Inflation is a phenomenon that affects all aspects of the economy and society. It may lead to political upheavals and adds to poverty. It influences consumer spending, business investment, employment rate, taxation policies, and rates of interest. Therefore, the study of inflation becomes important.

Meaning of Inflation

Inflation refers to a persistent rise in the general level of prices. It occurs when the aggregate demand exceeds the aggregate supply or when costs increase to push up the prices. Inflation is viewed as a fall in the real value of money also.

It was the neo-classical economists who first defined the term inflation. According to neo-classical economists, “Inflation is destroying disease born out of lack of monetary control whose results undermined the rules of business, creating havoc in markets and financial ruins of even the prudent.” They took inflation as a monetary phenomenon that is caused by a more rapid increase in the quantity of money than output.

But Keynes had a different view. According to him, if the money supply increases beyond the level of full employment, output ceases to rise and prices rise in prices rise in proportion to the money supply. This is what true inflation is. Up to the level of full employment, price rise may be caused by certain bottlenecks which is bottleneck inflation, not true inflation. Keynes ignored the cost aspect of inflation. Keynes even sees inflation as a form of taxation that the public finds hardest to evade.

Coulbourn defined inflation as too much money chasing too few goods.

Types of Inflation

On the basis of magnitude of rise in prices

• Creeping inflation - sustained rise in prices at an annual rate of less than 3% per annum; this mildest form of inflation is regarded safe and essential for economic growth; it becomes Chronic or Secular inflation if it sustains for a longer period of time.
• Walking or trotting inflation - the rate of price rise ranges between 3% and 10%; if not checked in the due course of time, it may become threatening.
• Running inflation - price rise becomes double-digit and remains between 10% and 20% per annum; demands immediate attention because the poor and middle-income people are hit hard by this type of inflation.
• Hyperinflation - prices rise at a very fast rate, even three-digit also; it becomes even difficult to measure the rate of inflation and inflation becomes absolutely uncontrollable causing the total collapse of the monetary system. During hyperinflation, money stops functioning as a store of value and a medium of exchange as people's faith in their domestic currency is completely eroded away. Venezuela experienced hyperinflation where in 2019, the rate of inflation rose to nearly 300000 percent. Similarly, in the wake of hyperinflation, the Government of Iran had to change its national currency from Rial to Toman and Gheran. 

On the basis of causes of inflation

• Demand-pull inflation - inflation caused by various factors that contribute to increase in demand such as an increase in money supply, excess of aggregate demand over the aggregate supply, and increase in population. The common demand-pull factors include rise in population, black money, rise in income, and excessive government expenditure.
• Cost-push inflation - this type of inflation occurs due to the increase in the cost of production of goods and services; for example rise in wages, profit-push, increase in the price of raw material, fuel, and energy. The common cost-push factors are infrastructure bottlenecks, rise in MSP of agricultural goods, rise in international prices such as fuel prices, hoarding and black marketing, and rise in indirect taxes.
• Sectoral inflation - the rise in prices of goods and services in one sector causes inflation in other sectors of the economy; for example, an increase in the price of fertilizers or diesel leads to an increase in the cost of agricultural produce from where it enters into the supply chain of agricultural produce.
• Development inflation - this type of inflation occurs when during the course of the development of the economy, the government spends money on projects of long-term gestation such as the building of highways, ports, railway lines, construction of canals, etc., inflation is bound to occur for some time.

On the basis of time of occurence

• War-time inflation - inflation that occurs during the course of war or a war-like situation; it occurs because in such a time, the scarce productive resources are diverted to produce military goods and equipment, and moreover, demand for goods of routine use increases out of panic.
• Post-war inflation - sometimes prices shoot up in the post-war period because of investment in reconstruction activities or a rise in pent-up demand; pent-up demand is such a demand that rises after the war, recession, or COVID-like pandemic is over because people rush to markets to purchase those goods and services the demand of which they kept postponing.
• Peace-time inflation - inflation that occurs during normal times; it is caused by increased government expenditure on capital projects of long gestation.

Other types of inflation

• Structural inflation - a type of inflation that is caused due to structural weaknesses such as supply bottleneck, lack of infrastructure, etc. in the economy; occurs most commonly in developing economies.
• Markup inflation - inflation that occurs when a firm raises its prices in order to maintain its desired markup; it causes an increase in the costs of other firms which, in turn, raise their prices.
• Open inflation - it occurs when markets for goods or factors of production are allowed to function freely, setting prices of goods and services without normal interference by authorities; thus, open inflation is the result of the uninterrupted operation of the market mechanism.
• Suppressed inflation - it occurs when government imposes physical and monetary controls to check open inflation; in such case, the market mechanism is not allowed to function normally by the use of licensing, price controls, and rationing in order to suppress the extensive rise in prices.

Inflationary Gap

The inflationary gap represents the difference between the current level of GDP and the GDP if the economy would be operating at the level of full employment. It occurs when the current GDP is more than the potential GDP. It is caused by the increased level of consumption at present. It occurs during the expansionary phase of an economy. It is called the inflationary gap because the gap leads to a rise in prices. 

Some definitions of inflationary gap

1. "Inflationary gap is an excess of planned expenditure over the available output at pre-inflation or base prices". - Keynes
2. "Inflationary gap is the amount by which aggregate expenditure would exceed aggregate output at full employment level of income". - Lipsey

Let us understand the inflationary gap with the help of an example:

Gross National Income at current prices                                        = Rs.100 (minus) Taxes                                                                                 = Rs.10  Disposable Income                                                                        = Rs.90  Gross National Product at pre-inflation prices                                = Rs.80 Government expenditure                                                                = Rs.20 Output available for consumption at pre-inflation prices                 = Rs.60 Inflationary Gap  (Rs.90 – Rs.60)                                                    = Rs.30

The term opposite to the inflationary gap is the deflationary gap. It occurs when the current level of real GDP is below the potential GDP, i.e GDP at full employment level.

How to address the inflationary gap?

1. By increase in savings so that the aggregate demand is reduced, but it has a risk of leading to deflationary tendencies;
2. By raising the available output to match the disposable income, but it is difficult to raise the output in the short-run;
3. By increasing taxes and reducing expenditures;
4. By issuing bonds and securities;
5. By decreasing the money stock, though Keynes was not in favour of monetary measures to control inflationary pressures within the economy
6. By increasing rates of interest

Phillips Curve

• It was propounded by the British economist A.W. Phillips.
• Phillips curve depicts the relationship between the rate of unemployment and the rate of inflation.
• According to the Phillips Curve, there is an inverse relationship between the rate of unemployment and the rate of increase in money wages. You know, an increase in money wages would bring inflation.
• At higher levels of unemployment, the rate of increase in money wages remains low and vice versa because at higher demand for labour, there would be very few unemployed and the employer would have to increase the wage rate to meet his demand for more workers.

Some economists like Friedman and Phelps are of the view that Phillips Curve relates to the short-run only and does not remain stable. In the long run, there will be no trade-off between inflation and (un)employment. 

Another economist James Tobin has modified the Phillips Curve to make it kinked-shaped. His view is that as the economy expands and employment grows, the curve becomes even more fragile and vanished until it becomes vertical at some critically low rate of unemployment. 

Policy implications of Phillips Curve

1. It suggests the extent to which monetary and fiscal policies can be used to control inflation without high levels of unemployment, i.e., it guides the authorities about the rate of inflation that can be tolerated with a given level of unemployment.
2. Its other implication is that because a particular level of unemployment will influence a particular rate of wage increase, the two goals of low unemployment and low rate of inflation may be incompatible.

The Phillips Curve failed to explain the economic situation of high unemployment and extremely high wage rates.

Inflation-related costs

Shoe Leather Cost

As inflation causes a fall in the real value of money, people rush to discover better prices for their money. Inflation increases the opportunity cost of holding money and leads to a fall in the real interest rate, therefore, people will hold less cash, buy more, and as a consequence, make more visits to banks to withdraw their deposits.

Investment is discouraged

Inflation discourages long-term investment decisions because of the uncertainty about future revenues and profits. This is why economic growth rates come low in countries with high rates of inflation.

Low growth and higher unemployment

A high rate of inflation is unwanted. Therefore, governments have to take various fiscal (such as an increase in tax rates, and a decrease in public expenditure) and monetary measures (such as an increase in rates of interest). These measures discourage savings and lower the level of investment causing a reduction in aggregate demand which leads to a decline in economic growth and unemployment.

Increased Tax Burden

This can be termed a fiscal drag also. During inflationary times, the tax burden on individuals increases due to two reasons - an increase in their nominal wages, and the government's fiscal measure to control inflation. This implies a social cost.

Redistribution of income

The rise in price and the consequent fall in the value of money lead to a decline in the real rate of interest. It benefits borrowers and harms lenders (if the rate of interest is not linked with the inflation index). Similarly, the real value of the principal amount of debt falls. So, overall the borrowers will have to pay less in real terms and the lenders have to bear losses in this respect. 

Increased trade deficit

During inflation, the export of goods and services falls and the imports become cheaper. Thus leading to more imports and fewer exports. This widens the current account deficit. This erodes the international competitiveness of domestic firms. To restore competitiveness, the exchange rate is lowered. But in the case of Economic Unions like the EU, individual countries cannot intervene to lower the exchange rate of the Euro. Therefore, such countries have to suffer.

Impact of inflation on future

A high rate of inflation would affect the future decisions and life prospects of individuals. People become more reluctant to save and invest. Sometimes, poor people have to compromise their diets, education, health, recreation, etc. All this may have long-term physical, psychological, and economic impacts on their lives and the generation to come.

Headline Inflation vs. Core Inflation

Headline Inflation

• It is a measurement of price inflation that takes into account the entire basket of commodities.
• Unlike core inflation, it considers changes in the prices of food and energy also. 
• Since the prices of foods and energy remain more volatile and increase rapidly in comparison with other prices of other commodities, therefore, headline inflation is considered less reliable and may not present an accurate picture of how an economy is behaving.
• Headline inflation is based on CPI-Combined.
• Headline inflation is more relevant for developing economies than developed economies.

Core Inflation

• In core inflation, changes in prices of more volatile commodities such as food items and fuel are not considered.
• Considering the temporary price shocks which are commonly seen in the prices of fuel and food may affect the estimated overall inflation numbers in such a way that the true picture of inflation may not be depicted which may affect the policy-making also.
• Thus to eliminate this possibility, the concept of core inflation has evolved.
• Headline inflation is more useful for the typical household because it reflects changes in the cost of living, while core inflation is used by central banks because core inflation is less volatile and shows the effects of supply and demand on GDP better.

Measurement of Inflation

Wholesale Price Index (WPI)

• WPI is used to measure the changes in the average price level of goods traded in the wholesale market.
• India's first WPI was published in 1942 with the base year 1939.
• In India, the WPI is compiled and published on monthly basis by the Department of Industrial Policy and Promotion (DIPP) of the Ministry of Commerce and Industry.
• Prices of about 697 commodities are tracked for the WPI. The commodities are classified under categories of primary articles, fuel and power, and manufactured products with different weights. However, the highest weight is given to the manufactured products and the least to fuel and power.
• The Government of India takes WPI as an indicator of the rate of inflation in the economy.
• The price used for the purpose of WPI are ex-factory prices, indirect taxes are not included in the prices for the purpose.
• It is important to note that WPI-based inflation is less affected by any change in the fiscal policy of the government.
• The Base Year used for the purpose is 2011-12.

Consumer Price Index (CPI)

• CPI is a measure of the weighted average of prices of a specified set of goods and services purchased by consumers.
• CPI tracks the prices of a specified basket of consumer goods and services.
• It is considered a cost of living index also.
• To focus more precisely on the effect of change in prices on different homogenous consumer groups, the following four categories of CPI are compiled in India.

S.No.	Index	Base Year	Compiled by
1	CPI-Industrial Workers (CPI-IW) - designed to measure the changes in the prices of a given basket of goods & services used by the industrial workers	2016	Labour Bureau under the Ministry of Labour and Employment, Government of India
2	CPI-Agricultural Labourers (CPI-AL) - designed to revise minimum wages for agricultural labour in different states	1986-87	- same as above-
3	CPI-Rural Labour (CPI-RL)	1986-87	-same as above-
4	CPI-Rural, CPI-Urban, CPI-Combined or CPI (Rural + Urban)	2012	Central Statistical Office (CSO) which has been now merged with the National Sample Survey Office (NSSO) to form National Statistical Office (NSO)

• For the purpose of determining the Dearness Allowance (DA), CPI is used.
• For inflation targeting, RBI and the Central Government are using CPI-Combined on the basis ofthe recommendation of Urjit Patel Committee.
• In CPI-Rural, housing component is not included.
• Weight of food and beverage is more in case of CPI-Rural than that in the case of CPI-Urban.
• CPI is a better meausre of inflation as compared to WPI and is more reliable for monetary policy decisions.
• CPI takes into account both goods and services, WPI takes into account goods only.

CPI Food Index is released by the CSO since 2014. It is computed on a point-to-point monthly basis with same base year 2012. In CPI Food Index, 'cereals and products' carries the highest weight. Other sub-groups considered are Milk and Milk Products, Vegetables, Oils & Fats, Egg, Fish & Meat, etc.

GDP Deflator

• It is the ratio between GDP at Current Prices and GDP at Constant Prices.

GDP Deflator = (GDP at Current Prices)/(GDP at Constant Prices)

• GDP deflator equals to '1' implies that there is no change in the general price level. 
• GDP deflator >1 implies inflation.
• GDP deflator <1 implies deflation.
• Though the GDP deflator is considered a better measure of inflation, still it is not preferred because GDP-related data are not available on monthly basis.

Producer Price Index (PPI)

• PPI measures average changes in prices that producers receive by selling their goods and services in domestic or international markets.
• It excludes the effect of indirect taxes on inflation.
• Unlike WPI, it takes into account both goods and services.
• Some advanced economies like the USA have shifted to PPI from the WPI as a measure of inflation.
• IMF has also recommended the use of PPI instead of WPI for measuring inflation.

Case of adoping PPI in India In 2014, the Government of India appointed B.N. Goldar Committee to examine whether or not PPI should replace WPI and suggthe est a methodology. The Committee's recommendations include: To shift from WPI to PPI on an experimental basis to measure inflation; Data from 'Supply Use Tables' to be used to compute experimental PPI; Base Year for experimental PPI should be 2011-12; To include the services price in the PPI basket; To include major export and import items while calculating experimental PPI

Base Effect on Inflation

• The base effect refers to the impact of the rise in the price levels in the previous year over the corresponding rise in the price levels in the current year.
• If the inflation rate was low in the corresponding period of the last year, then even a small increase in the price index will give a high rate of inflation in the current year. Similarly, if there is a rise in the price index in the corresponding period of last year and recorded high inflation, then an absolute increase in the price index will show a lower inflation rate in the present year.

Calculation of Year-on-Year Inflation [(Current Price Index - Last Year's Price Index)/Last Year's Price Index] x 100

Impact of Inflation

Impact on society

Inflation erodes the purchasing power of individuals and households. A persistent rise in prices leads to a fall in their level of consumption. A fall in the level of consumption indicates a lower standard of living (or deprivation). A deprived household would compromise on various basic essentials such as the education of children, quality of diet, and even health also. It impacts the physical and cognitive growth of children and the future of the entire society is compromised. A higher rate of inflation discourages investment which in turn, causes a higher rate of unemployment. 

Moreover, a persistently high rate of inflation breeds poverty. Poverty invites various other problems such as terrorism, Naxalism, drugs, trafficking, etc. These challenge the law and order and internal security of the country. Even such a country whose economy is in bad shape becomes more vulnerable to external threats also.

Quality human resources (educated and professional individuals) fly out of the country.

Inflation increases the economic gap among individuals because during inflation, the lower strata of society are more severally affected.

Impact of government

Inflation brings troubles for ruling regimes also. In India, the high rate of inflation during the second term of Dr. Manmohan Sing-led UPA government was one of the important causes of the defeat of UPA in the 2014 Lok Sabha elections. Circumstances created by the hyperinflation in Sri Lanka (in 2022) compelled Sri Lankan President Gotabaya Rajapaksa to resign.

Impact on environment

Sometimes, a high rate of inflation creates stress on natural resources also by contributing to deforestation and over-exploitation of natural resources to increase production to match the demand. 

Impact on economy

Generally, the domestic currency depreciates during inflation. This benefits the exporters. At a very high rate of price, exports may not remain globally competitive. In the case of an open economy, very high prices in the domestic market may stimulate imports also. So, the impact of inflation on foreign trade can be both ways.

Inflation benefits borrowers as their liabilities (in real terms) decrease. But lenders remain losers. In the initial phase, when the rate of inflation is moderate, the investors would be rewarded by the expanding economy. But beyond a certain level, it demotivates investors. They stop making investments and start shifting their capital to other countries. This leads to further depreciation of the domestic currency, and a fall in the level of investment and employment.

Inflation decreases the Marginal Propensity to Save and it skews the savings pattern in favour of unproductive assets like gold.

Measures to Control Inflation

Inflation Targeting

• Inflation targeting is a policy of the RBI that requires adjusting of the monetary policy to achieve a specified annual rate of inflation.
• In India, inflation targeting was recommended by Urjit Patel Committee in its report in 2014. Urjit Patel Committee which was appointed in 2013 was given the following mandate:

1. To revise and strengthen Monetary Policy Framework
2. To recommend an appropriate nominal anchor for the conduct of monetary policy

• Today, the RBI's Monetary Policy is primarily concerned with keeping a tab on inflation.
• Inflation targeting can be of two types:

1. Strict Inflation Targeting - it is used when a central bank is only concerned with keeping inflation as close to a given target as possible.
2. Flexible Inflation Targeting - it is used when the central bank is also concerned about other things such as interest rate, exchange rate, output and employment stability.

• Why does India need inflation targeting?

1. Real interest rates have remained negative during most of the post-global crisis of 2008.
2. External competitiveness is getting eroded due to continuous higher levels of inflation.
3. Due to inflation, there has been a large import of gold due to its increasing demand and it has resulted in a widening of the Current Account Deficit.
4. Continuous weakening of the exchange rate has occurred due to persistent high inflation.
5. Rise in inequality in the Indian economy due to increased rate of inflation.

• Based on the recommendation of the Urjit Patel Committee, RBI and the Government of India entered into an agreement in 2015. The two agreed on the following points:

1. Flexible Inflation Targeting as the official goal of RBI - the numerical target of CPI-based inflation has been fixed at 4 percent (with plus/minus 2 percent).
2. Flexible inflation target to be set by the Government of India in every years in consultation with the RBI.
3. CPI-Combined to be used as the measure of nominal anchor for policy decisions.

• Earlier, the inflation target at 4 percent (plus/minus 2 percent) was fixed for a period of five years from 2016-17 to 2020-21. In 2020-21, it has been extended for a further period of five years ending on 31st March 2026. 

Some Important Inflation-related Terms/Concepts

Inflation Tax

Inflation Tax is not any actual legal tax. It is a sort of penalty for holding cash. When the government prints more money or reduces interest rates, the market is flooded with cash. It raises inflation. In such a scenario, the persons holding securities or other physical assets and the investors in real estate suffer less in comparison with those who hold cash. The holders of cash suffer due to decrease in the value of the money, they face loss in purchasing power. This loss is termed as inflation tax.

Sacrifice Ratio

To control inflation, various monetary and fiscal measures are adopted. It is in the form of tighter monetary policy or a decrease in government expenditure. This causes fall in investment and ultimately economic growth. So, to control inflation, we have to sacrifice investment and growth for a period. The sacrifice ratio is the percentage loss of real output to 'one' percent reduction in inflation. 

Recession

A slowdown or a massive contraction in economic activities is known as a recession. It is the result of a significant fall in spending. This is tackled by adopting an expansionary monetary policy, cut in tax rates, and increase in government spending. 

Double-dip Recession

It occurs when an economy recovers for a short period from a recession before going into another recession again. It is also referred to as a 'W-shaped' recession. It has two dips with an intermediate recovery.

Deflation

Deflation occurs when there is a fall in the general price level of goods and services throughout an economy. It happens when supply increases demand. Deflation is accompanied by unemployment. The value of money increases during deflation. Measures taken to correct the deflationary situation are the same as in the case of recovery from recession.

Disinflation

A decrease in the rate of inflation is known as disinflation. So, it is a slowdown in the rate of increase of the general price level of goods and services. Disinflation is obviously a phase between the peak of inflation and the beginning of deflation.

Reflation

Recovery from deflation is reflation. It is a phase between the deepest dip during deflation and the start of inflation. It occurs when the economy in deflation is given stimulated to recover. The stimulants may include an increase in the money supply, a reduction in taxes, an increase in government expenditure, etc. As deflation is opposite to inflation, reflation is opposite to disinflation.

Stagflation

Stagflation is an economic situation where a high rate of inflation occurs along with stagnation ('zero' rate of economic growth). It is an economic condition of no growth, a relatively high level of unemployment, a rise in the price of goods and services, and a decline in the GDP. Though stagflation is a rare phenomenon. it is bad for the economy. 

Inflation Premium

As we have discussed already that inflation benefits borrowers. This benefit that accrues to the borrowers is termed as inflation premium.

Fiscal Drag

Wage rates rise during inflation. Many individuals move to higher tax brackets and have to pay a higher amount of taxes. As a result, spending decreases and economic growth slows down. This is called fiscal drag.