[Eco-102] Inflation – Concepts-Related Terms-Deflation-Stagflation-Trends-Inflation Targeting and more

Howdy,

As you know Economy as a subject has always been a traditional bottleneck for Civil Services aspirants. This is because most of us did not study it during our school days.

So in this series of articles, we will be taking up the numerous economic jargon, one by one and try to simplify them for you.

We aim to do the above by explaining various economic terms in a simple and a lucid manner. This will be especially beneficial for the students who are going to give their first attempt.

In this article we will discuss the concepts related to Inflation.

Table of Contents

  1. Inflation – Concepts, Definition 
  2. Types of Inflation
    1. Cost Push Inflation
    2. Demand Pull Inflation
    3. Structural Inflation
  3. Effects of Inflation
    1. On Value of Money
    2. On lenders and Borrowers
    3. On Individuals
  4. Related Terms
    1. Deflation
    2. Disinflation
    3. Stagflation
    4. Reflation
    5. Skewflation
    6. Philips Curve
    7. GDP Deflator
    8. Headline Inflation
    9. Core Inflation
    10. Base Effect
  5. Various Indexes related with Inflation
    1. Wholesale Price Index (WPI)
    2. Consumer Price Index (CPI)
  6. Steps to check Inflation
    1. Fiscal Policy
    2. Monetary Policy
    3. Flexible Inflation Targeting

This is going to be a three part series.

In Part 1 (which is this one) we will see the Topic 1,2,3 and 4 of table of contents.
In Part 2 we will learn about the various indexes related to inflation – CPI, WPI etc.
In Part 3 we learn about steps to control Inflation.

Inflation – Concepts, Definition and trends

In this article we are going to understand everything about Inflation. So let us begin with what do you mean by Inflation.

Inflation refers to a sustained/continuous rise in the general price level of goods and services in an economy over a period of time.

Here we must understand that inflation is rise in prices of basket of goods and services. If the price of only one good has gone up (for example, only there is price rise for 1 product), it does not constitute inflation.

Let us try to understand Inflation in terms of Aggregate Demand and Aggregate Supply and General Price level.

Aggregate Demand – It is the total demand of all products (goods and services) in an economy. It consists of four components of demands

      1. Consumption (C)
      2. Investment (I)
      3. Government Spending (G)
      4. Net Exports (i.e. Export-Import) (X-M)

Thus, Aggregate Demand = C + I + G + (X-M)

Aggregate Demand Curve represents the total demand in an economy at different price levels.

Forumias aggregate demand
Above figure shows the Aggregate Demand at different price levels

(Learning – Let us know in the comment section why Aggregate demand Curve always slopes downward)

Now when does aggregate demand curve shift? Which factors are responsible for it? Any change in the four components (mentioned above) will cause a change in the aggregate demand curve. 

For example – Government increases its expenditure (eg – increase in wages of MGNREGA or increase in amount of financial support given by government through PM KISAN), it will increase aggregate demand and aggregate demand curve will shift right. Similarly, Rise in net exports will increase the aggregate demand.

Aggregate Supply – Aggregate supply is the total output of goods and services that firms want to produce at each possible price level.

Forumias aggregate supply
Above diagram represents Aggregate Supply at various price levels

Equilibrium – As per the British Economist, John Maynard Keynes,when economy is functioning at full employment, aggregate supply will match aggregate demand. At this Equilibrium we will have general price level.

Now consider, due to any reason, aggregate demand rises at this equilibrium level, it will lead to inflation. It is because since economy is at full employment, so it is producing at its full capacity. It cannot produce any further. Thus any increase in aggregate demand will result in increase in price levels, i.e. Inflation. This type of inflation is known as Demand Pull Inflation

Similarly, if due to any reason, aggregate supply in economy (at equilibrium) declines, it will also lead to Inflation. This type of Inflation is known as Cost Push Inflation.

Types of Inflation

There are various drivers of inflation. Among them five major drivers are listed below

  1. Aggregate demand for goods and services is rising and it exceeds aggregate supply at full employment level. It is generally referred to as Demand Pull Inflation
  2. Aggregate Supply of goods and services decreases (due to rise in cost of production) while aggregate demand remains constant at full employment level
  3. Structural Inflation

Let’s see them now one by one:

  1. Demand-Pull Inflation
DefinitionWhen price rise because aggregate demand in an economy is greater than the aggregate supply (at full employment level) of goods and services. This rise in demand is such that it cannot be met by currently available supply of output. Demand for goods and services exceeds available supply

Thus there is a situation where too much money chasing few goods and services

Aggregate Demand > Aggregate Supply. Also, since economy is at its full-employment potential, this rise in demand cannot be met by increasing supply. Thus this rise in demand will lead to a rise in price levels resulting in Demand-Pull Inflation.

CausesRemember that the formula of Aggregate Demand which we earlier discussed is 

AD = C +I +G + (X-M). 

So increase in aggregate demand can be due to various factors

  • Rise in Government expenditure. 
    • Rise in MGNREGA wages
    • Rise in financial support given under PM-KISAN
    • Government provides Universal Basic Income (UBI)etc.
  • Steep rise in net exports
    • Suppose farmers in India are exporting huge quantities of foodgrains, onions, etc then demand will not  be met and may lead to demand pull food inflation.
  • Rise in house hold consumption
    • RBI adopts cheap money policy, cheaper credits are available. Thus people’s propensity to spend increases
    • 7th pay commission. People have more money. They spend more.
  • Rise in Private Investmets

ExampleIn the present COVID-19 outbreak, there is huge demand for the masks in India (as several states has made wearing masks compulsory when stepping out). This sudden rise in demand for masks may not be met by suppliers as they did not anticipated this situation. Thus  due to increase in demand, price of masks will increase.

Similarly, suppose Apple launches limited edition iphone with limited stock (supply). If there is huge demand for the iphone, the price will usually rise.

These are the example of single products. It for the entire economy aggregate demand > aggregate supply, then prices of goods and services will go up resulting in demand pull inflation.

Inflationary GapIn case of Demand Pull Inflation, aggregate demand > aggregate supply of goods and services (at full employment)

This excess demand represent Inflationary Gap.

Thus, If aggregate demand exceeds the aggregate value of output at the full employment level, there will exist an inflationary gap in the economy.

The inflationary gap results in price rise. Prices will continue to rise till this gap exists.

For example – Due to rise in government expenditure, purchasing power of people increase. This creates excess demand in an economy resulting in inflationary gap

How to Combat Demand Side InflationSteps have to be taken to reduce the demand. For Example

  • Government going for fiscal consolidation (rather than fiscal stimulus)[Contractionar Fiscal Policy]
    • Increase in Personal Income tax 
  • Monetary Policy measures by RBI. RBI adopting dear money policy
    • Increase in repo rate
    • Increase in CRR and SLR
    • Selling Government Security through Open market Operation (sucking out excess liquidity)
  • Sudden exports of items may be curbed by imposing Minimum Export Price

2. Cost Pull Inflation

DefinitionWhen price rise because aggregate supply in an economy declines or is lower than the aggregate demand (at full employment level) of goods and services. 

This decline in aggregate supply is majorly due to rise in production cost.

CausesThe cost push inflation is mainly due to increasing cost of production. The production cost can increase mainly due to following three factors

  1. Increase in wages of the employees
    1. 7th pay commission has increased the wages.
    2. Labour union forces management of manufacturing firm to increase the wages of workers
  2. Increase in prices of raw materials
    1. Rise in crude oil prices (due to various reasons) can lead to rise in input costs
    2. Decline in agricultural output due to floods, famine etc. 
  3. Increase in Profit margin by firms
    1. If firms decide to increase their profit margin, it results in increase in prices of goods and services. It usually happen when a single company id major supplier of the goods (monopoly)
  4. Increase in prices of imports
    1. Increase in prices of inputs which are imported can lead to rise in overall price of goods

ExampleA rise in prices of oil will lead to rise in input cost (transportation cost etc will increase) and thus will lead to cost push inflation.
Deflationary GapDeflationary gap is the amount by which actual aggregate demand falls short of aggregate supply at level of full employment. 

Deflationary gap causes a decline in output, income and employment along with persistent fall in prices.

How to Combat Cost Pull Inflation  Steps have to be taken to reduce the cost of production. For Example

  • Government providing subsidies
  • Government providing for maximum price at which a product can be sold
  • Improving supply side factors such as dismantling APMCs, Fertilzer subsidy reform etc

3. Structural Factors

It means that inflation is due to structural factors

For example

  • Under developed transportation sector will increase logistic cost and will result in overall increase in prices of commodities
  • Similarly, structural bottlenecks in agricultural sector such as APMCs, involvement of middlemen, imperfect price discovery leads to rise in food prices
  • Resource constraints (such as government Budget constrain) to finance infrastructure development.

Structural Inflation is generally significant in explaining the food inflation in India

Effects of Inflation

The question one can ask is why care about inflation? What difference does it make if the average level of prices changes?

Here we will discuss the effect of inflation on

  1. Value of Money
  2. Lenders and borrowers
  3. Effect on Individuals

Effect of Inflation on Value of Money

Inflation decreases the value of money over time. Money loses value when its purchasing power falls. Since inflation is a rise in the level of prices, the amount of goods and services a given amount of money can buy falls with inflation.

Inflation leads to decline in the value of money over a period of time. It erodes purchasing power of money.

For example – Let us suppose a person has Rs. 100 in 2019 and price of apple is Rs. 10 per apple. He/She can buy 10 apple. Now due to inflation, the price of apple in 2020 rises to Rs. 20 per apple. Thus a person can only buy 5 apples in 2020. Thus the purchasing power of money has declined in 2020 (can buy 5 apples only) over 2019 (can buy 10 apple). Thus the money has lost value.

Effect of Inflation on lenders and borrowers

Inflation is bad for lender and good for borrower. Inflation helps borrowers and hurt lenders. Inflation re-distribute wealth from creditors to lenders.

Lenders suffers due to inflation. It is because the money they get paid back has less purchasing power than the money they loaned out.

Let us understand this by an example.

Suppose a Lender A lends Rs. 100 to B at 10% interest rate in 2019. The prevailing price of Orange is Rs 10 per Orange. 

Now in 2020, The prevailing prices of orange is Rs. 15 per orange due to Inflation. B gives money back to A i.e Rs. 110. A can buy around 7 oranges. However earlier (in 2019) A can buy 10 oranges. Thus Money which was paid back to the A has less purchasing power (can buy around 7 oranges) than the money loaned out (can buy 10 oranges). Thus lenders A suffers due to Inflation

Borrowers benefit out of inflation. Inflation reduces the value of money. interest rate that a borrower pays is effectively lower thanks to inflation.

(Learning – Let us know in the comment section how deflation impact the lenders and borrowers)

Effect of inflation on Individuals

Inflation erodes the value of money. Thus it will hurt people with fixed income.

People on fixed salaries, fixed pensions etc will be negatively impacted by the inflation as they will be able to buy lesser.

However, businessman and entrepreneurs may benefit from inflation as the price of final product rises (faster than the input prices)

Related Terms 
Terms Description
DeflationDeflation is a decrease in the general price levels of goods and services. It is opposite of Inflation. During deflation prices of goods and services tend to fall.

Deflation occurs when inflation rate falls below 0%. Thus inflation is negative during Deflation.

Effects of Deflation

    1. It increases the value of Money
    2. It increases the Purchasing power of money. People can buy more from same amount of money. However, the do not spend as they 
    3. Deflation is good for lenders and bad for borrowers (apply the same logic as explained above). Deflation increases the real value of debt.
    4.  Thus deflation discourages borrowing (and by extension, consumption and investment today.)
    5. People may have less propensity to spend and more to save as they will hold on to in expectation of further decline in prices. 
    6. Economists consider Deflation bad for economy. Borrowing is discouraged. People’s consumption decline. It further leads to economy in recession.
    7. In deflation, there is a steep decline in the general price level, which indicates an unhealthy condition of the economy. It can cause high unemployment, increase layoff, fall in the wage rates, decrease profits, low demand, low income, restricted credit supply in the economy. Deflation often leads the economy to depression

Ways to Combat Deflation

    • Increase the credit supply in the economy. Reduce repo rate, CRR and SLR
Dis-inflationIt is slower rate of inflation. It means that there is still rise in prices but overall rate is slow. It is simply a slowing of Inflation.

For example – If the inflation rate for years 2016, 2017, 2018, 2019 are 10%, 8%, 6% and 4% respectively. Then it shows the dis-inflation in economy as inflation is slowing down.

The general price level rises in disinflation, but the rate of inflation decreases over the period.

Unlike inflation and deflation, which refer to the direction of prices, disinflation refers to the rate of change in the rate of inflation.

disinflation is not considered as problematic because prices do not actually drop, and disinflation does not usually signal the onset of a slowing economy.

Deflation vs Dis-Inflation
DeflationDis-Inflation
Prices of goods and services fall. Prices of goods and services do not fall. Their price rise but overall rate is slow
It is result of decline in overall price level in the economy.It is overall fall in inflation rate
Inflation is negativeInflation is positive. However, rate of inflation slows down (for example from 3% to 2%)
It signifies direction of prices of goods and servicesIt signifies rate of change in the rate of inflation
Harmful to the economy.Usually not harmful to the economy
Stagflation It is a situation where the inflation rate is high, the economic growth rate slows down, and unemployment is also high

Stagflation = High Inflation + High Unemployment + Stagnant Growth

It raises a dilemma for economic policy since actions designed to lower inflation may exacerbate unemployment, and vice versa. It is unusual because policies to reduce inflation make life difficult for the unemployed, while steps to alleviate unemployment raise inflation.

Stagflation led to the emergence of the Misery index

ReflationReflation is a fical or monetary policy enacted after a period of economic slowdown or contraction. Here the goal is to expand output, stimulate spending and curb the effects of deflation.

As such, the term “reflation” is also used to describe the first phase of economic recovery after a period of contraction.

Reflation policies can include reducing taxes, changing the money supply and lowering interest rates. 

SkewflationIt means that some sectors are facing inflation while other sectors of economy do not. 

For example – Food prices may rise due to due to increase in prices of onion and tomatoes, whereas prices of other commodities remain same

Philips CurveIt is a curve which provides relationship between inflation and unemployment. 

As per the Philips curve, there is inverse relationship between Inflation and Unemployment

The underlying logic behind the Phillips curve is that wages are quite “sticky”, or inflexible, in a market economy, so unemployment is bound to shoot up whenever workers refuse to accept lower wages.

GDP DeflatorIt is a measure of general price inflation. 

It is calculated by dividing nominal GDP by real GDP and then multiplying by 100. Nominal GDP is

the market value of goods and services produced in an economy, unadjusted for inflation (It is the

GDP measured at current prices). Real GDP is nominal GDP, adjusted for inflation to reflect changesin real output (It is the GDP measured at constant prices).  

GDP Deflator = (GDP at Current Prices/GDP at constant Price) * 100

GDP deflator is much more broader and comprehensive measure of inflation than CPI and WPI. GDP deflator reflects the prices of all domestically produced goods and

services in the economy whereas, other measures like CPI and WPI are based on a limited basket of

goods and services, thereby not representing the entire economy. Further, WPI doen not include services whereas, GDP deflator includes Services.

GDP deflator also includes the prices of investment goods, government services and exports, and excludes the price of imports.

GDP deflator is usually released quarterly or yearly (CPI and WPI are released monthly) by Ministry of Statistics and Program Implementation.

Head Line InflationIt is a measure of total inflation in an economy. 

In India, Consumer Price Index Combined (CPI -C) represents Headline Inflation

Core InflationCore Inflation is Headline Inflation minus the food and fuel inflation.

Core Inflation is also known as underlying inflation

It is a reflection of long term inflationary trend in the economy

Base EffectThe base effect refers to the impact of the rise in price level (i.e. last year’s inflation) in the previous year over the corresponding rise in price levels in the current year (i.e., current inflation)

when a change in the index in the base period has a considerable effect on the measured inflation, this is called base effect of inflation

For example – 

Case 1 – The price index of january 2016 is 110 and that of January 2017 is 120.

Now Inflation of jan 2017 = (120-110)/110 *100 which comes out to be 9.09 %

Case 2 – The price index for March 2017 is 180 and that of March 2018 is 190. Now Inflation of March 2018 = (190-180)/180*100 which comes out to be 5.55%

Now we see in both the case the increase in price index is 10 but the rate of inflation is different. This is due to the base effect

Previous Year Questions of Prelims
  1. Economic growth is usually coupled with? (UPSC-Pre-2011)
    1. Deflation
    2. Inflation 
    3. Stagflation 
    4. Hyperinflation
  2. A rise in general level of prices may be caused by (UPSC-Pre-2013)
    1. An increase in the money supply.
    2. A decrease in the aggregate level of output.
    3. An increase in the effective demand.

          Select the correct answer from the code given below

          a) 1 only 

          b) 1 and 2 only 

         c) 2 and 3 only 

         d) 1, 2 and 3

  1. Which is an appropriate description of deflation? [UPSC-CDS-2012-II]

        (a) it is a sudden fall in the value of a currency against other currencies.

        (b) It is a persistent recession in the economy.

        (c) It is a persistent fall in the general price level of goods and services.

        (d) It is fall in the rate of inflation over a period of time  

  1. A rapid increase in the rate of inflation is sometimes attributed to the “base effect”. What is “base effect”?(Asked in UPSC-Pre-2011)

        (a) It is the impact of drastic deficiency in supply due to failure of crops

        (b) It is the impact of the surge in demand due to rapid economic growth

        (c) It is the impact of the price levels of previous year on the calculation of inflation rate

        (d) None of the statements  

  1. Choose the correct statement from the following(s): (UPSC-Pre-2013)
         a) Inflation benefits the debtors.
         b) Inflation benefits the bondholders.
         c) Both A and B
         d) Neither A nor B  
  1. Which of the following measures should be taken when an economy is going through in inflationary pressures? [UPSC-CDS-2012-I]
    1. The direct taxes should be increased.
    2. The interest rate should be reduced.
    3. The public spending should be increased.

        Select the correct answer from the code given below

        (a) Only 1 

        (b) Only 2 

        (c) 2 and 3 

        (d) 1 and 2  

Looking forward to your answers in the comment down below.

 

That’s all for this post folks. In the next post we will learn about the different index used to measure inflation such as WPI/CPI etc. Do Comment down below and let us know what you thought about the post. See you in the next one.

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