IE/U4 Topic 5 Working Knowledge of Inflation and its impact on economy with special reference to INDIA
By inflation we mean a general rise in prices. To be more correct, inflation is a persistent rise in the general price level rather than a once-for-all rise in it.
On the other hand, deflation represents persistently falling prices. Inflation or persistently rising prices is a major problem in India today. When price level rises due to inflation the value of money falls. When there is a persistent rise in price level, the people need more and more money to buy goods and services.
To enable the people to meet their daily needs of consumption of goods and services when their prices are rising, their incomes must rise if they have to maintain their standard of living. For government employees, their dearness allowance is increased. Wages and salaries employed in the organised private sector are also raised, though after some time- lag.
But people with fixed incomes and those who are self-employed are unable to raise their prices and suffer a lot due to inflation. The poor suffer the most from persistent rise in prices, especially of food-grains and other essential items.
Rate of inflation during the seventies and eighties was very high as compared to the rates of inflation experienced earlier during previous periods. In India, in recent years, 2010-11, 2011-12 and 2012-13, rate of inflation as measured by consumer price index (CPI) has been in double digit figures. Prior to Jan. 2013, even WPI inflation was quite high which compelled Reserve Bank of India to adopt tight monetary policy.
Causes of Inflation:
Let us understand how the inflation originates or what causes it.
Depending upon the specific causes, three types of inflation have been distinguished:
(1) Demand-pull inflation,
(2) Cost-push inflation, and
(3) Structuralist inflation.
An important cause of demand-pull inflation is the excessive growth of money supply in the economy. We will explain this cause of inflation in the Monetarist Theory of Inflation. We will explain and discuss below these three types of inflation.
This represents a situation where the basic factor at work is the increase in aggregate demand for output either from the households or the entrepreneurs or government organised. The result is that the pressure of demand is such that it cannot be met by the currently available supply of output.
If, for example, in a situation of full employment, the government expenditure or private investment goes up, this is bound to generate an inflationary pressure in the economy. Keynes explained that inflation arises when there occurs an inflationary gap in the economy which comes to exist when aggregate demand for goods and services exceeds aggregate supply at full-employment level of output.
Basically, inflation is caused by a situation whereby the pressure of aggregate demand for goods and services exceeds the available supply of output (both being counted at the prices ruling at the beginning of a period). In such a situation, the rise in price level is the natural consequence.
Now, this imbalance between aggregate demand and supply may be the result of more than one force at work. As we know, aggregate demand is the sum of consumers’ spending on consumer goods and services, government spending on goods and services and net investment being contemplated by the entrepreneurs.
When aggregate demand for all purposes—consumption, investment and government, expenditure—exceeds the supply of goods at current prices, there is arise in price level. Since inflation is a continuous increase in the price level, not a one time rise in it, sustained inflation requires continuous increase in aggregate demand.
In the modem macroeconomics, inflation is explained with AD-AS model. Inflation can be explained by increase in aggregate demand (called “demand shock”) or decrease in aggregate supply or rise in cost of production generally called “supply shock”. Demand-pull inflation occurs when there is upward shift in aggregate demand when supply shocks are absent.
As stated above, demand-pull inflation occurs when there is increase in any component of aggregate demand, namely, consumption demand by households, investment by business firms, increase in government expenditure unmatched by increase in taxes (that is, deficit spending by the government financed by either creation of new money by the central bank or borrowing by the government from the market).
If aggregate supply of output does not increase or increases by a relatively less amount in the short run, this will cause demand-supply imbalances which will lead to demand-pull inflation in the economy, that is, general rise in price level.
Similarly, an inflationary process will be initiated if business firms anticipating the opportunities of making profits decide to invest more and to finance the new investment projects by borrowing from the banks being unable to get sufficient funds through savings out of profits and savings invested by the public in them.
This new investment by the firms leads to the increase in aggregate demand for goods and services. However, inflation will occur by this new investment if aggregate supply of output does not increase adequately in the short run to match the increase in aggregate demand.
Therefore, demand-pull inflation generally occurs when the economy is already working at full-employment level of resources or what is now generally called when there is natural rate of unemployment. This is because if aggregate demand increases beyond the full-employment level of output, output of goods cannot be increased adequately without much increase in cost.
Note that in developing countries such as India, there are difficulties of measuring employment, unemployment and full employment. Therefore in the Indian context, instead of full-employment level of output, we use full capacity output of the economy beyond which supply of output cannot be increased.
It is important to note that Keynes in his booklet How to Pay for the War published during the Second World War explained inflation in terms of excess demand for goods relative to the aggregate supply of their output. His notion of the inflationary gap which he put forward in his booklet represented excess of aggregate demand over full-employment output.
This inflationary gap, according to him, leads to the rise in prices. Thus, Keynes explained inflation in terms of demand-pull forces. Therefore, the theory of demand-pull inflation is associated with the name of Keynes.
Since beyond full-employment level of aggregate supply output cannot increase in response to increase in demand, this results in rise in prices under the pressure of excess demand. Aggregate supply curve, according to him, is vertical at full-employment level.
We can visualize situations where even though there is no increase in aggregate demand, prices may still rise. This may happen if there is initial increase in costs independent of any increase in aggregate demand.
The four main autonomous increases in costs which generate cost-push inflation have been suggested:
- Oil Price Shock
- Farm Price Shock
- Import Price Shock
- Wage-Push Inflation
Cost-Push inflation is also called supply-side inflation:
1. Oil Price Shock:
In the seventies the supply shocks causing increase in marginal cost of production became more prominent in bringing about cost-push inflation. During the seventies, rise in prices of energy inputs (hike in crude oil price made by OPEC resulting in rise in prices of petroleum products). The sharp rise in world oil prices during 1973-75 and again in 1979-80 produced significant supply shocks resulting in cost-push inflation.
The sharp rise in the price of oil leads to inflation in all oil-importing countries. The rise in oil price also occurred in 1990, 1999-2000 and again in 2003-08 which resulted in rise in rate of inflation in oil-importing countries such as India.
In recent years, there have been a good deal of fluctuations in oil prices; in some periods they go up and in some others they go down. It may be noted that rise in oil prices not only gives rise to the increase in inflation, but also adversely affects the balance of payments raising current account deficit of the oil-importing countries such as India.
2. Farm Price Shock:
Cost-push inflation can also come about from increase in prices of other raw materials, especially farm products, in economies such as that of India where they are of greater importance. In India when monsoon is not adequate or come very late or when weather conditions are quite unfavourable, they reduce the supply of agricultural products and raise their prices.
These farm products are raw materials for various industries such as sugar industry, other agro-processing industries, cotton textile industry, jute industry and as a result when prices of farm products rise they lead to rise in prices of goods which use the farm products as raw materials. This is farm price shock causing cost-push inflation.
Even rise in food prices or what is called food inflation is caused by supply-side factors such as inadequate rainfall or untimely monsoon and other adverse weather conditions and inadequate availability of fertilizers which lead to reduction in output of food grains is the example of cost-push or supply-side inflation.
3. Import Price Shock:
These days currencies of most countries of the world are flexible, that is, determined by demand for and supply of a currency and they can appreciate or depreciate every month in terms of the US dollar. For example, when the Indian rupee depreciates, more rupees are required to buy one US dollar and therefore in terms of rupees, imports become costlier.
The Indians who import raw materials for industries such as petroleum products, coal, machines and other equipment, oilseeds, fertilizers, Indian consumers who imports gold, cars and other final products have to pay higher prices in terms of rupees when Indian rupee depreciates against US dollar.
This raises the cost of production of the producers who in turn raise the prices of final products produced by them. This inflation is the result of import price shock. Thus depreciation of rupee causes cost-push inflation. For example, in the month of June 2013, there was sharp depreciation of the Indian rupee. The value of rupee fell by about 9.5 per cent in this single month from about Rs. 56 to a US dollar in the first week of June 2013 to around Rs. 61 to a dollar in the last week of June 2013.
4. Wage Push Inflation:
It has been suggested that the growth of powerful trade unions is responsible for the spread of inflation, especially in the industrialized countries. When trade unions push for higher wages which are not justifiable either on grounds of a prior rise in productivity or of cost of living they produce a cost-push effect.
The employers in a situation of high demand and employment are more agreeable to concede to these wage claims because they hope to pass on these rises in costs to the consumers in the form of hike in prices. If this happens we have cost-push inflation.
It may be noted that as a result of cost-push effect of higher wages, short-run aggregate supply curve of output shifts to the left and, given the aggregate demand curve, results in higher price of output.
Money and Sustained Inflation:
Many economists believe in the monetarist view of inflation. Increase in money shifts the aggregate demand curve to the right and if the economy is operating at full capacity (i.e., along the vertical part of the aggregate supply curve), the upward shift in aggregate demand curve will cause price level to rise. A big drawback of this approach is that it assumes that supply of output does not increase sufficiently to counter this effect of expansion in money supply on aggregate demand.
In this context there is a need to distinguish between a one-time increase in the price level and sustained inflation which occurs when the general price level continues to rise over a long period of time. It is generally believed by most of the economists that whatever be the initial cause of inflation (demand- pull, cost-push or inflationary expectations), for the price level to continue rising, period after period, it must be accommodated by expansion in money supply.
Sustained inflation is therefore considered as a purely monetary phenomenon. It is not possible for the price level to continue rising if the money supply remains constant. The increase in money supply continues shifting the aggregate demand curve to the right; if aggregate supply does not increase sufficiently to match the increase in aggregate demand, price level will continue rising.
Sustained inflation can be better understood when Government increases its expenditure without raising taxes. This leads to the increase in aggregate demand which, aggregate supply remaining constant, will cause a rise in price level. It is important to know what happens when the price level rises. The higher price level raises the demand for money to rise for transaction purposes.
With supply of money remaining constant, the greater demand for money causes interest rate to rise. The rise in interest rate crowds out private investment. If the Central Bank of a country wants to prevent the fall in the private investment, it will expand the money supply to keep the interest constant. But this expansion in money supply through its effect on aggregate demand will cause the price level to rise further if increase in more supply of output is not possible.
This further rise in price level will again cause greater demand for money leading to higher interest rate. And the Central Bank, if it is committed to keep the interest rate constant so that private investment does not decline, will further expand the money supply which will cause further inflation. This process could lead to hyperinflation which represents a rapid and continuous rise in price level, period after period.
The historical experience shows this hyperinflation in some countries when the Central Bank or Government of these countries kept pumping in more and more money either to finance its persistent budget deficit of the government year after year of to prevent the interest rate to rise. However, as mentioned above, hyperinflation disrupts the payment system and people’s loss of credibility of the currency. This leads to a deep crisis in the economy. If hyperinflation is to be avoided, then the process of rapid expansion in money supply must be halted.
Structuralist Theory of Inflation:
Structuralist theory, another important theory of inflation, is also known as structural theory of inflation and explains inflation in the developing countries in a slightly different way. The Structuralist argue that increase in investment expenditure and the expansion of money supply to finance it are the only proximate and not the ultimate factors responsible for inflation in the developing countries.
According to them, one should go deeper into the question as to why aggregate output, especially of food grains, has not been increasing sufficiently in the developing countries to match the increase in demand brought about by the increase in investment expenditure and money supply. Further, they argue why investment expenditure has not been fully financed by voluntary savings and as a result excessive deficit financing has been done.
Structuralist theory of inflation has been put forward as an explanation of inflation in the developing countries especially of Latin America. The well-known economists, Myrdal and Streeten, who have proposed this theory have analyzed inflation in these developing countries in terms of structural features of their economies. Recently Kirkpatrick and Nixon have generalized this structural theory of inflation as an explanation of inflation prevailing in all developing countries.
Myrdal and Streeten have argued that it is not correct to apply the highly aggregative demand- supply model for explaining inflation in the developing countries. According to them, there is a lack of balanced integrated structure in them where substitution possibilities between consumption and production and inter-sectoral flows of resources between different sectors of the economy are not quite smooth and quick so that inflation in them cannot be reasonably explained in terms of aggregate demand and aggregate supply.
In this connection it is noteworthy that Prof. V.N. Pandit of Delhi School of Economics has also felt the need for distinguishing price behaviour in the Indian agricultural sector from that in the manufacturing sector.
Thus, it has been argued by the exponents of structuralism theory of inflation that economies of the developing countries of Latin America and India are structurally underdeveloped as well as highly fragmented due to the existence of market imperfections and structural rigidities of various types.
The result of these structural imbalances and rigidities is that whereas in some sectors of these developing countries we find shortages of supply relative to demand, in others under utilisation of resources and excess capacity exist due to lack of demand. According to structuralists, these structural features of the developing countries make the aggregate demand-supply model of inflation inapplicable to them.
They therefore argue for analysing dis-aggregative and sectoral demand-supply imbalances to explain inflation in the developing countries. They mention various sectoral constraints or bottlenecks which generate the sectoral imbalances and lead to rise in prices.
Therefore, to explain the origin and propagation of inflation in the developing countries, the forces which generate these bottlenecks or imbalances of various types in the process of economic development need to be analyzed. A study of these bottlenecks is therefore essential for explaining inflation in the developing countries.
These bottlenecks are of three types:
(1) Agricultural bottlenecks which make supply of agricultural products inelastic,
(2) Resources constraint or Government budget constraint, and
(3) Foreign exchange bottleneck. Let us explain briefly how these structural bottlenecks cause inflation in the developing countries.
The first and foremost bottlenecks faced by the developing countries relate to agriculture and they prevent supply of food grains to increase adequately. Of special mention of the structural factors are disparities in land ownership, defective land tenure system which act as disincentives for raising agricultural production in response to increasing demand for them arising from increase in people’s incomes, growth in population and urbanization.
Besides, use of backward agricultural technology also hampers agricultural growth. Thus, in order to control inflation, these bottlenecks have to be removed so that agricultural output grows rapidly to meet the increasing demand for it in the process of economic development.
Resources Gap or Government’s Budget Constraint:
Another important bottleneck mentioned by structuralist relates to the lack of resources for financing economic development. In the developing countries planned efforts are being made by the Government to industrialise their economies. This requires large resources to finance public sector investment in various industries. For example, in India, huge amount of resources were used for investment in basic heavy industries started in the public sector.
But socio-economic and political structure of these countries is such that it is not possible for the Government to raise enough resources through taxation, borrowing from the public, surplus generation in the public sector enterprises for investment in the projects of economic development. Revenue raising from taxation has been relatively very small due to low tax base, large scale tax evasion, inefficient and corrupt tax administration.
Consequently, the government has been forced to resort to excessive deficit financing (that is, creation of new currency) which has caused excessive growth in money supply relative to increase in output year after year and has therefore resulted in inflation in the developing countries. Though rapid growth of money supply is the proximate cause of inflation, it is not the proper and adequate explanation of inflation in these economies.
For proper explanation of inflation one should go deeper and enquire into the operation of structural forces which have caused excessive growth in money supply in these developing economies. Besides, resources gap in the private sector due to inadequate voluntary savings and underdevelopment of the capital market have led to their larger borrowings from the banking system which has created excessive bank credit for it.
This has greatly contributed to the growth of money supply in the developing countries and has caused rise in prices. Thus, Kirkpatrick and Nixon write, “The increase in the supply of money was a permissive factor which allowed the inflationary spiral to manifest itself and become cumulative—it was a system of the structural rigidities which give rise to the inflationary pressures rather than the cause of inflation itself.”
Foreign Exchange Bottleneck:
The other important bottleneck which the developing countries have to encounter is the shortage of foreign exchange for financing needed imports for development. In the developing countries ambitious programme of industrialisation is being undertaken. Industrialisation requires heavy imports of capital goods, essential raw materials and in some cases, as in India, even food grains have been imported. Besides, imports of oil on a large scale are being made.
On account of all these imports, import expenditure of the developing countries has been rapidly increasing. On the other hand, due to lack of export surplus, restrictions imposed by the developing countries, relatively low competitiveness of exports, the growth of exports of the developed countries has been sluggish.
As a result of sluggish exports and mounting imports, the developing countries have been facing balance of payment difficulties and shortage of foreign exchange which at times has assumed crisis proportions. This has affected the price level in two ways.
First, due to foreign exchange shortage domestic availability of goods in short supply could not be increased which led to the rise in their prices. Secondly, in Latin American countries as well as in India and Pakistan, to solve the problem of foreign exchange shortage through encouraging exports and reducing imports devaluation in the national currencies had to be made. But this devaluation caused rise in prices of imported goods and materials which further raised the prices of other goods as well due to cascading effect. This brought about cost-push inflation in their economies.
Physical Infrastructural Bottlenecks:
Further, the structuralists point out various bottlenecks such as lack of infrastructural facilities, i.e., lack of power, transport and fuel which stands in the way of adequate growth in output. At present in India, there is acute shortage of these infrastructural inputs which are hampering growth of output.
Sluggish growth of output on the one hand, and excessive growth of money supply on the other have caused what is now called stagflation, that is inflation which exists along with stagnation or slow economic growth.
According to the structuralist school of thought, the above bottlenecks and constraints are rooted in the social, political and economic structure of these countries. Therefore, in its view a broad-based strategy of development which aims to bring about social, institutional and structural changes in these economies is needed to bring about economic growth without inflation.
Further, many structuralists argue for giving higher priority to agriculture in the strategy of development if price stability is to be ensured. Thus, we see that structuralist view is greatly relevant for explaining inflation in the developing countries and for the adoption of measures to control it. Let us further elaborate the causes of inflation in the developing countries.
The Social Costs and Effects of Inflation:
Having discussed the so called inflation fallacy we proceed to explain in detail the social cost and effects of inflation. Apart from reducing the purchasing power of people’s incomes, inflation inflicts some other costs on the society. To explain such costs of inflation it is necessary to distinguish between anticipated inflation and unanticipated (i.e., unexpected) inflation. As noted above, in case of anticipated inflation, the expected rise in price level is taken into account while making economic transactions, for example, in negotiating wage rate of labour etc.
Costs of Anticipated Inflation:
Suppose in an economy there has been annual inflation rate of 5 per cent for a long time in the past and everybody expects that this 5 per cent rate of inflation will continue in the future too. In such a case all contracts made by the people such as loan agreements with borrowers, wage contracts with labour, property lease contracts will provide for 5 per cent annual rise in rates of interest, wages, rent to compensate for inflation of that order.
That is, in any contract in which passage of time is involved 5 per cent rate of inflation will be taken into account and rates will be agreed to rise per period equal to the anticipated rate of inflation. If rates of interest, wages, rent etc. are agreed to rise at the anticipated rate of inflation, then there will be no cost of inflation except the following two types of costs – shoe-leather costs and menu costs which are not very high.
We explain below both these types of costs:
- Shoe-leather Costs:
This type of cost occurs because on account of inflation cost of holding money in the form of currency (i.e., notes and coins) rises with the increase in inflation rate. Such cost arises because no interest is paid on holding currency, while money kept in deposits with the bank or used for keeping bonds earns interest.
When inflation rate rises, the nominal interest rate on bank deposits rises, the interest lost by holding currency by the people therefore increases. In order to reduce the cost of holding currency people will tend to reduce their holdings of currency for transaction purposes. Accordingly, at a time people will hold less currency with them and keep as long as possible greater amount of money in bank deposits that yield interest.
Therefore, rather than withdrawing a large amount of currency from banks at a time, they will withdraw less money which is sufficient for meeting daily expenses for a few days, say for a week. But for doing so the people will make more trips to withdraw cash. More trips to a bank in a month involves greater cost to the people.
These costs have to be incurred on spending on petrol if car is used for making trips, more wear and tear of car, the time spent for making a trip. These costs of making more trips to the bank for withdrawing currency is metaphorically called shoe-leather costs of inflation, as walking to banks more often one’s shoes wear out more rapidly and one has to spend money on new shoes more often.
- Menu Costs:
The second type of anticipated inflation is menu costs, a term derived from a restaurant’s cost of printing a new menu. Menu costs arise because high inflation requires them to change their listed prices more often. Changing prices is somewhat more expensive because the firms have to print new catalogues listing new prices and distribute them among their customers. They have even to incur expenditure on advertisements to inform the public about their new prices.
- Macroeconomic Inefficiency in Resource Allocation:
A third cost of inflation arises because firms having menu costs change their prices quite infrequently. Given the reluctance to change prices frequently, the higher the rate of inflation, the greater the variability in relative prices of a firm. Suppose a firm issues a new catalogue listing prices of its products once in a year, say in the month of January of every year.
If during the year inflation occurs, there will be change in the relative prices of a firm to the general price level. If inflation rate of one per cent per month takes place in a year the firm’s relative prices to the general price level will fall by 12 per cent by the end of the year.
As a result, his sales will tend to be lower in the early part of the year (when its prices are relatively high) and higher in the later part of the year (when its prices are relatively low). Thus when due to inflation relative prices of a firm vary during a year as compared to the overall price level, it causes distortion in production and therefore leads to microeconomic inefficiencies in resource allocation.
- Inconvenience of Living:
Lastly, another social cost of inflation is the inconvenience of living in a world with a changing price level. Money is the yardstick with which we measure the value of transactions. When inflation is taking place the value of money changes and as a result it becomes difficult to correctly estimate the value of transactions in real terms every time a transaction is made during a year.
The rising price level makes it difficult to make optimal decisions about saving and investment and thus do the rational financial planning covering a long period of time. To quote Mankiw, “A dollar saved today and invested at a fixed nominal interest rate will yield a fixed dollar amount in the future. Yet the real value of that dollar amount – which will determine the retiree’s living standard – depends on the future price level. Deciding how much to save would be much simpler if people could count on the price level in 30 years being similar to its level today.”