CHAPTER – 11

INFLATION : PROBLEMS AND POLICIES

Introduction
Inflation refers to a situation of increase in the general price level over a period of time. It is a serious hurdle in the
process of growth, as it causes a rise in the prices of inputs. It also causes a rise in the rate of interest. Implying a rise in
the cost of investment. Further, it causes a fall in real income of the people.
1. Indicators of Inflation
a. Wholesale Price Index (WPI) :- It measures the change in wholesale prices on weekly basis. On the basis of
weekly indices, average annual WPI is worked out. Average annual wholesale prices of the current year are
related to average annual wholesale prices of the base year ( assumed as 100).
b. Consumer Price Index (CPI) :- It measures the change in retail prices on monthly basis. On the basis of
monthly indices, average annual CPI is worked out.
c. GDP Deflator :- It refers to the ratio between GDP at current prices and GDP at constant prices.
𝑮𝑫𝑷 𝒂𝒕 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑷𝒓𝒊𝒄𝒆𝒔
GDP Deflator = 𝑮𝑫𝑷 𝒂𝒕 𝑪𝒐𝒏𝒔𝒕𝒂𝒏𝒕 𝑷𝒓𝒊𝒄𝒆𝒔

If ‘ GDP at Current prices’ = ‘ GDP at Constant prices’, GDP deflator = 1, implying no change in price level.
2. Causes of Inflation :- Inflation is the consequence of a mismatch between demand and supply in the economy.
It occurs either when demand increases or when supply decreases. In India, inflation is triggered by both
demand and supply factors.
a. Increase in Money Supply :- Since the Second Five Year Plan, Supply of money has increased much more
than the Gross Domestic Product (GDP).
b. Deficit Financing :- In India, deficit financing refers to the policy of printing more notes. This is done for
funding deficit in the government budget. Budgetary deficit has recorded a significance rise over time. During
the First Plan, the amount of fiscal deficit was Rs. 350 crore; it increased to Rs. 64,869 crore during the Ninth
Plan. Reliance on deficit financing to cope with fiscal deficit has caused a substantial increase in money
supply. Accordingly, price level has tended to rise.
c. Rise in population :- The country has experienced population explosion since 1951. On account of rise in
population, demand for goods has shown a steep rise. This fuels the process of price rise.
d. Fall in Production :- Fall in production causes fall in supplies and therefore rise in prices. Industrial
production has also witnessed phases of decline due to shortage of raw materials, transport bottlenecks,
insufficient supply of machines & equipments, strikes and lockouts. These factors have also contributed to the
rise in price level.
e. Increase in Wages :- In India, every prices rise is followed by a rise in wages. And, every rise in wages is
followed by a rise in prices. Thus, there is a situation of wage – price spiral : wages catch prices and prices
catch wages.
 f. Administered Prices :- Price level in the country has also increased on account of the frequent hike in the
administered prices. It includes increase in railway freight, postal charges as well as the prices of petroleum
products.
g. Inflation Across the Borders :- Inflation across the borders has impacted price level in our country. Since
1980, crude oil prices have increased manifold. Prices of almost all raw materials imported from abroad have
also gone up.
h. Indirect Tax :- Prices in India have tended to rise on account of a frequent increase in indirect taxes like sales
tax, excise duty and customs duty. Other things remaining constant, higher the indirect taxes, higher the
market price of goods and services.
i. Credit Expansion :- Credit expansion has been one of the principal causes of inflation in India. Easy
availability of credit for the purchase of consumer goods has raised the level of demand quite significantly.
j. Black Money :- Unaccounted money plays a significant role in causing a spurt in the price level. In India, there
is a huge stock of black money. This money is lavishly spent. This raises the level of demand and triggers the
speed of inflation.
Cost Push Inflation and Demand Pull Inflation
Cost Push Inflation occurs when price level tends to rise owing to the rising cost of production. Rise in cost of
production may be related to expensive inputs. It may also be related to shortfall in production due to natural
factors such as floods or droughts or due to man – made factors such as strikes and lockouts in the factories.
Demand Pull Inflation occurs when price level tends to rise owing to the pressure of demand in the economy.
Rise in demand may be related to rise in money supply ( or income level) or consumers’ expectations.
3. Effect of Inflation Or Problems related to Inflation :-
a. Inflation Hinders the Process of Growth :- Rapid rise in prices hinders the process of growth as it adversely
impacts the rate of investment in the economy.
Inducement to invest is lowered owing to the rising cost of investment or the rising rate of interest.
b. Adverse Effect on the People with Fixed Income :- Price rise has an adverse effect on the people with fixed
income. On account of rise in price level, they can buy less goods than before. Their standard of living falls.
c. Increase in the Cost of Projects :- Cost of projects ( both in private and public sectors) tends to rise due to rise
in prices. As a result, plan outlays are to be frequently revised to achieve a given set of targets.
d. Adverse Impact on Balance of Payments :- Owing to inflation, exports become expensive. Domestic goods
lose their competitiveness in the international market. Exports, therefore, tend to fall.
e. Wage :– Price Spiral :- Consequent upon rise in the price level, real income of the wage – earners tends to
fall. Accordingly, they mount up pressure for a rise in money wage. This raises the cost of production, causing
a further rise in prices.
f. Inequality :- Inflation causes inequality in the distribution of income and wealth. Often, it is observed that
during inflation profits tends to rise faster than wages.
 g. Economic Stagnation :- Inflation lowers purchasing power of the people. Having spent bulk of their income
on the necessities of life, not much is left for the purchase of comforts and luxuries. Accordingly, size of the
market tends to shrink for the secondary and tertiary sectors of production.
h. Impact on FDI :- Inflation threatens the flow of FDI ( Foreign Direct Investment). First, because it implies a
rise in the cost of inputs and second, because it implies a decline in purchasing power of foreign currency (
say, US $) in the Indian markets.
i. Speculation and Hoarding :- ‘ Speculation and hoarding’ are the dangerous consequences of inflation.
Traders make speculative investment on inventory stocks.
4. Government Policies to Check Inflation
a. Price Control of Essential Goods :- Prices of certain essential goods are collected with a view to ensuring
their availability to all sections of the society. Controlled price refers to ceiling price, implying a
maximum price that a producer can charge for a product.
b. Procurement Price and Support Price :- Procurement price refers to price fixed by the government at
which it procures a part of the farmers’ produce to run its PDS (Public Distribution System). Support
price is that price which is offered by the government to the farmers for the purchase of their surplus
output.
MONETARY POLICY
1. A check on the Supply of Money :- The central bank of the country ( as a note issuing authority) puts a
check on the supply of money. Lesser the supply of money in the market, lower the purchasing power of the
people.
2. Increase in rate of Interest :- To check inflation, the central bank raises the bank rate. (Bank rate is the rate
of interest charged by the central bank from the commercial banks for the loans). It causes a rise in the
market rate of interest. ( Market rate of interest is the rate of interest charged by the commercial banks
from the general public for the loans).
3. Decrease in the Supply of Credit :- The central bank adopts several measures to reduce the supply of credit.
Important measures include :
a. Increase in CRR ( Cash Reserve Ratio). This compels the commercial banks to keep more cash
reserves as a percentage of the loans offered by them.
FISCAL POLICY
1. A Check on Public Expenditure :- During inflation, government expenditure is kept under check, so that
demand for goods and services in the economy does not rise.
2. Public Debt :- Public debt is allowed to rise through public borrowing. This reduces purchasing power of
the public.
3. Increase in Taxes :- Taxes are increased, so that disposal income of the people is reduced ( disposal income
= Income – Taxes on income). This further reduces purchasing power of the people. Implying a check on
demand and therefore a check on prices.
4. Surplus Budget Policy :- The government follows the policy of a ‘ Surplus Budget’ . it is a policy by which
government expenditure is kept lower than the government revenue.
5. Some General Suggestions to Control Inflation
a. Check on Supply of Money :- To check inflation, it is essential that supply of money is not allowed
to expand.
b. Check on Deficit Financing :- Deficit financing should be reduced to the bare minimum. This
requires a cut in unessential expenditure and reduction in subsidies.
c. Tax on Agriculture Income :- In India, agriculture income is by and large exempted from income tax.
This is largely owing to political reasons. A tax on agriculture income will certainly reduce budgetary
deficit of the government.
d. Distribution through Fair Price Shops :- Essential gods should be distributed among the poor
through fair price shops. This will reduce pressure of demand in the open market. Accordingly ,
inflation will be tamed.