Inflation is defined as an increase in the price of most everyday or common goods and services, such as food, clothing, housing, recreation, transportation, consumer staples, and so on. Inflation is defined as the average change in the price of a basket of goods and services over time. Inflation is defined as a drop in the purchasing power of a country's currency unit. The topic of inflation is very important for the UPSC IAS exam Economy Syllabus. Questions are asked frequently on this topic both in prelims and mains. In this article, we will see what is inflation, different ways to measure inflation and how inflation is measured in India.

What is inflation?

• Inflation is the rate at which the price of goods and services in a given economy rises.
• Inflation occurs when prices rise as manufacturing expenses, such as raw materials and wages, rise.
• Inflation can result from an increase in demand for products and services, as people are ready to pay more for them.
• Let us consider we can buy 1 litre of milk for Rs. 50 at the current time. Exactly 1 year before 1 litre of milk cost us Rs. 40.
• Here there is an increase of Rs. 10 per litre of milk or the purchasing power of Rs.40 has reduced from buying 1 litre of milk to 800ml of milk in 1 year.

• Therefore we can say that there is an inflation of 25% in milk prices compared to last year.

Causes of Inflation

Demand-Pull Inflation

Various variables might cause an increase in aggregate demand. Some of them are

• Fiscal Stimulus
• Population Pressure
• Increase in Net Exports
• Monetary Stimulus
• Policy Decisions

Cost-Push Inflation

The fundamental cause of cost-push inflation is rising production costs. The following reasons can cause production costs to rise.

• Employees' salaries being raised
• Raw material prices increasing
• Firms profit margins
• Import prices
• Increase in indirect taxes

(*Click to read more about causes of inflation.)

How to measure Inflation?

• A simple way to measure inflation is to compare the current prices of goods and services to the base year (target year of comparison). (To read more on this topic, click here Base Year)
• Let us consider we can buy 1 litre of milk for Rs. 50 at the current time. Exactly 1 year before 1 litre of milk cost us Rs. 40.
• Here there is an increase of Rs. 10 per litre of milk or the purchasing power of Rs.40 has reduced from buying 1 litre of milk to 800ml of milk in 1 year.

• Therefore we can say that there is an inflation of 25% in milk prices compared to last year.
• However, while calculating the inflation in an economy we consider different goods while calculating the inflation rate at different levels.
• Generally, inflation is measured in the following 3 places:
  • At Consumer Level - Consumer Price Index (CPI)
  • At Wholesale Level - Wholesale Price Index (WPI)
  • At Producers Level - Producers Price Index (PPI)

Impact of Inflation

Positive Impacts

• Increased Profits for Producers

  • In most cases, inflation benefits the producers of goods. They make more money because they can sell their products at higher prices.

• Increased Investment Returns

  • During periods of inflation, investors and entrepreneurs are given additional incentives to invest in productive activities. As a result, they benefit from higher returns.

• Increase in production output

  • When producers receive the appropriate investment, they produce more goods and services. As a result, inflation causes an increase in product/service production.

Negative Impacts

• Real-Income falls for groups with fixed income.

  • An individual's true income is the purchasing power of his income money. To put it another way, Real Income=Money Income/Price Level.
  • This means that people on fixed incomes, such as salaried workers, pensioners, and the like, will see a drop in real income. To put it another way, their purchasing power will reduce.

• Income Distribution Inequality Rises

  • Profits for business owners and entrepreneurs rise as a result of inflation.
  • As a result, income inequality becomes more pronounced during this time period.
  • People in fixed-income groups, on the other hand, see a decrease in their real income.

• Disturbs the Planning Process

  • Inflation raises the prices of goods, raw materials, and factor services. As a result, the government must spend more money to complete any investment project initiated during the planning period.
  • If the government fails to raise more financial resources through savings or taxation, the entire planning process is thrown off.

(*Click here to read more about the impact of inflation.)

Inflation Targeting

• Inflation Targeting is a central banking policy that focuses on altering monetary policy to attain a set annual inflation rate.
• Inflation targeting is founded on the assumption that preserving price stability, which is achieved by managing inflation, is the greatest way to generate long-term economic growth.
• New Zealand was the first country to embrace inflation targeting, and since then, a large number of nations, including India, have chosen it as their primary monetary policy tool.

Measures to control Inflation

• Inflation can be majorly caused due to two reasons. One is the Demand-Pull inflation and the other is the cost-push inflation on the supply side.
• In the case of demand-pull inflation all the control measures revolve around reducing the demand, this can be done by either reducing the money supply or increasing prices by taxation.
• In the case of cost-push inflation, the control measures revolve around increasing the supply to meet the demand in the market and reduce the prices by providing subsidies and technological expertise.
• In all cases, the inflation control measulres can be divided into Monetary Measures, Fiscal Measures and Administrative Measures.

Important Terms related to Inflation

The following are the terms associated with inflation along with their definitions:

Deflation

• Deflation is the inverse of Inflation. It is the persistent decrease in the price level. Deflation occurs when the inflation rate falls below 0%.

Recession

• A recession is a period of slow economic activity. A recession is usually preceded by a major drop in consumer expenditure.
• Such a slowdown in economic activity might endure for several quarters, thereby halting an economy's expansion.
• Economic metrics such as GDP, profits, employment collapse under this situation.

Disinflation

• Disinflation is the reduction in the rate of inflation. Disinflation occurs when the inflation rate falls below its current level but is still more than 0%.

Runaway/Hyperinflation

• When the rate of inflation is extremely high, it is called runaway/hyperinflation inflation. In this situation, money becomes worthless and new currency may have to be introduced.

Stagflation

• Stagflation is persistently high inflation, high employment and low growth resulting in a stagnant economy.

Base Effect

• It is a term that is commonly used in the context of inflation. The base effect is a distortion in a monthly inflation figure caused by exceptionally high or low levels of inflation in the previous month. A base effect can make determining inflation levels over time challenging.

Running/Galloping inflation

• When the rate of inflation reaches double digits (>10%), it is called running/galloping inflation.

Bottleneck Inflation

• When supply reduces dramatically while demand remains constant, the rise in prices is called bottleneck inflation. Supply-side issues, dangers, or mismanagement can lead to such circumstances. Bottleneck inflation is one of the examples of demand-pull inflation.

Core Inflation

• It is the total inflation in the country (Headline Inflation) minus the inflation in the food and energy articles (volatile articles).

Phillips Curve

• The Phillips curve is a graphic representation of the inverse relationship between unemployment and inflation. According to the hypothesis, the lower the unemployment rate, the higher the rate of inflation, and vice versa.

Reflation

• To recover from the recession, RBI tries to increase the money supply and the government tries to give fiscal stimulus in the form of tax cuts or subsidies. These actions take the economy from a deflationary path towards a reflationary path. Reflation is thus, the increase in price levels when the economy recovers from recession.

Inflation Tax

• The term "inflation tax" does not refer to a legal tax paid to the government; rather, it refers to the penalty for retaining currency during a period of high inflation.
• It is a form of taxation in which the government alters the money supply. When the supply of money expands, the value of existing money decreases, resulting in a form of tax on existing money holders.

Double Dip Recession

• When an economy experiences two periods of contraction mediated by a brief period of expansion, it is known as a double-dip recession.
• Double Dip Recession is also known as W-shaped recessions because the curve of gross domestic product (GDP) and other economic data on graphs resembles the letter W.

Skewflation

• Skewflation is the episodic price rise in one/small groups of commodities while prices of the remaining goods and services remain the same. Example: Price rise of onions.

GDP Deflator

• GDP Deflator is the ratio of the value of goods and services produced by an economy in a given year at current prices to the value of goods and services produced during the base year at current prices.
• The GDP deflator is used to determine how much of the growth in GDP is due to higher pricing rather than an increase in output.

Inflationary gap

• The inflationary gap is the difference between the general level of prices and the rise in the level of prices due to inflation.

Deflationary Gap

• A deflationary gap is a difference between the general level of prices and the fall in the level of prices due to deflation.

Monetary Inflation

• When inflation occurs due to the excessive money printed by the RBI it is called monetary inflation.

Open inflation

• A situation where the price level rises without any price control measures by the government is called open inflation.

Suppressed / Repressed inflation

• During war or pandemic like situations, the government imposes price controls and rationing to keep prices under check. But the moment these checks have been withdrawn the prices of the goods and services rise. This rise in prices is called repressed inflation.

Headline Inflation

• Headline inflation is the measure of total inflation within an economy. It is usually presented in the form of CPI or WPI.

Structural Inflation

• It is inflation that is a part of a particular economic system. A complete change in the economic policy would be needed to get rid of it.

Creeping inflation

• If the rate of inflation is low (up to 4%), it is called creeping inflation. It is safe and essential for job creation and economic growth.

Walking/Trotting inflation

• When the rate of inflation is moderate (4-9%), it is called walking/trotting inflation.

Misery index

• Misery Index is the Rate of inflation plus the rate of unemployment.

Note: To know more about these terms click on the relevant links:

Conclusion

Inflationary effects are not uniformly dispersed throughout the economy. Inflation rates that are unexpected or unanticipated are damaging to the economy. They contribute to market volatility, making it difficult for businesses to set long-term budgets. However, moderate inflation is good. It allows new employment and growth opportunities to the economy.