Inflation: UPSC Prelims Practice Quiz

When the general level of prices is falling over a period of time this is deflation, the opposite situation of inflation. It is also known as disinflation. But in contemporary economics, deflation or disinflation not used to indicate fall in prices. Instead, a price rise is termed a ‘rise in inflation’ and a price fall is termed a ‘fall in inflation’. The terms deflation or disinflation have become part of the macroeconomic policy of modern governments. In policy terms, the terms show a reduction in the level of national income and output, usually accompanied by a fall in the general price level. Such a policy is often deliberately brought about by the governments with the objective of reducing, inflation and improving the balance of payments (BoP) by reducing import demand. As instruments of deflation, any policy includes fiscal measures (as for example, tax increase) and monetary measures (as for example, increase in interest rate).

A rise in the general level of prices; a sustained rise in the general level of prices; persistent increases in the general level of prices ; an increase in the general level of prices in an economy that is sustained over time; rising prices across the board —is inflation. These are some of the most common academic definitions of inflation. If the price of one good has gone up, it is not inflation; it is inflation only if the prices of most goods have gone up.

The rate of inflation is measured on the basis of price indices which are of two kinds—Wholesale Price Index (WPI) and Consumer Price Index (CPI). A price index is a measure of the average level of prices, which means that it does not show the exact price rise or fall of a single good. The rate of inflation is the rate of change of general price level which is measured as follows: Rate of inflation (year x) = Price level (year x) –Price level (year x-1) / Price level (year x-1) ×100. This rate shows up in percentage form (%), though inflation is also shown in numbers i.e. digits.

An increase in factor input costs (i.e. wages and raw materials) pushes up prices. The price rise which is the result of increase in the production cost is cost-push inflation. The Keynesian school suggested controls on prices and incomes as direct ways of checking such inflation and ‘moral suasions’ and measures to reduce the monopoly power of trade unions as the indirect measures (basically, cost-push inflations chiefly used to happen due to higher wage demanded by the trade unions during the era). Today, the governments of the world use many tools to check such inflations—reducing excise and custom duties on raw materials, wage revisions, etc.

Governments around the world distanced themselves from this debate and have been taking recourse to all possible options while controlling inflation. The governments resort to the following options to check rising inflation: As a supply-side measure, the government may go for the import of goods that are in short supply— as a short-term measure (as happened in India in the case of ‘onion’7 and meeting the buffer stock norm of wheat). As a long-term measure, governments go on to increase production to match the level of demand. Storage, transportation, distribution, hoarding are the other aspects of price management in this category. As a cost side measure, governments may try to cool down the price by cutting down the production cost of the goods showing price rise with the help of tax breaks—cuts in the excise and custom duties (as happened in June 2003 in India in the case of crude oil and steel). This helps as a short-term measure. In the long-term, a better production process, technological innovations, etc. are helpful. Increasing the income of the people is the monetary measure to avoid the heat of such inflation.

For monetarists, a particular level of money supply for a particular level of production is healthy for an economy. Extra creation of money over the same level of production causes inflation. They suggested proper monetary policy (money supply, interest rates, printing of currencies, public borrowing, etc.) to check the situations of inflationary pressure on the economy. Monetarists cancelled the Keynesian theory of inflation.

For the monetarists a demand-pull inflation is creation of extra purchasing power to the consumer over the same level of production (which happens due to wage revisions at micro level and deficit financing at the macro level). This is the typical case of creating extra money (either by printing or public borrowing) without equivalent creation in production/supply i.e., ‘too much money chasing too little output’—the ultimate source of demand-pull inflation.

Inflationary Gap: the Inflationary gap is a situation which arises when Aggregate demand in an economy exceeds the Aggregate supply at the full employment level.

There exists a situation in an economy where inflation is fuelled up, not because of increase in Aggregate Demand but mainly due to increase in the cost of producing goods and services. This is called cost-push inflation. Deficit financing by the government – When the government spends more freely, prices go up. This causes an increase in aggregate demand in the economy which is known as demand-pull inflation.

This inflation takes place when the supply falls drastically and the demand remains at the same level. Such situations arise due to supply-side accidents, hazards or mismanagement which is also known as ‘structural inflation’. This could be put in the ‘demand-pull inflation’ category.