Inflation: Definition, Causes, Types & Key Terms

Introduction

• It is the gradual rise in prices of goods and services within a particular economy wherein, the purchasing power of consumers decreases, and the value of the cash holdings erode.         
• Inflation measures the average price change in a basket of commodities and services over time.
• The opposite and rare fall in the price index of this basket of items is called deflation. 
• In India, the Ministry of Statistics and Programme Implementation (MoSPI) measures inflation.

Causes of Inflation

• Demand-pull inflation: When aggregate demand surpasses the available goods and services, it leads to demand-pull inflation.
• The causes of Demand-pull inflation are:
  • Depreciation of rupee and Increase in Forex reserve.
  • Lower interest rates cause a rise in consumer spending and higher investment.
  • During festivals or special events, consumer spending often surges, driving up prices.
• Cost-Push Inflation: Rising production costs, such as higher wages or increased raw material prices, can result in cost-push inflation.
  • A spike in oil prices can increase production costs for various industries, causing them to raise prices. 
• Monetary Inflation: An increase in the money supply beyond the growth of goods and services can lead to monetary inflation.
  • Central banks printing more money or lowering interest rates excessively, leading to increased liquidity.
• Supply Chain Disruptions: Disruptions in the supply chain, such as natural disasters or global crises, can reduce the availability of goods, causing prices to rise.
  • The COVID-19 pandemic caused supply chain disruptions and shortages of various goods.
• Imported Inflation: A depreciation of the domestic currency can make imported goods more expensive, contributing to inflation.
  • Geopolitical Events: like the Russia-Ukraine war can elevate global oil prices, leading to imported inflation in oil-dependent countries such as India.

Types of Inflation

Based On Causes    

• Headline Inflation: Total inflation in the economy includes inflation in a basket of goods that includes commodities like food and energy.
  • Headline inflation may not present an accurate picture of an economy’s inflation trend since sector-specific inflationary spikes are unlikely to persist.
• Core Inflation: Change in the costs of goods and services but this excludes primary articles, food, etc. because of volatility/short term fluctuations.
  • Core Inflation is a reflection of a Headline inflation that may not present an accurate picture of an economy’s inflation trend since sector-specific inflationary spikes are unlikely to persist.
• Profit-Induced Inflation:  If the producers, due to their monopoly position, tend to mark-up their profit margin, it will lead to profit-induced inflation.
• Structural Inflation: Due to the weak structure of the institutions and markets in the economies, mostly the developing and low-income ones experience this kind of inflation.
  • Example:  Artificial shortage of foods/ goods due to hoarding and Poor agriculture produce due to poor monsoons, inadequate irrigation facilities etc.
• Core Inflation: It is based on the inclusion or exclusion of goods and services while calculating inflation. 
  • It shows price rise in all goods and services, excluding energy and food articles. It is quite popular in western economies. 
  • It was first used in 2000-01 in India but later fell out of fashion as prices in India depend more on food articles and energy requirements. 
  • Since 2015-16, new core-core inflation is also measured by India, which excludes food, fuel, light, transport, and communication.
• Refined Core Inflation: Economic Survey 2022 introduced the concept of refined core inflation.

Based on Speed  

• Creeping Inflation (1-4%); When the rate of inflation slowly increases over time. For example, the inflation rate rises from 2% to 3%, to 4% a year.
• Walking Inflation (2-10%): When inflation is in single digits – less than 10%. Central Banks will be increasingly concerned.
• Running Inflation (10-20%): When inflation starts to rise at a significant rate. It is usually defined as a rate between 10% and 20% a year.
• Galloping Inflation (20%-1000%): This is an inflation rate of between 20% up to 1000%. At this rapid rate of price increases, inflation is a serious problem and will be challenging to bring under control.
• Hyperinflation: Inflation rising at a very fast rate, can lead to a total collapse of the currency and economic crisis. 
• Examples: Germany in the 1920s, Zimbabwe in the 2000s, and Venezuela in the 2010s.

Key Terms and Terminologies

• Skewflation: It is the skewed rise in the price of some items while remaining item prices remain the same. 
  • Example: Seasonal rise in the price of onions.
• Stagflation: The situation of rising prices along with falling growth and employment. Inflation is accompanied by an economic recession. 
  • A combination of Inflation and unemployment (usually in the time of Recession).
• Disinflation: Reduction in the rate of inflation. 
  • Example: A fall in the inflation rate from 8% to 6%.
• Deflation: Fall in the level of prices of goods and services.
• Depression: Economic depression is a sustained, long-term downturn in economic activity.
• Reflation: Reflation is the act of stimulating the economy after a period of economic slowdown or contraction.
• Inflationary Gap: An inflationary gap exists when the demand for goods and services exceeds production due to higher levels of employment, increased trade activities, or elevated government expenditure.
  • The real GDP can exceed the potential GDP, resulting in an inflationary gap:
  • Inflationary Gap= Actual GDP−Anticipated GDP
• Deflationary Gap: Similar in concept to the inflationary gap, it represents the Shortfall in total spending over national income.
• Bottleneck Inflation: Also called structural inflation, it occurs when supply falls drastically and the demand remains at the same level.
• Inflation Tax: Due to price rise, wages increase, as wage increases taxes on this increase, generates more revenue for the government.
• Inflation Premium: Bonus brought by inflation to borrowers. Real interest rate (nominal IR adjusted to inflation) << Nominal interest rate (charged on lending).
• Inflation Spiral: Wage-price spiral i.e. when wages press prices up and prices pull wages down.
• Full Employment: A situation where all the resources in the economy are fully employed and operating at the maximum potential.
• Cobweb Phenomenon: Explains large scale fluctuations in the prices of Pulses in the Indian Market.
  • If prices were higher in the previous year, more farmers would sow pulses in the current year leading to its over- production and subsequent decline in the prices. 
  • The lower prices in the current year disincentive the farmers from growing crops in the next cropping season, leading to underproduction and subsequent increase in the prices.

Effect of Inflation on Economy

Conclusion

• Inflation, driven by various causes such as demand-pull, cost-push, and built-in factors, manifests in different types including moderate, galloping, and hyperinflation. 
• Its effects can range from eroding purchasing power and reducing real incomes to distorting economic decision-making and redistributing wealth. 
• However, understanding the causes, types, and effects of inflation is crucial for policymakers and individuals alike in formulating appropriate strategies to mitigate its adverse impacts and maintain economic stability.