Friday, 6 May 2011

What is Inflation

Inflation refers to a rise in price level after full employment level has been achieved. Under such conditions, only prices will rise, and the output will remain the same. The inflation rate is used to measure the rate of change in the overall price level of goods and services that we typically consume.

Inflation is good for investment, because the burden of loan repayment is reduced. For example, a company that borrows Rs 100 crore today will repay only Rs 78 crore (excluding interest payments) in real terms at the end of five years, if the rate of inflation is 5 per cent.

Types of Inflation

Depending on the rate at which prices rise, inflation is classified into three categories: creeping, running and hyper or galloping inflation.

Creeping Inflation

When the increase is small or gradual, it is called creeping inflation. Creeping inflation leads to a small increase in prices, which induces investment in the economy.

Running Inflation

If creeping inflation continues for a long period of time without any monetary or fiscal control, it may lead to running inflation. Price will then increase at 8 to 10 % per annum. If running inflation is not controlled, it may reduce savings in the economy and become a hindrance in the future for the economic growth.

Galloping Inflation

When monetary authorities completely lose control over running inflation, it will lead to galloping inflation. When inflation reaches double or triple digit figures, it is called galloping inflation. In galloping inflation, people expect the price to rise and so spend all their money quickly so that they can consume to the maximum extent possible. They believe that the purchasing power of the money they are having will fall further soon.

Sources of Inflation

It is important to identify the causes of inflation because formulation of economic policies depend on the type of inflation. Generally, when we analyze the economy as a whole, we define inflation as a state where aggregate demand for goods and services exceeds aggregate supply. When aggregate demand is higher than aggregate supply, the price level generally increases. If such a situation persists for a long period of time, it leads to inflation.

Measures to control Inflation

Inflation usually adversely affects helpless people and disturbs the social, political and economical equilibria. Hence, it need to be controlled. However, control of inflation does not mean absolute price stability. Absolute price stability is not the objective of any nation. People expect economic growth with price stability. Price stability without growth does not achieve economic objective of a nation. So, prices should be allowed to rise within certain limits (say, 2 to 3 percent), but this should not rise to such an extent that it takes away all the benefits of economic growth.

Inflation can be controlled through an integrated set of measures which may be classified as monetary, fiscal and other measures.

Monetary Measures

Monetary measures include adjustments in money supply and bank rates, open market operations and changes in reserve ratios.

Fiscal Measures

Fiscal measures include control on public expenditure, taxation, public borrowing and debt.

Other Measures

Other measure include price control and rationing, changes in wage policy, etc.

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