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PROJECT REPORT

ON
INFLATION

Submitted By:
YOGESH DHAWAN
ACKNOWLEDGEMENT

With a sense of gratitude, I would like to express my


indebtedness to who has acceded to my request to work on the report
“INFLATION”. I am thankful for her constant guidance and untiring
cooperation.

YOGESH
DHAWAN
INFLATION

INFLATION

It is more difficult inflation to define inflation than to experience it there are perhaps nearly
as many definitions of inflations as there are people who use the term .a short list of some
of them may prove interesting.
Inflation is :

• Any increase in the quantity of money

• Any increase in the general prices

• Any increase in the prices not caused by increased consumer preference for the
goods pr by a decreased physical supply

• Any increase in government debt that may affect prices

• Any increase in effective quantity of money

• Any increase in money and prices that does not result in increased output pof goods

• Any increase in prices that occurs after full employment have been reached

• Maintenance of constant price level when cost are falling

• Any increase in capital investment that cannot be continued without a continuous


increase in the quantity of money

• A situation in which the company losses faith in the ability of money to keep its
value and it rushes to get money in exchange of commodities of securities that
promise to be a better store of value.

A common stream of thoughts running through most of these definitions is the rising
prices. Therefore ordinarily we define inflation as a situation to which the general price
level in an economy is rising or in other words the value of money is falling.
As we can see in the graph that the price is rising over the time period, such a condition
when the price rise continuously over a period of time is called inflation.

TYPES OF INFLATION

We can distinguish between different types of inflation grouped on the following basis:

(1) According to the rate of inflation

The severity of inflation is often measured in terms of the rapidity of price rise. On the basis, a
quantitative distinction of inflation may be nude into three categories, viz: Moderate inflation; Running and
galloping inflation; and Hyperinflation.

a. Moderate Inflation

It is a mild and tolerable form of inflation. It occurs when prices are rising slowly when the rate of inflation is
less than 10 per cent annually, or it is a single digit int1ation rate, it is considered to be a moderate inflation in
the present the economy.
Prof. Samuelson observes that moderate inflation is typical today in most industrialized countries. The
following are the major characteristics of moderate inflation:
i. There is a single digit inflation rate (less than 10 per cent) annually.
ii. It does not disrupt the economic balance.
iii. It is regarded as stable Inflation in which the relative prices do not get far out of line.
iv. People’s expectations remain more or less stable under moderate inflation
v. Under a low inflation rate, the real interest rate is not too low or negative, so money can serve its role as a
store of value without difficulty.
vi. There are modest inefficiencies associated with moderate inflation.

Economists have arbitrarily laid down that a 3-4 per cent price rise per annum is a tolerable rate of inflation in
modern economies. Even the Chakravarthi Report of the Reserve Bank of India has accepted 3-4 per cent rate
of inflation annually to be an efficient and tolerable norm for the Indian economy. Incidentally, some
economists have described up to 3 per cent annual rate of inflation as ‘creeping inflation’ and if it exceeds 10
per cent, it is called ‘walking inflation.’ This means, Samuelson has clubbed ‘creeping’ and ‘walking’
inflation into ‘moderate’ inflation.

b. Running and Galloping Inflation

When the movement of price accelerates rapidly, running inflation emerges. Running inflation may record
more than 100 per cent rise in prices over a decade. Thus, when prices rise by more than 10 per cent a year,
running inflation occurs. Economists have not described the range of running inflation. But, we may say that a
double digit inflation of 10-20 per cent per annum is a running inflation. If it exceeds that figure, it may be
called ‘galloping’ inflation. According to Samuelson, when prices are rising at double or triple digit rates of
20, 100 or 200 per cent a year, the situation is described as ‘galloping’ inflation. Indian economy has
witnessed a sort of ‘running’ and ‘galloping’ inflation to some extent (not exceeding 25 per cent per annum)
during the planning era, since the Second Plan period. Argentina, Brazil and Israel, for instance, have
experienced inflation rates over 100 per cent in the eighties. Galloping inflation is really a serious problem. It
causes economic distortions and disturbances.

c. Hyperinflation

In the case of hyperinflation, prices rise every movement, and there is no limit to the height to which prices
might rise. Therefore, it is difficult to measure its magnitude, as prices ris~ by fits and starts. . In quantitative
terms, when prices rise over 1000 per cent in a year, it is called a hyperinflation. Austria, Hungary, Germany,
Poland and Russia witnessed hyperinflation in the wake of World War I. Hyperinflation notably took place in
Germany in 1920-1923. The German price index rose from 1 to 10,00,000,000 during
January 1922 to November 1923. Believe it or not, it is a fact!
The Main Features of Hyperinflation are
i. During hyperinflation, the price rise is severe. The price index moves up by leaps and bounds. It is over
1000 per cent per year. There is at least a 50 per cent price rise in a month, so that in a year it rises to about
130 times.
ii. It represents the most pathetic deterioration in people’s purchasing power.
iii. It is apparently generated by a massive fiscal dislocation.
iv. It is amplified by wage-price spiral.
v. Hyperinflation is a monetary disease.
vi. The velocity of circulation of money increases very fast.
vii. The structure of the relative prices of goods become highly unstable.
viii. The real wages tend to decline fast.
ix. Inequalities increase.
x. Overall economic distortions take place.

(2) According to the degree of control


On the basis of the degree of control exercised over the rising prices, we can distinguish between two types of
inflation, viz Open inflation and Repressed inflation.

a. Open Inflation

When the government does not attempt to prevent a price rise, inflation is said to be open. Thus, inflation is
open when prices rise without any interruption. In open inflation, the free market mechanism is permitted to
fulfill its historic function of rationing the short supply of goods and distribute them according to consumer’s
ability to pay. Therefore, the essential characteristics of an open inflation lie in the operation of the price
mechanism as the sole distributing agent. The post-war hyperinflation during the twenties in Germany is a
living Example of open inflation.

b. Repressed Inflation

When the government interrupts a price rise, there is a repressed or suppressed inflation. Thus, suppressed
inflation refers to those conditions in which price increases are prevented at the present time through an
adoption of certain measures like price controls and rationing by the government, but they rise on the removal
of such controls and rationing. The essential characteristic of repressed inflation, in contrast to open inflation,
is that the former seeks to prevent distribution through price rise under free market mechanism and substitutes
instead a distribution system based on controls. Thus, the administration of controls is an important feature of
suppressed Inflation . However, many economists like Milton and G.N.Halm opine that if there has to be any
inflation, it is better open than suppressed. Suppressed inflation is condemned as it breeds number of evils like
black market, hierarchy of price controllers and rationing officers, and uneconomic diversion of productive
resources from essential industries to non-essential or less essential goods industries since there is a free price
movement in the latter and hence are more profitable to investors.

CAUSES OF INFALTION

A general theory of price determination states that a price rise may occur due to either of
the following two situations:
• when the aggregate demand rises
• when the supply falls
An increase in aggregate demand, supply remaining unchanged, will push the prices
upwards, similarly, a fall in supply, demand remaining unchanged, will also push up the
prices
The explanation of inflation can be found in two sets of causes:
1) Those causes which produce a fall in supply. A fall in supply is more usually the
result of an increase in costs
2) those causes which induce an increase in demand
Inflation caused by the former set of causes as cost –push inflation
Inflation initiated by the latter set of causes is defined as demand pull inflation,

Cost-push inflation
The second major cause of inflation is seen as an increase in the cost of production. When the cost of
production increases, aggregate supply schedule shifts to the lift indicating that a lesser quantity is
supplied at the prevailing prices. With the aggregate demand schedule remaining unchanged. A fall in
supply pushes the price level upwards. Shift in supply curve from S1 to S2, S3, S4 results in
progressive increases in the prices level and establish cost push inflationary forces in the economy .

Factors of cost-push inflation


• Higher wage rates
A powerful organized trade union asks for higher wage rate for its members. whenever
the producers are forced to grant higher wage rate they find it easier to shift the burden
on to the consumer by charging higher prices for the commodities .This sets in a never
–ending wage price spiral.

• Higher profit margins


In this type of market situation, demand exceeds the supply; prices tend to rise under
the impact of high demand to the advantages of the producers. The producers may
choose to make gains out of the situation, by fixing higher profit margins, which again
would push the prices upwards. Thus, higher prices could be traced to higher profit
margins.
• Higher taxes
A further sources of cost push inflation is the various types of taxes imposed by the
state authorities, specially indirect taxes like excise duties .the producer have a
tendency to shift the higher burden of taxes to the consumer by hiking prices by the
amount of the taxes.

• Fall in the availability of basic inputs


Whenever the strategic and basic raw materials and the other inputs go shortly in
supply, this price tend to move upwards

• Administered higher prices of inputs


A number of important inputs are controlled by the state authorities, their prices are
administered by the state or by other supplying organisation. a price hike in any of the
inputs may suffice to raise the general

Demand-pull inflation

Demand-pull inflation occurs when there an excess demand over the available supplies
at the existing prices. In this type of situation the aggregate demand function shifts
upward to the right while no shift in the supply function take place.

In this fig Of is the level of output at full employment, i.e., output is assumed not to
exceed Of level. Beyond Of, increase in prices does not result in increase output
therefore the supply curve become a straight vertical line. It will be seen that demand
progressively increases from D1 to D2, D3, D4and D5 the price level also rises from P1
to P2, P3, P4 and P5. It would also seen that the increases in price level have been
caused exclusively by the increase in demand, supply playing a passive role.
Factors on demand side

• The money supply


The first major source of inflation is increase in the money supply in the economy.
Increase in money supply results primarily from increase in demand deposits and
expansion of loans and investment by the commercial bank.

• Disposable income
It refers to the income payments to factors after personal taxes have been paid. An
increase in disposable income results in an increase in the absolute amount of
consumption expenditure in the economy.

• Increase in business outlays


Increase in business outlays, or capital expansion, takes on speculative characters
during an inflationary boom. New equipment and plants and excessive inventories are
often financed by speculative borrowing and increase in replacement demand.

• Increased foreign demand


Is a factor responsible for increased demand is foreign expenditure for domestic goods
and services. This factor is particularly significant if a country maintains an export
surplus on its balance of trade.
Demand-pull and cost-push inflation to go together in an economy

Distinction between two lies in the causal sequences involved. cost-push inflation results
from increase in factor prices that causes increases in the final goods prices; these changes
in the factor prices can occur independently of the state of excess demand .demand-pull
inflation involves a reverse order of causation. It is the increase in the demand for final
goods that causes increase in their prices, these prices increase cause a rise in the demand
for factors of production ,which in turn, cause an increase in factor prices. Thus, there are
increases in the level of goods prices which cause increase in the level of factor prices. In
both the situations of inflation, anyway, there would exist
a) excess demand
b) a rise in the price of factor inputs
Therefore, it may not be possible of identify separately the forces which cause one or
another.

EFFECTS OF INFLATION
Modern economists are of the view that a mild degree of inflation is not only desirable but
is also a necessary condition of growth specially in developing economics which are
working with unemployed manpower and underutilized natural resources. A slowly rising
price level is an inducement for investors to undertake immolations and expand the level
and scale of production. However, it need not be overemphasized that a mild degree of
inflation is desirable only and only as long as it is kept within controls and is not allowed to
gallop further. Galloping or runaway inflation has quite a few serious consequences.

These can be grouped into three parts as follows:


• Changes in the Tempo of economic Activity
• Redistribution of Income and
• Redistribution of Wealth

Changes in the Tempo of economic activity

Rising prices affect the tempo of economic activity in a country. Rising prices will have
two sets of effects on economic activity.

Favorable Effects
Initially, with an increase in the price level, the profit margins of the producers send to
widen rise in prices invariably meets with an increase in the prices of the inputs also. But
the prices of inputs rise slowly as compared to the prices of the final products. The widened
profit margins encourage more investment, leading of employment of unemployed
resources and manpower. It leads to creation and earning of more income, and thus further
adding to the aggregate demand, and promoting the inflationary pressures.

Adverse Effects
But the favorable trends continue only so long as the prices are rising at a slow rate. But
once inflation becomes self-generating it creates uncertainty in the economic system. This
type of uncertainty is not desirable for investment and production activity. an excessively
high rate of rise in prices disturbs economic relationships and resulting chaos makes
impossible any study economic activity The tensions that prevailed in the economic
discourages entrepreneurs from taking risk involved in productions for distant future.
Inflation of this type results in decline in the quality of products produced also.

Effects on patterns of productions


Inflation also affects the pattern of production as changes in the general price of often alter
price relationships. The production of some commodities increases rapidly, that of others
increases slowly, and of some remains stationery or even falls. There is, therefore a
considerable diversion of resources from some lines of production to others.

Redistribution of income and wealth


Inflation does not hit all sections of the society alike. While a section of society may tend
to gain when inflations sets in, another section would invariably loose. These gains and
losses result in redistribution in income with the society. Let us examine the concrete
effects of inflation on various economic groups:
Debtors and Creditors
Debtors as an economic group tend to gain when inflation sets in .Debtors gain because
although the face value of their borrowings does not change, they are required to part with
lessor purchasing power towards the repayment of their loans.
Wage salary earners
Wage-salary earners and other individuals with fixed incomes tend to lose during inflation.
Although with an increase in the price level, wages also rise, but wages fail to keep pace
with the rising prices. Hence, the real wages and fixed incomes fall in value. Inflation badly
hits at their standard of living by hiking up its cost.
Investors

We can distinguish between two types of investors: (i) investors in equities, and (ii)
investors in bonds. Inflation favors the investor’s inequities, but is rather harsh on the
second type of investors. Equity dividends increase as a result of increasing corporate
earnings while bond income remains fixed, and purchases less in 'terms' of goods and
services.

The small middle class investor has much to lose during inflation. The major avenues
where his savings are channeled are fixed deposits with commercial banks, provident funds
and insurance. If inflation takes place, it may wipe out his entire savings. This has serious
-implications for economic development in a country like India where more than three
fourths of total savings originate in the household sector. Inflation may adversely affect the
will and ability to save on the part of the households, and may thus badly affect capital
formation and accumulation, which is the major source of growth in a developing
economy. Farmers as an economic group gain during inflation. This is especially true of
those farmers who grow inflation-sensitive crops. Like other producers, farmers also gain
because of the time-lag involved in the increase in the price of output and the prices of
inputs. Similarly like other debtors. Farmers can pay off their loans with the help of
depreciated currency, and thus gain out of inflation.
Other Effects
The other significant effects of inflation, as seen from the Indian experience, can be
summed up as follows:
1. Growth of Parallel Economy
.Inflation by distorting the relative price and wage structure has made it difficult for tax
authorities to track down money incomes in the various sectors of the economy and helped
in the consolidation and expansion of a parallel economy believed to be anywhere between
10 and 50 per cent of the GNP. It has handicapped activation of monetary policy towards
achievement of price stability and has instigated investment in real estate and speculation.
By preventing a rise in real interest rates inflation has cheapened capital to the extent that
capital intensity has been rising when the opposite was intended.
2. Rising Levels of Non-Plan Expenditure
The rising' levels of non-plan expenditure may be largely due to inflation. Subsidies may
not be the method to deal with the problem but they point to the irony of the situation most
succinctly-that if we do not give subsidies, we have more inflation, and if we give them,
then also we have it. People suggest that subsidies should be done away with but they do
not say that inflation
which really necessitates giving of subsidies has to be stopped.
3. Creation of a High Cost Economy
A most damaging effect of inflation is the creation of a high cost economy which is
sapping our competitive capacity in the world market. We talk in this connection of poor
technology, inefficient public sector, high money wages in relation to productivity but not
of inflation which could be the most important single factor making for high costs of
production in this country
Thus, to conclude, we may say that inflation redistributes income and wealth in such a way
that it imposes penalties on consumers, creditors small. Investors, wage, salary and fixed-
income earning grouped. an benefits businessmen, debtors and farmers.

MEASURES TO CHECK INFLATION

The various measures that can be adopted to check inflation can be classified in three
groups, viz.,

• MONETARY MEASURES

• FISCAL MEASURES

• NON-MONETARY MEASURES
Monetary measures

Monetary measures aim at regulating the supply of money in an economy. The supply
of money at any time consists of currency and bank deposits. Bank deposits which
create credit form a proportionately large share of money supply in economy. Therefore
the bent of monetary measures is to regulate the flow of bank credit.
A central bank is empowered to impose different types of controls and adopt different
types of measures to influence the flow of credit. These measures work through
influencing the cost, availability and purpose of bank credit.
Measures of control can be classified into two groups:-

 Qualitative controls
Qualitative controls aim at influencing the purpose for which resort is made to
bank credit. Among the various selective controls we may mention changing the
margin requirements, regulating the consumer credit and moral suasion

 Quantitative controls
Quantitative controls aim at influencing the cost and availability of credit.
Among these the most important ones are bank rate policy, open market operations
and variable reserve requirements.

Fiscal measures

Fiscal measures are a part of the budgetary operations of a government. These


measures work through the tools like public expenditure, taxation and public
borrowing. The principal purpose of fiscal measures as an anti-inflationary tool is to
mop up the excess purchasing power in the economy; to achieve this objective all the
three fiscal tools need to be applied simultaneously. Their operation is explained below:

• Public expenditure
Public expenditure is the expenditure by the state authorities that can serve as anti-
inflationary tool. The primary objective of the state authorities under these
circumstances must not only be to control their expenditure but also to visibly reduce it
so as to contract the influence of the increase in public spending.

• Taxation

The major attack on inflation is to come from the tax authorities. Increase in the tax
rates or imposition of new taxes mop up the large volume of surplus purchasing power
that gets into the hands of people and exerts a pressure on demand. In so far increased
taxation leads to a fall in the disposable purchasing power with the general public, it is
anti-inflationary in character.
• The taxes to be used for this purpose have to be carefully chosen. A choice has to
be made between direct taxes and indirect taxes.
• Public borrowing The effects of large budget deficits which are mainly
responsible for inflation can be partly counteracted by covering the deficits by the
public borrowing. Public borrowing also helps in taking a part of large amount of
purchasing power available to people off commodity markets and reduces the
inflationary pressures.

NON-MONETARY MEASURES

The major non-monetary measures that can be adopted are output adjustment, wage
policy and price control.

 Output adjustment
Increased production is admittedly a basic solution to the problem of inflation.
Since the inflationary gap requires reallocation of factor resources, vigorous
campaign against monopolistic attempts to raise factor costs in the strategic sector
of the economy , efficient and satisfactory labor-management relations.

 WAGE POLICY
One of the basic measures to combat inflation is to cut the wage price spiral. It
must be remembered that this type of spiral is and can be established only by the
organized action actions of trade unions. Therefore the major responsibility of
keeping wages in line with the general cost structure rest with the trade unions.
There are certain broad criterions by which trade unions formulate an appropriate
wage policy.

a) The trade union’s demand for higher wages should be made dependent on
increase in productivity. In this criterion is observed higher wage do not generally
increase unit cost and therefore do not increase unit price.

b) The trade unions should insist on payment of higher wages from the profit
margins i.e. wage increases should not be allowed to be a reason for price
rise also.
c) the trade unions should refrain from pressing for wage increases on the
ground of the cost of living, except when the general anti-inflationary programme fails to
prevent the prices of essentials from rising.

 Price control and rationing


A direct measure to curb inflationary pressures is imposition of price controls.
The function of price controls is to establish the legal upper limits beyond which the
prices of particular goods may not rise. Price control may be and effective auto-
inflation device; however its use is limited by the difficulties associated with the
implementation of various controls.