Inflation | Features of Inflation | Causes of Inflation | Effects of Inflation
Inflation | Meaning of Inflation
In ordinary language, inflation is a process of rising prices of goods and services.
Inflation is statistically measured in terms of percentage increase in the price index per unit of time.
When the price of goods and services increases, it is known as inflation.
Inflation decreases the purchasing power of money.
There are two types of inflation; they are cost-push and demand-pull.
Cost-push inflation is the decrease in the aggregate supply of goods and services due to an increase in the cost of production.
Cost of production increases due to an increase in the costs of raw materials and labour.
Demand-pull inflation is the increase in aggregate demand.
These demands are categorized into four sections; they are households, businesses, governments and foreign buyers.
Demand-pull inflation is caused by an expanding economy, increased government spending or overseas growth.
Definition of inflation
According to Crowther, “Inflation is a state in which the value of money is falling, i.e. the prices are rising”.
According to Gardner Ackley, “Inflation is a persistent and appreciable rise in the general level or average of prices.”
According to Coulborn, “Inflation is too much money chasing too few goods”.
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Features of Inflation | Characteristics of Inflation
The major features of inflation are as follows:
Inflation is a long-term operating process
It is dynamic in nature.
Inflation is a process of continuous and appreciable rise in the price level over a period.
Inflation is a rising trend in the price level.
Inflation is mainly caused by excess money supply.
It is a purely monetary phenomenon.
It is a full-employment phenomenon.
Inflation is caused by excess demand in relation to the supply of all types of goods and services.
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Causes of Inflation
Inflation is caused by an action, reaction and counter-action of economic forces. Hence, it is an economic phenomenon.
Excess aggregate demand in relation to the aggregate supply is the essence of inflation.
Inflation occurs by various factors.
The major factors are demand rising factors and supply reducing factors.
(A) Demand Raising Factors
The demand rising factors increases aggregate demand
Aggregate demand is higher than the aggregate supply of the economy which pulls the price level up.
Increase in money supply
Increase in money supply increase in bank loans.
An increase in bank loans increases the income of the people.
This leads to an increase in aggregate spending or demand.
But, at a very short period, aggregate supply remains constant.
It creates the condition of excess AD over AS; it increases the price level.
Increase in government expenditure
An increase in government expenditure may lead to an increase in prices by increasing the aggregate demand.
It increases aggregate demand directly by increasing the demand for goods and services from the public sector.
It increases aggregate demand indirectly by increasing the factor incomes in the form of wages and salaries of government employees.
Increase in private investment expenditure
An increase in business outlays in the form of investment expenditure is also responsible for the rise in prices.
Investment expenditure has a long maturation period.
It creates incomes in the form of wages and dividends.
These incomes increase in the output of goods and services only after a time gap.
Thus, an increase in investment expenditure exercises an upward pressure on prices, particularly in the short run, by increasing the demand for goods and services.
Increase in population
An increase in population is another factor for the inflationary rise in prices.
An increase in population means increased demand for most of the consumer goods and services.
It increases the aggregate demand for goods and services and puts pressure on the existing supply of goods and services.
Decrease in tax rate
When the tax rate decreases, the disposable income of people increases.
As a result purchasing power of money increases.
This makes an increase in the aggregate demand for goods and services in the economy.
An increase in aggregate demand pulls the price level up.
(B) Cost Raising Factors | Supply Reducing Factor
The supply reducing factors decreases aggregate supply.
Aggregate supply is less than aggregate demand of the economy which pushes the price level up.
Increase in wage rate
There are trade unions to take favour of labour.
They demand higher wage rates and higher wage rates are responsible for the rise in the prices.
An increase in the wage rate results in an increase in the cost of production.
Entrepreneurs would like to shift this increased wage cost to the consumers by charging higher prices for the commodities.
Increase in profit margin
In many countries, the prices of crucial commodities are determined by the government.
For example, the prices of petroleum products are determined by the government.
These prices are raised regularly by the government to promote the interest of the producers.
A price hike of such basic goods is likely to raise the general price level and thereby generate an inflationary trend.
Scarcity of inputs
Inflation may occur due to the scarcity of factors of production such as capital equipment, raw materials etc.
These shortages are bound to reduce the production of goods and services for consumption purposes
Thus, scarcity of output rises the price level.
Supply shocks
Supply shock in the form of higher oil prices by the OPEC (Organization of Petroleum Exporting Countries) is a major factor for price rise in recent years.
Petroleum prices are of crucial importance because petroleum products are used, directly or indirectly, in almost the entire economy.
Therefore, an increase in their price affects significantly the cost structure of almost all industries and commodities.
Periodic increase in oil prices has given a continual boost to the general price level.
Higher indirect taxes
Another cause of price rising is higher indirect taxes like excise duties, VAT, GST etc.
Indirect taxes are largely passed over by the producers to the consumers by increasing the prices of goods and services.
For example, prices of electronic goods rise because of higher excise duties imposed upon them.
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Effects of Inflation
When there is inflation in the country, the purchasing power of the people decreases as the prices of commodities and services are high.
The value of currency units decreases which impact the cost of living in the country.
When the rate of inflation is high, the cost of living also increases, which leads to a deceleration in economic growth.
The negative effects of inflation or consequences are explained below:
Disrupts price system
The market economy runs by market mechanism or price mechanism.
Inflation disrupts the smooth working of the price mechanism and results in the wrong allocation of resources.
Price mechanism helps to decide what to produce? how to produce? for whom to produce?
When the price is unstable, it cannot help for the right decision.
Reduces saving
Inflation may have an adverse effect on savings.
Inflation wipes out savings completely.
When the prices of goods and services increase, the purchasing power of money falls.
It means more money is required to buy the same quantity of goods and services.
Small savers deposit their savings at the banks and invest in government securities.
Inflation reduces their saving and investment.
Reduces foreign investment
Inflation not only reduces domestic savings but also discourages the inflow of foreign capital into the country.
If the value of money falls largely, it may drive out the foreign capital invested from the country.
Reduces production
A sharp rise in prices results in conditions of uncertainty in the economy.
The conditions of uncertainty in the economy have an adverse and dampening effect on investment and production activity.
As a result, production decreases.
Encourages storing
When price increases people (businessmen) start to store a large quantity of goods.
Due to storing a large quantity of goods, the demand increases.
This results in black marketing and causes a further price spiral (increase).
Increase inequality
Inflation increases inequality because rich people get benefits from it and poor people suffer loss from it.
Inflation redistributes income and wealth in such a way that it harms the consumers, creditors, small investors, labour, middle class and fixed income groups but do favour the businessmen, traders, investors etc.
As a result, it makes the rich richer and the poor poorest.
Socio-political effects
Periods of hyper-inflation are often associated with social and moral degradation.
Inflation leads to thefts, robberies and widespread corruption.
Corruption breeds during the inflation period not only among businessmen but also among government officials and politicians.
During the inflation period, people will be dissatisfied with the government.
The government may lose the faith of its public and it brings political instability.
Political instability causes many kinds of dissatisfactions and disturbances in a country.
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