Meaning of Inflation:

Inflation is often defined in terms of its supposed causes. Inflation exists when money supply exceeds available goods and services. Or inflation is attributed to budget deficit financing. A deficit budget may be financed by the additional money creation. But the situation of monetary expansion or budget deficit may not cause price level to rise. Hence the difficulty of defining ‘inflation’. 

Inflation may be defined as ‘a sustained upward trend in the general level of prices’ and not the price of only one or two goods. G. Ackley defined inflation as ‘a persistent and appreciable rise in the general level or aver­age of prices’. In other words, inflation is a state of rising prices, but not high prices. It is not high prices but rising price level that con­stitute inflation. It constitutes, thus, an over­all increase in price level. It can, thus, be viewed as the devaluing of the worth of money. In other words, inflation reduces the purchasing power of money. A unit of money now buys less. Inflation can also be seen as a recurring phenomenon. While measuring inflation, we take into ac­count a large number of goods and services used by the people of a country and then cal­culate average increase in the prices of those goods and services over a period of time. A small rise in prices or a sudden rise in prices is not inflation since they may reflect the short term workings of the market.

It is to be pointed out here that inflation is a state of disequilib­rium when there occurs a sustained rise in price level. It is inflation if the prices of most goods go up. Such rate of increases in prices may be both slow and rapid. However, it is difficult to detect whether there is an upward trend in prices and whether this trend is sus­tained. That is why inflation is difficult to define in an unambiguous sense. As inflation is a state of rising prices, de­flation may be defined as a state of falling prices but not fall in prices. Deflation is, thus, the opposite of inflation, i.e., a rise in the value of money or purchasing power of money. Disinflation is a slowing down of the rate of inflation.  As inflation is a state of rising prices, de­flation may be defined as a state of falling prices but not fall in prices. Deflation is, thus, the opposite of inflation, i.e., a rise in the value of money or purchasing power of money. Disinflation is a slowing down of the rate of inflation

Types of Inflation:

As the nature of inflation is not uniform in an economy for all the time, it is wise to distin­guish between different types of inflation. Such analysis is useful to study the distribu­tional and other effects of inflation as well as to recommend anti-inflationary policies. Infla­tion may be caused by a variety of factors. Its intensity or pace may be different at different times. It may also be classified in accordance with the reactions of the government toward inflation.

Thus, one may observe different types of inflation in the contemporary society:

A. On the Basis of Causes:

(i) Currency inflation:

This type of infla­tion is caused by the printing of cur­rency notes.

(ii) Credit inflation:

Being profit-making institutions, commercial banks sanction more loans and advances to the public than what the economy needs. Such credit expansion leads to a rise in price level.

(iii) Deficit-induced inflation:

The budget of the government reflects a deficit when expenditure exceeds revenue. To meet this gap, the government may ask the central bank to print additional money. Since pumping of additional money is required to meet the budget deficit, any price rise may the be called the deficit-induced inflation.

(iv) Demand-pull inflation:

An increase in aggregate demand over the available output leads to a rise in the price level. Such inflation is called demand-pull in­flation (henceforth DPI). But why does aggregate demand rise? Classical economists attribute this rise in aggre­gate demand to money supply. If the supply of money in an economy ex­ceeds the available goods and services, DPI appears. It has been described by Coulborn as a situation of “too much money chasing too few goods.” 

An increase in aggregate demand over the available output leads to a rise in the price level. Such inflation is called demand-pull in­flation (henceforth DPI). But why does aggregate demand rise? Classical economists attribute this rise in aggre­gate demand to money supply. If the supply of money in an economy ex­ceeds the available goods and services, DPI appears. It has been described by Coulborn as a situation of “too much money chasing too few goods.” 

Keynesians hold a different argu­ment. They argue that there can be an autonomous increase in aggregate de­mand or spending, such as a rise in con­sumption demand or investment or government spending or a tax cut or a net increase in exports (i.e., C + I + G + X – M) with no increase in money sup­ply. This would prompt upward adjust­ment in price. Thus, DPI is caused by monetary factors (classical adjustment) and non-monetary factors (Keynesian argument).

DPI can be explained in terms of Fig. 4.2, where we measure output on the horizontal axis and price level on the vertical axis. In Range 1, total spending is too short of full employment out­put, YF. There is little or no rise in the price level. As demand now rises, out­put will rise. The economy enters Range 2, where output approaches towards full employment situation. Note that in this region price level begins to rise. Ul­timately, the economy reaches full em­ployment situation, i.e., Range 3, where output does not rise but price level is pulled upward. This is demand-pull in­flation. The essence of this type of in­flation is that “too much spending chas­ing too few goods.”

(v) Cost-push inflation:

Inflation in an economy may arise from the overall increase in the cost of production. This type of inflation is known as cost-push inflation (henceforth CPI). Cost of pro­duction may rise due to an increase in the prices of raw materials, wages, etc. Often trade unions are blamed for wage rise since wage rate is not completely market-determinded. Higher wage means high cost of production. Prices of commodities are thereby increased.

A wage-price spiral comes into opera­tion. But, at the same time, firms are to be blamed also for the price rise since they simply raise prices to expand their profit margins. Thus, we have two im­portant variants of CPI wage-push in­flation and profit-push inflation.

Any­way, CPI stems from the leftward shift of the aggregate supply curve:

B. On the Basis of Speed or Intensity:

(i) Creeping or Mild Inflation:

If the speed of upward thrust in prices is slow but small then we have creeping inflation. What speed of annual price rise is a creeping one has not been stated by the economists. To some, a creeping or mild inflation is one when annual price rise varies between 2 p.c. and 3 p.c. If a rate of price rise is kept at this level, it is con­sidered to be helpful for economic development. Others argue that if annual price rise goes slightly beyond 3 p.c. mark, still then it is considered to be of no danger.

(ii) Walking Inflation:

If the rate of annual price increase lies between 3 p.c. and 4 p.c., then we have a situation of walking inflation. When mild inflation is allowed to fan out, walking inflation appears. These two types of inflation may be described as ‘moderate inflation’.

Often, one-digit inflation rate is called ‘moder­ate inflation’ which is not only predict­able, but also keep people’s faith on the monetary system of the country. Peoples’ confidence get lost once moderately maintained rate of inflation goes out of control and the economy is then caught with the galloping inflation.

(iii) Galloping and Hyperinflation:

Walking inflation may be converted into running inflation. Running inflation is danger­ous. If it is not controlled, it may ulti­mately be converted to galloping or hyperinflation. It is an extreme form of inflation when an economy gets shatter­ed.”Inflation in the double or triple digit range of 20, 100 or 200 p.c. a year is labelled “galloping inflation”.

(iv) Government’s Reaction to Inflation:

In­flationary situation may be open or suppressed. Because of anti-infla­tionary policies pursued by the govern­ment, inflation may not be an embar­rassing one. For instance, increase in income leads to an increase in con­sumption spending which pulls the price level up.

If the consumption spending is countered by the govern­ment via price control and rationing device, the inflationary situation may be called a suppressed one. Once the government curbs are lifted, the sup­pressed inflation becomes open infla­tion. Open inflation may then result in hyperinflation.

Cost of Inflation

If people can correctly anticipate the rate of inflation and fully adjust prices and income accordingly then the cost of inflation is minor. The inconvenience for consumers is to mentally adjust the notion of "fair prices" when they go shopping and for firms they will have to adjust price tags, price catalogues and menu to reflect price rise. Economists call the costs associated to the adjustment of price lists as Menu Costs of Inflation. However, people often make mistakes with this anticipation and do not fully adjust prices and income. This creates problems beyond the costs of inflation and these burdens are heavier when the rate of inflation is higher and fluctuations become more frequent.

1. Redistributive effects.
   Inflation distributes income away from people who earn fixed incomes and have no bargaining power. Pensioners, fixed income workers, and people who could not negotiate their rents suffer from inflation. Depositors who earned negative real interest rates also loss because they loss purchasing power for their savings. People who have property and the power to raise rents benefit as well as borrowers who benefit from lower real interest rate benefit from inflation.
2. Uncertainty and lack of investment.
   Generally, the higher rate of inflation, the more it fluctuates. Thus investors have a more difficult time in anticipating future profits and returns to their investments. This reduces the incentive to invest and in turn lessen the amount of injection into the economy.
3. Output effects.
   Aggregate Demand (AD) will not shifts out as much as it could and reduces the growth of the economy. This shift in AD can come about from a lower investment level in the economy (see point b above).
4. Effects on Balance of payment.
   Balance of Payment, roughly put, is an accounting measure that tracks total spending on foreign goods and services + capital outflows, and total incomes from exports + capital inflow. High inflation rate leads to local exports being less competitive in the world market. Export will fall. At the same time, imported goods become cheaper compared to local goods and imports increase. The balance of payment will deteriorate and/or exchange rate will depreciate against foreign currency. We will investigate the problem caused by a deterioration of balance of payment on the economy later.
5. Decision-making errors.
   When inflation rate is high and fluctuates frequently, consumers will have to estimate inflation rate in deciding their consumption and saving patterns. Whether or not, a person will keep most of his money in liquidity forms depends on what she expect the real interest rate in future. Government also has to take inflation into consideration in deciding what rates to offer for its bills and bonds. The expected returns to an investment will depend on the anticipated inflation rates on costs and revenue. More mistakes are more likely when inflation rate is both high and fluctuates frequently. When mistakes occur in making economic decisions, the economy run less efficiently as some resources can be mistakenly devoted to an investment that proved unprofitable when actual inflation rate exceeds the anticipated inflation rate.
6. Hyperinflation occurs when prices rise by several hundred per cent or even thousands per cent in a year. Firms will have little incentive to invest in this condition. Firms will have to raise prices constantly and worry about increase in costs of production. Workers will constantly demand for wage increase to keep ahead of inflation. This can lead to wage-price spiral where wages and prices chase each other resulting in AD constantly shifting to the right and AS constantly shifting to the left. People will not wish to save money and will spend the money all some tangible goods as soon as possible. The goods can then later be used for bartering later. Hyperinflation adds to the mental burden of all economic agents as everyone is preoccupied by the persistent increase in price level, the falling purchasing power of money, and the securing of goods. Hyperinflation is often caused by excessive monetary growth in an economy in which money chases after goods and services.
7. Political instability is likely when people experience high and increasing inflation rate. The classical example was Germany after World War 1 in which the annual inflation was 7000 billion percent by Autumn 1923. People were frustrated and gave rise to Hitler's fascist party in Germany. The recent case of hyperinflation was Zimbabwe which finally ended in January 2009. According to an independent estimate, the annnual inflation rate in Zimbabwe exceeded 1 million percent in May 2008 (The Boston Globe, 21 May 2008).

 

Costs of Deflation

1. Put businesses under pressure to reduce costs by all means to remain competitive. This may lead to employment insecurity.
2. Pressure to cut costs may erode the production base of the economy. Less funds for innovation leading to poorer quality control and probably higher unemployment. Less investment because anticipated deflation reduces the rate of returns to investment and profits.
3. It may make it difficult to reduce real value of debt burdens. Borrowers suffer under this condition.
4. Consumers may expect prices to fall further and will postpone purchase. This adds to more deflationary pressure for prices to fall further.

Causes Of Inflation

Inflation is mainly caused by excess demand/ or decline in aggregate supply or output. Former leads to a rightward shift of the aggregate demand curve while the latter causes aggregate supply curve to shift left­ward. Former is called demand-pull inflation (DPI), and the latter is called cost-push infla­tion (CPI). Before describing the factors, that lead to a rise in aggregate demand and a de­cline in aggregate supply, we like to explain “demand-pull” and “cost-push” theories of inflation.

1. Demand-Pull (demand-side) Inflation is the inflation caused by persistent rises in aggregate demand (see diagram 2 below). AD can increase with an increase in consumption, an expansionary monetary and fiscal policies from the government, and inflow of capital from abroad. As AD shifts from AD₁ to AD₂ as in diagram 2, say due to an increased consumption, firms will respond by increasing outputs and prices. The increase in price level depends on the steepness of AS. If AD stops at AD₁ then an increase in injection will cause an inflation as price level adjusts from p₁ to p₂ as in diagram 2. Once this short-run inflation has occurred, inflation will stop. For inflation to persist there must be a continuous shift in AD to the left from say AD₁ to AD₂ then to AD₃ and so on. In this process, real national income rises with inflation rate. However, the rise in national income will diminish for every increase in inflation rate when the slack in the economy lessens, i.e. the AS becomes more vertical. If AS becomes vertical where the economy is operating at full potential then any shift in the AD has no effect on real national output but only causes an increase in price level. That is excess demand bids up the prices of the fixed real output. "Too much money chasing after too few goods and services." A demand-pull inflation can cause a runaway inflation especially reinforced by wage-price spiral. A demand-pull inflation is typically associated with a booming economy and is the counterpart of demand-deficient unemployment.

Diagram 2. Demand-pull inflation

DPI originates in the monetary sector. Mon­etarists’ argument that “only money matters” is based on the assumption that at or near full employment excessive money supply will in­crease aggregate demand and will, thus, cause inflation. An increase in nominal money supply shifts aggregate demand curve rightward. This enables people to hold excess cash bal­ances. Spending of excess cash balances by them causes price level to rise. Price level will continue to rise until aggregate demand equals aggregate supply. Keynesians argue that inflation originates in the non-monetary sector or the real sector. Aggregate demand may rise if there is an increase in consumption expenditure following a tax cut. There may be an autonomous increase in business investment or government expendi­ture. Government expenditure is inflationary if the needed money is procured by the gov­ernment by printing additional money.

In brief, increase in aggregate demand i.e., in­crease in (C + I + G + X – M) causes price level to rise. However, aggregate demand may rise following an increase in money supply gen­erated by the printing of additional money (classical argument) which drives prices up­ward. Thus, money plays a vital role. That is why Milton Friedman argues that inflation is always and everywhere a monetary phenom­enon. There are other reasons that may push ag­gregate demand and, hence, price level up­wards. For instance, growth of population stimulates aggregate demand. Higher export earnings increase the purchasing power of the exporting countries. Additional purchasing power means additional aggregate demand. Purchasing power and, hence, aggregate de­mand may also go up if government repays public debt.

Again, there is a tendency on the part of the holders of black money to spend more on conspicuous consumption goods. Such tendency fuels inflationary fire. Thus, DPI is caused by a variety of factors.

2. Cost-push (supply-side inflation) is the inflation caused by persistent increase in the costs of production. It explains rising prices in terms of factors which raise per unit production cost. Cost-push inflation tends to be self-limiting. The amount of increase in price level depends on the steepness of AS curve.

(i) Wage-push inflation:Theoretically sound because labor costs usually take up 2/3 of production costs. Labour Unions demand wage hike independent of the demand for labour and successful negotiations lead to increase in wage rates. Costs of production increase and AS shifts to the left as in diagram 3 above. Price level increases and real national income/output decreases as in diagram 3. However, the power of labour union is waning in many countries.

(ii) Supply shock variant: "cost-push" due to unanticipated increase in the costs of raw materials or energy inputs. AS shifts to the left. E.g. 1973-74, 1979-80 and the recent (2007/8-) oil shocks. Inflation due to the persistent increase in the price of imported oil can be termed import-price-push inflation.

Exhaustion of natural resources lead to AS shifting to the left and causes inflation. A temporary inflation can also happen when faced by a bad harvest of grains and natural disasters that destroyed production capacities. Theoretically, a temporary deflation can happen with a bumper harvest. However, the latter case is more unlikely because prices tend to be sticky.

(iii) Profit-push inflation in which firms use their monopoly powers to push up prices independent of demand.

(iv) Tax-push inflation due to an increase say VAT.

 

Diagram 3. Cost-push inflation

In the real world it is often difficult to distinguish Demand-pull from Cost-push inflation. In fact, in most cases they occur together and interact with each other (see diagram 4 below). Say an increase in AD from AD₁ to AD₂ leads to a movement along the AS₁ curve and results in higher price level and output. Inflation can lead workers to demand a wage increase and AS shifts to the left from AS₁ to AS₂. There is a movement along the new AD₂ and results in higher price level and a fall in output. People with more income will further shifts AD from AD₂ to AD₃ which increase price level and output. This set up another round of wage demand and AS shifts to the left again. Inflation rises again but output may not have change so much form the initial level.

It is the cost factors that pull the prices up­ward. One of the important causes of price rise is the rise in price of raw materials. For in­stance, by an administrative order the govern­ment may hike the price of petrol or diesel or freight rate. Firms buy these inputs now at a higher price. This leads to an upward pres­sure on cost of production. Not only this, CPI is often imported from outside the economy. Increase in the price of petrol by OPEC com­pels the government to increase the price of petrol and diesel. These two important raw materials are needed by every sector, espe­cially the transport sector. As a result, trans­port costs go up resulting in higher general price level.

Again, CPI may be induced by wage-push inflation or profit-push inflation. Trade unions demand higher money wages as a compen­sation against inflationary price rise. If in­crease in money wages exceed labour produc­tivity, aggregate supply will shift upward and leftward. Firms often exercise power by push­ing prices up independently of consumer de­mand to expand their profit margins. Fiscal policy changes, such as increase in tax rates also leads to an upward pressure in cost of production. For instance, an overall in­crease in excise tax of mass consumption goods is definitely inflationary. That is why govern­ment is then accused of causing inflation.

Finally, production setbacks may result in decreases in output. Natural disaster, gradual exhaustion of natural resources, work stop­pages, electric power cuts, etc., may cause ag­gregate output to decline. In the midst of this output reduction, artificial scarcity of any goods created by traders and hoarders just simply ignite the situation. Inefficiency, corruption, mismanagement of the economy may also be the other reasons. Thus, inflation is caused by the interplay of various factors. A particular factor cannot be held responsible for any inflationary price rise.

 

Diagram 4. Interaction between demand-pull inflation and cost-push inflation

Structural (demand-shift) Inflation is inflation caused by the structural change in the pattern of demand or supply in an economy.
The previous two types of inflation are short-run phenomenon while structural inflation can be more permanent. A structural change in the pattern of demand can lead to certain industries or industries concentrated in a certain region going out of business. If prices and wages are sticky downwards in the contracting industries and prices and wages rise in the expanding industries then the economy will still experience an over all increase in price level. The rate of inflation will rise further if the contracting industries cause a reduction in aggregate supply and AS shifts to the left as in diagram 3 above. People who lives in a region in which a contracting industries used to dominate will suffer from both structural unemployment and structural inflation.

Expectations and Inflation. Inflation is influenced by people's expectation of future inflation as much as by shift in AS and/or AD curves. If people expects inflation to be high in future then their action will cause a higher inflation rate. For example, if consumers expects inflation to rise in near future then they will buy now before the actual price increase. One easy way to model this expectation is to use adaptive expectation in which data from today or now is used to predict rate tomorrow. For instance, if the inflation rate is 3% this month then we expect next month's inflation is 3% under adaptive expectation. Another way to model expectation is to use rational expectation where all available information is used to predict rate tomorrow.

Measures to deal with Inflation

1. Fiscal Policy
   1. To combat Demand-pull inflation (where AS is vertical), a government can use deflationary or contractionary policy to reduce the rate of growth of aggregate demand. This can be done by increase income tax and cutting government spending.
   2. Cost-push inflation, government can lower corporate tax, lower income tax, and lower government spending (reduces the crowding out effect) to encourage investment and higher productivity.
      In order to reduce the rate of increase in costs of production, a government can also use supply side policy of restraining the bargaining power of labour union, and to provide incentives, grants, and subsidies for firms to increase productivity. These programmes can involve encouraging R&D, subsidies and tax break for investing in productivity enhancing technology, and training schemes for workers. If inflation is fueled by increase in food prices such as rice due to poor and inadequate supply then government can increase subsidise to the cultivation of rice as happen in Malaysia. The effect of supply-side is not immediate. Furthermore, subsidies and grants may actually increase AD that adds to demand-pull inflation.
2. Monetary Policy that reduces money supply and increases interest rates.
3. Income Policy – inflation adjustment index. Allow a Cost of Living Adjustment (COLA) index be built into employment contract so to reduce the inflation burden on fixed income earners. This COLA index will also improve efficiency as it does away with the need of labour unions negotiating for a wage increase substantially above the inflation rate that may cause further cost-push inflation.
4. Exchange rate policies – pegging, exchange rate regime. If inflation is caused by an inflow of hot money from abroad that raises AD then government can stop this flow of hot money by placing restriction on the movement of speculative money, say into the stock markets. Local currency becomes not freely convertible in the foreign currency market.
5. Targets- expectation : Inflation Target : the rationale here is that when public knows the objective of inflation target then the public can anticipate policy actions. If public is convinced of the efficacy of government target then it will be easier for this target to be met and inflation be kept within target.
6. Hyperinflation case: A government in this case has to modify public's expectation and build public confidence in local currency. A change in government and/or monetary authority that is committed to fight inflation can be helpful to modify public's expectation. A commitment to tight monetary policy is reflected by a controlled government spending, immediate stop to a policy of excess monetary growth, a new currency with smaller denominations, and transparency in fighting inflation. Transparency can means reporting the statistical figures of money supply, government spending and inflation regularly to public. Sometimes, a country experiencing an hyperinflation will need to switch and adopt the use of hard currencies like US dollar to stop the hyperinflation from spiralling up.

Effects of Inflation:

People’s desires are inconsistent. When they act as buyers they want prices of goods and services to remain stable but as sellers they expect the prices of goods and services should go up. Such a happy outcome may arise for some individuals; “but, when this happens, others will be getting the worst of both worlds.”

When price level goes up, there is both a gainer and a loser. To evaluate the conse­quence of inflation, one must identify the na­ture of inflation which may be anticipated and unanticipated. If inflation is anticipated, peo­ple can adjust with the new situation and costs of inflation to the society will be smaller.

In reality, people cannot predict accurately fu­ture events or people often make mistakes in predicting the course of inflation. In other words, inflation may be unanticipated when people fail to adjust completely. This creates various problems.

One can study the effects of unanticipated inflation under two broad head­ings:

(a) Effect on distribution of income and wealth; and

(b) Effect on economic growth.

(a) Effects of Inflation on Distribution of Income and Wealth:

During inflation, usu­ally people experience rise in incomes. But some people gain during inflation at the ex­pense of others. Some individuals gain be­cause their money incomes rise more rapidly than the prices and some lose because prices rise more rapidly than their incomes during inflation. Thus, it redistributes income and wealth.

Though no conclusive evidence can be cited, it can be asserted that following catego­ries of people are affected by inflation differ­ently:

(i) Creditors and debtors:

Borrowers gain and lenders lose during inflation because debts are fixed in rupee terms. When debts are repaid their real value declines by the price level increase and, hence, creditors lose. An individual may be interested in buying a house by taking loan of Rs. 7 lakh from an in­stitution for 7 years.

The borrower now wel­comes inflation since he will have to pay less in real terms than when it was borrowed. Lender, in the process, loses since the rate of interest payable remains unaltered as per agree­ment. Because of inflation, the borrower is given ‘dear’ rupees, but pays back ‘cheap’ ru­pees. However, if in an inflation-ridden economy creditors chronically loose, it is wise not to advance loans or to shut down business.

Never does it happen. Rather, the loan-giving institution makes adequate safeguard against the erosion of real value. Above all, banks do not pay any interest on current account but charges interest on loans.

(ii) Bond and debenture-holders:

In an economy, there are some people who live on interest income—they suffer most. Bondhold­ers earn fixed interest income: These people suffer a reduction in real income when prices rise. In other words, the value of one’s sav­ings decline if the interest rate falls short of inflation rate. Similarly, beneficiaries from life insurance programmes are also hit badly by inflation since real value of savings deterio­rate.

(iii) Investors:

People who put their money in shares during inflation are expected to gain since the possibility of earning of business profit brightens. Higher profit induces own­ers of firm to distribute profit among inves­tors or shareholders.

(iv) Salaried people and wage-earners:

Any­one earning a fixed income is damaged by in­flation. Sometimes, unionised worker suc­ceeds in raising wage rates of white-collar workers as a compensation against price rise. But wage rate changes with a long time lag. In other words, wage rate increases always lag behind price increases. Naturally, inflation results in a reduction in real purchasing power of fixed income-earners.

On the other hand, people earning flexible incomes may gain during inflation. The nominal incomes of such people outstrip the general price rise. As a re­sult, real incomes of this income group in­crease.

(v) Profit-earners, speculators and black marketers:

It is argued that profit-earners gain from inflation. Profit tends to rise during inflation. Seeing inflation, businessmen raise the prices of their products. This results in a bigger profit. Profit margin, however, may not be high when the rate of inflation climbs to a high level.

However, speculators dealing in business in essential commodities usually stand to gain by inflation. Black marketers are also ben­efited by inflation.

Thus, there occurs a redistribution of in­come and wealth. It is said that rich becomes richer and poor becomes poorer during infla­tion. However, no such hard and fast gener­alisation can be made. It is clear that someone wins and someone loses during inflation.

These effects of inflation may persist if in­flation is unanticipated. However, the redistributive burdens of inflation on income and wealth are most likely to be minimal if inflation is anticipated by the people. With anticipated inflation, people can build up their strategies to cope with inflation.

If the annual rate of inflation in an economy is anticipated correctly people will try to protect them against losses resulting from inflation. Workers will demand 10 p.c. wage increase if inflation is expected to rise by 10 p.c.

Similarly, a percent­age of inflation premium will be demanded by creditors from debtors. Business firms will also fix prices of their products in accordance with the anticipated price rise. Now if the en­tire society “learn to live with inflation”, the redistributive effect of inflation will be mini­mal.

However, it is difficult to anticipate prop­erly every episode of inflation. Further, even if it is anticipated it cannot be perfect. In addi­tion, adjustment with the new expected infla­tionary conditions may not be possible for all categories of people. Thus, adverse redistributive effects are likely to occur.

Finally, anticipated inflation may also be costly to the society. If people’s expectation regarding future price rise become stronger they will hold less liquid money. Mere hold­ing of cash balances during inflation is unwise since its real value declines. That is why peo­ple use their money balances in buying real estate, gold, jewellery, etc. Such investment is referred to as unproductive investment. Thus, during inflation of anticipated variety, there occurs a diversion of resources from priority to non-priority or unproductive sectors.

(b) Effect on Production and Economic Growth:

Inflation may or may not result in higher output. Below the full employment stage, inflation has a favourable effect on production. In general, profit is a rising function of the price level. An inflationary situation gives an incen­tive to businessmen to raise prices of their prod­ucts so as to earn higher volume of profit. Ris­ing price and rising profit encourage firms to make larger investments. As a result, the multi­plier effect of investment will come into opera­tion resulting in a higher national output. How­ever, such a favourable effect of inflation will be temporary if wages and production costs rise very rapidly.

Further, inflationary situation may be as­sociated with the fall in output, particularly if inflation is of the cost-push variety. Thus, there is no strict relationship between prices and output. An increase in aggregate demand will increase both prices and output, but a supply shock will raise prices and lower output. Inflation may also lower down further pro­duction levels. It is commonly assumed that if inflationary tendencies nurtured by experi­enced inflation persist in future, people will now save less and consume more. Rising sav­ing propensities will result in lower further outputs. One may also argue that inflation creates an air of uncertainty in the minds of business community, particularly when the rate of in­flation fluctuates. In the midst of rising infla­tionary trend, firms cannot accurately estimate their costs and revenues. That is, in a situa­tion of unanticipated inflation, a great deal of risk element exists. It is because of uncertainty of expected inflation, investors become reluc­tant to invest in their business and to make long-term commitments. Under the circum­stance, business firms may be deterred in in­vesting. This will adversely affect the growth performance of the economy.

However, slight dose of inflation is neces­sary for economic growth. Mild inflation has an encouraging effect on national output. But it is difficult to make the price rise of a creep­ing variety. High rate of inflation acts as a dis­incentive to long run economic growth. The way the hyperinflation affects economic growth is summed up here. We know that hyper-inflation discourages savings. A fall in savings means a lower rate of capital forma­tion. A low rate of capital formation hinders economic growth. Further, during excessive price rise, there occurs an increase in unpro­ductive investment in real estate, gold, jewel­lery, etc. Above all, speculative businesses flourish during inflation resulting in artificial scarcities and, hence, further rise in prices.

Again, following hyperinflation, export earn­ings decline resulting in a wide imbalances in the balance of payment account. Often gallop­ing inflation results in a ‘flight’ of capital to foreign countries since people lose confidence and faith over the monetary arrangements of the country, thereby resulting in a scarcity of resources. Finally, real value of tax revenue also declines under the impact of hyperinfla­tion. Government then experiences a shortfall in investible resources. Thus economists and policymakers are unanimous regarding the dangers of high price rise. But the consequence of hyperinfla­tion are disastrous. In the past, some of the world economies (e.g., Germany after the First World War (1914-1918), Latin American coun­tries in the 1980s) had been greatly ravaged by hyperinflation.