Inflation
Unit-3
Inflation
Inflation is the rate of increase in prices over a given period of time.
Inflation is typically a broad measure, such as the overall increase in prices or the
increase in the cost of living in a country.
Features of Inflation:
1. Persistent rise in prices
2. Excessive money supply
3. Vicious circle of spiral inflation
Types of Inflation ( Based on rate of inflation)
● Creeping inflation (1-4%)
● Walking inflation (>4 to 10%)
● Running inflation (10-20%)
● Galloping inflation (20%-1000%)
● Hyperinflation (> 1000%)
Based on causes
Inflation means a sustained increase in the general price level. The main two types
of inflation are
● Demand-pull inflation – this occurs when the economy grows quickly and
starts to ‘overheat’ – Aggregate demand (AD) will be increasing faster than
aggregate supply (LRAS).
● Cost-push inflation – this occurs when there is a rise in the price of raw
materials, higher taxes, e.t.c
Demand-pull inflation
This occurs when AD increases at a faster rate than AS. Demand-pull inflation will typically occur when the
economy is growing faster . If demand exceeds supply, firms will respond by pushing up prices.
● If aggregate demand (AD) rises
faster than productive capacity
(LRAS), then firms will respond
by putting up prices, creating
inflation.
● Inflation – a sustained
increase in the price level.
● Demand-pull inflation – inflation
caused by AD increasing faster
than AS.
● Excess demand and ‘too much money chasing too few goods.’
● The economy is at (or very close to) full employment/full capacity.
● The economy will be growing at a rate faster than the long-run trend rate.
● A falling unemployment rate.
Causes demand pull inflation
● Lower interest rates.
● Rising wages.
● Devaluation.
● Rise in govt expenditure
● Expansionary monetary and Fiscal policy
● Low rate of taxes
Cost -push inflation
● Cost-push inflation (also known as wage-push inflation) occurs when overall
prices increase (inflation) due to increases in the cost of wages and raw
materials.
● Higher costs of production can decrease the aggregate supply (the amount of
total production) in the economy. Since the demand for goods hasn't
changed, the price increases from production are passed onto consumers
creating cost-push inflation.
Causes for the cost-push inflation
Cost-push inflation
Effects of Inflation
1. Decreases the purchasing power
2. Increases the spending
3. Encourages investment
4. Lowers the interest rates
5. Increases growth
6. Rises the employment level
7. Production activities suffer
8. High cost of production
9. Less production in market
10. Unemployment rises
11. Income and consumption level decreases
12. Rises rate of interest
Effects of cost -push inflation
1.
Effects of inflation on Economy- Favorable
1. Increase in production
2. Better returns on investment
3. Rise in profit
4. More employment and better income
5. Share market profit rises
Effects of inflation on Economy- Unfavorable
1. Fixed income group - suffer
2. Inequality of rises in distribution of income and wealth
3. Rises the unemployment level
4. Upsets the economic planning
5. Capital formation reduces
6. Export income suffres
7.
Measures to control inflation
Measures to control inflation
Monetary measures ( Central Bank)
1. Credit regulation
2. Demonisting currency
3. Printing new currency
Fiscal policy measure ( Government)
1. Reducing unnecessary expenditure ( Unplanned & non developmental)
2. Increase the tax rate
3. Encourage savings
4. Surplus / Balanced budget
5. Rising public debt
Contd..
Other measures :
1. Increase the production
2. Rational wage policy
3. Price control
Inflationary gap
Inflationary gap
● An inflationary gap, is the amount by which the actual gross domestic product
(GDP) exceeds potential full-employment GDP.
● It is one type of output gap, the other being a recessionary gap.
● The concept of the inflationary gap introduced by John Maynard Keynes in
his work, “How to Pay for War?” (1940).
● In it, the concept was employed to study and solve problems regarding war
finance.
Inflationary gap
● Inflationary gap happens when demand for goods and services is greater than
production as a result of situations like high employment, high government
expenditure, and high levels of trade activity.
● Then, the real GDP ends up higher than the potential GDP—there is an
inflationary gap.
● It’s called an inflationary gap because the higher real GDP leads to higher
levels of consumption throughout the economy, increasing prices over time.
Causes for inflationary gap
1. Expansionary monetary and Fiscal policy
2. Boom stage of trade cycle
3. Over utilization of resources
4. Increase in income level
5. Large scale of production
Effects of inflationary gap
1. Rise in aggregate demand
2. Rise in money supply
3. High prices
4. Low purchasing power
5. Rise in competition between producers
6. Scarcity of resources
How Can Governments Reduce Inflationary Output Gaps?
● Increasing taxes
● Reducing overall government spending
● Reducing transfer payments
● Increasing interest rates
● Issuing govt. bonds and securities
