What is Inflation?

According to many classical writers, inflation is a situation when too

much money chases too few goods and services. Inflation is measured
by the Consumer Price Index(CPI).

Therefore, there is an imbalance between the money supply and the

Gross Domestic Product (GDP). There are many types of inflation like
demand-pull inflation, cost-push inflation, supply-side inflation. But
Inflation can be divided into two broad types:

1. Open inflation – when the price level in an economy rises

continuously and

2. Repressed inflation – when the economy suffers from inflation

without any apparent rise in prices.

According to Keynes, inflation is an imbalance between the aggregate

demand and aggregate supply of goods and services. Therefore, if the
aggregate demand exceeds the aggregate supply, then the prices keep
rising.

Causes of Inflation

• Primary Causes

• Increase in Public Spending

• Deficit Financing of Government Spending

• Increased Velocity of Circulation

• Population Growth

• Hoarding

• Genuine Shortage

• Exports

• Trade Unions

• Tax Reduction

• The imposition of Indirect Taxes

• Price-rise in the International Markets

Having understood the inflation meaning, let’s take a quick look at

the factors that cause inflation.

Primary Causes

In an economy, when the demand for a commodity exceeds its supply,

then the excess demand pushes the price up. On the other hand, when
the factor prices increase, the cost of production rises too. This leads to
an increase in the price level as well.

Increase in Public Spending

In any modern economy, Government spending is an

important element of the total spending. It is also an important
determinant of aggregate demand.
Usually, in lesser developed economies, the Govt. spending increases
which invariably creates inflationary pressure on the economy.

Deficit Financing of Government Spending

There are times when the spending of Government increases beyond

what taxation can finance. Therefore, in order to incur the extra
expenditure, the Government resorts to deficit financing.

For example, it prints more money and spends it. This, in turn, adds to
inflationary pressure.

Increased Velocity of Circulation

In an economy, the total use of money = the money supply by the

Government x the velocity of circulation of money.

When an economy is going through a booming phase, people tend to

spend money at a faster rate increasing the velocity of circulation of
money.

Population Growth

As the population grows, it increases the total demand in the market.

Further, excessive demand creates inflation.
Hoarding

Hoarders are people or entities who stockpile commodities and do not

release them to the market. Therefore, there is an artificially created
demand excess in the economy. This also leads to inflation.

Genuine Shortage

It is possible that at certain times, the factors of production are short in

supply. This affects production. Therefore, supply is less than the
demand, leading to an increase in prices and inflation.

Exports

In an economy, the total production must fulfill the domestic as well as

foreign demand. If it fails to meet these demands, then exports create
inflation in the domestic economy.

Trade Unions

Trade union work in favor of the employees. As the prices increase,

these unions demand an increase in wages for workers. This invariably
increases the cost of production and leads to a further increase in prices.

Tax Reduction

While taxes are known to increase with time,

sometimes, Governments reduce taxes to gain popularity among
people. The people are happy because they have more money in their
hands.
However, if the rate of production does not increase with a
corresponding rate, then the excess cash in hand leads to inflation.

The imposition of Indirect Taxes

Taxes are the primary source of revenue for a Government. Sometimes,

Governments impose indirect taxes like excise duty, VAT, etc. on
businesses.

As these indirect taxes increase the total cost for the manufacturers
and/or sellers, they increase the price of the product to have a minimal
impact on their profits.

Price-rise in the International Markets

Some products require to import commodities or factors of production

from the international markets like the United States. If
these markets raise prices of these commodities or factors of
production, then the overall production cost in India increases too. This
leads to inflation in the domestic market.

Non-economic Reasons

There are several non-economic factors which can cause inflation in an

economy. For example, if there is a flood, then crops are destroyed.
This reduces the supply of agricultural products leading to an increase
in the prices of the commodities.
Investment in Gold, Real estate, stocks, mutual funds, and other assets
are some of the ways to deal with Inflation.

Impacts of Inflation

Inflation is not necessarily bad for the economy. For example, creeping
inflation can generate good effects on the overall economy of a country.
In this article, we will look at the favourable and unfavourable impacts
of inflation.

Favourable Impacts of Inflation

The favourable impacts of inflation are as follows:

Higher Profits

Inflation, usually, benefits the producers of products. They experience

better profits since they can sell their products at higher prices.

Better Investment Returns

During inflation, investors and entrepreneurs receive added incentives

for investing in productive activities. Therefore, they receive better
returns.
Increase in Production

Once the producers receive the right investment, they create more
goods and services. Hence, inflation leads to an increase in production
of products/services.

More Employment and Better Income

Since production increases, there is an increased demand for the various

factors of production, including manpower. Therefore, employment and
income increases during inflation.

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.

Benefits to Borrowers

During inflation, the purchasing power of money decreases. Therefore,

if the borrower is paying a rate of interest which is less than the
inflation rate, then he gains in the process. This is because the real
value of the money that the borrower returns is actually less than that of
the money borrowed.

Unfavourable Impacts of Inflation

The unfavourable impacts of inflation are as follows:

Fixed-Income Groups experience a fall in income
The true income of an individual is the purchasing power of his money
income. In other words,
Real Income=Money Income/Price .

For people belonging to the fixed-income group like salaried

individuals, pensioners, etc. this means that they will experience a fall
in real income. In other words, their purchasing power will reduce.

Inequality in Income Distribution Increases

During inflation, businessmen and entrepreneurs experience an increase

in profits. On the other hand, people belonging to the fixed-income
groups experience a decline in their real income. Hence, the inequality
in income distribution becomes acute during this period.

Upsets the Planning Process

During inflation, the prices of goods, raw materials, and factor services
increase. Therefore, the Government has to spend more money to
complete any investment project taken up during the planning period.

If the Government fails to raise more financial resources through

savings or taxation, then it upsets the entire planning process.
Speculative Investment Increases

Let’s say that the price levels are rising at a very fast rate. People are
unsure about how much the prices will rise in the next few weeks or
months. In such cases, many people start speculative investments.

For example, they might start purchasing shares, gems, land, etc. just
for speculative purposes. This is done with the objective of earning
quick profits. Such investments do not help in creating productive
capital in the economy.

Harmful Effects on Capital Accumulation

Let’s say that rising prices become chronic in an economy. During such
periods, people start preferring goods to money since the real value of
money will fall in the future. Also, people start preferring immediate
consumption to consumption in the future.

Therefore, the general desire to save starts reducing. As the willingness

and ability to save reduces, the amount of funds available for further
investment reduces too. Therefore, the overall impact on the capital
accumulation of the economy is negative since capital accumulation in
an economy depends on the growth of investment.

Lenders face Losses

Under favourable impacts of inflation, we mentioned that borrowers

benefit from inflation. Therefore, lenders stand a chance of losing
during such periods. This is because they receive an amount having
lower purchasing power than the amount loaned.

Negative Impact on Export Income

Since the prices of raw materials and factors of production increase, the
prices of export items also increase during inflation. Hence, their
demand in the foreign markets might fall which leads to a fall in the
export income of the country.

Controlling Inflation: Important Measures to Control Inflation

Some of the important measures to control inflation are as follows: 1.

Monetary Measures 2. Fiscal Measures 3. Other Measures.

Inflation is caused by the failure of aggregate supply to equal the

increase in aggregate demand. Inflation can, therefore, be controlled
by increasing the supplies of goods and services and reducing money
incomes in order to control aggregate demand.

The various methods are usually grouped under three heads: monetary
measures, fiscal measures and other measures.

1. Monetary Measures:
Monetary measures aim at reducing money incomes.

(a) Credit Control:

One of the important monetary measures is monetary policy. The
central bank of the country adopts a number of methods to control the
quantity and quality of credit. For this purpose, it raises the bank
rates, sells securities in the open market, raises the reserve ratio, and
adopts a number of selective credit control measures, such as raising
margin requirements and regulating consumer credit. Monetary policy
may not be effective in controlling inflation, if inflation is due to cost-
push factors. Monetary policy can only be helpful in controlling
inflation due to demand-pull factors.

(b) Demonetisation of Currency:

However, one of the monetary measures is to demonetise currency of
higher denominations. Such a measures is usually adopted when there
is abundance of black money in the country.

(c) Issue of New Currency:

The most extreme monetary measure is the issue of new currency in
place of the old currency. Under this system, one new note is
exchanged for a number of notes of the old currency. The value of
bank deposits is also fixed accordingly. Such a measure is adopted
when there is an excessive issue of notes and there is hyperinflation in
the country. It is a very effective measure. But is inequitable for its
hurts the small depositors the most.

2. Fiscal Measures:
Monetary policy alone is incapable of controlling inflation. It should,
therefore, be supplemented by fiscal measures. Fiscal measures are
highly effective for controlling government expenditure, personal
consumption expenditure, and private and public investment.
The principal fiscal measures are the following:
(a) Reduction in Unnecessary Expenditure:
The government should reduce unnecessary expenditure on non-
development activities in order to curb inflation. This will also put a
check on private expenditure which is dependent upon government
demand for goods and services. But it is not easy to cut government
expenditure. Though this measure is always welcome but it becomes
difficult to distinguish between essential and non-essential
expenditure. Therefore, this measure should be supplemented by
taxation.

(b) Increase in Taxes:

To cut personal consumption expenditure, the rates of personal,
corporate and commodity taxes should be raised and even new taxes
should be levied, but the rates of taxes should not be so high as to
discourage saving, investment and production. Rather, the tax system
should provide larger incentives to those who save, invest and
produce more.

Further, to bring more revenue into the tax-net, the government

should penalise the tax evaders by imposing heavy fines. Such
measures are bound to be effective in controlling inflation. To
increase the supply of goods within the country, the government
should reduce import duties and increase export duties.
(c) Increase in Savings:
Another measure is to increase savings on the part of the people. This
will tend to reduce disposable income with the people, and hence
personal consumption expenditure. But due to the rising cost of
living, people are not in a position to save much voluntarily.

Keynes, therefore, advocated compulsory savings or what he called

‘deferred payment’ where the saver gets his money back after some
years. For this purpose, the government should float public loans
carrying high rates of interest, start saving schemes with prize money,
or lottery for long periods, etc. It should also introduce compulsory
provident fund, provident fund-cum-pension schemes, etc. All such
measures increase savings and are likely to be effective in controlling
inflation.

(d) Surplus Budgets:

An important measure is to adopt anti-inflationary budgetary policy.
For this purpose, the government should give up deficit financing and
instead have surplus budgets. It means collecting more in revenues
and spending less.

(e) Public Debt:

At the same time, it should stop repayment of public debt and
postpone it to some future date till inflationary pressures are
controlled within the economy. Instead, the government should
borrow more to reduce money supply with the public.
Like monetary measures, fiscal measures alone cannot help in
controlling inflation. They should be supplemented by monetary, non-
monetary and non-fiscal measures.

3. Other Measures:
The other types of measures are those which aim at increasing
aggregate supply and reducing aggregate demand directly.

(a) To Increase Production:

The following measures should be adopted to increase
production:
(i) One of the foremost measures to control inflation is to increase the
production of essential consumer goods like food, clothing, kerosene
oil, sugar, vegetable oils, etc.

(ii) If there is need, raw materials for such products may be imported
on preferential basis to increase the production of essential
commodities,

(iii) Efforts should also be made to increase productivity. For this

purpose, industrial peace should be maintained through agreements
with trade unions, binding them not to resort to strikes for some time,

(iv) The policy of rationalisation of industries should be adopted as a

long-term measure. Rationalisation increases productivity and
production of industries through the use of brain, brawn and bullion,
(v) All possible help in the form of latest technology, raw materials,
financial help, subsidies, etc. should be provided to different
consumer goods sectors to increase production.

(b) Rational Wage Policy:

Another important measure is to adopt a rational wage and income
policy. Under hyperinflation, there is a wage-price spiral. To control
this, the government should freeze wages, incomes, profits, dividends,
bonus, etc.

But such a drastic measure can only be adopted for a short period as it
is likely to antagonise both workers and industrialists. Therefore, the
best course is to link increase in wages to increase in productivity.
This will have a dual effect. It will control wages and at the same time
increase productivity, and hence raise production of goods in the
economy.

(c) Price Control:

Price control and rationing is another measure of direct control to
check inflation. Price control means fixing an upper limit for the
prices of essential consumer goods. They are the maximum prices
fixed by law and anybody charging more than these prices is punished
by law. But it is difficult to administer price control.

(d) Rationing:
Rationing aims at distributing consumption of scarce goods so as to
make them available to a large number of consumers. It is applied to
essential consumer goods such as wheat, rice, sugar, kerosene oil, etc.
It is meant to stabilise the prices of necessaries and assure distributive
justice. But it is very inconvenient for consumers because it leads to
queues, artificial shortages, corruption and black marketing. Keynes
did not favour rationing for it “involves a great deal of waste, both of
resources and of employment.”

Conclusion:
From the various monetary, fiscal and other measures discussed
above, it becomes clear that to control inflation, the government
should adopt all measures simultaneously. Inflation is like a hydra-
headed monster which should be fought by using all the weapons at
the command of the government.