What is Inflation?
Inflation refers to the continuous rise in the prices of goods and services leading to declining in the purchasing capacity of a country’s currency. In other words, a general increase in the prices of goods and services over time is called inflation.
Because of inflation as the purchasing capacity of the currency comes down to zero that currency will be discontinued from circulation.
(At present, the lowest denomination coin which is legal tender in India is 50 paise coin. However, according to the guidelines of the RBI, 50 paise coins can be used only for a payment of up to 10 Rs.)
How it affects us?
- Inflation adversely affects our savings. It affects the poor the most. It is mainly because the poor do not have a surplus. Hence, the moment the price increases his consumption is affected.
- On the other hand, the rich have a surplus that can be invested in other assets, and as the price of other commodities and services increases, the value of that asset may increase. This increase in the value of the asset will neutralize the impact of the increase in the price of consumption.
- As inflation increases at a rapid pace, the lender will be at a loss whereas the borrower will be benefited. Hence, with the rapid increase in inflation in order to ensure their profit, the banks will also increase the interest rate while lending. As the interest rate on loans increases, it becomes costlier for the consumer to borrow, and the consumption declines.
- It also becomes costlier for the investors to borrow. Hence, investment and production are also affected.
Therefore, it can be said that if inflation increases at a rapid pace it will affect economic growth in the country.
If the increase in inflation is much higher as compared to the interest paid by banks on the deposits, the consumer will prefer consuming that amount of money rather than depositing it with the bank. Hence, in order to attract more and more deposits, the bank will have to increase the interest rate even on deposits.
Types:
Based on Causes:
Based on the cause behind inflation, it can be classified into three different types-
- Demand-pull Inflation
- Cost-push inflation
- Structural inflation
Demand-pull inflation-
It takes place in any economy because of an increase in demand. If in case the flow of money in the economy i.e. the liquidity is high either because of an increase in our income or employment opportunities or because of a decline in the interest rate on borrowing or an increase in the expenditure of the government, the consumer is left with surplus money. Due to this the consumption or the demand increases. If this increase in demand is not adequately matched with supply then the price will increase leading to demand-pull inflation. That is the reason why every economy tries to create more and more employment opportunities but employment opportunities have to be created only to the extent that they do not accelerate inflation beyond control. This is referred to as NAIRU.
NAIRU (Non-Accelerating Inflation Rate of Unemployment)-
Demand-pull inflation is always associated with economic growth. As the demand increases, the companies try to produce more and more which leads to economic growth. However, the gap between the demand and supply should not be very high otherwise demand-pull inflation will not be beneficial. The goods and services will go beyond the reach of common people. That is the reason why employment opportunities should be created in a productive manner. It means that along with an increase in income of an individual, he should also contribute to supply.
In a developing economy like India demand-pull inflation is a common phenomenon. More and more employment opportunities are being created leading to a continuous increase in demand which is the cause behind demand-pull inflation.
Cost-push inflation-
Cost-push inflation does not take place because of an increase in demand. It takes place in an economy mainly because of an increase in the cost of production. In other words, if the price of raw material or any other input increases, the price of the final product or service will increase even without an increase in demand. For example- Crude oil is the source of production of diesel and diesel is the most important source of fuel in production activities. Hence, if diesel becomes more costly the cost of production will increase leading to cost-push inflation. Cost-push inflation is not directly associated with demand but it may be indirectly associated with demand.
Structural inflation-
It takes place in any economy because of structural deficiencies. In other words, if the storage and transportation facilities are not adequate and even if the goods are produced in sufficient quantity, they will fail to reach the market in adequate quantity. Structural inflation can also happen because of hoarding, cartelization, or black marketing. Hence, it can be said that structural inflation is that inflation takes place because of supply-side problems when a middleman or a dealer procures a commodity in huge quantity and instead of supplying it in the market, stores that commodity for a long period of time creating an artificial shortage of product in the market then it is termed as hoarding. When the producers of a commodity or providers of a service mutually decide to increase the price, setting aside competition then it is termed cartelization (both hoarding and cartelization are illegal).
Indian Context
In India, inflation exists because of all the three factors- demand-pull, cost-push and structural problems. India is a developing economy where employment opportunities are continuously being created. At the same time, public expenditure because of infrastructure development as well as welfare schemes remains high. This results in demand-pull inflation. The flow of black money in the economy is also an important cause behind demand-pull inflation. Similarly, India is not self-sufficient in terms of the production of a number of raw materials or other inputs. So, the country depends upon the import of these raw materials. Hence, the moment the price of raw materials in the international market increases cost-push inflation in India becomes obvious. Along with the storage facilities, transportation facilities also lead to price rises. Black marketing, hoarding, and cartelization are common problems.
In India, the RBI is responsible for controlling inflation. Inflation targeting and keeping inflation within the set target is the responsibility of the RBI. However, the RBI through its monetary policies can only control demand-pull inflation that too only to a limited extent. The RBI can only control credit flow in the economy by taking away surplus money from the banking system. However, in this process economic growth is affected. The RBI can’t control that part of inflation which is driven by black money. In case the public expenditure (expenditure of the government) remains high the monetary policies become ineffective. At the same time, in controlling cost-push inflation and structural inflation the role of government and state government is more important as compared to the RBI. Hence, inflation can be controlled only through the combined efforts of the RBI, the central government as well as state government.
Types of inflation based on rate-
Based on the rate of increase in inflation, it can broadly classify into four different types.
Creeping inflation-
If inflation remains between 0-3% (mainly it is above 0), it is termed creeping inflation. It is a common characteristic of developed economies. Since the demand in developed economies remains low, the rate of inflation also remains low. It is a sign that the economy is completely under control and the demand is also not very high.
Walking or Trotting Inflation-
If inflation remains above 3% and up to 10% then it is termed walking/trotting inflation. It is a common characteristic of developing economies. It shows that the demand is high and some type of cost-push and structural factors are also present. However, if walking inflation is at the upper side then it is a cause of concern.
Runaway Inflation-
When inflation remains above 10% and up to 30% then it is termed as runaway inflation. It shows that inflation is moving at a rapid pace and it is going completely beyond control. It is very bad for any economy.
Galloping/Hyperinflation-
When inflation goes completely beyond control and may move to any extent then it is termed galloping/hyperinflation. It is a sign of a failed economy and is extremely bad.
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