnings,
borrowing and lending activities accordingly.

Some people, mainly from poorer background, are habituated to hold cash; even
they do it during high inflation. The value of money erodes during inflation;
therefore, there is a cost associated with holding of cash. The cost accrued for
such a feature is often called ‘inflation tax’. This is not an actual legal tax paid to
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Inflation the government; rather it refers to the penalty for holding cash at a time of high
inflation. For example, suppose you are holding Rs. 1000 in cash and the
inflation rate is 10 per cent. After one year, the cash you are holding will be the
same (i.e., Rs. 1000) while purchasing power of money will decline by 10 per
cent (i.e., goods which are available for Rs. 100, will be priced at Rs. 110 after
one year). Thus, the cash you are holding will be equivalent to Rs. 900 only in
today’s prices.

If an investor is holding securities, real estate or other assets, the effect of

inflation may be negligible. We discuss below the effect of inflation on different
segments of society.

8.3.1 Debtors and Creditors

During periods of rising prices, debtors gain and creditors lose. When prices rise
the value of money falls. Though debtors return the same amount of money (or
nominal money), they pay less in terms of goods and services (or real money).
This is because the value of money is less than when they borrowed the money.
Thus, the burden of the debt is reduced and debtors gain.

On the other hand, creditors lose. Although they get back the same amount of
money which they lent, they receive less in real terms because the value of
money falls. Thus, inflation brings about a redistribution of real wealth in favour
of debtors at the cost of creditors.

8.3.2 Fixed Income Groups

Persons with fixed salary are at a loss when there is inflation. The reason is that
their salaries are slow to adjust when prices are rising. Workers may gain or lose
depending upon the speed with which their wages adjust to rising prices. If the
labour unions are strong, workers may get their wages linked to the cost of living
index. In this way, workers may be able to protect themselves from the adverse
effects of inflation. There is often a time lag between the raising of wages by
employers and the rise in prices. Thus, workers lose because by the time wages
are hiked, the cost of living index has increased further. Moreover, if the workers
have entered into contractual wages for a fixed period, they lose when prices
continue to rise during the period of contract. Overall, the wage earners are in the
same position as the white-collar workers.

The recipients of ‘transfer payments’ such as pensions, unemployment benefits,

social security, etc. and recipients of interest and rent live on fixed incomes. All
such persons lose during inflation because they receive fixed payments for a
period, while the value of money continues to fall.

8.3.3 Traders and Investors

Proprietary income earners such as producers, traders and real estate holders gain
during periods of rising prices. Let us discuss the case of the producers. When
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prices are rising the value of their inventories (goods in stock) rise in the same Causes and Effects of
proportion. So, their profits go up as their sales go up. The same is the case with Inflation
traders in the short run. But producers receive more profit in another way – input
prices do not increase in the same proportion as output prices. This is because
wage rate and prices of certain raw materials increase with a time lag. The
owners of real estates are gainers during inflation because the prices of landed
property usually increase faster than the general price level.

8.3.4 Agriculturalists

Agriculturists are of three types, viz., landlords, peasant proprietors, and landless
agricultural workers. Landlords lose during rising prices because they get fixed
rents. Peasant proprietors, however, who own and cultivate their farms gain.
During periods of high inflation, prices of farm products increase faster than the
cost of production – wage rate and land revenue do not rise to the same extent as
the rise in the prices of farm produce. Landless agricultural workers, however,
are hit hard by rising prices. Their wages are not raised by the farm owners;
government does not revise minimum wages frequently and trade unionism is
absent among them.

8.3.5 Government

The government as a debtor gains at the expense of households who are its
principal creditors. This is because interest rates on government bonds are fixed
and are not raised to offset expected rise in prices. The households however stand
to gain as tax payers. The taxes are paid with a lag, on income earned during the
year, and the real value of taxes is reduced because of inflation. Thus, the net
effect on households while dealing with the government is complex. As creditors,
real value of their assets declines and as tax-payers, real value of their liabilities
declines during inflation.

8.4 COST OF DIS-INFLATION

In the previous section we saw that inflation results in re-distribution of income

and the lower income groups suffer the most. High inflation is seen to have led to
discontent among people; sometimes leading to political instability and fall of
government in many countries. Thus, the consequences of inflation are not only
economic, but also social and political. In view of this, policy makers always try
to control inflation. In fact, many countries, including India, pursue ‘inflation
targeting’ as the only objective of monetary policy. When there is high inflation,
the government has to adopt a tight monetary policy so that aggregate demand is
brought under control. The policies are geared towards reduction of the inflation
rate, that is, dis-inflation.

During periods of high inflation, there is fair chance that government revenue is
much less than government expenditure resulting in huge fiscal deficits. In order
to finance the deficit, the government has three options, viz., (i) borrow from
public, (ii) run down on foreign exchange reserve, and (iii) print money. Usually
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Inflation a government running huge deficit is already under heavy debt and paying a high
amount of interest. Hence, further borrowing becomes difficult. Moreover, such
governments also have low foreign exchange reserve and therefore, printing
money becomes an easy option which fuels the rate of inflation. You can recall
the Indian condition in 1990-91 when it was loaded with heavy debt, foreign
exchange reserve was abysmally low, and there was double-digit inflation. In
general, high inflation puts the economy out of gear and it becomes difficult to
maintain economic stability.

For reducing the rate of inflation, policy makers in an economy have to reduce
aggregate demand, through imposition of restrictions on consumption and
investment, and cutting down on government expenditure. When investment
(both private and public) is reduced, there is an adverse effect on economic
growth (remember that the multiplier effect works for decrease in investment
also). Further, with the decline in investment, there is a fair chance that
unemployment in the country will increase. In fact, the ‘Phillips Curve’ (to be
discussed in another Unit) describes the relationship between inflation and
unemployment. Empirically it is observed that the relationship between inflation
and unemployment is inverse, at least in the short run. An implication of the
Phillips Curve is that a lower rate of inflation is possible only if the government
is willing to accept a higher rate of unemployment. Thus, there could be a trade-
off between inflation and unemployment in the short run. Higher unemployment
brings in another set of problems – lower economic growth, growing poverty,
social discontent, and possibility of political instability.

Sacrifice Ratio

Slower economic growth puts pressure on fiscal targets – revenue generation is

adversely affected as growth rate slows down while government expenditure
increases due to cost escalation. The high fiscal deficit is a source of not only
inflation, but also government debt. Very often we measure the cost of inflation
in terms of ‘Sacrifice Ratio’, which is defined as follows:

Sacri ice ratio =

For example, for a country, inflation declined by 2 per cent while output declined
by 5 per cent. Thus, sacrifice ratio is 5/2, that is, 2.5. The sacrifice ratio indicates
the potential output that has to be sacrificed for reducing inflation by one per
cent.

Cold Turkey or Gradualism

In the process of disinflation, a question arises: whether the policy makers should
go for a rapid decline in inflation rate or they should follow such a policy that
reduction in inflation is gradual. The classical economists suggest that dis-
inflation process should be rapid – this strategy is sometimes referred to as ‘cold
turkey’. According to this view, government policy of disinflation should be
visible, and people should believe that the government is sincerely trying to
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reduce inflation. In the process it will reduce expected inflation. The Keynesian Causes and Effects of
economists however suggest a ‘gradual approach’, as there are several frictions in Inflation
the economy. In an economy there are several wage contracts which require time
to expire and thus some time is required for the economy to adjust to the new
inflation target set by the government. During the adjustment period the
unemployment rate could be very high. According to the Keynesian view, the
cold turkey approach may not lower inflation expectations, because people may
doubt whether it is possible to bring down inflation so rapidly. Further, according
to them, the cost of rapid decline in inflation would be enormous in terms of high
unemployment and unsustainable politically.

Check Your Progress 2

1) Unexpected inflation will (tick the correct answer)

a. Hurt borrowers.
b. Hurt lenders.
c. Hurt borrowers and lenders equally.
d. Have no effect on either borrowers or lenders.
2) Give a brief account the cost of dis-inflation for an economy.

…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
……………....................................................................………………………

8.5 LET US SUM UP

There are mainly two types of inflation, viz., (i) demand-pull inflation, and (ii)
cost-push inflation. Both types of inflation cause an increase in the overall price
level within an economy. Demand-pull inflation occurs when aggregate demand
for goods and services in an economy rises more rapidly than an economy’s
productive capacity. Cost-push inflation, on the other hand, occurs when prices
of production process/factor inputs increase. Rapid wage increases or rising raw
material prices are common causes of this type of inflation. In the long run,
inflation occurs because of expanding money supply. However, there are several
factors such as business cycles, international oil prices, and changes in exchange
rate that can cause inflation in the short run. Also, we learnt from the structural
theory of inflation that structural factors such as saving-investment gap, food
shortages, foreign exchange scarcity, and infrastructural bottlenecks are the real
causes of inflation in developing countries.

Inflation has economic, social and political implications. Inflation leads to re-
distribution of wealth, usually in favour of the rich. Further, we discussed the
effect of inflation on various sections of society. Certain groups of people in
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Inflation society are affected by inflation more adversely than others. Generally, people
with fixed incomes such as workers, salaried persons, teachers, pensioners,
interest and rent earners, are made worse off during inflation because their
incomes do not increase as fast as the prices.

8.6 ANSWERS/HINTS TO CHECK YOUR

PROGRESS EXERCISES

Check Your Progress 1

1) 1-b, 2-d, 3-a, 4-c.

2) d
3) According to the Keynesian view, demand-pull inflation occurs when
aggregate demand exceeds aggregate supply at full employment level
of output thereby attributing inflation to the relationship between the
aggregate expenditure (C+I+G) and full employment level of output.
Refer to Sub-Section 8.2.1.
Keynesian theory of cost-push inflation attributes the basic cause of
inflation to supply side factors, particularly to the possibility that
rising production costs will lead to inflation. Refer to Sub-Section
8.2.2.

Check Your Progress 2

1) b
2) Refer to Section 8.3 and answer.

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