What Does Inflation Mean?

The rate at which the general level of prices for goods and services is rising,
and, subsequently, purchasing power is falling. Central banks attempt to stop
severe inflation, along with severe deflation, in an attempt to keep the
excessive growth of prices to a minimum.

Inflation: What Is Inflation?

Inflation is defined as a sustained increase in the general level of prices for
goods and services. It is measured as an annual percentage increase. As
inflation rises, every dollar you own buys a smaller percentage of a good or
service.

The value of a dollar does not stay constant when there is inflation. The
value of a dollar is observed in terms of purchasing power, which is the real,
tangible goods that money can buy. When inflation goes up, there is a
decline in the purchasing power of money. For example, if the inflation rate
is 2% annually, then theoretically a $1 pack of gum will cost $1.02 in a year.
After inflation, your dollar can't buy the same goods it could beforehand.

There are several variations on inflation:

Deflation is when the general level of prices is falling. This is the
opposite of inflation.
Hyperinflation is unusually rapid inflation. In extreme cases, this can
lead to the breakdown of a nation's monetary system. One of the most
notable examples of hyperinflation occurred in Germany in 1923, when
prices rose 2,500% in one month!
Stagflation is the combination of high unemployment and economic
stagnation with inflation. This happened in industrialized countries during
the 1970s, when a bad economy was combined with OPEC raising oil
prices.

In recent years, most developed countries have attempted to sustain an

inflation rate of 2-3%.

Causes of Inflation
Economists wake up in the morning hoping for a chance to debate the
causes of inflation. There is no one cause that's universally agreed upon,
but at least two theories are generally accepted:
Demand-Pull Inflation - This theory can be summarized as "too much
money chasing too few goods". In other words, if demand is growing faster
than supply, prices will increase. This usually occurs in growing economies.

Cost-Push Inflation - When companies' costs go up, they need to

increase prices to maintain their profit margins. Increased costs can
include things such as wages, taxes, or increased costs of imports.

Costs of Inflation
Almost everyone thinks inflation is evil, but it isn't necessarily so.
Inflation affects different people in different ways. It also depends on
whether inflation is anticipated or unanticipated. If the inflation rate
corresponds to what the majority of people are expecting (anticipated
inflation), then we can compensate and the cost isn't high. For example,
banks can vary their interest rates and workers can negotiate contracts
that include automatic wage hikes as the price level goes up.

Problems arise when there is unanticipated inflation:

Creditors lose and debtors gain if the lender does not anticipate inflation
correctly. For those who borrow, this is similar to getting an interest-free
loan.
Uncertainty about what will happen next makes corporations and consumers
less likely to spend. This hurts economic output in the long run.
People living off a fixed-income, such as retirees, see a decline in their
purchasing power and, consequently, their standard of living.
The entire economy must absorb repricing costs ("menu costs") as price
lists, labels, menus and more have to be updated.
If the inflation rate is greater than that of other countries, domestic products
become less competitive.

People like to complain about prices going up, but they often ignore the fact
that wages should be rising as well. The question shouldn't be whether
inflation is rising, but whether it's rising at a quicker pace than your wages.

Finally, inflation is a sign that an economy is growing. In some situations,

little inflation (or even deflation) can be just as bad as high inflation. The
lack of inflation may be an indication that the economy is weakening. As
you can see, it's not so easy to label inflation as either good or bad - it
depends on the overall economy as well as your personal situation.

Inflation: How Is It Measured?

Measuring inflation is a difficult problem for government statisticians. To do
this, a number of goods that are representative of the economy are put
together into what is referred to as a "market basket." The cost of this basket
is then compared over time. This results in a price index, which is the cost of
the market basket today as a percentage of the cost of that identical basket in
the starting year.

In North America, there are two main price indexes that measure inflation:

Consumer Price Index (CPI) - A measure of price changes in consumer

goods and services such as gasoline, food, clothing and automobiles. The
CPI measures price change from the perspective of the purchaser. U.S.
CPI data can be found at the Bureau of Labor Statistics.
Producer Price Indexes (PPI) - A family of indexes that measure the average
change over time in selling prices by domestic producers of goods and
services. PPIs measure price change from the perspective of the seller. U.S.
PPI data can be found at the Bureau of Labor Statistics.

You can think of price indexes as large surveys. Each month, the
U.S. Bureau of Labor Statistics contacts thousands of retail stores,
service establishments, rental units and doctors' offices to obtain price
information on thousands of items used to track and measure price
changes in the CPI. They record the prices of about 80,000 items each
month, which represent a scientifically selected sample of the prices
paid by consumers for the goods and services purchased.

In the long run, the various PPIs and the CPI show a similar rate of
inflation. This is not the case in the short run, as PPIs often increase
before the CPI. In general, investors follow the CPI more than the PPIs.
Types of Inflation

Inflation is a situation of sustained and inordinate increase in the prices of

goods and services. Read on to understand the various types of inflation.
When there is a rise in general price level for all goods and services it is
known as inflation. An inflationary movement could be because of the rise
in any single price or a group of prices of related goods and services.

Types of Inflation

There are four main types of inflation. The various types of inflation are
briefed below.

Wage Inflation: Wage inflation is also called as demand-pull or excess

demand inflation. This type of inflation occurs when total demand for
goods and services in an economy exceeds the supply of the same. When
the supply is less, the prices of these goods and services would rise,
leading to a situation called as demand-pull inflation. This type of
inflation affects the market economy adversely during the wartime.

Cost-push Inflation: As the name suggests, if there is increase in the cost

of production of goods and services, there is likely to be a forceful
increase in the prices of finished goods and services. For instance, a rise
in the wages of laborers would raise the unit costs of production and
this would lead to rise in prices for the related end product. This type of
inflation may or may not occur in conjunction with demand-pull
inflation.

Pricing Power Inflation: Pricing power inflation is more often called as

administered price inflation. This type of inflation occurs when the
business houses and industries decide to increase the price of their
respective goods and services to increase their profit margins. A point
noteworthy is pricing power inflation does not occur at the time of
financial crises and economic depression, or when there is a downturn
in the economy. This type of inflation is also called as oligopolistic
inflation because oligopolies have the power of pricing their goods and
services.

Sectoral Inflation: This is the fourth major type of inflation. The

sectoral inflation takes place when there is an increase in the price of
the goods and services produced by a certain sector of industries. For
instance, an increase in the cost of crude oil would directly affect all the
other sectors, which are directly related to the oil industry. Thus, the
ever-increasing price of fuel has become an important issue related to
the economy all over the world. Take the example of aviation industry.
When the price of oil increases, the ticket fares would also go up. This
would lead to a widespread inflation throughout the economy, even
though it had originated in one basic sector. If this situation occurs
when there is a recession in the economy, there would be layoffs and it
would adversely affect the work force and the economy in turn.

Other Types of Inflation

Fiscal Inflation: Fiscal Inflation occurs when there is excess government

spending. This occurs when there is a deficit budget. For instance, Fiscal
inflation originated in the US in 1960s at the time President Lydon
Baines Johnson. America is also facing fiscal type of inflation under the
presidentship of George W. Bush due to excess spending in the defense
sector.

Hyperinflation: Hyperinflation is also known as runaway inflation or

galloping inflation. This type of inflation occurs during or soon after a
war. This can usually lead to the complete breakdown of a country’s
monetary system. However, this type of inflation is short-lived. In 1923,
in Germany, inflation rate touched approximately 322 percent per
month with October being the month of highest inflation.

What is Inflation?
The measure of price increases within a set of goods and services over a
period of time is known as inflation. The most common gauge of inflation is
known as the CPI, or consumer price index, which measure the price
increases (decreases) of basic consumer goods and services. The GDP
deflator is another very important measure of inflation as it measures the
price changes in goods that are produced domestically. In effect, inflation
decreases the value of your money and makes it more expensive to buy
goods and services.
Causes OF Inflation
There are a few different reasons that can account for the inflation in our
goods and services; let's review a few of them.
Demand-pull inflation refers to the idea that the economy actual demands
more goods and services than available. This shortage of supply enables
sellers to raise prices until an equilibrium is put in place between supply and
demand.
The cost-push theory , also known as "supply shock inflation", suggests that
shortages or shocks to the available supply of a certain good or product will
cause a ripple effect through the economy by raising prices through the
supply chain from the producer to the consumer. You can readily see this in
oil markets. When OPEC reduces oil supply, prices are artificially driven
up and result in higher prices at the pump.
Money supply plays a large role in inflationary pressure as well.
Monetarist economists believe that if the Federal Reserve does not
control the money supply adequately, it may actually grow at a rate
faster than that of the potential output in the economy, or real GDP.
The belief is that this will drive up prices and hence, inflation. Low
interest rates correspond with a high levels of money supply and allow
for more investment in big business and new ideas which eventually
leads to unsustainable levels of inflation as cheap money is available. The
credit crisis of 2007 is a very good example of this at work.
Inflation can artificially be created through a circular increase in wage
earners demands and then the subsequent increase in producer costs which
will drive up the prices of their goods and services. This will then translate
back into higher prices for the wage earners or consumers. As demands go
higher from each side, inflation will continue to rise.
Effects OF Inflation
The effects of inflation can be brutal for the elderly who are looking to retire
on a fixed income. The dollars that they expect to retire with will be worth
less and less as time goes on and inflation goes higher.
When the balance between supply and demand spirals out of control, buyers
will change their spending habits as they meet their purchasing thresholds
and producers will suffer and be forced to cut output. This can be readily
tied to higher unemployment rates. When extremes arise in the
supply/demand structure, imbalances are created.
The mortgage crisis of 2007 is a great example of this. Home prices were
increasing at a very rapid rate from 2002 to 2005 and got to the point
where the prices became too high, forcing buyers to step aside. This lack
of demand forced sellers to drop prices back to a point where there is
demand. As I write this article, this equilibrium has still not come into
the real estate market. This is due to many factors, as you will read in
our mortgage crisis article, but the extreme acceleration of inflation in
home prices is directly correlated to the pullback we are seeing.
A similar example can be seen in the internet euphoria in the stock market
back in 1998 to 2000. This rapid acceleration in stock prices eventually
became unsustainable and led to a disastrous fall.
The point that is being made is that if inflation is not contained and rises at
an unsustainable rate; the stronger the impact on the other side. There is a
saying; "the bigger they are, the harder they fall".

INFLATION DRAGON - IT'S GROWTH AND TENTACLES

A.D. Sharma*

One of the most important topics in economic discussions today is

price inflation. Sometimes it assumes serious political implications.
What are the determining factors of price inflation? How does inflation
occur? How does it affect the process of economic growth? Can we
make out different categories of inflation and can we determine as to
which of its types is a lesser evil for the economy and which one is to be
detested? There is no denying that inflation has to be fought hard and
the country be relieved of its grip.

Types

There can be demand-pull inflation or cost-push inflation. Or else,

there can be inflation resulting from a quick price rice of a particular
commodity due to failure of a crop and the supply of the concerned
commodity falling short of demand. Such an inflation is not much of a
cause of worry. The effect of such a price rise can reverse in the
following year. Inflation is bad when all commodities or at least most of
the commodities are affected by price escalations. Such an inflation can
upset the very apple-cart of the whole economy. It can disturb the
structure of any entrepreneurial expectations and disturb the whole
production system.

Prices had escalated by 18.2 per cent in 1980-81 when the prices of
most of the commodities and services had shot up.

The economic scenario in the country in the recent past has been
dominated by unprecedented happenings. Prices, particularly of
vegetables had touched a new high. Vegetables, had gone almost out of
reach for the ordinary people. A routine economic explanation of this
will be an excess of demand over supply. Numerous factors determine
the volume of demand and supply for any given period.

Theoretically speaking, it can be said that supply may be affected by

cost of production, availability of inputs and technology. But India is a
special case where supply is affected by factors not easily controllable.
The reasons are not far to seek. The Indian economy is dominated by
the primary sector, depending largely on nature, low per capita income
and lack of education. But at the same time it has a technologically
advanced industrial sector, fast means of communication and liberal
economic policies.

When we look at the history of price rise, the statistics clearly

demonstrates that inflation is caused due to factors not within human
control. Over the decades prices have been increasing following
droughts or floods. Fear of scarcities has also aggravated it.

Agrarian Economy

India is a country where two-thirds of its population still depends on

agriculture for livelihood. Almost 20 percent of India's exports consists
of primary goods. A 25 per cent of GDP is earned from the primary
sector. Even a large section of industrial sector also depends on
agriculture for raw material and other inputs. Still it largely depends on
the mercy of nature.

Too much or too little rain may bring misery and suffering for the
whole economy and its people. And a good monsoon can bring hopes of
prosperity and satisfaction. The reason is not far to seek. Only 33 per
cent of the sown area in India is irrigated through modern means while
the rest of the farms are dependent on the mercy of nature which can be
good, bad or indifferent. Being close to the equator, India has to suffer
frequent storms as well. What will be the degree of volatility in an
economy under such conditions can be anybodyÕs guess. The
unimaginably high prices of some of the vegetables and cereals in the
past few months are examples of natureÕs niggardliness. Statistics
shows that inflation occurs whenever there has been either too much or
too little rain.

Of late, the rate of inflation has been around 8 per cent. The outcome
of dependence on nature is multifold. In the first place the agricultural
products become short in supply. Secondly, the prices inflate since their
demand remains at the same level, causing disparity in supply and
demand. Thirdly, the cost of production of industrial goods using inputs
from the primary sector also increases due to short supply. As an
outcome the prices of these goods go up while their supply gets reduced.

There have been years when the prices and the inflation rate were as
high as 22.7 per cent as happened in 1973-74.

Excess Money Supply

Talking in terms of aggregates, an excess of money supply over the

supply of goods and services will always result in an immediate upsurge
in prices. This is because an effective demand increases at the given
level of supply.

In case of India, money supply has increased 332 times over the past
47 years (1951-1997) whereas the volume of total production (GNP) has
increased only 108 times during the same period. No one can blame the
heavens for the present state of economy. Heavy deficit financing has
been the main culprit.

Nothing much has to be said about black money and its role in
causing inflation. Any money which is unaccounted for will mostly be
spent on consumption and, that too, on conspicuous consumption. One
thing that cannot be debated is that whenever there will be excess of
money or purchasing power over supply, the natural outcome will be
inflation. In fact, money inflation always causes price inflation.

Patterns

Another significant factor behind inflation is that an average Indian

consumer spends a considerable percentage of his income on food,
whereas in any developed country this proportion is very meagre. The
basic reason for this is that the per capita income in India is very low at
only $ 390 per year according to World Development Report 1998
compared to $ 28740 in USA and $ 37850 in Japan.

Naturally, if there is scarcity of food articles or even its apprehension,

the increase in their prices fuels inflation. It will naturally upset the
consumption pattern of an average consumer and may put a question
mark on the economic system as a whole. Any rise in wages is absorbed
in the increased prices, leaving no room for improving the living
standards of the common people.It hurts the psychology of the masses.

Hoarding

Hoarding is usually referred to in the context of profiteers and black

marketers. No doubt, unscrupulous businessmen resort to hoarding
with the aim of reaping high profits. This happens whenever there is
even an apprehension of scarcity. So, whenever a monsoon is
unfavourable, goods go out of market even though new crops are yet to
come and they may not be affected by the bad season at all. This creates
tension and panic. Although there is no scarcity as such, the profiteer
creates it artificially. The panic-struck consumer makes frantic
purchases and the demand escalates. This artificial scarcity and undue
increase in demand leads to an increase in prices and a vicious circle of
created scarcity and panic buying starts, aggravating the situation.

Solution

A well planned, reasonable and balanced intervention by the

government can perhaps offer a panacea.

The interests of the economy and the society are served only when
interests of both the consumer and the seller are adequately protected.

Free play of market forces is justified only in theory. In practice

many other things should be taken care of such as the availability of
resources, the state of technology and infrastructure, the level of
awareness and reasoning and the capacity to absorb imperfections.
 A country like India with an ever-increasing population and
dominated by the primary sector where nature plays a significant role
and even an apprehension of scarcities can create panic, cannot really
be left to its fate in the hands of the market forces.

The public distribution system has to be geared up, made more

effective and efficient. A tough control over possible hoarders, profiteers
and self-seeking elements is a must. The supply and demand sides have
to be regulated. This is necessary till the economy develops itself fully to
sustain any jerk without losing balance.

What is also very essential is that the people have to understand the
facts and logistics of price inflation. They have to ignore the short-term
causes and have to resist artificial panic created by forces out to
destabilise the economy. This will certainly take away much of the
steam out of the gory play of the forces stoking inflation.