MEANING OF INFLATION
It is defined differently by different writers.
" a state in which the value of money is falling, i.e prices are rising" Crowther
" a continuing increase in the general price level"Brooman
"a persistent and appreciable rise in the general level of prices". Edward Shapiro
“too much money chasing too few goods” Coulbourn
The common idea is that there is too much of supply of money that results in an increase in prices.
The demand for goods increases due to the increase in the supply of money without any increase in
the supply of goods. This results in rising prices.
Types of Inflation
There are different types of inflation. Classification is on the basis of degree of price rise.
Creeping InflationIt is themild form of inflation.Not at all dangerous for theeconomy.Almost 3%
increase in price per annum is called creeping inflation.
Walking InflationRise in prices becomes more than creeping inflation. Here increase in prices by
3% to 6% per annum.
Running InflationThe rise in prices may be more than 10% per year.
Galloping or Hyper InflationPrices rise every moment and there is no limit to prices rise. Prices
start rising at the rate of more than 50% a month.
Open InflationPrices are permitted to rise without being suppressed by government
Suppressed InflationPrice rises are controlled by the government. They rise once controls are
lifted. Eg.war time controls.
Sporadic InflationRise in the price level in some sectors of the economy. Prices of certain goods
rise due to shortage. Under this situation supply cannot be increased at short notice.
Comprehensive InflationPrices of every commodity rise throughoutthe economy. Price level rises
in all sectors of the economy.
Partial (Semi) InflationIncrease in the price level due to increase in the quantity of money before
reaching the level of full employment. Prices rise due to rising costs associated with higher wages
and diminishing returns in production.
Full Inflation If the money supply continues to increase after reaching the full employment level,
aggregate demand increases resulting in an increase in the price level.
Ratchet InflationThere is excessive aggregate demand in certain sectors and inadequate in others.
Price tends to be rigid in the downward direction due to price administration by trade unions. Prices
rise in the excess demand sectors. Prices do not fall in the deficient demand sectors. The net effect
is an overall increase in the price level.
For example, Demand is excessive in capital goods industry and it is less in consumer goods
industry. Price rises in the capital good industry. Prices are not falling in the consumer goods
,industry due to downward rigidity. Thus the aggregate price level is pushed upwards which results
in inflation.
Mark-up Inflation In setting the price, the management fixmark-up to its material and labour cost.
Mark-up is based on anticipation of future costs and prices. The magnitude of mark-up depends up
on the pressure of demand felt in the economy. When demand is higher the mark-up tends to be
higher and less when demand is low and costs are high. This practice of introducing mark up and
there by the increase in the price level, is known as mark-up inflation.
Bottleneck Inflation Inflationary situation before full employment due to the imperfect elasticity
of supply of goods, is known as bottleneck inflation. As aggregate demand increases with increase
in money supply, supply of goods does not increase in proportion, due to imperfect elasticity.
Supply is limited due to a number of bottlenecks like
a. Market imperfections like imperfect knowledge, imperfect mobility of factors, imperfect
divisibility of factors etc.
b. Under developed economies are faced with the shortage of labour, capital, transport system,
power facilities etc.
c. Unemployment and underemployment and a high marginal propensity to consume limits the
supply of goods.
d. Export of a large volume of production.
Reflation A type of inflation occurring during the recovery from a depression or recession in which
prices are restored to a so called desirable level by decreasing the purchasing power of money.
Agflation Inflation caused by the rise in global agricultural prices.
Disinflation A reduction in the rate of inflation is known as disinflation.
THEORIES OF INFLATION
1. The Classical Theory Of Inflation
Based on quantity theory of money, which states level of prices (P) depends on the supply of
money (M). The greater the quantity of money, the higher the level of prices.
P = f(M)
Inflation caused by a rise in money supply. It is based on the equation of exchange developed by
Irving Fisher
MV=PT
M -supply of money in the economy.
V -velocity of circulation of money.Average number of times each unit of money
changes hands.
P -general level of prices and
T -volume of transactions.
V and T are assumed as constants.
, So any increase in M must lead to a proportional rise in P. Thus the cause of inflation is the growth
in the quantity of money. Remedy for inflation is a reduction in the quantity of money.
2. Demand Pull Inflation
Inflation caused by an increase in aggregate demand is called demand-pull inflation. When the
aggregate demand is raised from an existing level, it causes the price level to rise.A shift in the
aggregate demand curve can arise as a result of an increase in private as well as government
expenditures. Increased government and private expenditures result in a larger money supply.
Price level
S
P2
P1
D2
P0 D1
S D0
0 Y0 Real income
Real national income is measured on the X axis, price level on the Y axis. The aggregate supply
curve slopes upwards and becomes perfectly inelastic at income level Y0 corresponding to the full
employment level.
When the aggregate demand curve shifts from DOto D1, the price level rises form P0 to P1 .But
once the price level is increased, efforts are made to maintain expenditures at the original level in
real terms. This will cause the aggregate demand curve to shift upward again, causing the price
level to rise further. Thus the continuous shift in the aggregate demand curve results in a price
increase.
3. Keynes' Theory Of Inflation
According to Keyns increase in AD leads to inflation.This additional AD is created because of the
increase in real factors (1)increase in consumption due to increase in mps
(2) increase in investment due to increase in the MEI
(3) increase in government expenditure.
These change may take place even when supply is held constant.This increase in AD while AS is
kept constant, create a demand –supply gap. It is known as inflationary gap. According to Keyns
these inflationary gap is the reason for inflation.Keyns expressed his view on inflation in his book,
It is defined differently by different writers.
" a state in which the value of money is falling, i.e prices are rising" Crowther
" a continuing increase in the general price level"Brooman
"a persistent and appreciable rise in the general level of prices". Edward Shapiro
“too much money chasing too few goods” Coulbourn
The common idea is that there is too much of supply of money that results in an increase in prices.
The demand for goods increases due to the increase in the supply of money without any increase in
the supply of goods. This results in rising prices.
Types of Inflation
There are different types of inflation. Classification is on the basis of degree of price rise.
Creeping InflationIt is themild form of inflation.Not at all dangerous for theeconomy.Almost 3%
increase in price per annum is called creeping inflation.
Walking InflationRise in prices becomes more than creeping inflation. Here increase in prices by
3% to 6% per annum.
Running InflationThe rise in prices may be more than 10% per year.
Galloping or Hyper InflationPrices rise every moment and there is no limit to prices rise. Prices
start rising at the rate of more than 50% a month.
Open InflationPrices are permitted to rise without being suppressed by government
Suppressed InflationPrice rises are controlled by the government. They rise once controls are
lifted. Eg.war time controls.
Sporadic InflationRise in the price level in some sectors of the economy. Prices of certain goods
rise due to shortage. Under this situation supply cannot be increased at short notice.
Comprehensive InflationPrices of every commodity rise throughoutthe economy. Price level rises
in all sectors of the economy.
Partial (Semi) InflationIncrease in the price level due to increase in the quantity of money before
reaching the level of full employment. Prices rise due to rising costs associated with higher wages
and diminishing returns in production.
Full Inflation If the money supply continues to increase after reaching the full employment level,
aggregate demand increases resulting in an increase in the price level.
Ratchet InflationThere is excessive aggregate demand in certain sectors and inadequate in others.
Price tends to be rigid in the downward direction due to price administration by trade unions. Prices
rise in the excess demand sectors. Prices do not fall in the deficient demand sectors. The net effect
is an overall increase in the price level.
For example, Demand is excessive in capital goods industry and it is less in consumer goods
industry. Price rises in the capital good industry. Prices are not falling in the consumer goods
,industry due to downward rigidity. Thus the aggregate price level is pushed upwards which results
in inflation.
Mark-up Inflation In setting the price, the management fixmark-up to its material and labour cost.
Mark-up is based on anticipation of future costs and prices. The magnitude of mark-up depends up
on the pressure of demand felt in the economy. When demand is higher the mark-up tends to be
higher and less when demand is low and costs are high. This practice of introducing mark up and
there by the increase in the price level, is known as mark-up inflation.
Bottleneck Inflation Inflationary situation before full employment due to the imperfect elasticity
of supply of goods, is known as bottleneck inflation. As aggregate demand increases with increase
in money supply, supply of goods does not increase in proportion, due to imperfect elasticity.
Supply is limited due to a number of bottlenecks like
a. Market imperfections like imperfect knowledge, imperfect mobility of factors, imperfect
divisibility of factors etc.
b. Under developed economies are faced with the shortage of labour, capital, transport system,
power facilities etc.
c. Unemployment and underemployment and a high marginal propensity to consume limits the
supply of goods.
d. Export of a large volume of production.
Reflation A type of inflation occurring during the recovery from a depression or recession in which
prices are restored to a so called desirable level by decreasing the purchasing power of money.
Agflation Inflation caused by the rise in global agricultural prices.
Disinflation A reduction in the rate of inflation is known as disinflation.
THEORIES OF INFLATION
1. The Classical Theory Of Inflation
Based on quantity theory of money, which states level of prices (P) depends on the supply of
money (M). The greater the quantity of money, the higher the level of prices.
P = f(M)
Inflation caused by a rise in money supply. It is based on the equation of exchange developed by
Irving Fisher
MV=PT
M -supply of money in the economy.
V -velocity of circulation of money.Average number of times each unit of money
changes hands.
P -general level of prices and
T -volume of transactions.
V and T are assumed as constants.
, So any increase in M must lead to a proportional rise in P. Thus the cause of inflation is the growth
in the quantity of money. Remedy for inflation is a reduction in the quantity of money.
2. Demand Pull Inflation
Inflation caused by an increase in aggregate demand is called demand-pull inflation. When the
aggregate demand is raised from an existing level, it causes the price level to rise.A shift in the
aggregate demand curve can arise as a result of an increase in private as well as government
expenditures. Increased government and private expenditures result in a larger money supply.
Price level
S
P2
P1
D2
P0 D1
S D0
0 Y0 Real income
Real national income is measured on the X axis, price level on the Y axis. The aggregate supply
curve slopes upwards and becomes perfectly inelastic at income level Y0 corresponding to the full
employment level.
When the aggregate demand curve shifts from DOto D1, the price level rises form P0 to P1 .But
once the price level is increased, efforts are made to maintain expenditures at the original level in
real terms. This will cause the aggregate demand curve to shift upward again, causing the price
level to rise further. Thus the continuous shift in the aggregate demand curve results in a price
increase.
3. Keynes' Theory Of Inflation
According to Keyns increase in AD leads to inflation.This additional AD is created because of the
increase in real factors (1)increase in consumption due to increase in mps
(2) increase in investment due to increase in the MEI
(3) increase in government expenditure.
These change may take place even when supply is held constant.This increase in AD while AS is
kept constant, create a demand –supply gap. It is known as inflationary gap. According to Keyns
these inflationary gap is the reason for inflation.Keyns expressed his view on inflation in his book,
