UNIT IV
INFLATION, DEFLATION AND
LESSON 8:
INFLATION , DEFLATION AND
REFLATION
Hello students now lets take a look at a very interesting topic
BUSINESS ECONOMY II
that is Inflation
Objective of the module
Meaning and Explanation
Demand and cost Inflation
Introduction
If money is to serve its good purpose its value must remain
stable. Changes in value of money lead to harmful conse-
quences in the economy at large.
Some broad effects of changes in value of money are traced
below:
1. Price fluctuations implies that the value of money is
unstable. This adversely affect the confidence in money fails
to serve as a good store of value.
2. Even as a means of payments it looses its growth. It may
also become a source of peril and confusion. Since prices of
all goods do not change in the same order, the relative price
structure is distorted. When prices of necessaries tend to
rise while those of luxuries may be falling, there is regressive
effect, as the poor consumers suffer, while the rich are
benefited while spending their money.
3. Price variations in product and factor markets are not
uniform. Thus, thecost-functions and revenues in different
categories of production differ. As a result, profitability of
firms and industry tend to differ. Marginal productivity of
different factors in different uses never tend to identical
when the value of money fluctuates in segregated manner.
This obstructs the optimal utilisation of resources. This
may also cause maladjustment and wastefulness in the
eXploitation of countrys productive resources.
4. When value of money changes incoherently in different
types of real and financial assets, assets portfolio
management becomes a difficult task. It also distorts the
pattern of wealth distribution and position of the wealth
holders. Say, for instance, when share prices fall but real
estate prices rises,then person who has invested in shares is
a looser while person occupying a real estate of the same
amount is a gainer.
Such changes in different values of wealth due to unstable value
of money distorts the pattern of income distribution. Conse-
quently, savings and investment may be adversely affected. It
also disturb business expectations and business planning.
Business risks would be high when value of money in not
stable.
5. Effects of rising prices in general- inflation effects - are also
different from the effects of falling prices in general - the
deflation effects. Especially, tempo of growth process and
economic development is disturbed -due to instability in
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48
UNEMPLOYMENT
the value of money. It also adversely affects the course
of economic planning and programming both at macro and
micro levels.
In short, most of such harmful effects are indirectly by the
menace of , inflation and deflation. Inflation implies declining
value of money: Deflation implies rising value of money. We
shall therefore, discuss these topics in details in this chapter.
Meaning of Inflation
Inflation is commonly understood as a situation of substantial
and rapid general increase in the level of prices and consequent
deterioration in the value of money over a period of time.
The behaviour of general prices is measured through price
indices. The trend of price indices reveals the course of inflation
or deflation in the economy. As Lerner says, a price rise which is
unforeseen and uncorrected is inflationary.
Thus, inflation is statistically measured in terms of percentage
increase in the price index, as a rate per cent per unit of time -
usually a year or a month.
Usually, the wholesale price index (WPI) numbers are used to
measure inflation. Alternatively, the consumer price index (CPI)
or the cost of living index number can be adopted in measuring
the rate of inflation.
A Few Definitions
Inflation is like an elephant to the blind men. Different
economists have defined inflation differently. We may, thus,
enlist a few important definitions of inflation as under which
would give us a comprehensive idea about this intricate
problem.
Harry Johnson defines inflation as a substained rise in prices.
Crowther, similarly defines inflation as a state in which the
value of money is falling, i.e., prices are rising.2
The common feature of inflation is a price rise, the degree of
which may be measured by price indices.
Edward Shapiro, puts it thus: Recognising the ambiguities our
words contain, we will define inflation simply as a persistent
and appreciable rise in the general level of prices.3
Prof. Samuelson puts it thus: Inflation occurs when the
general level of price and costs is rising.Authors like Throp and
Quandt, however, opine that it is of great help to defme
inflation in terms of observable phenomenon and for this
reason the process of rising prices should be considered as
inflationary.
There are, at least, two distinct views on the concept of
inflation. To some economists, inflation is a pure monetary
phenomenon, while to others, it is a postfull employment
phenomenon.
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Inflation As A Pure Monetary Phenomenon
Monetarists, in general, regard inflation as a purely monetary
phenomenon. It is held that when money supply exceeds the
normal absorbing capacity of the economy, it leads to persis-
tently rising prices. In other words, when there is overexpansion
of money supply and too much money chasing too few goods,
inflation occurs. Milton Friedman, puts thus, Inflation is
always and everywhere a monetary phenomenon.
Goldenweiser goes on to state that Inflation occurs when the
volume of money activity bidding forr goods and services
increases faster than the available supply of goods, when the
growth of national income in money units is greater than its
growth in physical units.
The monetarists view, in fact, is a corollary to the quantity
theory of money. Other things being equal, if money supply
increases, there is inflation or a rise in prices.
This evidently follows from the Fisherian equation:
MV =P T
Assuming
V and T to be constant,
P rises directly in proportion to the increase in money supply
(M).
Economists such as Milton Friedman, Hawtrey and
Goldenweiser who looked upon inflation as a purely monetary
phenomenon, firmly believed in the quantity theory of money.
But the theory failed to explain the phenomenon of hyper-
inflation, where the rise in the prices may cause an increase in the
money supply which, in turn, may cause a further rise in prices.
In fact, the phenomenon of money and prices chasing each
other in a vicious spiral is so indivisible that it is not very easy to
determine which is the cause and which is the effect in the
dynamic process of inflation. Moreover, the quantity theory is
quite misleading and confusing if one were to analyse a
situation of depression, in which the government resorts to the
usual fiscal and monetary techniques to counteract the evils of
depression, and the result is both an increase in money supply
and a rise in prices.
Inflation As A Post-full Employment Phenomenon
Although inflation by its nature is commonly conceived as a
monetary phenomenon, a group of economists, including
Pigou and Keynes, regarded inflation as a phenomenon of full
employment. In particular, the Keynesian theory of inflation is
based on the concept of full employment. In the Keynesian
view, rising prices in all situations cannot be termed inflation. In
a situation of underemployment, when an increase in money
supply and rising prices are accompanied by an expansion of
output and employment, inflation does not occur. Sometimes,
due to bottlenecks in the economy, an increase in money supply
may cause costs and prices to rise more than the expansion of
output and employment. This is known as semi-inflation or
bottleneck inflation. Once full-employment level is reached, the
entire increase in money supply is reflected by rising prices-a case
of a true inflation.
Inflation occurs in a situation where there is an increase in
demand expressed through more money spending but no
corresponding increase in production either due to bottlenecks
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11.251
operating in the economy or because the economy has already
BUSINESS ECONOMY II
reached the full employment level.
In Keynes view, thus, rising prices in all situations cannot be
termed as inflation. In a condition of under-employment,
when an increase in money supply and rising prices are accompa-
nied by the expansion of output and employment, but
when1here are bottlenecks in the economy, an increase in money
supply may cause cost and prices to rise more than the expan-
sion of output and employment. This may be termed as
semi-inflation or reflation till the ceiling of full employ-
ment is reached. Once full employment level is reached, the
entire increase in money supply is reflected simply by the rising
prices - the real inflation.
Incidentally, Keynes mentions the following four related terms
while discussing the concept of inflation:
1. Reflation,
2. Inflation,
3. Disinflation, and
4. Deflation.
Using a trade cycle model (as in Figure 1) we may clarify these
terms as under:
1. Reflation. It is a situation of rising prices, deliberately
undertaken to relieve a depression. With rising prices,
employment, output and income also increase till the
economy reaches the full employment ceiling.
In the below diagram, the FF line represents the full employ-
ment ceiling and represents the normal path. In the beginning
when the economy is at a point of below full employment
equilibrium, an increase in money supply leads the economy to
move on the path ofAB. However, till the economy reaches the
pointB, price rise is accompanied by the expansion of employ-
ment and output. The situation is, thus, described as
semi-inflation or reflation.
fig. 1: The Model of a Trade Cycle
Inflation. It occurs when prices rise after the stage of full
employment is reached in the economy, with no corresponding
rise in employment and output. The following are the main
characteristics of inflation:
Inflation is a long-term operating dynamic process.
Inflation is a process of persistently ris.ing price level.
Inflationary price rise is persistent and is irreversible within a
short time; thus, it should be distinguished from a price
rise which may occur temporarily, due to short-term scarcity
or during a cyclical upswing.
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 A cyclical movement is not inflation. Inflation is a rising
BUSINESS ECONOMY II
trend in the price level.
Inflation is endogenous to the economic system.
Inflation is fostered by the interaction of a multitude of
economic factors. (g) Inflation, in a real sense, is a post-full
employment phenomenon. (h) By and large, inflation is also a
monetary phenomenon. It is usually characterised by an
overflow of money and credit. In fact, the root causeof
inflation is the expansion of money supply beyond the normal
absorbing capacity of the economy.
In Figure 1, the economys path up to BC is inflationary,
Disinflation. When prices are falling due to anti-inflationary
measures adopted by the authorities, with no corresponding
decline in the existing level of employment, output and
income, the result is disinflation.
When acute inflation afflicts the community, disinflation is
adopted as a cure. Disinflation is said to take place when
deliberate attempts are made to curtail expenditure of all sorts
to lower prices and money incomes for the benefit of the
community.
In Figure 1, the path CD represents disinflation.
Deflation: It is a condition of falling prices accompanied by a
decreasing level of employment, outpUt and income. Deflation
is just the opposite of inflation. Deflation occurs when the total
expenditure of the community is not equal to the existing
prices. Consequently, the value of money goes up and prices
fall. However, each and every fall in price cannot be called
deflation. The process of reversing inflation without either
creating unemployment or reducing output is called
disinflation and not deflation.Deflation is an under-
employment phenomenon. In Fig. I, the path DEG shows
deflation.
Contemporary Views on Inflation
For all practical purposes, Emile James defined inflation as a
self-perpetuatingand irreversible upward movement of prices,
caused by an excess of demand over capacity to supply. Here,
Prof. James points ab oUt that excess demand may be demand
for investment as well as for consumer goods. The phrase
capacity to supply in the definition stresses that any increase in
demand, at a given moment, constitutes a call for an increase in
production. If the productive apparatus can meet the challenge,
there will be no inflation. Inflation can come aboUt only if
expansion in production or supply is held back by some
obstacle, such as full employment of resources or occasionally,
by some constraints, and market imperfections. In this sense,
the term inflation is also applicable to an economy when a
rise in the price level may not lead to increased output beyond a
certain stage due to the existence of bottlenecks, even. though
the stage of full employment is not attained. Briefly then, apart
from price rise, the existence of excess demand is regarded as an
essential characteristic of inflation.
It is generally believed that inflation is accompanied by growth
in employment.
However, in recent years, the world has been experiencing a
situation in which the price level has been continuously rising
but simultaneously there has been a rise in the rate of unem-
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50
ployment and stagnation in the rate of growth. To describe this
situation, Professor Samuelson has coined a new term,
stagflation. As Samuelson says, Stagflation involves inflation-
ary rises in prices and wages at the same time so that people are
unable to find jobs and firms are unable to find customers for
what their plants can produce.In short, stagflation refers to a
situation of recession and rising unemployment accompanied
by a rising price level.flats, etc. are much high and fascinating
than the rate of returns on shares, and bonds in an inflationary
economy.
9. Interest rates in the unaccounted and unorganised sectors
tend to be higher than the organised sectors of the money
market.
10. Labour unrest, strikes, lock-outs, etc. are common.
Organised labour force successfully resists any reduction in
real wages and pushes up the money-wages, thereby
accelerating the process of cost-plish inflation.
11. In an inflationary economy, the government is trapped in
the cob-web of ever increasing public expenditure, larger
budgets, higher taxes, larger public debts, huge deficit
financing and a large number of controls, which, in turn,
encourage black money and dual accounting system,
blackmarketing, smuggling and other antisocial activities on
account of the deterioration of the communitys morals in
general caused by the inflationary impact.
In short, an economy is inflationary because it is inflationary.
There tends tobe a vicious circle of inflation when it is curbed
immediately. In the long period, the state of unchecked
inflation becomes a built-in feature of the economy and people
expect the rate of inflation to accelerate further.
Students now lets try to understand inflation in a different way
Meaning of Inflations
Different economists have offered different definitions of the
term inflation. In fact, there is a plethora of defInitions on the
subject. Inflation in the popular mind is generally associated
with rapidly rising prices which cause a decline in the purchasing
power of money. Prof. Hawtrey defines inflation as the issue
of too much currency. Prof. Kemmerer has defined inflation as
too much currency in relation to the physical volume of
business being done. Prof. Coulbourn has defined inflation as
too much money. chasing too few goods. These definitions
given by Hawtrey, Kemmerer, and Coulbourn belong to the
same category. They seek to establish cause and effect relation-
ship between supply of money and the price level. According to
these definitions, the rise in the pricelevel is caused by an
increase in the supply of money. The increase in the supply of
money is the cause, the rise in the price-level is the effect.
But the above cause and effect relationship between supply of
money and the price-level was reversed in Germany after the
First World War. The rise in the price-level, instead of being the
result, was actually the cause of the expansion of money supply
in Germany in .the post-war period. In other words, it was the
rise in prices which caused the expansion of money supply in
Germany. It is in this context that Prof. Einzig has drawn a
distinction between money inflation and price inflation.
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-According to him, money inflation is the first stage of inflation
in which the excess of money supply over business require-
ments pushes up the price-level. Price inflation is the second
stage of inflation when the rising price-level necessitates a rapid
expansion of the supply of money. During price inflation, the
prices rise with such rapidity that even the money supply cannot
keep pace with them. The stage of inflation is referred to as
hyper-inflation. To our mind, Einzigs definition of inflation
appears to be the best because it fully explains the phenomenon
of inflation. In the words of Einzig, Inflation is that state of
disequilibrium in which an expansion of purchasing power
tends to cause or is the effect of an increase in the price-leveL
An analysis of this definition reveals the fact that the rise in the
price-level is not only the result but also the cause of the
expansion of money supply.
But recently, Prof. Keynes has linked up the concept of inflation
with the phenomenon of full employment. According to
Keynes, an inflationary rise in the price-level cannot take place
before the point of full employment. An expansion of money
supply will not lead to a rise in the price-level so long as there
are unemployed resources in the economy. The price-level will
rise only after the point of full employment has been reached.
According to Keynes, the rise in the price-level after the point of
full employment is true inflation.
Approaches to the Theory of Inflation
There are two main approaches to the theory of inflation:
i. The Quantity Theory of Money Approach, and
ii. The Excess Demand Approach.
i. The Quantity Theory of Money Approach
According to this approach, it is the increase in the quantity of
money which causes an inflationary rise in the price-level. This
approach looks upon inflation as a purely monetary phenom-
enon. It has been subjected to criticism in recent years:
a. This approach does not adequately explain the
phenomenon of hyper-inflation which took place in
Germany in the post-war period. It was the rise in the price-
level which caused an increase in the supply of money there.
b. This approach is not applicable to an economy which
suffers from depression and unemployment.
An expansion of money in such an economy may not necessar-
ily result in an inflationary rise in the price-level. An expansion
of money supply in such an economy, instead of raising the
price-level, will go to increase output and employment.
ii. Thee Excess Demand Approach
This approach has been developed in recent years by the
Cambridge economists, particularly Keynes. According to them,
Just as the price of any good is determined by the demand for
and the supply of it, so also the general price-level is determined
by the total demand for and total supply of the group of
goods concerned. Thus, according to this approach, inflation is
that situation in which the total demand for goods exceeds the
total supply of goods at current prices. The sole cause of
inflation, according to this approach, is the existence of a
persistent excess demand in the economy. This phenomenon
of excess demand can arise in a number of situations, such as,
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during the war, or during the planning period, or during a
BUSINESS ECONOMY II
period of technological improvements.
There is, however, no fundamental difference between the two
approaches. The excess demand can become effective only
through an increased supply of money. The increased supply of
money is thus the causal factor of inflation. Ultimately, there is
no basic difference between the quantity theory of money
approach and the excess demand approach. The excess demand
approach is, however, more popular than the quantity theory of
money approach.
The above explanation of excess demand approach highlights
the various factors that cause the emergence of excess demand
in the economy. The emergence of excess demand in the
economy can be attributed to two main factors:
i. Increase in the demand for goods and services, and
ii. Decrease in the supply of goods and services. The factors
causing an increase in demand include increase in public
expenditure, increase in private expenditure, increase in
exports, reduction in taxation and repayment of past
internal debts. The factors causing a decrease in supply
include such things as shortage of supplies of factors of
production, hoarding by traders and consumers, etc.
Demand Inflation and Cost Inflation
Broadly speaking, there are two main causes of inflation: (I) an
increase in effective demand, and (ii) an increase in production
cost. The former gives rise to demand inflation while the latter
leads to cost inflation.
Demand-Pull Inflation
Demand-pull inflation is caused by an increase in the aggregate
effective demand for goods and services in the economy. The
effective demand increases due to increased money incomes of
the factors of production consequent upon increased invest-
ment in the economy. This demand inflation is marked by a
considerable rise in commodity and factor prices in the
economy. This type of inflation generally arises in thePost-war
period when people rush up to give vent to their pent-up
demand for goods and services. The demand inflation can be
tackled by the government by curtailing unnecessary demand
through the adoption of monetary and fiscal measures.
Cost-Push Inflation
The cost-push inflation is caused by an increase in production
costs. It is generally caused by two factors: (a) an increase in
wages, and (b) an increase in the profit-margins of the
entrepreneurs. The increase in wages may be caused by a
monopolistic labour union through pressure tactics. This
attempt on the part of the trade unions to push up wages
invariably causes cost inflation in the economy. Cost inflation is
also caused by an organized attempt on the part of the
industrialists to push up their profit margins. But the profits-
push elements are not so important in causing inflation as the
wage-push elements are. Powerful trade unions get the wages
pushed up even without an equivalent increase in the productiv-
ity of the workers. Under these circumstances, the increase in
wages cannot but result in an increase in prices. When cost
inflation arises in one particular industry, it soon spreads to the
other factors of economy as well, the reason being that the
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 various sectors of the economy are closely linked with each
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other.
It should be noted that demand inflation and cost inflation are
not mutually exclusive concepts. Demand inflation, when it
once starts, may soon land the economy into cost inflation. An
increase in the prices of consumer goods is invariably accompa-
nied by the demand for higher wages on the part of the
workers. The prices of raw materials may also. register a rise
under the impact of demand inflation. An increase in wages
and the prices of raw materials will naturally lead to the
emergence of cost inflation in, the economy. It is, thus, difficult
to demarcate the line between demand inflation and cost
inflation. Of the two types of inflations, cost inflation is much
more difficult to control than demand inflation.. Demand
inflation can be tackled by adopting various types of monetary
and fiscal measures to mop up surplus purchasing power from
the hands of the public, but cost inflation cannot be so easily
controlled through monetary and ftscal measures. Any attempt
to cut down wages by the authorities will be met by stiff
resistance on the part of the workers.
Students in some lessons I have introduced exercise for practice
to enable you to answer in a structural manner.I hope it will
help you all.
Exercise for Practice
Ex. 1.
Distinguish between cost-push and demand-pull inflation.
Why is it difficult to separate the one from the other?
Hints:
you may point out that it is often difftcult to separate demand-
pull inflation from cost-push inflation. Demand-pull inflation,
when it starts, soon lands the economy into cost-push infla-
tion. Demand inflation results in a steep rise in the prices of
consumer goods. The workers agitate and through concerted
action get their wages raised. This soon results in increases in
production costs or in cost-push inflation. For a detailed
treatment of this aspect,.}
the Keynesian Theory of Inflationary Gap.
Inflationary Gap arises when money expands more than in
proportion to income-earning activity. Explain and suggest the
necessary measures to bridge any such gap in a developing
economy.
Inflationary Gap
Real inflation, according to Keynes, comes into being only if
monetary expansion continues even beyond the point of full
employment. Then every additional expansion of money
supply shall exert its full effect on prices, raising them to higher
and higher levels. Keynes tried to explain the phenomenon of
inflation in terms of his well-known concept of inflationary gap
in his famous pamphlet entitled How to Pay for the War? The
Keynesian concept of inflationary gap represents the technique
of statistically measuring the pressure of inflation in the
economy. The inflationary gap for the economy, as a whole, may
be deftned in the words of Prof. Kurihara, as an excess of
anticipated expenditure over available output at base prices.
The anticipated total expenditure referred to in the above
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deftnition depends upon the net disposable income of the
community. The net disposable income of the community, in
its own turn, is arrived at by subtracting taxation and saving out
of the total money income. Net disposable income = total
money income taxation saving. Anticipated total expenditure of
the community is determined by tbe aggregate consumption,
investment and government outlays. Thus,total anticipated
expenditure = C + I + G (where, C represents consumption
expenditure, I denotes investment expenditure, and G shows
government outlays on goods and services).
The real output, on the other hand, is determined by the
conditions of employment, plus the technological basis of the
economy. The inflationary gap is a situation where the antici-
pated expenditure (i.e., the demand for output) exceeds the
available output at pre-inflation prices. It is measured by the
difference between the net disposable income on the one hand
and the available output on the other.
The inflationary gap may develop in the economy like this. To
start with, there is an increase either in private investment or in
government outlays. This has the result of raising the money
income of the community to higher levels, but the real output
of goods and services does not increase because the economy is
already operating at the point of full employment. The failure
of the economy to raise its output in response to the increase in
the money income results in the emergence of the inflationary
gap. The inflationary gap is, thus, the result of excess demand
in the economy. In other words, the inflationary gap is equal to
net disposable income minus real output of goods and
services. The inflationary gap has been explained in the Table
below which represents the state of affairs in an imaginary
wartime economy
TABLE (In croses of Rupees)
Demand side Supply Side
Total Money Income .300 Gross National Product
Minus Taxes 50 (at per inflation prices) .270
Total Disposal Income ..250 Minus War Expenditure .90
Minus Saving 50 Available Output for
Net Disposable Income 250 Civilian Consumption
(at pre-inflation prices) .180
Hence,Inflationary Gap =200-180 = Rs. 20 crore
The above Table relates to a wartime economy. There is a clear
inflationary gap of Rs. 20 crore in the economy. So long as this
inflationary gap continues to exist, the price-level shall go on
rising upwards. But if somehow this inflationary gap of Rs. 20
Crore is wiped out, there shall be no inflation at all. The
government can reduce a part of this inflationary gap by cutting
down disposable income through taxes. The whole of the gap
cannot be wiped out through taxation, because in that case there
is bound to be tax:resistance and popular unrest. So it is
advisable to remove the inflationaryc-gap through taxes as well
as induced savings. Yet another way to reduce or narrow down
the inflationary gap is to increase the supply of consumer
goods. But in wartime, the scope for increasing the supply of
consumer goods for civilians is rather limited. So the only
methods available for narrowing down the inflationary gap
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during wartime are taxes and public borrowings. It should,

BUSINESS ECONOMY II
however, be remembered that the inflationary gap cannot be
completely wiped out during wartime.
Hence, the possibility of inflation is always there in a wartime
economy. The inflationary gap can also arise in a planned
economy where the anticipated expenditure may exceed the total
output of goods and services. Thus, whenever the amount of
disposable income exceeds the volume of output available, an
inflationary gap is bound to arise in the economy. If, on the
contrary, the volume of output exceeds the disposable money
income, then a deflationary gap is bound to emerge, giving rise
to a falling price-level in the economy.higher and higher levels.
Since the economy is already operating at the point of full
employment, the supply of money income increases more
rapidly than the output of goods and services in the economy.
With the expenditure increasing faster than the output of
goods and services, the prices will naturally rise to equate the
increased expenditure with the money value of output at a
higher price-level. The inflationary gap may, therefore, be
defined as the amount by which the monetary demand exceeds
the value of current output at existing .prices. In order to keep
prices constant, the output should be increased by an amount
that is sufficient to absorb the excess demand caused by the
increased government expenditure. The price-level can remain
constant only if the output of goods and services increases
from OMI to OM2. This amount of output is equal to the
excess demand P1N1 caused by the increased government
expenditure. The inflationary gap of P1N1-in the diagram can be
wiped out only if the output of goods and services increases by
M1M2
The concept of inflationary gap is a very useful concept in
economic analysis. It not only measures statistically the pres-
sures of inflation in the economy, it also highlights the nature
and the extent of anti-inflationary measures, both fiscal and
monetary, which the government can adopt to cure the
economy of the malady of inflation. /
The Shrinking Dollar
Inflation: definition
A rise in the general price level
Note that this does not mean that all prices are rising.
Deflation, the opposite of inflation, is a decrease in the
general price level.

Notes -

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