InflationAndDeflation

Unit14

Unit14InflationAndDeflation
Structure
14.1 14.2 Introduction Objectives Meaningandkindsinflation 14.2.1 Causesofinflation 14.2.2 Effectsofinflation 14.2.3 Antiinflationarymeasuresormeasurestocontrolinflation 14.2.4 Theinflationarygap 14.3 14.4 Deflation SelfAssessmentQuestions1 Summary TerminalQuestions AnswertoSAQsandTQs

INFLATION

14.1 Introduction
Inflation refers to a period of steady rise in price level. It is generally considered as a monetary phenomenoncausedbyexcesssupplyofmoney.Therearedifferentkindsofinflationdemandpull inflationandcostpushinflation,etc..Inflationiscausedbyanumberoffactorslike,increaseinthe supplyofmoney,increaseintheincomes,increaseinexports,consumptionetc.,onthedemandside andshortageinthesupplyoffactorsofproduction,operationofthelawofdiminishingreturns,war, hoarding etc., on the supply side. The effects of inflation are different on different sections of the society.Amildinflationisbeneficialtoeconomicgrowth,producersandbusinessmenarebenefited by it.But when it assumes larger proportions itbecomes dangerousto thegrowth of theeconomy and is painful to consumers and laborers. A number of antiinflationary measures like monetary, fiscalandadministrativeareadoptedtocontrolinflation.
SikkimManipalUniversity

372

InflationAndDeflation

Unit14

The concept of inflationary gap was first developed by J.M.Keynes, which means an excess of anticipatedexpenditureoveravailableoutputatabaseprice. Phillipscurveexplainstherelationshipbetweeninflationandunemployment. Stagflation is anew concept developedtoexplain the situationof stagnant conditions in economic activitywhenthereisinflationintheeconomy. Deflationisjusttheoppositeofinflation.Itisessentiallyaperiodoffallingpricesandriseinthevalue ofmoney.Deflationismoredangerousthaninflation. LearningObjectives: Afterstudyingthisunit,youshouldbeabletounderstandthefollowing

1. Defineinflationanddistinguishbetweendifferentkindsofinflation. 2. Describethecausesofinflationanditseffectsondifferentsectionsofthesociety. 3. Explaindifferentmeasuresthatcanbeadoptedtocontrolinflation. 4. Analyzetheconceptofinflationarygap. 5. Understandtheconditionsofstagnationandadoptsuitablemeasurestotacklethesituation. 6. Definedeflationitsmeaningandeffectsonproductionanddistribution.

14.2.MeaningAndKindsOfInflation Inflation has become a global phenomenon in recent years. Inflation is a sin every government denouncesitandeverygovernmentpracticesit.Prof.ML.Stigum.Developmenteconomicsisvery muchassociatedwithinflation.Anindepthstudyofinflationisofparamountimportancetoastudent ofmanagerialeconomics. The term inflation is used in many senses andhence it is very difficult to give generally accepted, universally agreeable and precise definition to the term inflation. Popularly inflation is associated withhighprices,whichcausesadeclineinthevalueofmoney. Inflation iscommonlyunderstoodasasituationofsubstantialandrapidgeneralincreasein thelevelofpricesandconsequentdeteriorationinthevalueofmoneyoveraperiodoftime.It refers to the average rise in the general level of prices and fall in the value of money. Prof.Crowtherdefinesinflationasastateinwhichthevalueofmoneyisfallingi.e.Pricesarerising. Prof.Samuelsonputsitthus,inflationoccurswhenthegenerallevelofpricesandthecostisrising. AccordingtoProf.ParkinandBade,Inflationisanupwardmovementintheaveragelevelofprices.
SikkimManipalUniversity

373

InflationAndDeflation

Unit14

Itsoppositeisdeflation,adownwardmovementintheaveragelevelofprices.Thus,thecommon featureofinflationisriseinpricesandthedegreeofinflationmaybemeasuredbypriceindices. Inflationisstatisticallymeasuredintermsofpercentageincreaseinthepriceindex,asarate percentperunitoftimeusuallyayearoramonth. Thetrendofpriceindicesrevealsthecourse of inflation in the economy. Usually, the Wholesale price Index [WPI] numbers are used to measureinflation.Alternatively,theConsumerpriceIndex[CPI]orthecostoflivingIndexcan be adopted in measuring the rate of inflation. In order to measure the percentage rateof inflation, Prof,Rowansuggeststhefollowingformula ChangeinPrice[t] Percentagerateofinflation,P[t]= Price[t1] X100

Changeinprice[t]=P[t]P[t1].Here,P=priceleveland[t],[t1]aretheperiodsofcalendartime towhichtheobservationsaremade. Mostoftheeconomistsconsideredinflationaspurelyamonetaryphenomenon.Accordingtothis approach,itisincreaseinthequantityofmoney,whichcausesaninflationaryriseinthepricelevel. Anexpansioninmoneysupplyunaccompaniedbyanexpansioninthesupplyofgoodsandservices inevitablyresultsinpricerise.ProfKemmererthinks,Inflationwillexistwhentheamountofmoney in the country is much in excess of the physical volume of goods and services. Prof Coulbourn explainsitasToomuchofmoneychasingtoofewgoods.ToHawtreyInflationistheissueoftoo muchofmoney.ProfEinzigisoftheopinionthatmoneysupplyandrisingpricelevelarebothcause and effect by themselves. In his own words, Inflation is that state of disequilibrium in which an expansion of purchasing power tends to cause or is the effect of an increase of the price level. Therefore, Prof. Milton Friedman remarks Inflation is always and everywhere a monetary phenomenon. The classical economists advocated quantity theory of money and as such they analyzed the causes of inflation in terms of money. This approach failed to explain the causes of hyperinflation,whichappearedinGermanyafterFirstWorldWarandthistheoryisnotapplicableto aneconomysufferingfromdepressionandunemployment. TheCambridgeeconomistslikeLordKeynesandA.CPigouviewedinflationasaphenomenonof full employment. According to Keynes an inflationary rise in price cannot take place before the point of full employment. An expansion of money supply in a situation of under employment
SikkimManipalUniversity

374

InflationAndDeflation

Unit14

equilibrium, leads to increasedproduction of goods and services and expansion in employmentby using unemployed resources. Any rise in price level before the point of full employment is called Semi inflation or Bottleneck inflation. This will continue till all unemployed men and other resources are employed.Beyond this stage,any increase in money supply will lead toonly rise in prices,butnot to rise inproduction and employment. Hence accordingto Keynes, the rise in price levelafterthepointoffullemploymentisthetrueinflation. Accordingtoanotherapproachthesolecauseofinflationistheexistenceofapersistentexcess demand in the economy. Inflation is the excess demand over the supply of everything after the limitsofthesupplyhavebeenreached. TYPESOFINFLATION Depending upon the rateof rise in pricesand the prevailing situation inflation hasbeen classified underdifferentheads: 1.Creepinginflation:Whentheriseinpricesisveryslowlikethatofasnailorcreeper,(lessthan3 %)itiscalledcreepinginflation. 2.Walkinginflation:Whenthepriceriseismoderate(isintherangeof3to7%)andtheannual inflationrateisofasingledigit,itiscalledwalkinginflation.Itisawarningsignalforthegovernment tocontrolitbeforeitturnsintorunninginflation. 3.Runninginflation:Whenthepricesriserapidly,atarateofspeedof10to20percentperannum, itiscalledrunninginflation.Suchinflationaffectsthepoorandmiddleclassesadversely.Itscontrol requiresstrongmonetaryandfiscalmeasuresotherwiseitleadstohyperinflation. 4. Hyper Inflation: Hyper inflation is also called by various names like jumping, runaway, or galloping inflation. During this period prices rise very fast, at double or triple digit rates from more than20to100percentperannumormoreandbecomesabsolutelyuncontrollable.Suchasituation bringsatotalcollapseofthemonetarysystembecauseofthecontinuousfallinthepurchasingpower ofmoney. 5.DemandpullInflation Itmaybedefinedasasituationwherethetotalmonetarydemandpersistentlyexceedstotal supply of goods and services at current prices, so that prices are pulled upwards by the continuousupwardshiftoftheaggregatedemandfunction. Itarisesasaresultofanexcessive aggregate effective demand over aggregate supply of goods and services in a slowly growing economy.Supplyofgoodsandserviceswillnotmatchwithrisingdemand.Theproductiveabilityof
SikkimManipalUniversity

375

InflationAndDeflation

Unit14

theeconomyissopoorthatitisdifficulttoincreasethesupplyataquickerratetomatchtheincrease indemandforgoodsandservices. When exports increase the money income of the people rises. With excess money income, purchasingpower,demand,pricesmoveintheupwarddirection. Itisessentialtonotethatdemandpullinflationistheresultofincreaseinmoneysupply.Thisleads to fall in the interest rate rise in investment increase in production increase in the incomes of factors of production increase in the demand for goods and services and finally, in the level of prices.Thus,excesssupplyofmoneyresultsinescalationofprices. Again,whenthereisadiversionofproductiveresourcesfromtheproductionofconsumergoodsto either capital or defense goods or nonessential goods, prices start rising in view of scarcity of consumergoodsandexcessincomeinthehandsofpeople.Itisclearfromthefollowingdiagram
Y S P2 P1 PriceLevel P F D S 0 Y Output X D1

D2

In the diagram, the point F indicates the equilibrium position where aggregate demand is equal to aggregatesupplyofgoodsandservices.OPisthepricelevelandOYindicatesthesupplyofgoods andservices.Asdemandincreases,supplybeingconstant,thepricelevelrisesfromOPtoOP1and OP2. 6.CostPushInflation Itreferstoasituationwhereinpricesriseonaccountofincreasingcostofproduction.Thus, inthiscase,riseinpriceisinitiatedbygrowingfactorcosts.Hence,suchapriceriseistermedas

SikkimManipalUniversity

376

InflationAndDeflation

Unit14

costpushinflationaspricesarebeingpushedupbytherisingfactorcosts.Anumberoffactors contributefortheincreaseincostofproduction. 1. Demandforhigherwagesbythelabourclass. 2. Fixingupofhigherprofitmarginsbythemanufacturers. 3. Introductionofnewtaxesandraisingthelevelofoldtaxes. 4. Increaseinthepricesofdifferentinputsinthemarket. 5. Riseinadministrativepricesbythegovernmentetc., Thesefactors inturn causeprices to rise in themarket.Outof many causes, rise in wages is the mostimportantone.Itisestimatedandbelievedthatwagesconstitutenearly70%ofthetotalcostof production.Ariseinwagesleadstoariseinthetotalcostofproductionandaconsequentriseinthe pricelevel.Thuscostpushinflationoccursduetowagepushorprofitpush. We canexplainthecostpushinflationwiththehelpofthefollowingdiagram. Inthediagram,thepointFindicatestheoriginalequilibriumpositionwheredemandandsupplyare equal to each other. OP is theoriginal price level and OY is the supply. A is the new equilibrium pointwhenthesupplycurveshiftsupwardsonaccountofcostpushfactors.OP1willbethenew pricelevel,whichishigherthantheoriginalone.OY1willbethenewsupplyandsoon.
Y S P4 H

PriceLevel

P3 P2 P1 P S1 S 0

G B S3 A F D

D2 D1

Y2 Y1

Y RealOutput

SikkimManipalUniversity

377

InflationAndDeflation

Unit14

14.2.1. CausesOfInflation Demandside Increaseinaggregativeeffectivedemandisresponsibleforinflation.Inthiscase,aggregatedemand exceedsaggregatesupplyofgoodsandservices.Demandrisesmuchfasterthanthesupply.We canenumeratethefollowingreasonsforincreaseineffectivedemand. 1.Increaseinmoneysupply Supplyofmoneyincirculationincreasesonaccountofthefollowingreasonsdeficitfinancingbythe government,expansioninpublicexpenditure,expansioninbankcreditandrepaymentofpastdebt bythegovernmenttothepeople,increaseinlegaltendermoneyandpublicborrowing. 2.Increaseindisposableincome Aggregate effective demand rises when disposable income of the people increases. Disposable incomerisesonaccountofthefollowingreasonsreductionintheratesoftaxes,increaseinnational incomewhiletaxlevelremainsconstantanddeclineinthelevelofsavings. 3.Increaseinprivateconsumptionexpenditureandinvestmentexpenditure An increase inprivateexpenditureboth on consumptionandon investment leads to emergenceof excessdemandinaneconomy.Whenbusinessisprosperous,businessexpectationsareoptimistic and prices are rising, more investment is made by private entrepreneurs causing an increase in factorprices.Whentheincomesofthefactorsrise,thereismoreexpenditureonconsumergoods. 4.IncreaseinExports Anincreaseintheforeigndemandforacountrysexportsreducesthestockofgoodsavailablefor homeconsumption.Thiscreatesshortagesinthecountryleadingtoriseinpricelevel. 5.ExistenceofBlackMoney The existence of black money in a country due to corruption, tax evasion, blackmarketing etc, increases the aggregate demand. People spend such unaccounted money extravagantly thereby creatingunnecessarydemandforgoodsandservicescausinginflation. 6. Increase in Foreign Exchange Reserves: It may increase on account of the inflow of foreign money in to the country. Foreign Direct Investment may increase and nonresident deposits may alsoincreaseduetothepolicyofthegovernment. 7.Increaseinpopulationgrowthcreatesincreaseindemandforeverythinginacountry. 8.Highratesofindirecttaxeswouldleadtoriseinprices.
SikkimManipalUniversity

378

InflationAndDeflation

Unit14

9.Reductionintheratesofdirecttaxeswouldleavemorecashinthehandsofpeopleinducing themtobuymoregoodsandservicesleadingtoanincreaseinprices. 10.Reductioninthelevelofsavingscreatesmoredemandforgoodsandservices.

II.Supplyside Generally,thesupplyofgoodsandservicesdonotkeeppacewiththeeverincreasingdemandfor goodsand services. Thus, supply doesnot match with thedemand. Supplyfalls short of demand. Increaseinsupplyofgoodsandservicesmaybelimitedbecauseofthefollowingreasons. 1.Shortageinthesupplyoffactorsofproduction When there is shortage in the supply of factors of production like raw materials, labor, capital equipments etc. there will be a rise in their prices. Thus, when supply falls short of demand, a situationofexcessdemandemergescreatinginflationarypressuresinaneconomy. 2.Operationoflawofdiminishingreturns Whenthelawofdiminishingreturnsoperate,increaseinproductionispossibleonlyatahighercost which de motivates the producers to invest in large amounts. Thus production will not increase proportionatelytomeettheincreaseindemand.Hence,supplyfallsshortofdemand. 3.HoardingsbyTradersandspeculators Duringthe period of shortage and rise in prices,hoarding of essential commoditiesbytraders and speculatorswiththeobjectofearningextraprofitsinfuturecreatesartificialscarcityofcommodities. Thiscreatesasituationofexcessdemandpavingthewayforfurtherinflation. 4.HoardingbyConsumers Consumersmayalsohoardessentialgoodstoavoidpaymentofhigherpricesinfuture.Thisleadsto increaseincurrentdemand,whichinturnstimulateprices. 5.RoleofTradeunions Trade union activities leading to industrial unrest in the form of strikes and lockouts also reduce production.Thiswillleadtocreationofexcessdemandthateventuallybringsariseinthepricelevel. 6.RoleofnaturalCalamities Natural calamities such as earthquake, floods and drought conditions also affect adversely the suppliesofagriculturalproductsandcreateshortageoffoodgrainsandrawmaterials,whichinturn createsinflationaryconditions.
SikkimManipalUniversity

379

InflationAndDeflation

Unit14

7.War.Duringtheperiodofwar,shortageofessentialgoodscreateriseinprices. 8.Internationalfactorsalsowouldcauseeithershortageofgoodsandservicesorriseintheprices offactorinputsleadingtoinflation.E.g.,Highpricesofimports. 9.Increaseinpricesofinputswithinthecountry.

III.RoleofExpectations Expectations also play a significant role in accentuating inflation. The following points are worth mentioning: 1. If people expect further rise in price, the current aggregate demand increases which in its turn causesaraiseintheprices. 2.Expectationsabouthigherwagesandsalariesaffectverymuchthepricesofrelatedgoods. 3.Expectationsofwageincreaseofteninducesomebusinesshousestoincreasepricesevenbefore upwardwagerevisionsareactuallymade. Thus,manyfactorsareresponsibleforescalationofprices.

14.2.2.EffectsOfInflation
Positivesideofeffectsofinflation: 1. Leads to rise in investment: Rise in prices leads to a rise in profits, incomes, savings, and finallythevolumeofinvestmentbythebusinessmen. 2. Creates better opportunities: Rise in prices, which is much higher than theproduction costs, createsbetterandmoreopportunitiesinnewfieldsofbusinessactivities. 3. Encourage entrepreneurship: As profits rise, it encourages entrepreneurs to enter in to businessfieldinanincreasingmanner 4. Inflationtax: Governmentinordertocoverthedeficitinthebudgetmayresorttoinflationtax. 5. Fullutilizationofresources: Ithelpsinfullerutilizationofallkindsofeconomicresourcesinan economyastheeffortsofentrepreneursaresuitablyrewardedintheformofhigherprofits.

SikkimManipalUniversity

380

InflationAndDeflation

Unit14

6. Leads to increase in the demand for money: Asprice rises, people require more money to buythesamequantityofgoodsandservices.Hence,itleadstoexpansioninmoneysupplyinthe country,whichleadstohighergrowthrateintheeconomy. 7. Itisanecessarycostofdevelopment: Itbecomesinevitableduringtheprocessofeconomic development.Infact,inflationpromoteseconomicdevelopmentandeconomicdevelopmentresults ininflation.Thus,bothofthemgotogether. Effectsonproduction: 1.Alowinflationratestimulateseconomicgrowth:Asmallamountofinflationisoftenviewedas having a positive effect on the economy. For example, a mild inflation has a stimulating or tonic effect on the economy. Rise in price leads to increase in profit ratio investment output employmentandincomesinaneconomy. 2.Disturbstheworkingofpricemechanism:Themostharmfuleffectofinflationisthatitdisrupts thesmoothworkingofthepricemechanismandeconomicsystemandasaconsequence,economic adjustmentsbecomeverydifficult. 3.Adverseeffectsoninvestmentandproduction: Riseinpriceleadstofallinthevalueofmoney reductioninpurchasingpowerreductioninsavingsreductionininvestmentandproduction. 4.Adverseeffectsonsavingsandcapitalformation:Capitalformationsuffersasaconsequence ofdepreciationinthevalueofmoneyanditmaybedrivenoutofthecountry.Similarly,itdiscourages theinflowofforeigncapitalintothecountry. 5. Creates business uncertainty: Production will be adversely affected on account of business uncertainty. A sort of tension prevails during the period of inflation, which discourages the entrepreneursfromtakingrisksinvolvedinproduction. 6. Reduces production: On account of fall in the rate of capital formation and uncertainty in business,totalvolumeofproductiondeclines. 7.Leadstochangeinthepatternofproduction: Itaffectsthepatternofproduction.Resources willbedivertedfromtheproductionofessentialgoodstoluxurygoodstoreaphigherprofitmargins. 8. Leads to hoardings and black marketing: During inflation, the traders hoard essential goods withaviewtogethigherprofits.Thebuyersalsohoardessentialgoodsforthefearofpayinghigher pricesinfuture.Thusitalsoleadstothegrowthofblackmarketing.
SikkimManipalUniversity

381

InflationAndDeflation

Unit14

9. Develops a sellers market: During inflation the sellers market develop. As prices are rising peoplewanttosellawaytheirgoodsratherthanbuythem.Qualityofgoodsandservicesalsowillbe affectedbyinflation. 10.Encouragesspeculativeactivities:Speculativeactivitiesgainmomentumduringinflation. 11. Distortion in resource allocation: It leads to diversion of resources from productive uses to unproductiveuseswiththesoleobjectiveofearningmoreprofitsbytheentrepreneurs.Withrisein prices,the costsofdevelopmentprojects also will goup leading to more diversion of resources to completethesameprojectbythegovernment. B)Effectsondistribution 1.Leadstounequaldistributionofincomeandwealth: Prolongedandpersistentinflationleads to inequitabledistributionof wealth and income in the society. Inflation robs the poor to enrich the rich. Rich entrepreneurs earn more profits at the cost of customers. This leads to unequal distributionofincomeandwealthasrichbecomesricherandpoorbecomesmuchpoorer. 2.Inflationcreateshardshipsforfixedincomeearners:Rentiers,bondholderswithfixedratesof interest, holders of government securities, persons who live on past savings, pensioners etc, are adverselyaffectedastheirmonetaryincomeremainsthesamewhilethevalueofmoneyfalls. 3. Debtors gain and creditors lose: During inflation generally debtors gain as they return the borrowedmoneywhenitsfacevalueislessandcreditorslosebecausetheygetbacktheirmoney withdepreciationinitsvalue. 4. Adverse effects on wageearners and salaried class: The wage earners, salaried class and middleclasspeopleareworstaffectedastheirlivingstandardsdeteriorateduetoescalationofprices whiletheirmoneyincomesremainthesame. 5.Entrepreneursandbusinesscommunitygain:Businessmenwelcomeinflationastheystand togainbyrisingprices.Theirinventoryvaluerises.Priceoffinishedproductsrisemuchfasterthan theproductioncosts.Hencetheirprofitmarginsalsowouldgoupsubstantially. 6.Effectsoninvestors:Ifinvestorsinvesttheircapitalonequitysharesanddebentures,theystand to gainbecause their pricesare rising. On theother hand, ifthey investonbonds and securities, theylosebecausetheirincomesfromthemremainthesame.

SikkimManipalUniversity

382

InflationAndDeflation

Unit14

7.Effectsonfarmers:Virtuallyfarmersarethegainersbecausepricesofagriculturalgoodsriseon theonehand&costofcultivationlagsbehindpricesreceived. Inflation favors one group at the expense of other groups. It is generally regressive in nature, as manypeoplecannotprotecttheirownselfinterest. C)Socialandpoliticaleffectsofinflation 1.Socialeffects:Inflationisapowerfulengineofwealthdistributorinfavoroftherich.Itwidensthe gap between the rich and the poor and thus hampers social justice. It creates a sense of heart burninginpoorersectionsofthesociety.Itleadstosocialconflictsbetweentherichandpoor. 2.Moral and ethical effects: In order to earn higher profits, business people resort to black marketing,adulteration,smuggling,hoarding,qualitydeteriorationandothersuchantisocialtactics. Hence,inflationgivesaseriousblowtobusinessmoralityandethics.Thegeneralmoralitydeclines, corruptionincreases.Thisleadstooveralldiscontentmentsamongpeople. 3. Political effects: Deterioration in social and ethical standards and discontentment among the people reflects in political uncertainty. People loose faith in the administrative ability of the Govt., whichgivesplaceforanexplosivepoliticalsituationinthecountry.HyperinflationinGermanyduring 1920sisaglaringexamplefortheriseofHitlerasadirector.Ithasbeenrightlysaidthat,Hitleris thefosterchildofinflation. 4.Impactofdemonstrationeffect: Itencouragesconsumerismandacountrymayhavetosuffer onaccountofdemonstrationeffects. D)ExternaleffectsofInflation 1.Reducesthevolumeofexports:Itreducesthevolumeofexportsofanation,asdomesticprices aremuchhigherthaninternationalprices. 2.Createexchangeratedifficulties:Fallinthevalueofhomecurrencymayreduceexternalvalue ofacurrencyandthuscreateproblemsinthedeterminationofrateexchangebetweenthecurrencies ofdifferentcountries. 3. Discourage the inflow of foreign capital: It discourages the inflow of foreign capital into a country.Thusinflationhasfarreachingconsequencesonaneconomy.

SikkimManipalUniversity

383

InflationAndDeflation

Unit14

4. Decline in international competitiveness: If a country experiences a high rate of inflation compared to other nations, in that case, the international competitivenessof the given country will decline. Thus,inflationhasfarreachingconsequencesonaneconomy. 14.2.3.AntiInflationaryMeasuresOrMeasuresToControlInflation Theantiinflationarymeasuresarebroadlyclassifiedinto3categories. I.MONETARYMEASURES Inflationisbasicallyamonetaryphenomenon.Excessmoneysupplyoverthequantityofgoodsand services is mainly responsible for rise in prices. Hence, monetary authorities aim at reducing and absorbing excess supply of money in an economy. The following are some of the antiinflationary monetarymeasures: 1. The volume of legal tender money may be reduced either by withdrawing a part of the notes alreadyissuedorbyavoidinglargescaleissueofnotes. 2.Restrictionsonbankcredits. 3.Freezingandblockingparticulartypeofassets. 4.Increasingbankrateandotherinterestrates. 5.SaleofGovt.,securitiesintheopenmarketbycentralbank. 6.RaisingthelegalreserverequirementslikeCRRandSLR 7.Prescribingahigher margin that bank and other lenders must maintainfor the loans granted by themagainststocksandshares. 8.Regulationofconsumerscredit. 9.Rationingofcreditetc. Thus,thegovernmenttocontrolinflationmayexercisevariousquantitativeandqualitativetechniques ofcreditcontrols. II.FISCALMEASURES Thefollowingaresomeoftheimportantantiinflationaryfiscalmeasures: 1.Reductioninthevolumeofpublicexpenditure.
SikkimManipalUniversity

384

InflationAndDeflation

Unit14

2.Riseinthelevelsoftaxes,introductionofnewtaxesandbringingmorepeopleunderthecoverage oftaxes. 3.Moreinternalborrowingsbypublicauthorities. 4.Postponingtherepaymentofdebttopeople. 5.Controlonthevolumeofdeficitfinancing. 6.Preparationofasurplusbudget. 7.Introductionofcompulsorydepositschemes. 8.Incentivetosavings. 9.Divertingthepublicexpendituretowardstheprojectswherethetimegapbetweeninvestmentand productionisleast,(smallgestationperiod). 10. Tariffs should be reducedto increase imports and thus allow apart ofthe increased domestic moneyincometoleakout. 11.InducingwageearnerstobuyvoluntarilyGovt.,bondsandsecuritiesetc. Thus,Fiscalmeasuressucceedtoagreaterextenttocontaininflationinitsownway. III.OTHERMEASURESdirectoradministrativemeasures Direct controls refer to the regulatoryor administrative measures takenby the government directly withanobjectiveofcontrollingriseinprices.Moderngovernmentsdirectlyinterveneintheworkingof theeconomyinseveralways.Hence,thegovernmentstakeseveralconcretemeasurestocheckthe riseinprices.Thefollowingaresomeofthesedirectmeasurestakenbymoderngovernments. 1.Expansioninthevolumeofdomesticoutputsoastomeettheeverincreasingriseinthedemand forthem. 2.Directcontrolofpricesandintroductionofrationing. 3.Controlofspeculativeandgamblingactivities. 4.Wageprofitfreezebyadoptingappropriatewageprofitpolicy. 5.Adoptinganappropriateincomepolicy.

SikkimManipalUniversity

385

InflationAndDeflation

Unit14

6. Overvaluation of currency.Over valuationofdomestic currency intermsofforeign currencies in order to increase imports to add to the stocks with in the country anddecrease in exports so that moregoodswillbecomeavailablefordomesticconsumption. 7. Indexing: It refers to monetary corrections by periodic adjustments in money incomes of the peopleandinthevalueoffinancialassets,savingdeposits,etcheldbythepublicinaccordancewith the changes in price level. For if price rises by 15%, the money incomes and the value of the financialassetsshouldbeincreasedby15%underthesystemofindexing. 8.Controlofpopulation.Itisconsideredasoneofthemostimportantmethodsbecauseifpopulation iscontrolled,itispossibletokeepacheckondemandforgoodsandservices. 9. Exhortations it implies authoritative persuasions, publicity campaigns etc., National saving campaign,requeststotradeunionforvoluntaryresistancetodemandforriseinwagescompaniesto restrictdividenddistributionstoworkersandmanagementtoincreaseproductivityandoutputetc. Theabovesaidmeasuresaretobeemployedinajudiciousmannerinordertocombatthedemonof inflationinacountry. 14.2.4. TheInflationaryGap J.M.Keynes invented the term inflationary gap to describe a situation when there is excess of anticipated expenditure over the available output at base prices. It is a gap between /money incomesofthecommunityandtheavailablesupplyofoutputofgoodsandservices.Accordingto Lipsey The inflationary gap is the amount by which aggregate expenditure would exceed aggregateoutputatthefullemploymentlevelofincome.Thelargertheaggregateexpenditure, the larger is the gap and more rapid the inflation. During a war period, the volume of money expenditurebythegovernmentincreases,resultinginincreasedincomewiththecommunityleading toincreasedconsumptionexpenditureandinvestment.Givenaconstantaveragepropensitytosave, risingmoneyincomesatfullemploymentlevelleadtoanexcessofdemandoversupplyandresultin thedevelopmentofinflationarygap.

SikkimManipalUniversity

386

InflationAndDeflation

Unit14

Wecanexplainthiswithanillustration:(Rs.Crores) 1.GrossNationalIncomeatcurrentprices 20,000 2.LessTaxes 5,000

3.PersonalIncome(grossdisposableincome) 15,000 4.LessSavingsofthecommunity 5.DisposableIncome 3,000 12,000

6.GrossNationalProductatpreinflationprices 15,000 7.Governmentexpenditure(tomeetthewarrequirements) 8.Outputavailableforconsumptionatpreinflationprices 9.Inflationarygap(12,0009,000) 6,000 9,000 3,000

Now the net disposable income with the community is 12,000, but theavailable outputfor civilian consumptionisonly9,000.ThereisexcessofdemandoveravailablesupplytotheextentofRs.3000 crores.Thisisreferredtoastheinflationarygap.ThoughKeynesassociatedaninflationarygapwith war,suchagapcanariseevenduringtheperiodofeconomicdevelopment. WecanshowtheinflationarygapdiagrammaticallyusingtheKeynesianconceptsofaggregate supplyandaggregatedemand:
Y

AS

(C+I+G) Expenditure A E

YF

Y1

X Income

SikkimManipalUniversity

387

InflationAndDeflation

Unit14

YFisthefullemploymentlevelofincome45degreelinerepresentsaggregatesupply(AS)and C+I+Gline(AD).Thecommunitysaggregatedemandcurveintersectstheaggregatesupplycurveat E,atOY1levelofincome,whichisgreaterthanthefullemploymentlevelofincomeYF.Theamount bywhichaggregatedemand(YFA)exceedstheaggregatesupply(YFB)atthefullemploymentlevel ofincomeistheinflationarygap(AB). Measurestowipeoutinflationarygap 1. Increaseinsavingstoreduceaggregatedemand. 2. Raisetheoutputtomatchthedisposableincome. 3. Raisethetaxestomopuptheexcesspurchasingpower. Thefirsttwomeasureshavealimitedscope,monetarypolicyalsocannotbeveryeffectivesothe governmentwillhavetorelymoreonfiscalmeasuresliketaxationtowipeouttheinflationarygap. Stagflation The present day inflation is the best explanation for stagflation in the whole world. It is inflation accompanied by stagnation on the development front in an economy. Instead of leading to full employment, inflation has resulted in unemployment in most of the countries of the world. It is a globalphenomenontoday.Bothdevelopedanddevelopingcountriesarenotfreefromitsclutches. Stagflationisaportmanteauterminmacroeconomicsusedtodescribeaperiodwithahigh rateofinflationcombinedwithunemploymentandeconomicrecession.Inflationarygapoccurs whenaggregatedemandexceedstheavailablesupplyanddeflationarygapoccurswhenaggregate demand is less than the aggregate supply. These are two opposite situations. For instance, when inflation goes unchecked for some time, and prices reach very high level, aggregate demand contracts and a slump follows. Private investment is discouraged. Inflationary and deflationary pressuresexistsimultaneously.Theexistenceofaneconomicrecessionattheheightofinflationis calledstagflation. Theeffectsofrisinginflationandunemploymentareespeciallyhardtocounteractforthegovernment andthecentralbank.Ifmonetaryandfiscalmeasuresareadoptedtoredressoneproblem,theother getsaggravated.Say,ifacheapmoneypolicyandpublicworksprogrammeareadoptedtoremedy unemployment inflation gets aggravated. On the other hand, if a dear money policy and stringent fiscal measures are followed unemployment will get aggravated. It is the most difficult type of

SikkimManipalUniversity

388

InflationAndDeflation

Unit14

inflation that the world is facing today. Keynesian remedial measures have not succeeded in containing inflation but actually have aggravated unemployment. Thus, the world stands today betweenthedevil(inflation)anddeepsea(unemployment). PhillipsCurve A.W.PhillipstheBritisheconomistwasthefirsttoidentifytheinverserelationshipbetweentherateof unemployment and the rate of increase in money wages. Phillips in his empirical study found that when unemployment was high, the rate of increase in money wage rates was low and when unemploymentwaslow,therateofincreaseinmoneywagerateswashigh. Phillipscallsitasthetradeoffbetweenunemploymentandmoneywages.Thisisillustratedinthe figurebelow.

Y GrowthofMoneywages(%) 0 UnEmployment PC

Inthefigurethehorizontalaxisrepresentstherateofunemploymentandtheverticalaxisrepresents the rate of money wages. In thefigure PC represents thePhillips curve PC is sloping downwards andisconvextotheoriginofthetwoaxesandcutsthehorizontalaxis.TheconvexityofPCshows that money wagesfall with increase in the rateof unemploymentor conversely money wages rise withdecreaseintherateofunemployment. Thisinverserelationshipbetweenmoneywageratesandunemploymentisbasedonthenatureof business activity. During the period of rising business activity wage rate is high and the rate of

SikkimManipalUniversity

389

InflationAndDeflation

Unit14

unemploymentislowandduringperiodsofdecliningbusinessactivitywagerateislowandtherate ofunemploymentishigh. PaulSamuelsonandRobertSolowextendedthePhillipscurveanalysistotherelationshipbetween the rate of change inprices and the rateof unemployment and concluded that there is a tradeoff betweenthelevelofunemploymentinacountryandtherateofinflation.

Y P1 P2 Rateofinflation

P3

U1 U2 UnEmployment

U3

Wecanusethesamefiguretoillustratethisconcept,insteadofmoneywagesweshowriseinthe pricelevelontheOYaxis.Itwillbeclearfromtheabovefigure,thatthehighertherateofinflation, theloweristherateofunemploymentinthecountryandlowertherateofinflation,thehigherthe rateofunemploymentinthecountryi.e.,onecanbeachievedatthecostoftheother.Phillipscurve analysiscanbeaguidetothegovernmentinstrikingabalancebetweenthemeasurestobeadopted tosolvetheproblemofunemploymentandinflation.

14.3.Deflation
Meaning Deflationisjustoppositetoinflation.Itisessentiallyaperiodoffallingprices,fallinincomesandrise inthevalueofmoney.AccordingtoProf.CrowtherDeflationisthatstateoftheeconomywherethe valueofmoneyisrisingorthepricesarefalling.Buteveryfallinpricelevelisnotdeflation.Inthe wordsofProf.PigouDeflationisthatstateoffallingpriceswhichoccursatthetimewhenoutputof goodsandservicesincreasesmorerapidlythanthevalueofmoneyincomeintheeconomy.Prof.
SikkimManipalUniversity

390

InflationAndDeflation

Unit14

PaulEinziggivesabetterandconvincingdefinition.Inhisviewdeflationisastateofdisequilibrium inwhichacontractionofpurchasingpowertendstocause,oristheeffectofadeclineofpricelevel. Thus,fallinpricelevelisboththeresultaswellasthecauseoffallinmoneysupply. EffectsofDeflation Deflationlikeinflationwillhavebothdampeningandencouragingeffectsondifferentsectionsofthe society. OnProduction Deflationhasanadverseeffectonthelevelofproduction,businessandemployment.Fallindemand and fall in prices force many firms to quit the industry or operate partially. Wages are reduced or workersareretrenched.Itcreatesahopelesssituationinthefieldofproduction. OnDistribution Deflation affects adversely distribution of income too. In the first place, producers, merchants and speculatorslosebadlyduringthisperiodbecausepricesofthegoodsfallatamuchgreaterrateand faster than their costs. Being unable to manage with the situation many are compelled to quit the industry. Failureofbusinessandinabilitytorepaytheloansincurredwiththebanksworsensthepositionof themerchantsandtheproducers. Debtorslosewhilethecreditorsgain.Fixedincomegroupsenjoyabetterstandardoflivingasthe moneyincomeisfixed,therewillbeariseintheirrealincomes. Thesalariedpersonsandwageearnerswillbenefitbydeflation. However,thebeneficialeffectsofdeflationarefarlesscomparedtoitsadverseeffects.Duringthis periodbecauseofunemployment,fallingincomes,fallingoutput,akindofpessimisticatmosphereis establishedintheentireeconomy. MethodstoControlDeflation Antideflationarymeasuresareoppositeofthosewhichareusedtocontrolinflation. Monetarypolicy CentralbankwillhavetofollowacheapmoneypolicyreducingtheBankRate, organizingopenmarketpurchaseofsecurities,reducingthemarginrequirementsetctoencourage

SikkimManipalUniversity

391

InflationAndDeflation

Unit14

borrowing.Butbecauseoffallingpricesandlowmarginalefficiencyofcapital,cheapmoneypolicyof thecentralbankmaynotbeveryeffectiveincontrollingdeflation. FiscalPolicy: Fiscalmeasureslikedeficitfinancing,reductionintaxrates,taxconcessions,public works programmers, may prove to be more efficient in improving the situation than the monetary measures. Other measures Price support programmes, rationing of essential commodities, import of

essentialgoods,grantofsubsidies,developmentofinfrastructure,marketingfacilitiesetc.,tosome extentmayeasethesituation. Bothinflationanddeflationaredangerous.Ofthetwodeflationismoredangerousasitcripplesthe systemandestablishesahopelesssituationeverywhere. SelfAssessmentQuestions1 1. Thevalueofmoneyandpricelevelare___related. 2. Thestatesteadyriseinpriceleveliscalled____. 3. Accordingto____Inflationisaphenomenonwheretoomuchmoneychasestoofewgoods. 4. Theinflationarysituationwherepeoplegowithbasketfulofmoneyandcomehomewithpocketful ofcommoditiesis______/______/_________. 5. TheGovernmentsgofor______financingtofinancepublicexpenditure. 6. Theconceptofinflationarygapwasintroducedby_____. 7. Thetradeoffbetweeninflationandunemploymentiscalledthe____Curve. 8. Asituationwhereinflationisaccompaniedbystagnationiscalled__________. 9. Astateofsteadyfallinpriceiscalled________________.

14.4 Summary
Inflation refers to a period of general rise in price level. There are different types of Inflation, like demandpullinflation,costpushinflationetc.Inflationiscausedbyanumberoffactorslikeriseinthe supplyofmoney,increaseinexports,blackmoney,riseinthecoastofproduction,hoarding,waretc. Itaffectsdifferentsectionsofthepopulationdifferently.Producers,merchants,debtorsgainwhilethe consumers, laborers, fixed income groups suffer. A number of measures like monetary, fiscal and physicalcontrolsareadoptedtocontrolinflation
SikkimManipalUniversity

392

InflationAndDeflation

Unit14

Inflationary gap is a Keynesian concept it arises when the expenditure is in excess of the goods availableintheeconomy. Phillipscurveexplainstheinverserelationshipthatexistsbetweentherateofunemploymentandthe rate of increase in money wages. Paul Samuelson and Robert Solow using Phillips curve explain how at a higher of inflation rate of unemployment is low and at lower rate of inflation the unemploymentrateishigh.Itservesasagoodguidetothegovernmentandthemonetaryauthorities toadoptappropriatepoliciestotackletheproblemofunemploymentandinflation. Deflationisastateoffallingprices,incomes,outputandemployment.Asdeflationhasthedangerof creatingconditionsofdepressionitmustbecuredadoptingvariousmonetaryandfiscalmeasures. TerminalQuestions 1. Defineinflation.Discussdifferentkindsofinflation. 2. Whatisinflation?Explainthecausesofinflation. 3. Describetheeffectsofinflationandthemeasuresadoptedtocontrolit. 4. Explaintheconceptofinflationarygap. 5. Whatisdeflation?Explaintheeffectsofdeflationandthemethodsadoptedtocontrolit. AnswertoselfAssessmentQuestions1 1. Inversely 2. Inflation 3. Coulborn 4. Jumping/galloping/hyperinflation 5. Deficit 6. Keynes 7. Philips 8. Stagflation 9. Deflation

SikkimManipalUniversity

393

InflationAndDeflation

Unit14

AnswertoTerminalQuestions 1. Refertounit14.6 2. Refertounit14.6 3. Refertounit14.2.2 4. Refertounit14.2.4 5. Refertounit14.3

SikkimManipalUniversity

394