Inflation – Concepts, Facts, and Policy – UPSC Economy Notes

Introduction: Inflation refers to a persistent increase in the average price of goods and services. While moderate price rises can indicate economic growth, steep inflation can have detrimental effects on the entire economy. Excessive inflation adversely impacts economic elements such as growth, budgetary balance, welfare, purchasing power, and more. It disproportionately affects the poor as a larger portion of their income is required for consumption, diminishes savings, raises interest rates, hampers investment, and leads to currency depreciation, making imports more expensive and contributing to further inflation. Achieving moderate, long-term inflation is crucial for maintaining macroeconomic stability. Government policies are designed to foster growth with price stability.

Key Points:

1. Moderate vs. Steep Inflation: Moderate inflation can be indicative of economic growth, while steep inflation poses multiple challenges for the economy.
2. Impact of Steep Inflation:
   • Economic Hurt: Steep inflation adversely affects various economic factors.
   • Purchasing Power Reduction: It reduces the purchasing power of money.
   • Disproportionate Impact on the Poor: The poor are more severely affected as a higher percentage of their income is required for consumption.
   • Savings Reduction: Inflation diminishes savings.
   • Interest Rate Impact: It leads to an increase in interest rates.
   • Dampened Investment: Inflation dampens investment.
   • Currency Depreciation: Steep inflation contributes to the depreciation of the currency, making imports costlier and feeding back into inflation.
3. Macroeconomic Stability: The overall stability of the economy is closely tied to inflation levels, emphasizing the need for sustainable, moderate inflation.
4. Government Policies: Government policies strive for growth with price stability, aiming for moderate, long-term inflation.

Understanding inflation and formulating effective policies is crucial for maintaining a balance between economic growth and stability.

Inflation and its Types:

Inflation is categorized based on the rate of price growth and can manifest in various forms:

1. Creeping Inflation:
   • Rate: Up to 4% annually.
   • Significance: Considered positive for the system, indicating growth and stability.
   • Economic Impact: Encourages reasonable profits, fostering investment by producers and traders.
   • Deterrent to Deflation: Acts as a deterrent to deflationary trends.
2. Trotting Inflation:
   • Description: A progression from creeping inflation with an increasing rate of price growth.
   • Potential Outcome: If uncontrolled, may escalate into galloping inflation.
3. Galloping Inflation:
   • Rate: Around 8-10% annually.
   • Concerns: Represents a higher and more concerning level of inflation.
   • Outcome: If not addressed, may further escalate into runaway inflation.
4. Runaway Inflation:
   • Description: Represents an inflationary cycle without any tendency toward equilibrium.
   • Cause: Often caused by reckless fiscal policies leading to excess money through deficit financing.
   • Consequences: Can result from war, social upheavals, and diversion of resources for military purposes.
   • Outcome: May lead to hyperinflation.
5. Hyperinflation:
   • Severity: Prices are out of control.
   • Rate: Monthly inflation rate of 20% or more.
   • Causes: Result of reckless fiscal policies, war, or social upheavals destabilizing production.
   • Consequences: Could lead to monetary collapse, loss of currency value, and potential shifts to barter or foreign currency dominance.
6. Note: Tolerance levels for inflation rates vary from country to country, with developed nations generally having lower tolerance levels compared to developing countries.

Other Inflation-Related Concepts:

1. Deflation:
   • Definition: Prices grow at a rate less than zero.
   • Effect: Increases the value of money, allowing for the purchase of more goods and services with the same amount of currency.
2. Disinflation:
   • Definition: Reduction in the rate of inflation.
   • Scenario: Prices are still increasing, but the rate of growth is slowing.
   • Causes: Reduction in money supply, economic slowdown, increased supplies leading to cheaper prices, etc.
3. Stagflation:
   • Description: Combination of inflation and rising unemployment during a recession.
   • Scenario: High inflation, slowed economic growth or recession, and increased unemployment.
   • Challenge: Standard policy interventions may not be effective, posing challenges for economic management.
4. Reflation:
   • Definition: Return of inflation after a period of deflation and recession, indicating economic growth.
   • Example: Post the great recession (2007-09), when growth was revived in the US and EU.
5. Open Inflation:
   • Context: Governments subsidize goods and services to maintain affordability.
   • Result: Inflation that occurs when the government does not suppress it with subsidies and monetary policy.
6. Suppressed Inflation:
   • Definition: Government takes fiscal and monetary actions to manage inflation at a moderate level.
   • Concern: Inflation is managed but not entirely resolved, and may re-emerge if fiscal policies change.
7. Headline Inflation:
   • Definition: Measure of total inflation, unadjusted.
   • Experience: Represents overall inflation as reported, reflecting what consumers experience.
   • Contrast: Contrasted with core inflation for a better understanding.

These concepts help provide a comprehensive view of the various nuances and scenarios related to inflation and its management.

Core or Underlying Inflation:

Definition: Core or underlying inflation measures the long-run trend in the general price level, excluding temporary effects.

Calculation: To calculate core inflation, certain items are excluded from the computation. These typically include changes in the price of fuel and food, especially the processed food part of manufacturing.

Rationale for Exclusion:

• Volatility: Excluded items are volatile, subject to short-term fluctuations.
• Seasonality: Excluded items, particularly food, often exhibit seasonal variations.

Objective: Core inflation aims to eliminate transitory effects, providing a more stable and reliable measure of the underlying inflationary trend.

Purpose: The main argument for using core inflation is that central banks should respond effectively to demand-side factors, such as the money available in the market and demand for credit, rather than reacting to supply shocks like those related to energy and food prices.

Comparison with Headline Inflation:

• Inclusion: Headline inflation includes the official rate of price increase without excluding any item from the basket.
• Scope: Both headline and core inflation are calculated at both wholesale and consumer levels.
• Preference in Targeting: When targeting inflation, central banks may prefer to consider CPI (Combined, i.e., rural and urban) headline inflation, as has been the case with the RBI in India since 2015.

By distinguishing core inflation from headline inflation, policymakers gain insights into the persistent inflationary trends, allowing for more effective and targeted monetary policy responses.

FAQs

1. What is inflation?

• Inflation refers to the rate at which the general level of prices for goods and services rises, eroding purchasing power. It’s commonly measured as the percentage change in the Consumer Price Index (CPI) or the Producer Price Index (PPI) over a specific period, typically a month or a year.

2. What causes inflation?

• Inflation can be caused by various factors, including:
  • Demand-pull inflation: When aggregate demand exceeds aggregate supply, typically fueled by increased consumer spending, investment, or government expenditure.
  • Cost-push inflation: Arises when production costs, such as wages or raw materials, rise, leading producers to pass these costs onto consumers through higher prices.
  • Built-in inflation: Occurs when workers demand higher wages to keep up with rising prices, leading to a cycle of wage-price increases.
  • Monetary factors: Expansionary monetary policies, such as increasing the money supply or lowering interest rates, can also contribute to inflation by boosting demand.

3. How does inflation affect the economy?

• Inflation impacts the economy in various ways:
  • Reduced purchasing power: As prices rise, the value of money decreases, leading to a decline in consumers’ purchasing power.
  • Uncertainty: High or unpredictable inflation can disrupt economic planning and investment decisions, leading to uncertainty and reduced economic growth.
  • Redistribution of income and wealth: Inflation can redistribute income and wealth, benefiting debtors (who repay loans with less valuable currency) but harming savers and fixed-income earners.
  • Interest rates: Central banks often respond to inflation by raising interest rates to curb spending and stabilize prices, which can affect borrowing costs and investment.

4. How is inflation measured?

• Inflation is typically measured using various price indices, including:
  • Consumer Price Index (CPI): Measures the average change in prices paid by urban consumers for a basket of goods and services, representing typical household spending patterns.
  • Producer Price Index (PPI): Tracks the average change in prices received by domestic producers for their output, providing insights into inflationary pressures at the wholesale level.
  • GDP deflator: Calculates the ratio of nominal GDP to real GDP, reflecting the overall price level of goods and services included in GDP.

5. How do policymakers address inflation?

• Policymakers employ various tools to manage inflation, including:
  • Monetary policy: Central banks adjust interest rates, regulate the money supply, and conduct open market operations to influence borrowing costs and aggregate demand.
  • Fiscal policy: Governments may implement measures such as taxation, public spending, and budget deficits to stimulate or restrain economic activity, indirectly affecting inflation.
  • Supply-side policies: Efforts to enhance productivity, reduce production costs, and promote competition can help mitigate cost-push inflation and boost long-term economic growth.

In case you still have your doubts, contact us on 9811333901. 

For UPSC Prelims Resources, Click here

For Daily Updates and Study Material:

Join our Telegram Channel – Edukemy for IAS

• 1. Learn through Videos – here
• 2. Be Exam Ready by Practicing Daily MCQs – here
• 3. Daily Newsletter – Get all your Current Affairs Covered – here
• 4. Mains Answer Writing Practice – here

Visit our YouTube Channel – here