Definition Of

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DEFINITION OF 'INFLATION'
The rate at which the general level of prices for goods and services is rising, and,
subsequently, purchasing power is falling. Central banks attempt to stop severe
inflation, along with severe deflation, in an attempt to keep the excessive growth
of prices to a minimum.
Concept
In economics, inflation is a sustained increase in the general price level of goods and services in
an economy over a period of time.[1] When the general price level rises, each unit of currency buys
fewer goods and services. Consequently, inflation reflects a reduction in the purchasing power per
unit of money – a loss of real value in the medium of exchange and unit of account within the
economy.[2][3] A chief measure of price inflation is the inflation rate, the annualized percentage change
in a general price index (normally theconsumer price index) over time.[4]
Inflation affects an economy in various ways, both positive and negative. Negative effects of inflation
include an increase in the opportunity cost of holding money, uncertainty over future inflation which
may discourageinvestment and savings, and if inflation were rapid enough, shortages of goodsas
consumers begin hoarding out of concern that prices will increase in the future. Positive effects
include ensuring that central banks can adjust real interest rates (to mitigate recessions),[5] and
encouraging investment in non-monetary capital projects.
Economists generally believe that high rates of inflation and hyperinflation are caused by an
excessive growth of the money supply.[6] However, money supply growth does not necessarily cause
inflation. Some economists maintain that under the conditions of a liquidity trap, large monetary
injections are like "pushing on a string".[7][8] Views on which factors determine low to moderate rates
of inflation are more varied. Low or moderate inflation may be attributed to fluctuations
in real demand for goods and services, or changes in available supplies such as during scarcities.
[9]

However, the consensus view is that a long sustained period of inflation is caused by money

supply growing faster than the rate of economic growth. [10][11]

Feature/characterics
1. The phenomenon is not to be equated with the fact of high prices. It is a phenomenon of rising
prices. It is a continuous fall in the purchasing power of money in absolute terms.

2. In an economy which uses money and credit and which operates under the guidance of market
mechanism, some adjustment of individual prices is always going on in response to the dynamism of
changing demand and supply forces. In other words, in such an economy, a continuous shift is taking
place in relative prices. However, inflationary process is not the adjustment of individual prices, or
relative prices. It is a process of continuous price rise in absolute terms, that is, a process of
continuous fall in the purchasing power of money. The phenomenon of price rise is not restricted to
only selected items. Its coverage keeps increasing and more and more prices start rising.
3. There is no absolute rate of price rise, which can be said to demarcate between inflationary and
non-inflationary situations. This is because, by its very nature, an inflationary process is a
continuous and cumulative one. Having started once, the rate of price rise keeps gathering
momentum and is bound to exceed any prescribed rate. Unless we are able to check it through some
means, the rate of price rise becomes so high that it leads to the collapse of the entire monetary
system of the country.
4. As we have noted before, in a market economy, several individual prices are always under a
process of adjustment in response to forces of demand and supply forces. In addition, there is a close
input-output relationship between different categories of economic activities. In other words, when
one price changes, there is generally an increase in input cost of several other economic activities
which in turn leads to further price rise. The result is that it is possible for any individual price rise to
become a cause for an inflationary process. We cannot keep an eye on only some selected prices and
be sure that inflationary process would not start.
5. On account of input-output relations between different industries, inflationary process keeps
increasing its coverage. With the passage of time, more and more prices are engulfed by it. It also
leads to an increasing rate of price rise. It becomes a self-feeding cumulative process.
6. On account of close interaction between industries, we do not have any predetermined set of
causes and 'effects' of inflation. A given macro-variable alternatively becomes its cause and effect.
For example, an increase in wage rate can result in an increase in production costs. Higher
production costs can become the cause of higher prices, which in turn can become the cause of
further rise in wages.
7. Higher prices necessitate a greater need for means of payment in the form of currency and credit.
The authorities also require more funds to finance their activities. As a result, they increase the
supply of currency. And at the same time, there is a greater generation of credit in the economy.
However, increasing supply of money and credit helps in pushing prices further up, leading to the
need for still additional supply of money and credit. Thus, a continuous increase in the supply of
money and credit becomes an essential feature of inflation.
8. When inflationary process gains strength, it gives rise to expectations of further price rise. This
increases the speed with which people spend their money balances.

9. When expectations of price rise become widespread, the suppliers develops tendency to hold back
supplies, pile up stocks and create an artificial scarcity. They find that to hold back existing supplies
is becoming increasingly more profitable than to produce fresh.
10. Price expectations also alter the asset preferences of the community. People prefer to hold more
of non-monetary assets, which are expected to retain their 'real' purchasing power as against
nominal money balances, which are continuously losing their purchasing power.
11. In the initial stages, there is an increase in interest rate because the lenders want to be
compensated for the loss in the purchasing power of their loans. In later stages, however, money
starts losing value so fast that the entire financial system may be disrupted and eventually collapses.
12. In the initial stages of inflation, the economy registers a growth in the output and employment
along with an increase in prices. That is to say, rising prices provide an incentive to investors and
producers in the form of higher expected profit. They are ready to invest more even in the face of
rising rate of interest. However, in later stages of inflation.
(i) The phenomenon of increasing costs
(ii) Expectations of further rice rise
(iii) Other factors lead to a fall in real output and prices while there is an exponential growth in the
supply of money.
13. Right from the beginning, there is a growing inequality in income distribution. Contractual
incomes {like wages, interest, rent, etc.) lag behind while non- contractual and for residual incomes
(like profit) increase in both absolute terms and as a proportion of the national income.
14. Inflation is the result of market imperfections. If the demand and supply flows are able to adjust
themselves to changing prices without time lags, a persistent price rise cannot take place and
inflationary process cannot come into existence.
Advantage & disadvantage

The Advantages of Inflation:
1. Deflation (a fall in prices – negative inflation) is very harmful.
During a prolonged period of deflation and very low inflation, the Japanese economy
has suffered lower growth because of deflationary pressures. When prices are falling
people are reluctant to spend MONEY because they are concerned that prices will be
cheaper in the future, therefore, they keep delaying purchases. Also, deflation increases

the real value of DEBT and reduces the disposable income of individuals who are
struggling to pay off their DEBT. When people take on a debt like a mortgage, they
generally expect an inflation rate of 2% to help erode the value of debt over time. If this
inflation rate of 2% fails to materialize, their debt burden will be greater than expected.
2. Moderate inflation enables adjustment of wages. It is argued a
moderate rate of inflation makes it easier to adjust relative wages. For example, it may
be difficult to cut nominal wages (workers resent and resist nominal wage cut). But, if
average wages are rising due to moderate inflation, it is easier to increase the wages of
productive workers wages; unproductive workers can have their wages frozen – which is
effectively a real wage cut. If we had zero inflation, we could end up with more real
wage unemployment, with firms unable to cut wages to attract workers.
3. Inflation enables adjustment of relative prices. Similar to the last point,
moderate inflation makes it easier to adjust relative prices. This is particularly important
for a single CURRENCY like the Eurozone. Southern European countries like Italy,
Spain and Greece became uncompetitive, leading to large current account deficit.
Because Spain and Greece cannot devalue in the Single Currency, they are having to
cut relative prices to regain competitiveness. With very low inflation in Europe, this
means they have to cut prices and cut wages, which causes lower growth (due
to effects of deflation). If the Eurozone had moderate inflation, it would be easier for
southern Europe to adjust and regain competitive without resorting to deflation.
4. Inflation can boost growth. At times of very low inflation the economy may be
stuck in a recession. Arguably targeting a higher rate of inflation can enable a boost in
economic growth. This view is controversial. Not all economists would supporttargeting
a higher inflation rate. However, some would target higher inflation, if the economy was
stuck in a prolonged recession.
For example, the Eurozone has had a very low inflation rate in 2013-14, and this has
corresponded to very weak economic growth and very high UNEMPLOYMENT. If the
ECB had been willing to target higher inflation, then we could have seen a rise in
Eurozone GDP.

Disadvantages of Inflation:
Inflation is usually considered to be a problem when the inflation rate rises above 2%.
The higher the inflation, the more serious the problem it is. In extreme circumstances
hyperinflation can wipe away peoples savings and cause great instability, e.g. Germany
1920s, Hungary 1940s, Zimbabwe 200s. However, in a modern economy, this kind of
hyperinflation is rare. Usually inflation is accompanied with HIGHER INTEREST
RATES so savers do not see their savings wiped away. However, inflation can still
cause problems.

Inflationary growth tends to be unsustainable leading to a damaging period of boom
and bust economic cycles. For example, the UK saw high inflation in the late 1980s,
but this economic boom was unsustainable and when the government tried to reduce
inflation, it led to the recession of 1990-92.

Inflation tends to discourage INVESTMENT and long-term economic growth. This is
because of the uncertainty and confusion that is more likely to occur during periodsof
high inflation. Low inflation is said to encourage greater stability and encourage firms to
take risks and INVEST.

Inflation can make an economy uncompetitive. For example, a relatively higher rate of
inflation in Italy can make Italian exports uncompetitive, leading to lower AD, a current
account deficit and lower economic growth. This is particularly important for countries in
the Euro-zone because they can’t devalue to restore competitiveness.
Reduce value of savings. Inflation leads to a fall in the value of MONEY. This makes
savers worse off – If inflation is higher than interest rates. High inflation can lead to a

redistribution of income in society. Often it is pensioners who lose out most from
inflation. This is particularly a problem if inflation is high and interest rates low.

Menu costs – costs of changing prices lists, which becomes more frequent during high
inflation. Not so significant with modern technology.
Cause

1. Demand pull inflation
If the economy is at or close to full employment then an increase in AD leads to an increase
in the price level. As firms reach full capacity, they respond by putting up prices, leading to
inflation. Also, near full employment, workers can get higher wages which increases their
spending power.

AD can increase due to an increase in any of its components C+I+G+X-M

We tend to get demand pull inflation, if economic growth is above the long run trend rate of
growth. The long run trend rate of economic growth is the average sustainable rate of
growth and is determined by the growth in productivity.
Example of demand pull inflation in the UK
In the 1980s, the UK experienced rapid economic growth. The government cut

interest rates and also cut taxes. House prices rose by up to 30% fuelling a positive wealth
effect and a rise in consumer confidence. This increased confidence led to higher spending,
lower saving and an increase in borrowing. However, the rate of economic growth reached
5% a year – well above the UK’s long run trend rate of 2.5 %. The result was a rise in
inflation as firms could not meet demand. It also led to a current account deficit. You can
read more about this inflation at the Lawson Boom of the 1980s

2. Cost Push Inflation
If there is an increase in the costs of firms, then firms will pass this on to consumers. There
will be a shift to the left in the AS.

Cost push inflation can be caused by many factors
1. Rising wages
If trades unions can present a common front then they can bargain for higher wages. Rising
wages are a key cause of cost push inflation because wages are the most significant cost
for many firms. (higher wages may also contribute to rising demand)
2. Import prices
One third of all goods are imported in the UK. If there is a devaluation then import prices will
become more expensive leading to an increase in inflation. A devaluation / depreciation
means the Pound is worth less, therefore we have to pay more to buy the same imported
goods.

In 2011/12, the UK experienced a rise in cost-push inflation, partly due to the depreciation in
the Pound against the Euro. (also due to higher taxes)
3. Raw Material Prices
The best example is the price of oil, if the oil price increase by 20% then this will have a
significant impact on most goods in the economy and this will lead to cost push inflation.
E.g. in early 2008, there was a spike in the price of oil to over $150 causing a temporary rise
in inflation.

4.

Profit Push Inflation

When firms push up prices to get higher rates of inflation. This is more likely to occur during
strong economic growth.
5. Declining productivity
If firms become less productive and allow costs to rise, this invariably leads to higher prices.
6. Higher taxes
If the government put up taxes, such as VAT and Excise duty, this will lead to higher prices,
and therefore CPI will increase. However, these tax rises are likely to be one-off increases.
There is even a measure of inflation (CPI-CT) which ignores the effect of temporary tax
rises/decreases.

CPI-CT is less volatile because it ignores the effect of taxes. In 2010, some of the UK
CPI inflation was due to rising taxes.

Rising house prices
Rising house prices do not directly cause inflation, but they can cause a positive wealth
effect and encourage consumer led economic growth. This can indirectly cause demand pull
inflation
Printing more money
If the Central Bank prints more money, you would expect to see a rise in inflation. This is
because the money supply plays an important role in determining prices. If there is more
money chasing the same amount of goods, then prices will rise. Hyperinflation is usually
caused by an extreme increase in the money supply

Type of inflation
WHOLESALE INFLATION
Wholesale or headline inflation is measured on the basis of the changes in wholesale price index (WPI).
Since it is based on the wholesale prices, it helps the government to spot the price rise in advance.
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However, wholesale inflation lost its relevance after the government decided to change the frequency of
reviewing the index from a weekly to monthly basis, and the Reserve Bank of India shifted its monetary
focus from wholesale to retail inflation.

RETAIL INFLATION
Retail inflation is calculated on the basis of changes in the Consumer Price Index (CPI). Since it
measures the impact of price rise, it is more relevant for financial planning for the average investor.
While people from big cities should use the urban variant, those from villages and smaller cities can use
the rural one.

FOOD INFLATION
Food inflation is a subset of headline inflation and is expected to rise further in the coming months due to
a deficit in the monsoon rains.
Given the large number of people below the poverty line, it is a major cause for concern for developing
countries like India. It is essential for investors to take this inflation into account while planning their
finances.

HOUSING INFLATION
Housing inflation is another subset of headline inflation. It is rising at a faster clip compared with the
headline inflation and was above 15% two years ago.
The cost of housing is a major expenditure for city dwellers and is more important for them. This is why
one must consider it while planning for the real estate goals.

LIFESTYLE INFLATION

As an individual's income increases, there is a gradual improvement in lifestyle—bigger house, branded
clothes, better car. These additional expenses result in what is termed as lifestyle inflation.
So the expenses increase not just on account of the rise in prices, but also due to a better lifestyle. Since
the rise depends on the individual, it is not possible to put a number that is applicable to all.
However, one must consider it while computing long-term goals, such as retirement planning or children's
wedding.
EDUCATION INFLATION
Though education inflation is also a subset of headline inflation, it only measures the increase in cost of
education and stationery.

It is essential to provide for this inflation while planning for your child's studies because most of the higher
education is now subsidised and the subsidy might not be available by the time your ward reaches
adulthood.

MEDICAL INFLATION
Medical inflation is relatively under control in India due to the government restrictions on drug price rise
and technological innovation to keep a tab on medical equipment costs.
However, medical expenses are bound to rise as you grow older and you need to consider a higher rate
of inflation so that you face any problem during your sunset years.

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