BBA I Semester Managerial Economics Inflation Study Material Notes
Table of Contents
BBA I Semester Managerial Economics Inflation Study Material Notes: Meaning of Inflation Types of Inflations Cost-Push Inflations Demand-Pull Inflations Causes of Inflations Factors Affecting Demand Monetary Measures Measures to Contro Inflation Other Measures On Distribution of Income and Wealth Effects of Inflation Exercise
CTET Paper Level 2 Science Set II Multiple Choice Model Paper in Hindi
INFLATION
1 MEANING OF INFLATION
Inflation has been defined in different ways by economists. According to Friedman, “Inflation is always and everywhere a monetary phenomenon” But economists do not agree that money supply alone is the cause of inflation. Economists, therefore, define inflation in terms of a continuous rise in prices. Johnson defines “inflation as a sustained rise” in prices. Brooman defines it as “a continuing increase in the general price level.”
Inflation Study Material Notes
2. TYPES OF INFLATION
Inflation is of various types. We discuss below some of its important types.
1 Creeping Inflation. When the rise in prices is very slow like that of a snail or creeper, it is called creeping inflation. In terms of speed, a sustained rise in prices of annual increase of less than 3 per cent per annum is creeping inflation.
2. Walking or Trotting Inflation. When prices rise moderately and the annual inflation rate is a single digit. in prices is in the intermediate range of 3 to 6 per cent per annum or less than 10 per cent.
3. Running Inflation. When prices rise rapidly like the running of a horse at a rate or speed of 10 to 20 per cent per annum, it is called running inflation.
4. Hyperinflation. When prices rise very fast at double or triple digit rates from more than 20 to 100 per cent per annum or more, it is called runaway or galloping inflation or hyperinflation.
The speed with which prices tend to rise is illustrated in Figure 1. The curve C shows creeping inflation when within a period of ten years the price level has been shown to have risen by about 30 per cent. The curve W depicts walking inflation when the price level rises by more than 50 per cent during ten years. The curve R illustrates running inflation showing a rise of about 100 per cent in ten years. The steep Time in years curve H shows the path of hyperinflation when prices rise by more than 120 per cent in less than one year.
5. Semi-Inflation. According to Keynes, so long as there are unemployed resources, the general price level will not rise as output increases. But a large increase in aggregate expenditure will face shortages of supplies of some factors. This may lead to increase in costs, and prices start rising. This is known as semi-inflation or bottleneck inflation because of the shortages in supplies of some factors.
6. True Inflation. According to Keynes, when the economy reaches the level of full employment, any increase in aggregate expenditure will raise the price level in the same proportion. This is because it is not possible to increase the supply of factors and hence of output after full employment. This is called true inflation.
7. Open Inflation. Inflation is open when “markets for goods or factors of production are allowed to function freely, setting prices of goods and factors without normal interference by the authorities.” There are no checks or controls on the distribution of commodities by the government. Increase in demand and shortage of supplies lead to open inflation.
8. Suppressed Inflation. When the government imposes physical and monetary controls to check open inflation, it is known as repressed or suppressed inflation. The market is not allowed to function normally by the use of licensing, price controls and rationing in order to suppress rise in prices. Therefore, suppressed inflation leads to black marketing, corruption, hoarding and profiteering.
9. Stagflation. It is a situation where the economy experiences stagnation as well as inflation. The word stagflation is the combination of ‘stag’ plus ‘flation’ taking ‘stag’ from stagnation and ‘flation’ from inflation.
Stagflation is a situation when recession is accompanied by a high rate of inflation. It is, therefore, also called inflationary recession. Its principal cause has been excessive demand in commodity markets, thereby causing prices to rise, and at the same time the demand for labour is deficient, thereby creating unemployment in the economy.
The 2008 recession in the world has led to stagflation in almost all countries.
10. Sectoral Inflation. Sectoral inflation arises initially out of excess demand in particular industries. But it leads to a general price rise because prices do not fall in the deficient demand sectors.
11. Reflation is a situation when prices are raised deliberately in order to encourage economic activity. When there is depression and prices fall abnormally low, the monetary authority adopts measures to put more money in circulation so that prices rise. This is called reflation.
Inflation Study Material Notes
2. DEMAND-PULL INFLATION
Demand-Pull or excess demand inflation is a situation often described as “too much money chasing too few goods.” According to this theory, an excess of aggregate demand over aggregate supply will lead to inflationary rise in prices. Friedman holds that “inflation is always and everywhere a monetary phenomenon.” The higher the growth rate of the nominal money supply, the higher the rate of inflation. When the money supply increases, people spend more in relation to the available supply of goods and services. This bids prices up and leads to inflation.
The demand-pull inflation is illustrated in Figure 2 Suppose the money supply is increased at a given price level OP as determined by the demand and supply curves D and SS. respectively. The initial full employment situation Oy, at this price level is shown by the interaction of these curves at point E.
Now with the increase in the quantity of money, the aggregate demand increases which shifts the demand curve D to D, to the right. The aggregate supply being fixed, as shown by the vertical portion of the supply curve SS, the D, 3 curve intersects it at point E. This raises the ? price level to OP
4. COST-PUSH INFLATION
Cost-push inflation is caused by wage increases enforced by unions and profit increases by employers. Cost-push inflation is Supply caused by wage-push and profit-push to prices for the following reasons:
1 Rise in Wages. The basic cause of cost-push inflation is the rise in money wages more rapidly than the productivity of labour. In advanced countries, trade unions are very powerful. They press employers to grant wage increases more than of increases in the productivity of labour. It raises the cost of production of commodities. Employers, in turn, raise prices of their products. Higher wages enable workers to buy as much as before, in spite of higher prices. On the other hand, the increase in prices induces unions to demand still higher wages. In this way, the wage-cost spiral continues, thereby leading to cost-push or wagepush inflation.
2. Sectoral Rise in Prices. Again, a few sectors of the economy may be affected by money wage increases. The prices of their products also rises. In many cases, their products such as steel, raw materials, etc. are used as inputs for the production of commodities in other sectors. As a result, the production cost of other sectors will rise and thereby push up the prices of their products. Thus wage-push inflation in a few sectors of the economy may soon lead to inflationary rise in prices in the entire economy.
3. Rise in Prices of Imported Raw Materials. An increase in the prices of imported raw materials may lead to cost-push inflation. Since raw materials are used by the manufacturers of the finished goods, their the cost of production also rises. Thus a continuous rise in the prices of raw materials leads to a cost-price-wage spiral.
4. Profit-Push Inflation. Oligopolist and monopolist firms raise the prices of their products to offset the rise in labour and production costs so as to earn higher profits. Thus profit-push inflation will result.
Cost-push inflation is illustrated in Figure 3. where S,S is the supply curve and D is the demand curve. Both intersect at E which is the full employment level OY, and the price level OP is determined. Given the demand, as shown by the D curve, the supply curve S, is shown to shift to S, as a result of cost-push factors. It intersects the D curve at E, showing rise in the price level from OP to OP, and fall in aggregate output from
Inflation Study Material Notes
5. CAUSES OF INFLATION
Inflation is caused when the aggregate demand exceeds the aggregate supply of goods and services. We analyse the factors which lead to increase in demand and the shortage of supply. Factors Affecting Demand
Both Keynesians and monetarists believe that inflation is caused by increase in the aggregate demand. They point towards the following factors which raise it.\
1 Increase in Money Supply. Inflation is caused by an increase in the supply of money which leads to an increase in aggregate demand. The higher the growth rate of the money supply, the higher is the rate of inflation.
2. Increase in Disposable Income. When the disposable income of the people increases, it raises their demand for goods and services. Disposable income may increase with the rise in national income or reduction in taxes or reduction in the saving of the people.
3. Increase in Public Expenditure. Government expenditure has been increasing at a high rate, thereby raising aggregate demand for goods and services. Governments of both developed and developing countries are providing more facilities under public utilities and social services, and also nationalizing industries and starting public enterprises with the result that they help in increasing aggregate demand.
4. Increase in Consumer Spending. The demand for goods and services increases when consumer expenditure increases. Consumers may spend more due to conspicuous consumption or demonstration effect. They may also spend more whey they are given credit facilities to buy goods on hire-purchase and instalment basis.
5. Cheap Monetary Policy. Cheap monetary policy or the policy of credit expansion also leads to increase in the money supply which raises the demand for goods and services in the economy.
6. Deficit Financing. In order to meet its rising expenses, the government resorts to deficit financing by borrowing from the public and even by printing more notes. This raises aggregate demand in relation to aggregate supply, thereby leading to an inflationary rise in prices.
7. Expansion of the Private Sector. The expansion of the private sector also raises the aggregate demand. Huge investments increase employment and income, thereby creating more demand for goods and services.
8. Black Money. The existence of black money in all countries due to corruption, tax evasion etc. increases the aggregate demand. People spend such unearned money, thereby creating unnecessary demand for commodities. This raises the price level further.
9. Repayment of Public Debt. Whenever the government repays its past internal debt to the public, it leads to increase in the money supply with the public. This raises the aggregate demand for goods and services.
10. Increase in Exports. When the demand for domestically produced goods increases in foreign countries, this raises the earnings of industries producing them. These, in turn, create more demand for goods and services within the economy.
Factors Affecting Supply
There are also certain factors which reduce the aggregate supply. They are as follows
1 Shortage of Factors. One of the important causes affecting the supplies of goods is the shortage of such factors as labour, raw materials, power supply, capital, etc. They lead to excess capacity and reduction in industrial production.
2. Industrial Disputes. In countries where trade unions are powerful, they also help in curtailing production. Trade unions resort to strikes. As a result, production falls, thereby reducing supplies of goods.
3. Natural Calamities. Drought or floods adversely affect the supplies of agricultural products. They create shortages of food products and raw materials, thereby helping inflationary pressures.
4. Artificial Scarcities. Artificial scarcities are created by hoarders and speculators who indulge in black marketing. Thus they reduce supplies of goods and raise their prices.
5. Increase in Exports. When the country produces more goods for export than for domestic consumption, this creates shortages of goods in the domestic market. This leads to inflation in the economy.
6. Lop-sided Production. If there is production of comforts, luxuries, or basic products and neglect of essential consumer goods in the country, this creates shortages of consumer goods. This again causes inflation.
7. Law of Diminishing Returns. If industries in the country are using old machines and methods of production, the law of diminshing returns operates. This raises cost per unit of production, thereby raising the prices of products.
8. International Factors. In modern times, inflation is a worldwide phenomenon. When prices rise in major industrial countries, their effects spread to almost all countries with which they have trade relations. Often the rise in the price of a basic raw material like petrol in the international market leads to rise in the price of all related commodities in a country, 6.
Inflation Study Material Notes
MEASURES TO CONTROL INFLATION
We have studied above that inflation is caused by the failure of aggregate supply to equal the increase in aggregate demand. Inflation can, therefore, be controlled by increasing the supplies and reducing money incomes in order to control aggregate demand. The various methods are usually grouped under three heads: monetary measures, fiscal measures and other measures.
1 Monetary Measures
Monetary measures aim at reducing money incomes.
(a) Credit Control. The central bank of the country adopts a number of methods to control the quantity and quality of credit. For this purpose, it raises the bank rates, sells securities in the open market, raises the reserved ratio, and adopts a number of selective credit control measures, such as raising margin requirements and regulating consumer credit.
(b) Demonetization of Currency. One of the monetary measures is to demonetize currency of higher denominations. Such a measure is usually adopted when there is an abundance of black money in the country.
(c) Issue of New Currency. The most extreme monetary measure is the issue of new currency in place of the old currency. Under this system, one new note is exchanged for a number of notes of the old currency. The value of bank deposits is also fixed accordingly. Such a measure is adopted when there is an excessive issue of notes and there is hyper inflation in the country
2. Fiscal Measures
Fiscal measures are highly effective for controlling government expenditure, personal consumption expenditure, and private and public investment. The principal fiscal measures are the following:
(a) Reduction in Unnecessary Expenditure. The government should reduce unnecessary expenditure on non-development activities in order to curb inflation. This will also put a check on private expenditure which is dependent upon government demand for goods and services.
(b) Increase in Taxes. To cut personal consumption expenditure, the rates of personal, corporate and commodity taxes should be raised and even new taxes should be levied. But the rates of taxes should not be so high as to discourage saving, investment and production. Rather, the tax system should provide larger incentives to those who save, invest and produce more. Further, to bring more revenue into the tax-net, the government should penalise the tax evaders by imposing heavy fines. Such measures are bound to be effective in controlling inflation. To increase the supply of goods within the country, the government should reduce import duties and increase export duties.
(c) Increase in Savings. Another measure is to increase savings on the part of the people. This will tend to reduce disposable income with the people, and hence personal consumption expenditure. The government should float public loans carrying high rates of interest, start saving schemes with prize money, or lottery for long periods, etc. It should also introduce compulsory provident fund, provident fund-cum-pension schemes, etc. compulsorily. All such measures to increase savings are effective in controlling inflation.
(d) Surplus Budgets. An important measure is to adopt anti-inflationary budgetary policy. For this purpose, the government should give up deficit financing and instead have surplus budgets. It means collecting more in revenues and spending less.
(e) Public Debt. At the same time, it should stop repayment of public debt and postpone it to some future date till inflationary pressures are controlled within the economy. Instead, the government should borrow more to reduce money supply with the public.
Inflation Study Material Notes
3. Other Measures
The other types of measures are those which aim at increasing aggregate supply and reducing aggregate demand directly.
(a) To Increase Production. The following measures should be adopted to increase production: () One of the foremost measures to control inflation is to increase the production of essential consumer goods like food, clothing, kerosene oil, sugar, vegetable oils, etc. (ii) If there is need, raw materials for such products may be imported to increase the production of essential commodities. (iil) Efforts should also be made to increase productivity. For this purpose, industrial peace should be maintained through agreements with trade unions, binding them not to resort to strikes for some time. (iv) The policy of rationalisation of industries should be adopted as a long-term measure. Rationalisation increases productivity and production of industries through the use of brain, brawn and bullion. (v) All possible help in the form of latest technology, raw materials, financial help, subsidies, etc. should be provided to different consumer goods sectors to increase production.
(6) Rational Wage Policy. Another important measure is to adopt a rational wage and income policy. Under hyperinflation, to control this, the government should freeze wages, incomes, profits, dividends, bonus, etc. But the best course is to link increase in wages to increase in productivity. This will have a dual effect. It will control wages and at the same time increase productivity, and hence increase production of goods in the economy.
(c) Price Control Price control is another measure of direct control to check inflation
(d) Rationing. Rationing aims at distributing consumption of scarce goods so as to make them available to a large number of consumers. It is applied to essential consumer goods such as wheat, rice, sugar, kerosene oil, etc. It is meant to stabilise the prices of necessaries and assure distributive justice.
Conclusion. From the various monetary, fiscal and other measures discussed above, it becomes clear that to control inflation, the government should adopt all measures simultaneously. Inflation is like a hydra-headed monster that should be fought by using all the weapons at the command of the government.
7. EFFECTS OF INFLATION
Inflation affects different people differently. This is because of the fall in the value of money. When prices rise or the value of money falls, some groups of the society gain, some lose and some stand in between. Broadly speaking, there are two economic groups in every society, the fixed income group and the flexible income group. People belonging to the first group lose and those belonging to the second group gain. The reason is that price movements in the case of different goods, services, assets, etc. are not uniform. When there is inflation, most prices are rising, but the rates of increase of individual prices differ much. Prices of some goods and services rise faster, of others slowly, and of still others remain unchanged. We discuss below the effects of inflation on redistribution of income and wealth, production, and on the society as a whole.
Inflation Study Material Notes
1 On Distribution of Income and Wealth
Inflation tends to increase inequalities in the distribution of income and wealth. The poor and middle classes suffer because their wages and salaries are more or less fixed but the prices of commodities continue to rise. They become more poor. On the other hand, businessmen, industrialists, traders, real estate holders, speculators, and others with variable incomes gain during rising prices. The latter category of persons become rich at the cost of the former group. The effects of inflation on different groups of society are discussed below.
(1) Debtors and Creditors. During periods of rising prices, debtors gain, creditors lose. When prices rise, the value of money falls. Though debtors return the same amount of money but they pay less in terms of goods and services. This is because the value of money is less than when they borrowed the money. Thus the burden of the debt is reduced and debtors gain. On the other hand, creditors lose. Although they get back the same amount of money which they lent, they receive less in real terms, because the value of money falls. Thus there is transfer of wealth from creditors to debtors.
(2) Salaried Persons. Salaried workers such as clerks, teachers, and other white collar persons lose when there is inflation. The reason is that their salaries are slow to adjust when prices are rising.
(3) Wage Earners. Wage earners may gain or lose depending upon the speed with which their wages adjust to rising prices. If their unions are strong, they may get their wages linked to the cost of living index. In this way, they may be able to protect themselves from the bad effects of inflation. But the problem is that there is often a time-lag between the raising of wages by employers and the rise in prices. So workers lose because by the time wages are raised, the cost of living index may have increased further.
(4) Fixed Income Group. Pensioners, recipients of interest and rent belong to the fixed income group. Pensioners get fixed pensions. Similarly, the rentier class consisting of interest and rent receivers get fixed payments. The same is the case with the holders of fixed interestbearing securities, debentures and deposits. All such persons lose because they receive fixed payments, while the value of money continues to fall with rising prices.
(5) Equity Holders and Investors. Persons who hold shares or stocks of companies gain during inflation. For when prices are rising, business activities expand which increase profits of companies. As profits increase, dividends on equities also increase at a faster rate than prices. But those who invest in debentures, securities, bonds, etc. which carry a fixed interest rate lose during inflation because they receive a fixed sum while the purchasing power is falling.
(6) Businessmen. Businessmen of all types, such as producers, traders and real estate holders gain during periods of rising prices. Take producers first. When prices are rising, the value of their inventories (goods in stock) rise in the same proportion. So they profit more when they sell their stocked commodities. The same is the case with traders in the short-run. But producers profit more in another way. Their costs do not rise to the extent of the rise in the prices of their goods. This is because prices of raw materials and other inputs and wages do not rise immediately to the level of the price rise. The holders of real estates also profit during inflation because the prices of landed property increase much faster than the general price level.
(7) Agriculturists. Agriculturists are of three types : landlords, peasant proprietors, and landless agricultural workers. Landlords lose during rising prices because they get fixed rents. But peasant proprietors who own and cultivate their farms gain. Prices of farm products increase more than the cost of production. For prices of inputs and land revenue do not rise to the same extent as the rise in the prices of farm products. On the other hand, the landless agricultural workers are hit hard by rising prices. Their wages are not raised by the farm owners, because trade unionism is absent among them. But the prices of consumer goods rise rapidly. So landless agricultural workers are losers.
Conclusion. Thus inflation redistributes income from wage earners and fixed income groups to profit recipients, and from creditors to debtors. In so far as wealth redistributions are concerned, the very poor and the very rich are more likely to lose than middle-income groups. This is because the poor hold what little wealth they have in monetary form and have few debts, whereas the very rich hold a substantial part of their wealth in bonds and have relatively few debts. On the other hand, the middle-income groups are likely to be heavily in debt and hold some wealth in common stock as well as in real assets.
Inflation Study Material Notes
2. Effects on Production
When prices start rising production is encouraged. Producers earn windfall profits in the future. They invest more in anticipation of higher profits in the future. This tends to increase employment, production and income. But this is only possible up to the full employment level. Further increase in investment beyond this level will lead to severe inflationary pressure within the economy because prices rise more than production as the resources are fully employed. So inflation adversely affects production after the level of full employment. The adverse effects of inflation on production are discussed below.
(1) Misallocation of Resources. Inflation causes misallocation of resources when production of essential to non-essential goods from which they expect higher profits.
(2) Reduction in Production. Inflation adversely affects the volume of production because the expectation of rising prices alongwith rising costs of inputs bring uncertainty. This reduces production.
(3) Fall in Quality. Continuous rise in prices creates a sellers’ market. In such a situation, producers produce and sell sub-standard commodities in order to gain higher profits. They also indulge in the adulteration of commodities.
(4) Hoarding and Black-marketing. To profit more from rising prices, producers hoard stocks of their commodities. Consequently, an artificial scarcity of commodities is created in the market. The producers sell their products in the black market which increases inflationary pressures
(5) Reduction in Saving. When prices rise rapidly, the propensity to save declines because more money is needed to buy goods and services than before. Reduced saving adversely affects investment and capital formation. As a result, production is hindered.
(6) Hinders Foreign Capital. Inflation hinders the inflow of foreign capital because the rising costs of materials and other inputs make foreign investments less profitable.
(7) Encourage Speculation. Rapidly rising prices create uncertainty among producers who indulge in speculative activities in order to make quick profits.
Inflation Study Material Notes
3. Other Effects
Inflation leads to a number of other effects which are discussed as under.
(1) Government. Inflation affects the government in various ways. It helps the government in financing its activities through inflationary finance. As the money income of the people increases, government collects that in the form of taxes on incomes and commodities. So the revenues of the government increase during rising prices. Moreover, the real burden of the public debt decreases when prices are rising. But the government expenses also increase with rising production costs of public projects and enterprises. There is also increase in administrative expenses as prices and wages rise. On the whole, the government gains under inflation for rising wages and profits spread an illusion of prosperity within the country.
(2) Balance of Payments. Inflation affects adversely the balance of payments of a country. When prices rise more rapidly in the home country than in foreign countries, domestic products become costly compared to foreign products. This tends to increase imports and reduce exports, thereby making the balance of payments unfavorable for country.
(3) Exchange Rate. When prices rise more rapidly in the home country than in foreign countries, it lowers the exchange rate in relation to foreign currencies.
(4) Collapse of the Monetary System. If hyper-inflation persists and the value of money continues to fall many times in a day, it ultimately leads to the collapse of the monetary system, as happened in Germany after World War I.
(5) Social. Inflation is socially harmful. By widening the gulf between the rich and the poor, rising prices create discontentment among the masses. Pressed by the rising cost of living, workers resort to strikes which lead to loss in production. Attracted by profit, people resort to hoarding, black-marketing, adulteration, manufacture of substandard commodities, speculation, etc. Corruption spreads in every walk of life. All this reduces the efficiency of the economy.
(6) Political. Rising prices also encourage agitations and protests by political parties opposed to the government. And if they gather momentum and become unhandy they may bring the downfall of the government. Many governments have been sacrificed at the after of inflation.
Inflation Study Material Notes
EXERCISES
1 What is inflation? Explain its economic effects on different people.
2. Discuss the causes of inflation. How can it be controlled?
3. Explain demand-pull inflation.
4. Write notes on: open and suppressed inflation, stagflation, hyperinflation, true inflation, open inflation, sectoral inflation, disinflation.
5. Explain cost-push inflation.
6. What are the effects of inflation on production?
