Types Of Inflation

BUSINESS ECONOMY II

LESSON 9: TYPES OF INFLATION Good morning student now take a look at very interesting topic that is type of inflation

The following are the major characteristics of moderate inflation:

Objective of Lesson

i.

• Types of inflation On different grounds, economists have classified inflation into various types. A few important categories are discussed below. Chart 1 pinpoints the classification of inflation. Chart 1 Classification or Types of Inflation

Accordin g to the rate of inflation

According to The nature of Time period of occurrence

1.Moderte inflation

1. War-time Inflation

(a) Creeping (b) Walking

2. Post-war Inflation

2.Running inflation

3. Peace-time Inflation

There is a single digit inflation rate (less than 10 per cent) annually.

ii. It does not disrupt the economic balance. iii. It is regarded as stable Inflation in which the relative prices do not get farout of line. iv. People’s expectations remain more or less stable under moderate inflation.

According to The scope or coverage: 1.Compre hensive inflation

According to the Government’s Reaction: 1.Open inflation 2.Repressed inflation

2.Sporadic inflation

According to the causes: 1.Credit-inflation 2.Deficit inflation 3.Scarcity inflation 4.Profit-inflation 5.Foreign trade inflation

3.Galloping Inflation

6.Tax-inflation

4.Hyper Inflation

7.Cost or wage inflation 8.Demand inflation

1. Moderate, Gal1oping and Hyperinflation The severity of inflation is often measured in terms of the rapidity of price rise. On the basis, a quantitative distinction of inflation may be nude into three categories, viz: Moderate inflation; Running and galloping inflation; and Hyperinflation.

v. Under a low inflation rate, the real interest rate is not too low or negative, so money can serve its role as a store of value without difficulty.

a. Moderate Inflation

vi. There are modest inefficiencies associated with moderate inflation.

It is a mild and tolerable form of inflation. It occurs when prices are rising slowly When the rate of inflation is less than 10 per cent annually, or it is a single digit int1ation rate, it is considered to be a moderate inflation in the present the economy.

Economists have arbitrarily laid down that a 3-4 per cent price rise per annum is a tolerable rate of inflation in modern economies. Even the Chakravarthi Report of the Reserve Bank of India has accepted 3-4 per cent rate of inflation annually to be an efficient and tolerable norm for the Indian economy.

Prof. Samuelson observes that moderate inflation is typical today in most industrialised countries.

Incidentally, some economists have described up to 3 per cent annual rate of inflation as ‘creeping inflation’ and if it exceeds

54

© Copy Right: Rai University

11.251

Samuelson’s opinion, moderate inflation is not a serious problem. While some economists feel that even a walking inflation should make us more cautious, as it represents a warning signal for the occurrence of running or double digit and eventually a galloping inflation, if it is not checked in time. Running and Galloping Inflation When the movement of price accelerates rapidly, running inflation emerges. Running inflation may record more than 100 per cent rise in prices over a decade. Thus, when prices rise by more than 10 per cent a year, running inflation occurs. Economists have not described the range of running inflation. But, we may saythat a double digit inflation of 10-20 per cent per annum is a running inflation. If it exceeds that figure, it may be called ‘galloping’ inflation. According to Samuelson, when prices are rising at double or triple digit rates of 20, 100 or 200 per cent a year, the situation is described as ‘galloping’ inflation. Indian economy has witnessed a sort of ‘running’ and ‘galloping’ inflation to some extent (not exceeding 25 per cent per annum) during the planning era, since the Second Plan period. Argentina, Brazil and Israel, for instance, have experienced inflation rates over 100 per cent in the eighties. Galloping inflation is really a serious problem. It causes economic distortions and disturbances. Hyperinflation

In the case of hyperinflation, prices rise every movement, and there is no limit to the height to which prices might rise. Therefore, it is difficult to measure its magnitude, as prices ris~ by fits and starts. . In quantitative terms, when prices rise over 1000 per cent in a year, it is called a hyperinflation. Austria, Hungary, Germany, Poland and Russia witnessed hyperinflation in the wake of World War I. Hyperinflation notably took place in Germany in 1920-1923. The German price index rose from 1 to 10,00,000,000 during January 1922 to November 1923. Believe it or not, it is a fact! The Main Features of Hyperinflation are

i.

During hyperinflation, the price rise is severe. The price index moves up by leaps and bounds. It is over 1000 per cent per year. There is at least a 50 per cent price rise in a month, so that in a year it rises to about 130 times.

ii. It represents the most pathetic deterioration in people’s purchasing power. iii. It is apparently generated by a massive fiscal dislocation. iv. It is amplified by wage-price spiral. v. Hyperinflation is a monetary disease. vi. The velocity of circulation of money increases very fast. vii. The structUre of the relative prices of goods become highly lU1stable. viii. The real wages tend to decline fast. 11.251

ix. Inequalities increase. x. Overall economic distortions take place. These speed categories of inflation are graphically depicted as in Figure 2 where t represents time variable and p denotes increases in the price level. It must be remembered that the difference between all these four types of inflation is one of degree than of kind. They are species of the same genus. War, Post-War and Peace-Time Inflation On the basis of the nature of time-period of occurrence, we have: • war-time inflation;

• post-war inflation; and • peace-time inflation. a. War-Time Inflation

It is the outcome of certain exigencies of war, on account of increased government expenditure on defence which is of an unproductive nature. By such public expenditUre, the government apportions a substantial production of goods and services out of total availability for war which causes a downward shift in the supply; as a result, an inflationary gap may develop. b. Post-war Inflation

It is a legacy of war. In the immediate post-war period, it is usually experienced. This may happen when the disposable income of the community increases, when war-time taxation is withdrawn, or public debt is repaid in the post-war period. c. Peace-time Inflation

By this is meant the rise in prices during the normal period of peace. Peacetime inflation is often a result of increased government outlays on capital projects having a long gestation period; so a gap between money income and real wage goods develops. In a planning era, thus, when government’s expenditure increases, prices may rIse. Comprehensive and Sporadic Inflation

• From the coverage or scope point of view, we have: • comprehensive or economy-wide inflation, and • sporadic inflation. a. Comprehensive Inflation

When prices of every commodity throughout the economy rise, it is called economy-wide or comprehensive inflation. It is a normal inflationary phenomenon and refers to a rise in the general price level b. Sporadic Inflation

This is a kind of sectional inflation. It consists of cases in which the averages of a group of prices rise because of increases in individual prices due to abnormal shortage of specific goods. When the supply of some goods become inelastic, at least temporarily, due to physical or structural constraints, sporadic inflation has its sway. For instance, during drought conditions when there is a failure of crops, foodgrain prices shoot up. Sporadic inflation is a situation in which direct price control, if skilfully used, is most likely to be beneficial to the community at large.

© Copy Right: Rai University

55

BUSINESS ECONOMY II

10 per cent, it is called ‘walking inflation.’ This means, Samuelson has clubbed ‘creeping’ and ‘walking’ inflation into ‘moderate’ inflation.

BUSINESS ECONOMY II

Open and Repressed Inflation An inflation is open or repressed according to the government’s reaction to the prevalence of inflationary forces in the economy. a. Open Inflation

When the government does not attempt to prevent a price rise, inflation is said to be open. Thus, inflation is open when prices rise without any interruption. In open inflation, the free market mechanism is permitted to fulfil its historic function of rationing the short supply of goods and distribute them according to consumer’s ability to pay. Therefore, the essential characteristics of an open inflation lie in the operation of the price mechanism as the sole distributing agent. The post-war hyperinflation during the twenties in Germany is a living example of open inflation. b. Repressed Inflation

When the government interrupts a price rise, there is a repressed or suppressed’inflation. Thus, suppressed inflation refers to those conditions in which price increases are prevented at the present time through an adoption of certain measures like price controls and rationing by the government, but they rise on the removal of such controls and rationing. The essential characteristic of repressed inflation, in contrast to open inflation, is that the former seeks to prevent distribution through price rise under free market mechanism and substitutes instead a distribution system based on controls. Thus, the administration of controls is an important feature of suppressed inflation. However, many economists like Milton Frie,dman and G.N.Halm opine that if there has to be any inflation, it is better open than suppressed. Suppressed inflation is condemned as it breeds auumber of evils like black market, hierarchy of price controllers and rationing officers, and uneconomic diversion of productive resources from essential industries to non-essential or less essential goods industries since there is a free price movement in the latter and hence are more profitable to investors. 5. Types of Inflation Based on the Causes Inducing Inflation According to the cause of rising prices, one can consider several types of inflation as follows: a. Credit Inflation

Inflation which is caused by excessive expansion of bank credit or money supply is referred to as credit or money inflation. b. Deficit Inflation

It is the inflation caused by deficit financing. When the government budgets contain heavy deficit financing, through creating new money, the purchasing power in the community increases and prices rise.This may be referred as to as deficit-induced inflation. During a planning era, when government launches upon heavy investment, it usually resorts to deficit financing, when adequate resources are not found. An inflationary spiral develops due to deficit financing, when adequate resources are not found. An inflationary spiral develops due to deficit financing, when the production of consumption goods fails to keep . pace with the increased money expenditure. 56

c. Scarcity Inflation

Whenever scarcity of real goods occurs or may be artificially created by the hoarding activities of unscrupulous traders and speculators which may result into black-marketing, thereby causing prices to go up, such type of inflation may be described as scarcity inflation. d. Profit Inflation

In his recent book, Growthless Inflation by Means of Stockless Money, Prof. Brahmananda menti°!ls profit inflation a;, a unique category of inflation. The concept of profit inflation was originated by Keynes in his Treatise on Money. According to Keynes, the price level of consumption goods is a function of the investment exceeding savings. He considered the investment boom as a reflection of profit boom. Inflation is unjust in its distribution effect. It redistributes income in favour of profiteers and against the wage-earning class. During inflation, thus, the entrepreneur class may tend to expect an upward shifting of the marginal effiCiency of capital (MEC); hence, entrepreneurs are induced to invest more even by borrowing at higher interest rates. Eventually, investment exceeds savings and economy tends to reach a higher level of money income equilibrium. If economy is operating at full employment level or if there are bottlenecks of market imperfections, real output will not rise proportionately, so the imbalance between money income a.nd real income is corrected through rising prices. e. Foreign-Trade Induced Inflation

For an international economy, we may categorise the following two types of inflation as being caused by factors pertaining to the balance of payments.: i.

Export-Boom Inflation; and

ii. Import Price-hike Inflation. i. Export-Boom Inflation

When a country having a sizeable export component in its foreign trade experiences a sudden rise in the demand for its exportables against the inelastic supply of exportables in the domestic market, it obviously implies an excessive pressure of demand which is revealed in terms of persistent inflation at home. Again, trade gains and sudden influx of exchange remittances may lead to an increase in monetary liabilities which is further reflected in the rising pressure of demand for domestic output causing an inflationary spiral to get further momentum. Such a permanent case for an export-boom inflation is, however, ruled out in the Indian economy, because neither export trade is a significant portion of Domestic National Product nor is there a continuous boom of export-demand, causing tenus of trade to move up favourably all the time. ii. Import Price-hike Inflation

When prices of import components rise due to inflation abroad, the domestic costs and prices of goods using these imported parts vill tend to rise. Such an int1ation is referred to as imported intluion. For instance, hike in oil prices by the Arab countries was responsible for accelerating. inflationary price rise in many oil-importing countries, including India to some extent.

© Copy Right: Rai University

11.251

Year to year increase in commodity taxation such as excise duties and sales tax may lead to rise in prices of taxed goods. Such an inflation is termed as tax inflation or tax-induced inflation.

prices are pulled upwards by the continuous upward shift of the aggregate demand function. By using the aggregate demand and supply curves, in Fig. 4, the demand-pull process can be graphically illustrated.

g. Cost Inflation

When inflation emerges on account of a rise in cost factor, it is called cost inflation. It occurs when money incomes (wage rate, particularly) expand more than real productivity. Cost inflation has its course through the level of money costs of the factors of production and in particular through the level of wage rates. Due to a rising cost of living index, workers demand higtKl’ wages, and higher wages in their turn increase the cost of production, which a producer generally meets by raising prices. This process of spiralling may each higher and higher levels. In this case, however, cyclical anti-inflation remedies of monetary controls are not relative effective. Wage inflation is an important variant of cost inflation. Wage push inflation occurs when money wages are raised without corresponding improvement in the productivity of the workers. h. Demand Inflation

When there is an excess of aggregate, detrland against the available aggregate supply of goods and services, prices tend to rise. It is called demand-induced inflation. Population-growth, rising money income, etc. forces playa significant role in generating demand inflation.

Types of inflation Demand-Pull vs. Cost-Push Inflation Broadly speaking, there are two schools of thought regarding the possible causes of inflation. One school views the demandpull element as an important cause of inflation, while the other group of economists holds that inflation is mainly caused by the cost-push element. Demand-Pull Inflation

According to the demand-pull theory, prices rise in response to an excess of aggregate demand over existing supply of goods and services. The demand-pull theorists point out that inflation (demand-pull) might be caused, in the first place, by an increase in the quantity of money, when the economy is operating at fullemployment level. As the quantity of money increases, the rate of interest will fall and, consequently, investment will increase. This increased investment expenditure will soon increase the income of the various factors of production.As a result, aggregate consumption expenditure will increase leading to an effective increase in the effective demand. With the economy already operating at the level of full employment, this will immediately raise prices, and inflationary forces may emerge. Thus, when the general monetary demand rises faster than the general supply, itpulls up prices (commodity prices as well as factor prices, in general). Demand-pull inflation, therefore, m:anifests itself when there is active cooperation, or passive collusion, or a failure to take counteracting measures by monetary authorities. Demand-pull or just demand inflation may be defined as a situation where the total monetary demand persistently exceeds total supply of real goods and services at current prices, so that

11.251

In Fig. 4, the X-axis measures real output, and the Y-axis measures the price level. Curves D, Dl and D2 represent the aggregate demand curves. The SS curve represents the aggregate supply function, which slopes upward from left to right and, at point F it becomes a vertical straight line. The point F suggests that the economy has reached a level of full employment. Hence, the real output tends to be fixed or inelastic at this point. Assuming that the D curve intersects the S curve at point F, the real output or income is at full employment and the price level is OP. When there is an increase in the aggregate demand function beyond D, either due to an increase in autonomous investment (I), or because of an increase in the propensity to consume (C), or government spending increase in the propensity to consume (C), or government spending (G), represented by a shift in the aggregate demand curve, such asD l’ D 2' the supply of total real output being inelastic, the prlce level tends to rise from P to PI and then to P2. However, demand-pull inflation can also occur without an increase in the money supply. This can happen when either the marginal efficiency of capital increases or the marginal propensity to consume rises, so that investment expenditures may rise, thereby leading to rise in the aggregate demand which will exert its influence in raising prices beyond the level of full employment already attained in the economy. According to the demand-pull theorists, during the process of demand inflation, rise in wages accompanies or follows the price rise as a natural consequence. Under the condition of rising prices, when the rate of profit is increasing, producers are inclined in general to increase investment and .employment, in that they bid against each other for labour, so that labour-prices (i.e. wages) may rise. In short, the inflationary process, described by the demand inflation theory, implies the following sequences:, Increasing demand increasing prices - increasing costs - increasing income increasing demand - increasing prices - and so on.

© Copy Right: Rai University

57

BUSINESS ECONOMY II

j. Tax Inflation

BUSINESS ECONOMY II

Causes of Demand-Pull Inflation

It should be noted that the concept of demand-pull inflation is associated with a situation of full employment where increase in aggregate demand cannot be met by a corresponding expansion in the supply of real output. There can be many reasons for such excess monetary demand: 1. Increase in Public Expenditure. There may be an increase in the public expenditure (G) in excess of public revenue. This might have been made possible (or rendered necessary) through public borrowings from banks or through deficit financing, which implies an increase in the money supply.

wages constitute nearly seventy per cent of the total cost of production. This is specially true for a country like India, where labour intensive techniques are commonly used. Thus, a rise in wages leads to a rise in the total cost of production and a consequent rise in the price level, because fundamentally, prices are based on costs. It has been said that a rise in wages causing a rise in prices may, in turn, generate an inflationary spiral because an increase would motivate the workers to demand higher wages. Indeed, any autonomous increase in costs, such .1S a rise in the prices of imported components or an increase in indirect

2. Increase in Investment. There may be an increase in the autonomous investment (iI in firms, which is in excess of the current savings in the economy. Hence, the flow of total expenditure tends to rise, causing an excess monetary demand, leading to an upward pressure on prices. 3. Increase in MPC. There may be an increase in the marginal propensity to consume (MPC), causing an excess monetary demand. This could be due to the operation of demonstration effect and such other reasons. 4. Increasing Exports and Surplus Balance of Payments. In an open economy, an increasing surplus in the balance of payments also leads to an excess demand. Increasing exports also have an inflationary impact because there is generation of money income in the home economy due to export earnings but, simultaneously, there is reduction in the domestic supply of goods because products are exported. If an export surplus is not balanced by increased savings, or through taxation, domestic spending will be in excess of the value of domestic output, marketed at current prices. 5. Diversification of Goods. A diversion of resources from the consumption goods sector either to the capital good sector or the military sector (for producing war goods) will lead to an inflationary pressure because while the generation of income and expenditure continues, the current flow of real—output decreases on account of high gestation period involved in these sectors. Again, the ppportunity cost of war goods is quite high in terms of consumption goods meant for the civilian sector. This leads to an excessive monetary demand for the goods and services against their real supply, causing the prices to move up. In short, it is said that the demand-pull inflation could be averted through deflationary measures adopted by the monetary and fiscal authorities. Thus, passive policies are responsible for demand-pull inflation. Cost-Push Inflation

A group of economists hold the opposite view that the process of inflation is initiated not by an excess of general demand but by an increase in costs, as factors of production try to increase their share of the total product by raising their prices. Thus, it has been viewed that a rise in prices is initiated by growing factor costs. Therefore, such a price rise is termed as “cost-push” inflation as prices are being pushed up by the rising factor costs. Cost-push inflation, or cost inflation, as it is sometimes called, is induced by the wage-inflation process. It is believed that

58

taxes (excise duties, etc.), may initiate a cost-push inflation. Basically, however, it is wage-push pressures which tend to accelerate the rising price spiral. The phenomenon of cost-push inflation is graphically illustrated in Fig. 5. In the figure, the 0 curves represent the aggregate demand function, and the S curves, the aggregate supply function. The full-employment level of income is OY, which can be maintained only at rising price levels, P, PI, P2' P3. Now, if we begin with price level P, F is the point of intersection of the aggregate supply curve; D and SSo’ Let us assume that the aggregate supply function shifts upward as Sl’ which becomes a vertical straight line at point A, and merges with the SF line (the previous supply curve at full-employment level). The upward shift in the supply curve may be attributed to either an increase in money wages due to trade unions’ successful collective bargaining, or to the profit-motivated monopolists or oligopolists, who might have raised the prices of goods. Anyway, as the aggregate supply curve shifts to S}’ the new equilibrium point A is determined at OY} level of real output, which is less than full-employment level, atP } level of prices. This means that with a rise in the price level, unemployment increases’. It is regarded as the cost of holding the price level close to f. Similarly, a further shift in the aggregate supply curve to S2 on account of a further wage-push, implies a new equilibrium pointB. This causes theinc-ome level’to fall further to Y2,and prices to rise to P2. If, however, the government or monetary authority is committed to maintain, full employment, there will ~ more public spending or more credit

© Copy Right: Rai University

11.251

Cost-push inflation may occur either due to wage-push or profit-push. Costpush analysis assumes monopoly elements either in the labour market or in the product market. When there are monopolistic labour organisations, prices may rise due to wage-push. And, when there are monopolies in the product market, the monopolists may be induced to raise the prices. in order to fetch high profits. Then, there is profit-push in raising the prices. However, the cost-push hypothesis rarely considers autonomous attempts to increase profits as an important inflationary element. Firstly, because profits are generally a small fraction of the total price, a rise in profits would have only a slight impact on prices. Secondly, the monopolists generally hesitate to raise prices in absence of obvious demand-pull elements. Finally, the motivation for profit-push is weak since, at least in corporations, those who make the decision to raise prices are not the direct beneficiaries of the price increase. Hence cost-push is generally conceived as a synonymous with wage-push. When wages are pushed up, cost of production increases to a considerable extent so that prices may rise. Since wages are pushed up by the demand for high wages by the labour unions, wage-push may be .equated with union-push. According to one variant of the cost-push theory, sectoral shifts in demand are prime-movers in the inflationary process. Starting with an autonomous shift in demand, a rise in wages and prices could result in one sector and this rise could elicit further shifts of demand. This happens because thete is a close link between different goods through inputs. One good serves as an input in the production of the other goods, and consequently, when the price of the input rises, the prices of output will also rise. For instance, when due to a rise in wages in the steel industry, price of steel may rise, and this will raise the prices of vehicles, machines, etc., using. steel as input. The rise in the prices of vehicles may in turn raise the cost of transport and manufactured goods. Similarly, prices of tractors, etc. may increase due to high prices of steel so that costs of agriculture may rise, hence food and raw material prices will also rise. All these ultimately raise the cost of living, leading to increase in wage rates. Thus, inflation once sets in motion due to the phenomenon of costpush in one industry or sector spreads throughout the economy.

wages - incomes). Normally, thus, it is difficult to be precise as to whether an inflation is cost-push or demand-pull. A cost-push inflation is much more difficult to control than a demand-pull type. A demand-pull inflation can be controlled by adopting restrictive monetary and fiscal policies so as to drain off excessive monetary demand. But cost-push inflation is not susceptible to a direct controls. In order to check cost-push inflation, there is a strong need on the part of labourers and entrepreneurs for restraint in their wage and pricing policies.

Recap Demand-Pull The inflation resulting from an increase in aggregate demand is called demand-pull inflation. Such an inflation may arise from any individual factor that increases aggregate demand, but the main ones that generate ongoing increases in aggregate demand are

• Increases in the money supply • Increases in government purchases • Increases in the price level in the rest of the world Cost-Push Inflation • An increase in wage rates

• An increase in the prices of raw materials These sources of a decrease in aggregate supply operate by increasing costs, and the resulting inflation is called cost-push inflation Other things remaining the same, the higher the cost of production, the smaller is the amount produced. At a given price level, rising wage rates or rising prices of raw materials such as oil lead firms to decrease the quantity of labor employed and to cut production.”

Notes -

Concluding Remarks It is, however, impossible to state whether demand-pull or cost-push elements are the prime causes of an inflationary spiral. It rather seems that there may be a demand-cum-cost inflation as both entrepreneurs and workers use. the mark-up their wages to protect their share of total produt. On the other hand, if wages rise, entrepreneurs will raise prices to adjust mark-up to the previous level of profits. Thus, demand-pull inflation may generate cost-push elements of inflation (as ‘Yorkers’ will demand high wages in view of rising cost of living index), and the costpush inflation may in turn generate demand-pull inflationary elements (as workers monetary demand for consumption goods will increase due to high 11.251

© Copy Right: Rai University

59

BUSINESS ECONOMY II

expansion, causing the price level to rise to much more - such as from P to P 3 and P4. In this case, the sequence of equilibrium points become A-B-G-H.