Inflation may be defined as a persistent and appreciable rise in the general price level. Inflation is statistically measured in terms of percentage increase in the price index over a period of time usually a year or a month.
Inflationary gap: The inflationary gap is the amount by which aggregate demand exceeds aggregate supply at the full employment level of income. The inflationary gap is explained diagrammatically in the following figure.
In the figure YF is the full employment level of income, the 45° line represents aggregate
supply (AS), and the C + I + G line represent the aggregate demand (AD). The economy’s aggregate demand curve (AD) intersects the aggregate supply curve (AS) at point E at the income level OY1 which is greater than the full employment income level OYF. The amount by which aggregate demand YFA exceeds the aggregate supply YFB at the full employment income level is the inflationary gap. This is AB in the figure. Thus, the inflationary gap leads to inflationary pressures in the economy which are the result of excess aggregate demand.
Types of Inflation
There are several types of inflation in the economy which are classified on different basis. Some of the important types of inflation are discussed below.
Galloping or Hyperinflation: When prices rises between 20% to 100% per annum or even more, it is called galloping or hyperinflation. Such a situation brings a total collapse of the monetary system because of the continuous fall in the purchasing power of money.
Demand-Pull and Cost-Push Inflation:. Demand-pull inflation takes place when aggregate demand is rising while the available supply of goods is less. The monetarists emphasize the role of money as the principal cause of demand-pull inflation while the Keynesians emphasize the increase in aggregate demand as the causes of inflation. On the other hand, Cost-push inflation is caused by wage increases enforced by trade unions and profit increases by employers.
Comprehensive and Sporadic Inflation: When the prices of all commodities in the economy rise it is called comprehensive inflation. On the other hand, sporadic inflation is a sectoral inflation in which the prices of a few commodities rise because of certain physical bottlenecks which may impede any attempt to increase their production.
Open and Suppressed Inflation: Inflation is said to be open when the government takes no steps to control the rise in the price level. Thus open inflation is the result of the uninterrupted operation of the market mechanism. On the other hand, inflation is said to be suppressed when the government actively intervenes to check the rise in the price level.
Mark-up Inflation: This type of inflation resulted from the peculiar method of pricing adopted by the big business organizations. According to this method, the big business organizations calculate their production costs first and then add to these costs a certain mark-up to yield the targeted rate of profit.
Besides the above types of inflation, there are several other types of inflation which are classified on the basis of time or the causes of inflation. On the basis of time there are peacetime, wartime and postwar inflation. On the basis of factors causing inflation there are credit inflation, deficit-induced inflation, scarcity-induced inflation etc.
Stagflation : In this type, there is fall in the output and employment levels. Due to various pressures, the entrepreneurs have to raise the price to maintain their margin of profit. But as they only partially succeed in raising the prices, they are faced with a situation of declining output and investment. Thus, on one side there is a rise in the general price level and on the other side, there is a fall in the output and employment.
Causes of Inflation
Broadly speaking inflation arises when the aggregate demand exceeds the aggregate supply of goods and services. We analyse the factors which lead to increase in demand and the shortage of supply.
Factors Causing Increase in Demand: Both Keynesians and monetarists believe that inflation is caused by increase in the aggregate demand. Following are the factors which cause an increase in the size of demand:
Apart from the above factors, expansion of the private sector, existence of black money and the repayment of public debt by the government also increases the aggregate demand for goods and services in the economy.
Factors Causing Shortage of Supply: Following are the factor which result in a reduction in the supply of goods and services:
International Factors: In modern times, inflation is a worldwide phenomenon. When prices rise in major industrial countries, their effects spread to almost all countries with which they have trade relations. Often the rise in price of a basic raw material like petrol in the international market leads to rise in the price of all related commodities in a country.
Measurement of Inflation in India :
Inflation is measured by general price index. General Price index measures the changes in average prices of goods and services. A base year is selected and its index is assumed as 100 and on this basis price index for the current year is calculated.
If the index of the current year is below 100, it indicates the state of deflation and, on the contrary, if index of the current year is above 100 it indicates the state of inflation.
Wholesale Price Index (WPI) India:
On the recommendation of Working Group under the Chairmanship of Prof. Abhijit Sen, Member Planning Commission Government has changed the base year of Wholesale Price Index (WPI) from 1993 – 94 to 2000 – 01. The new base year 2000 – 01 became operational w.e.f. 01 April, 2006. It was again changed to 2004-05 recently.
Inflation rate and the value of money (or the purchasing power of money) are inversely correlated. Hence, the value of money can also be measured with the help of price indices. The value of money declines when price index goes up and vice – versa.
Measures to Control Inflation
Inflation is caused by the failure of aggregate supply to equal the increase in aggregate demand. Therefore, inflation can be controlled by increasing the supplies of goods and reducing money income. The various measures to control inflation are discussed below.
The monetary measures to control inflation generally aims at reducing money incomes. These are:
Monetary policy alone cannot control inflation. Therefore, it should be supplemented by fiscal measures. The principal fiscal measures are discussed below.
Other (Direct) Measures
Other measures to control inflation generally aims at increasing aggregate supply and reducing aggregate demand directly. These are :-
(a) To Increase Production. The following measures should be adopted to increase production:
(i) The government should encourage the production of essential consumer goods like food, clothing, kerosene oil, sugar, vegetable oils, etc.