INFLATION & DEFLATION

Concept and Definition of Inflation

In general, inflation means the increase in general price level or decrease in purchasing power of money (or value of money). Inflation usually refers to a general rise in the level of prices of goods and services over a period of time. This is also referred to as price inflation. The term inflation originally referred to the debasement of currency, and was used to describe increases in the money supply; however, debates regarding cause and effect have led to its primary use today in describing price inflation. Inflation can also be described as a decline in the real value of money. When the general level of prices rises, each monetary unit buys fewer goods and services. Inflation is measured by calculating the inflation rate, which is the percentage rate of change for a price index, such as the consumer price index.

Economists generally agree that high rates of inflation and hyperinflation are caused by high growth rates of the money supply. Views on the factors that determine moderate (neither large nor small) rate of inflation are more varied. However, there is general consensus that in long run, inflation is caused by money supply increasing faster than the growth rate of the economy.

Inflation originally referred to the debasement of the currency, where gold coins were collected by the government, melted down, mixed with other metals and reissued at the same nominal value. By mixing gold with other metals, could increase the total number of coins issued using the same amount of gold. However, this action of government increased the money supply, and lower the relative value of money. As the real value of each coin had decreased, the consumer had to pay more coins in exchange for goods and services of the some value. In the 19th century, the word inflation started to appear as a direct reference to the action of increasing the amount of currency units by the central bank.

In some schools of economics and particularly in the United States in the 19th century, inflation originally was used to refer to increase of the money supply, while deflation meant decreasing it. However classical political economists from Hume to Ricardo did distinguish between and debate the cause and effect: Balloonists, for example, argued that the Bank of England had over-issued banknotes and caused the depreciation of bank notes (Price inflation).

There are many definitions of inflation. By inflation most people understand a sustained and substantial rise in prices. For example, Crowther defines inflation as a state in which the value of money is falling, i.e., prices are “rising”. According to Harry G. Johnson, “we define inflation as substantial increase in prices”. Milton Friedman writes: “By inflation I shall mean a steady and sustained rise in prices.”

According to these definitions, inflation is a process of change in the economy which has the following features:

(1) There is an abnormal-more than 8% rise in the price level;

(2) The price level rises continuously for over 2-3 years;

(3) Too much money chases too few goods. That is, there is an excessive supply of money in relation to the supply of goods and services demanded by the people.

Types of Inflation

Inflation in all countries are not the same types. In some countries, prices increases very slowly while in some countries price increases very rapidly. Therefore, experience tells us that there are many types of inflation. We explain below the various ways in which these types of inflation can be classified. This classification is based on different considerations.

(1)        On the basis of rapidity with which prices rise, inflation may be classified into four types:

(a)  Creeping Inflation: It is the mildest form of inflation and is not considered to have any dangerous effects on the economy. Slow Price increased is called creeping inflation in which prices rise by not more than 3% Per annum.

(b) Walking Inflation:     The next stage, from the point of view of rapidity of inflation, is walking inflation. When creeping inflation continues over a decade and prices rise from 30% to 40%, this may be described as walking inflation.

(c) Running Inflation: When the speed price-rise increases, walking inflation gets converted into running inflation. Running inflation would record a 100% increase in price over a period of ten years.

(e) Galloping or Hyper Inflation: In galloping inflation, prices rise every moment. The prices may rise by 100% within a year. Hyper inflation is an indication of serious disequilibrium in the economic system.

Above given four stages of inflation can be illustrated graphically as follows:

In above given figure, time period is measured along on X-axis and inflation rate on Y-axis. ‘C’ represents creeping inflation. In this situation, it takes around 10 years for the increase in price by 10% ‘W’ represents the walking inflation. In this type of inflation, price increases by 30% to 40% in the period of 10 years. ‘R’ represents the running inflation. In such a situation, price increases by 100% in 10 years. ‘H’ represents the hyper inflation or galloping inflation. In this type of inflation, price increases by 100% in a one year of time period.

(2)        On the basis of the processes through which it is induced, inflation may be classified into three types;

(a) Deficit-induced inflation: Deficit-induced inflation is that which is the result of continuous deficit financing by the government.

(b) Wage-induced inflation: Wage-induced inflation is that which is caused by a faster increase in money wages than the productivity increases allow.

(c) Profit-induced inflation: profit-induced inflation is that which is due to a sustained increase in the profits of the manufacturers due to monopoly influences.

(3)        On the Basis of Time, inflation may also be classified into three types;

(a)  War-time inflation: War-time inflation emerges when the government spends more than its revenue. The government uses a considerable portion of available output. Hence, there is a downward shift of supply to the civilian population thereby giving rise to an inflationary gap.

(b) Post-war inflation: Post-war inflation occurs because the government may withdraw war-time taxes. This would add to the disposable income of the community. Besides this, the excess liquidity accumulated during war-time might manifest itself into excessive demand and therefore, lead to inflation.

(c) Peace-time Inflation: Inflation in normal times is called peace-time inflation. For example, the inflation experienced in under-developed countries due to excessive aggregate expenditures is peace-time inflation.

(4)     On the basis of scope, inflation is considered to be of two types: Comprehensive inflation and sporadic inflation. When there is a general rise in prices and the prices of all the commodities increases, this is comprehensive inflation. Whereas comprehensive inflation is economy-wide, sporadic inflation is of sectoral nature. Sporadic inflation results when aggregate supply is limited by physical conditions and can not be expanded quickly.

(5)        Inflation may also be classified into ‘Open’ inflation and ‘suppressed’ inflation. In open inflation, prices rise freely without any government intervention. A suppressed inflation is one in which government attempts to suppress the manifestation of inflationary pressures by controlling prices, exchange rates and credit creation by bank. The Hyper inflation in 1920’s in Germany, Hungary, Russia were examples of open inflation. Inflation in Germany after the Second World-War was an example of suppressed inflation.

Causes of Inflation

In the long run inflation is generally believed to be a monetary phenomenon while in the short-run and medium term it is influenced by the relative elasticity of wages, prices and interest rates.

A great deal of economic literature concerns the question of what causes inflation and what effect it has. There are different schools of thought as to what causes inflation. However, inflation in the economy will occur due to two factors, i.e., increase in effective demand and increase in production cost. The inflation caused by the increase in demand is known as demand-pull inflation and on the other hand, the inflation caused by the increase in cost of production is known as cost-push inflation. There are many other factors within these two reasons which are explained below.

  • Demand-pull Inflation

Demand-pull inflation caused by increase in aggregate demand due to increased private and government spending, etc. Demand-pull inflation is constructive to a faster rate of economic growth since the excess demand and favorable market conditions will stimulate investment and expansion. The demand-pull inflation occurs when the aggregate demand exceeds the available supply of goods and Services in existence. The process of demand-pull inflation is when the supply of money increases, rate of interest falls. This increases the investment which increases money income. As a result, the expenditure on consumption goods and investment expenditure increases. Due to this, demand increases than supply and the demand-pull inflation occurs. This can be illustrated with the help of figure;

In the figure given above, ‘AS’ is the given aggregate supply curve of the economy and each aggregate demand curve (AD0 to AD4) Shows the level of aggregate demand associated with the rising levels of money income in the economy when aggregate demand increases from AD0 to AD2, output as well as prices increase. But as the level of full employment is reached at Qf and the supply curve becomes perfectly inelastic, increases in income beyond AD2 lead to what Keynes termed “true inflation”. The rise in prices upto P2 is called “bottleneck inflation”, which is due to imbalances, shortages and rising costs in the economy as the level of full employment is approached. Beyond the point E, the aggregate supply function is assumed to be vertical and prices are rising directly due to increases in the level of money income.

According to this concept, the inflation occurs when the demand further increases after reaching the state of full employment. In such situation aggregate demand will be more than the aggregate supply because after the state of full employment supply won’t increase despite the increase in demand. Thus, price of goods will increase. This is known as demand-pull inflation.

Causes of demand-pull inflation

Demand-pull inflation caused by the following factors:

(i) Increase in the quantity of money:

The demand for goods increases rapidly when the quantity of money increases rapidly in the economy. So, increase in demand due to increase, in the quantity of money creates the ‘demand-pull inflation’.

(ii) Increase in public expenditure:

            In modern time, the government spends more than revenue due to the increase in government activities. This creates fiscal deficit. Some part of the deficit is met by the government by printing new notes on account of this the expansion of money increases and inflation occurs.

(iii) Reduction in taxation:

            If the government reduces taxes, households are left with more disposable income in their pockets. This leads to increase consumer spending. Thus, increasing aggregate demand and eventually causing demand-pull inflation.

(iv) Shortage of goods and services:

The price level increases when the supply of goods and services is lower in relation to demand. The production and supply decrease due to the scarcity of factors of production, hoarding by businessmen, natural calamity, scarcity of raw-materials, etc.

(v) Redistribution of income:

Redistribution of income will increase the demand for goods and services. This is because increase in the income of the people will increase their propensity to consume. Increase in consumption will increase the demand which will lead to increase in price and the ‘demand-pull inflation’ will be resulted.

  • Cost-Push Inflation

Cost-push inflation is also called “supply shock inflation”, caused by drops in aggregate supply due to increased prices of inputs, for example. Take for instance a sudden decrease in the supply of oil which would increase oil prices. Producers for whom oil is a part of their costs could then pass this on to consumers in the form of increased prices.

Inflation is also caused by increase in the cost of production. As a result of increase in the cost of production, the aggregate supply declines in relation to existing demand of goods and services. Thus, the inflation that occurs due to the pressure of cost is called cost-push inflation. Cost-push inflation can be illustrated with the help of figure:

 

In above given diagram, aggregate output is shown on the horizontal axis and price level is shown on the vertical axis, ‘AS’ is the aggregate supply curve and ‘AD’ is the aggregate demand curve. Let us suppose that the economy is in equilibrium at the full employment level at the point where output is Q0. The corresponding price level is P0. Now, let us further suppose that there is an upward shift of costs of production from the position of AS0 to AS1. If the money income remains at the same level equilibrium output will fall to Q1 and the price level will rise to P1. Similarly, if the supply function assumes the position AS2, output will diminish to Q2 and prices will be pushed up to P2. This rise in the price level is commonly known as cost push inflation.

The causes of cost push inflation are explained as follows:

(1) Wage- Induced inflation (wage-push Inflation) :

Wage- induced inflation caused by the use of bargaining power of trade unions in raising per unit wage costs. Where trade unions have strong bargaining power, even when the worker’s productivity does not rise, they are able to get wage rates pushed up. Such pushes will lead to autonomous shift in the cost of production even if aggregate demand and level of income remain unchanged. When wages are increased without any corresponding rise in productivity, the resultant upward shift in the aggregate supply function will lead to cost-push inflation.

(2) Profit-induced inflation (profit-push inflation):

Another cause of cost-push inflation is the profit-push. It can occur only under imperfectly competitive markets. Where the monopolists and the oligopolists raise prices of their products more than the increase in cost, this may lead to cost-push inflation.

(3) International Reasons (Supply-Shock inflation): 

Every country of the world will have some kind of business or economic relationship with other countries. The countries like Nepal are dependent on foreign countries for construction materials, raw materials, every including consumer goods. Hence, if the prices of these goods increase in foreign countries, the price in Nepal also automatically increase. If the inflation occurs due to price raised by foreign countries such as the price of petroleum by OPEC, it is know as ‘supply-shock’ inflation.

Effects of Inflation

             An increase in the general level of prices implies a decrease in the real value of money. That is, when the General level of prices rises, each monetary unit buys fewer goods and services. Many people are willing to accept inflation if it can provide full employment because then it is a small price to pay. But we should not underestimate the socially unacceptable effects of inflation. It is true that unemployment is an economic as well as a social evil but this should not blinds to the evils of inflation. We explain below now inflation affects the economic, social, political and moral life of the people.

In general, high or unpredictable inflation rates are regarded as bad for following reasons:

  • Uncertainty:

Uncertainty about future inflation may discourage investment and saving.

  • Redistribution:

Inflation redistributes income from those on fixed incomes, such as pensioners, and shifts it to those who draw a variable income, for example from wages and current profits which may keep pace with inflation. The real value of retained profits is destroyed at the rate of inflation as the historical cost balances stay fixed like pensioners fixed income. However, debtors may be helped by inflation due to reduction of the real value of debt burden

  • International Trade:

Where fixed exchange rates are imposed, higher inflation than in trading partners economies will make exports more expensive and tend toward a weakening balance of trade. A sustained higher level of inflation than in the trading partners economies will also, over the long-run, put upward pressure on the implicit exchange rate making the fix unsustainable and potentially inviting an exchange rate crisis.

  • Cost-push inflation:

Rising inflation can prompt trade unions to demand higher wages, to keep up with consumer prices. Rising wages in turn can help fuel inflation. In the case of collective bargaining, wages will be set as a factor of price expectations. This will be higher when inflation has an upward trend. This can cause a wage spiral. In a sense, inflation begets further inflationary expectations.

  • Hoarding:

People buy consumer durables as stores of wealth in the absence of viable alternatives as a means of getting  rid of excess cash before it is devalued, creating shortages of the hoarded objects.

  • Hyperinflation:

In inflation gets totally out of control, it can grossly interfere with the normal working of the economy, hurting its ability to supply.

Some possibly positive effects of inflation include:

Keynesians believe that nominal wages are slow to adjust downwards. This can lead to prolonged disequilibrium and high and high unemployment in the labors market. Since inflation would lower the real wage if nominal wages are kept constant, Keynesian argue that some inflation is good for the economy. As it would allow labour markets to reach equilibrium faster.

The primary tools for controlling the money supply are the ability to set the discount rate, the rate at which banks can borrow from the central bank, and open market operations which are the central bank’s interventions into the bonds market with the aim of affecting the nominal interest rate. If an economy finds itself in a recession with already low, or even zero, nominal interest rates, then the bank cannot cut these rates further in order to stimulate the economy-this situation is known as a liquidity trap. A moderate level of inflation tends to ensure that nominal interest rates rather than the money supply in determining inflation.

 

A fundamental concept in inflation analysis is the relationship between inflation and unemployment, called the Phillips curve. This model suggests that there is a trade-off between price stability and employment. Therefore, some level of inflation could be considered desirable in order to minimize unemployment.

Remedies or measures to Control Inflation

Today most central banks are tasked with keeping inflation at a low level, normally 2 to 3% per annum within the targeted low inflation range which could range from 2 to 6% per annum.

It has been noted that inflation inflicts much suffering on the helpless people and disrupts society economically, socially, morally and politically. Hence, there is need for controlling inflation. There are a number of methods that have been suggested to control inflation. Control of inflation requires an integrated set of measures which may be classified as monetary, fiscal, direct controls and other measures.

  • Monetary measures:

             The central Bank should use both quantitative and qualitative techniques of credit control in order to achieve the objective of controlled expansion of credit. Central banks such as the U.S. Federal Reserve can affect inflation to a significant extent through setting interest rates and through other operations (i.e., using monetary policy). High interest rates and slow growth of the money supply are the traditional ways through they have different approaches. For instance, some follow a symmetrical inflation target while others only control inflation when it rises above a target, whether express or implied.

Monetarists emphasize increasing interest rates to fight inflation. Keynesians emphasize reducing demand in general often through fiscal policy, using increased taxation or reduced government spending to reduce demand as well as by using monetary policy. Supply-side economists advocate fighting inflation by fixing the exchange rate between the currency and some reference currency such as gold. This would be a rerun to the gold standard. All of these policies are achieved in practice through a process of open market. The bank rate may be raised; Securities may be sold in the open market and even resource ratios may, be increased. These steps would curb credit expansion by the commercial banks and hence control inflationary pressures in the economy.

However, anti-inflationary monetary policy suffers from certain limitations. First, since marginal efficiency of investment is too high during inflationary period, investment may become interest inelastic. Besides this, if the banks have excess reserves, the central banking techniques of monetary management may not be of much use in combating inflation. Similarly, if there is deficit induced inflation, the Central Bank can hardly do any thing to curtail the excessive monetary demand which has arisen due to structural deficiencies.

Notwithstanding its limitations, monetary policy has a role. It can assist in the expansion of productive sectors of the economy and restrict speculative inventory build-ups. In short, we may say that monetary measures should be used along with other measures to keep the inflation under control, even though its role is relatively a modest one.

  • Fiscal Measures

             The policy related to public expenditure, public revenue and public debt is known as fiscal policy. The main anti-inflationary fiscal measures are as follows:

(1) Reduction in public expenditure:

            Increase in the volume of public expenditure can contribute much to inflation by increasing the disposable income in the hands of the people. Moreover, public expenditure, being autonomous in nature, has a multiplier effect on the levels of income, output and employment of the country. Therefore, reduction in government spending is bound to reduce inflationary pressure.

(2) Increase in Taxes:

Mobilization of additional resources in the form of higher taxation also helps in combating inflation. As more taxes are imposed, the size of disposable income is reduced and thus the inflationary gap is narrowed down. All this effort will help in reducing the inflationary pressures in the country.

(3) Control over Deficit Financing:

            Deficit financing has been held to be the root cause of inflation in many countries. Excessive deficit financing and the resultant increase in money supply often lead to inflationary pressures. Therefore, the government should keep its deficits to the minimum possible when the economy is threatened with inflation.

(4) Increase in public Borrowings:

            During inflationary period, the government may launch a campaign to increase savings and thus reduces the extra purchasing power. The government may offer to the people bonds which bear attractive interest rates. If price rise assumes an alarming proportion, the government may force the people to save some portion of their incomes compulsorily. Ultimately, these activities of the government controls inflation. Despite it has some imitations, but fiscal measures are important instruments of anti-inflationary strategy. When used in co-ordination with monetary policy, fiscal policy serves a very useful purpose in fighting inflation.

  • Other Measures

             Apart from monetary and fiscal measures, direct controls and other measures may also be used to control inflation. Direct measures may be both voluntary and compulsory. The people may be persuaded to save more by restraining expenditure on inessential consumer goods. But direct measures may also contain an element of compulsion. The government may take certain compulsory deductions from salaries and wages to credit it to the employee’s saving fund account. Thus, a part of purchasing power of the people can be kept blocked as long as the inflationary pressures are not relieved.

Direct measures also include price controls and rationing. Price control and rationing may prove helpful in arresting inflationary pressures only if an efficient public distribution system exists. Shortages of essential consumer goods will encourage black market transactions and the scope of black money will also increase. Therefore, direct controls must be accompanied by an active enforcement mechanism.

During the period of galloping inflation, an appropriate income policy may also have to be controlled. Ceilings on wage payments and also on dividend payments may be imposed. These policies will keep down the disposable income and narrow down the inflationary-gap. On the other side, checks on wages and profits keep the cost of production low and hence const-push inflation will be checked.

The ultimate remedy against inflation lies in increasing production in all the sectors, for anti-inflation measures are only short-run measures. Intensive farming and full use of industrial capacity can go a long way in controlling inflation. In fact, it is the effective remedy for inflation.

The contribution of non-economic factors in combating inflation should also not be minimized. Peaceful atmosphere, political stability, firm and dynamic leadership, efficient and honest administration, promoting standards of efficiency and sense of responsible citizenship are the prerequisites for any sound policy to combat inflation.

Thus, we find that in order to control inflation we need a multipronged policy of co-ordinating short-period and long-period measures. Only then, we can hope to keep

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