Meaning of inflation
Inflation is an increase in the overall price level. It happens when many prices increase simultaneously. Different economists understand and define the concept ‘inflation’ in different ways. Some economists like Crowther, Gardner Ackley, Harry Johnson regarded inflation as a phenomenon of rise in prices.” Harry Johnson defines, “inflation as a sustained rise in prices.” According to Crowther, “inflation is a state in which the value of money is falling, i.e., the prices are rising.” But economists like Friedman, Coulborn, Kemmeter regarded inflation as a monetary phenomenon. Coulborn defines inflation as, “too much money chasing too few goods.” According to Friedman, “inflation is always and everywhere a monetary phenomenon.” Thus, inflation refers to a situation of continuously rising prices of commodities and factors of production resulted from excess money supply. It as a persistent and appreciable rise in general price level.
Keynes defined, “Inflation as a phenomenon of full employment.” In his view rising prices in all situations can not be termed inflation. According to him, inflation starts only after full employment. In a situation of unemployment, when an increase in money supply and rising price level are accompanied by an expansion of output and employment, inflation does not occur. Sometimes due to bottlenecks in the economy, an increase in money supply may cause costs and prices to rise more than the expansion of employment and output, but he termed such a rise in prices as semi-inflation. Once the full employment level is reached, the entire increase I money supply is reflected by rising prices – a case of true inflation. Such inflation possesses a real threat to the economy and is to be worried about.
For all practical purpose, Emile James defied inflation, “as a self perpetuating ad irreversible upward movement of price level, caused by an excess demand over capacity of supply.” The excess demand may be the demand for investment as well as for consumer goods. The phrase ‘capacity of supply’ in the definition stresses that any increase in demand constitutes a call for an increase in production. If the excess demand is met by the increase in production there will be no inflation. Inflation can some about only if expansion in production or supply is held back by some obstacles. In this sense, the term inflation is also applicable to an economy where a rise in the price level may not lead to increased output beyond a certain stage due to the existence of bottlenecks, even though the stage of full employment is not attained. In short, apart from price rises, the existence of excess demand over supply is regarded as an essential condition for inflation.
Features of Inflation
The main features of inflation are explained below:
1. Inflation refers to a process of rising prices and not a state of high prices. It shows a state of disequilibrium between the aggregate demand and aggregate supply at the existing prices, necessitating a rise in the general price level.
2. Inflation refers to a situation of appreciable or considerable rise in prices. This implies that every type of rise in price level is not inflationary in character. A modest and gradual rise in the price level, say between 1 to 2 percent per annum is essential in achieving and maintaining high level of employment and satisfactory rate of economic growth. Such a rise in price level is essential for toning up and healthy functioning of the economy and therefore, is not regarded as inflationary rise. It is only when the prices becomes excessive and unhealthy that is regarded as inflationary in character.
3. Rise in price should not only appreciable but prolonged in order to be called as inflationary price rise. Inflations does not refer to a one-time rise in the price level but rather to persistent rise in the price level. Moreover, rise in the price for a short time of period, say 6 months or a year is not regarded as inflationary in nature. It is only when price level increase continues over a long period that is regarded as inflationary in nature.
1. Inflation is measured as the rate of increase in the price level as indicated by the price level. Inflation is generally measured in terms of GNP/GDP (Gross National Product/Gross Domestic Product) deflator or CPI (Consumer Price Index) or Producer Price Index (PPI).
2. Inflation is a long term operating dynamic economic process.
3. Inflation is fostered by the action, reaction and counteraction of economic forces.
4. Pure inflation starts after full employment.
5. Excess demand in relation to the supply of everything is the essential of inflation.
6. Inflation may be demand-pull or cost-push.
On the basis of the government reaction (or control) inflation can be of two types. They are as follows:
1 . Open Inflation
If the government takes no steps to check the price rise and the market mechanism is allowed to function without any interference, it is called open inflation. In other words, inflation is open when there is no price rise and it exists in the economy in the absence of government controls on price rise. According to Milton Friedman, open inflation is an “inflationary process in which prices are permitted to rise without being suppressed by the government price control or similar techniques.” The post-war hyper inflation during the ‘twenties’ of the 20th century in Germany, Austria and Russia performs the function of allocation of scarce resources among competing industries. If there were shortage of any particular resource, the market mechanism would raise its price and allocate it to those industries, which can afford to pay higher price for it.
2. Suppressed Inflation
If the government actively makes efforts to check the price rise through price control and rationing, it is called suppresses inflation. These measures can check the prices as long as their effect continues. Once these measures are with drawn, the demand for goods increases and the suppressed inflation becomes open inflation. Thus, suppressed inflation means to defer current demand to divert demand from controlled goods to uncontrolled goods. Wartime government controls on commodity prices are examples of suppressed inflation while post-war inflations, which emerge on the removal of price controls, are examples of suppressed inflation developed into an open inflation with vengeance.
Suppressed inflation results in many evils. It creates many difficult administrative problems. A hierarchy of price controllers, supply officers and rationing officers with their assistants, comes into existence. There develops a black market through which the controlled prices goods are sold. Such activities soon develop hidden price inflation, which is more dangerous than the open inflation.
It also leads to the diversion of economic resources from more essential goods producing industries whose prices are statutory fixed towards those industries, which produce relatively non-essential goods, whose production becomes more profitable since the prices of such goods are free to rise. According to Milton Friedman, suppressed inflation is worse than open inflation.
To the neo-classical and their followers at the University of Chicago, inflation is fundamentally a monetary phenomenon. In the words of Friedman, “Inflation is always and everywhere a monetary phenomenon… and can be produced only by a more rapid increase in the quantity of money than output.” But economists do not agree that money supply alone is the cause of inflation. As pointed by Hicks, “Our present troubles are not of a monetary character.” Economists, therefore, define inflation in terms of a continuous rise in prices. Johnson defines “inflation as a sustained rise” in prices. Brooman defines it as “a continuing increase in the general price level.” Shapiro also defines inflation in a similar vein “as a persistent and appreciable rise in the general level of prices.” Dernberg and McDougall are more explicit when they write that “the term usually refers to a continuing rise in prices as measured by an index such as the consumer price index (CPI) or by the implicit price deflator for gross national product.”
However, it is essential to understand that a sustained rise in prices may be of various magnitudes. Accordingly, different names have been given to inflation depending upon the rate of rise in prices.
1 Creeping inflation. When the rise in prices is very slow like that of a snail or creeper, it is called creeping inflation. In terms of speed, sustained rise in prices of annual increase of less than 3 % per annum is characterized as creeping inflation. Such an increase in prices is regarded safe and essential for economic growth.
2 Walking or trotting inflation. When prices rise moderately and the annual inflation rate is a single digit. In other words, the rate of rise in prices is in the intermediate range of 3 to 7 % per annum or less than 10 %. Inflation at this rate is a warning signal for the government to control it before it turns into running inflation.
3 Running inflation. When prices rise rapidly like the running of a horse at a rate of speed of 10 to 20 % per annum, it is called running inflation. Such inflation affects the poor and middle classes adversely. Its control requires strong monetary and fiscal measures, otherwise it leads to hyperinflation.
4 Hyperinflation. When prices rise very fast at double or triple digit rates from more than 20 to 100 % per annum or more, it is usually called runaway or galloping inflation. It is also characterized as hyperinflation by certain economists. In reality, hyperinflation is a situation when the rate of inflation becomes immeasurable and absolutely uncontrollable. Prices rise many times everyday. Such a situation brings a total collapse of the monetary system because of the continuous fall in the purchasing power of money.
The speed with which prices tend to rise is illustrated in figure. The curve C shows creeping inflation when within a period of ten years the price level has been shown to have risen by about 30 %. The curve W depicts walking inflation when the price rose by more than 50 % during ten years. The curve R illustrates running inflation showing a rise of about 100 % in ten years. The steep curve H shows the path of hyperinflation when prices rose by more than 120 % in less than one year.
Demand Pull Inflation and Cost Push Inflation
Demand Pull Inflation
Demand- pull inflation occurs when the demand for goods and services exceeds the supply available at existing prices, i.e, when there is excess demand for goods and services. It is mainly caused by demand raising factors such as increase in money supply, public expenditure, export and population and decrease in tax rate, etc. this is a situation of disequilibrium which can be corrected partly by increase in prices and partly by increase in output upto full employment level, and entirely by increase in price level and results in emergence of inflation. It is mainly characterized by rise in output income and employment with the rise in price level.
Demand – pull inflation is illustrated in figure. Aggregate demand curves show different quantities of goods and services demanded in the entire economy at various prices. Like themarket demand curve, aggregate demand curve is negatively sloping. Aggregate supply curve slopes upward to the right till the full employment output level, and becomes perfectly inelastic thereafter. It shows that an increase in output is associated with increase in prices till the attainment of full employment, and output cannot increase thereafter.
In fig. AD1 curve intersects AS curve at E1, giving Y1and P1 the original output and price respectively. An increase in aggregate demand shifts the aggregate demand curve to AD2. This leads to excess demand of E1H at P1 price necessitating an increase in output and price to eliminate excess demand. New equilibrium takes place at E2 corresponding to intersection of AD2 with As. Excess demand pulls up the price ad output to P2 and Y2. Thus, one time shift in aggregate demand gives rise to one time increase in price. As we know, inflation refers to a persistent rather than one-time rise in the price level. If there is another and then yet another increase in demand and thereby rightward shift in the AD curves, there will another and then yet another increase in the price level. It is obvious from figure that up to full employment level of output (YF), an increase in demand results in increase in both output (Y2, YF, etc.) and the price level (P2, P3, etc.). this happens till AD3 demand curve and corresponding P3 price level. But increase in aggregate demand thereafter leads to increase in the price level only. For example, an increase in AD aggregate demand from AD3 to AD4 results in equilibrium shifting from E3 to E4 as a consequence of which price level rises from P3 to P4, but output remains at YF. Keynes describes such as a rise in price level after the attainment of full employment output as pure inflation.
Increase in aggregate demand may originate either through real factors or monetary factors. Among the various real factors tat may produce rightward shift of aggregate demand curve are increased in government spending, a decrease in taxes, an increase in consumption expenditure, an increase in export demand, an increase in investment expenditure, etc. on the monetary side, demand-pull inflation may result mainly from increase in money supply. However, there is disagreement among economists over the relative importance of monetary and real facts casing inflationary rise in the prices. According to some economists, like Milton Friedman, inflation is always and everywhere a monetary phenomenon produced by a sharp increase in money supply. Other economists, like J. R Hicks, feel that real factors play crucial role in producing inflationary rise in prices.
Another explanation of inflation in terms of forces operating from the supply side or the cost side. It is known as supply or cost theory of inflation, popularly known as cost-push inflation. It occurs when aggregate demand exceeds aggregate supply due to cost raising factors. It is mainly characterized by fall in output, income and employment with the rise in price level. Cost-push inflation is mainly caused by cost raising factors such as increase in wage cost, increase in profit margin, supply-shock, etc.
Cost-push inflation may be classified as wage-push, profit-push and supply-shock inflation.
a. Wage-push inflation: it is attributed to the exercise of monopoly power of labour unions to get money wages enhanced above the competitive labour market wage rate or productivity of labour. Strong trade unions are able to press employers to grant money wage-rate increase greater than the increase in the productivity of labour. This leads to increase in per unit cost. As a consequence, as producers raise their prices to cover the higher cost. A series of increases in wage rates leads to a series of increase in prices-inflation. This is wage-push variant of cost-push inflation.
b. Profit-push inflation: it is argued that in imperfect market, prices are largely ‘administered prices’ determined by management rather than market determined. Te administered prices are adjusted upward in a greater proportion than the rate of increase in input prices or even without increase in input prices. When firms increase the administered price with a view to increasing profit margins, profit-push inflation will arise. In other words, a series of increase in the profit margins will lead to increase in cost of production and thereby prices resulting in inflationary rise in price.
c. Supply shock inflation: another variant of cost-push inflation is the supply shock inflation. It is a sudden, unexpected disturbance in the supply position of some major commodities or key industrial inputs. The supply-shock inflation occurs generally due to sudden rise in the prices of high weightage items in the price index umber, e.g. food prices due to crop failure, and prices of some key industrial inputs like, coal, steel, steel, cement, basic chemicals and petroleum products. The rise in the price may be caused by supply bottlenecks in the domestic economy or international events causing bottlenecks if the movement of internationally-traded goods and causing, thereby shortage of supply and rise in the prices of imported industrial inputs. The sudden rise in the OPEC oil prices during 1970s due to Arab-Israel war is the famous example of the supply shock.
Causes of Inflation
Inflation is caused when the aggregate demand exceeds the aggregate supply of goods and services. We analyze the factors which lead to increase in demand and the storage of supply.
A. Factors affecting demand
Both Keynesians and monetarists believe that inflation is caused by increase in the aggregate demand. They point towards the following factors which raise it.
1. Increase in Money Supply. Inflation is caused by an increase in the supply of money which leads to increase in aggregate demand. The higher the growth rate of the nominal money supply, the higher is the rate of inflation. Modern quantity theorists do not believe that true inflation starts after the full employment level. This view is realistic because all advanced countries are faced with high levels of unemployment and high rates of inflation.
2. Increase in Disposable Income. When the disposable income of the people increases, it raises their demand for goods and services. Disposable income may increase with the raise in the national income or reduction in taxes or reduction in the saving of the people.
3. Increase in Public Expenditure. Government activities have been expanding much with the result that government expenditure has also been increasing at a phenomenal rate, thereby raising aggregate demand for goods and services. Government of both developed and developing countries are providing more facilities under public utilities and social services, and also nationalizing industries and starting public enterprises with the result that they help in increasing aggregate demand.
4. Increase in Consumer Spending. The demand for goods and services increases when consumer expenditure increases. Consumers may spend more due to conspicuous consumption or demonstration effect. They may also spend more when they are given credit facilities to buy goods on hire-purchase and installment basis.
5. Cheap Monetary Policy. Cheap monetary policy or the policy of credit expansion also leads to increase in the money supply which raises the demand for goods and services of the economy. When credit expands, it raises the money income of the burrowers which, in turn, raises aggregate demand relative to supply, thereby leading to inflation. This is also known as credit-induced inflation.
6. Deficit Financing. In order to meet its mounting expenses, the government resorts to deficit financing by burrowing from the public and even by printing more notes. This raises aggregate demand in relation to aggregate supply, thereby leading to inflationary rise in prices. This is also known as deficit-induced inflation.
7. Expansion of the Private Sector. The expansion of private sector also tends to raise the aggregate demand. For huge investments increase employment and income, thereby creating more demand for goods and services. But it takes time for the output to enter the market.
8. Black Money. The existence of black money in all countries due to corruption, tax evasion, etc. increases the aggregate demand. People spend such unearned money extravagantly, thereby creating unnecessary demand for commodities. This tends to raise the price level further.
9. Repayment of Public Debt. Whenever the government repays its past internal debt to the public, it leads to increase in the money supply with the public. This tends to raise the aggregate demand for goods and services.
10. Increase in Exports. When the demand for domestically produced goods increases in foreign countries, this raise the earning of industries producing export commodities. These, in turn, create more demand for goods and services with in the economy.
B. Factors Affecting Supply
There are also certain factors which operate on the opposite side and tend to reduce the aggregate supply. Some of the factors are as follows:
1. Shortage of Factors of Production. One of the important causes affecting the supplies of goods is the shortage of such factors as labour, raw materials, power supply, capital etc. They lead to excess capacity and reduction in industrial production.
2. Industrial Dispute. In countries where trade unions are powerful, they also help in curtailing production. Trade unions resort to strikes and if they happen to be unreasonable from the employers view point and are prolonged, they force the employers to declare lock-outs. In both cases, industrial production falls, thereby reducing supplies to goods. If the unions succeed in raising money wages of their members to a very high level than the productivity of labour, this also tends to reduce the production and supply of goods.
3. Natural Calamities. Drought or foods is a factor which adversely affects the supplies of agricultural products. The latter, in turn, create shortages of food products and raw materials, thereby helping inflationary pressures.
4. Artificial Scarcities. Artificial scarcities are created by hoarders and speculators who indulge in black marketing. Thus they are instrumental in reducing supplies of goods and raising their prices.
5. Increase in Exports. When the countries produce more goods for export than for domestic consumption, this creates shortages of goods in the domestic market. This leads to inflation in the economy.
6. Lop-sided Production. If the stress is on the production of comfort, luxuries, or basic products to the neglect of essential consumer goods in the country, this creates shortages of consumption goods. This again causes inflation.
7. Law of Diminishing Returns. If industries in the country are using old machines and outmoded methods of production, the law of diminishing returns operates. This raises cost per unit of production, thereby raising the prices of products.
8. International Factors. In modern times, inflation is a worldwide phenomenon. When prices rise in major industrial countries, their effects spread to almost all countries with which they have trade relations. Often the risk in the price of a basic raw material like petrol in the international market leads to rise in the price of all related commodities in a country.
Effects of Inflation
Inflation affects different people differently. This is because of the fall in the value of money. When prices rises or the value of money falls, some groups of the society gain, some lose and some stand in between, broadly speaking, there are two economic groups in every society, the fixed income group and the flexible income group. People belonging to the first group lose and those belonging to the second group gain. The reason is that the price movements in the case of different goods, services, assets, etc are uniform. When there is inflation, most prices are rising, but the rates of increase of individual prices differ much. Prices of some goods and services rise faster, of other slowly and of still others remain unchanged. We discuss below the effects of inflation on redistribution of income and wealth, production, and on the society as a whole.
1. Effects on Redistribution of Income and Wealth
There are two ways to measure the effects of inflation on the redistribution of income and wealth in a society. First, on the basis of the change in the real value of such factor incomes as wages, salaries, rents, interest, dividends and profits. Second, on the basis of the size of distribution of income over time as a result of inflation, i.e. whether the incomes of rich have increased and that of the middle and poor classes have declined from those whose money incomes are relatively flexible.
The poor and middle classes suffer because their wages and salaries are more or less fixed but the prices of commodities continue to rise. They become more impoverished. On the other hand, businessmen, industrialists, traders, real estate holders, speculators, others with variable income gain during rising prices. The latter category of persons becomes rich at the cost of the former group. There is unjustified transfer of income and wealth from the poor to the rich. As a result, the rich roll in wealth and indulge in conspicuous, while the poor and middle classes live in abject misery and poverty.
But which income group of society gains or loses from inflation depends on who anticipates inflation and does not. Those who correctly anticipate inflation, they can adjust their present earnings, buying, borrowing, and lending activities against the loss of income and wealth due to inflation. They, therefore, do not get hurt by the inflation. Failure to anticipate inflation correctly leads to redistribution of income and wealth. In practice, all persons are unable to anticipate and predict the rate of inflation correctly so that they cannot adjust their economic behaviour accordingly. As a result, some persons gain while others lose. The net result is a redistribution of income and wealth. The effects of inflation on different groups of society are discussed below.
(1) Debtors and Creditors. During period of rising prices, debtors gain and creditors lose. When prices rise the value of money falls. Though debtors return the same amount of money, but they pay less in terms of goods and services. This is because the value of money is less than when they borrowed the money. Thus the burden of the debt is reduced and debtors gain. On the other hand, creditors lose. Although they get back the same amount of money which they lent, they receive less in real terms because the value of money falls. Thus inflation brings about a redistribution of real wealth in favour of debtors at the cost of creditors.
(2) Salaried Persons. Salaried workers such as clerks, teachers, and other white collar persons lose when there is inflation. The reason is that their salaries are slow to adjust when prices are rising.
(3) Wage earners. Wage earner may gain or lose depending upon the speed with their wages adjust to rising prices. If their unions are strong, they may get their wages linked to the cost of living index. In this way they may be able to protect themselves from the bad effects of inflation. But the problem is that there is often a time lag between the raising of wages by employers and the rise in prices. So workers lose because by the time wages are raised, the cost of living index may have increased further. But where the unions have entered into contractual wages for a fixed period, the workers lose when prices continue to rise during the period of contract. On the whole, the wage earners are in the same position as the while collar persons.
(4) Fixed Income Group. The recipients of transfer payments such as pensions, unemployment insurance, social security, etc. and recipients of interest and rent live on fixed incomes. Pensioners get fixed pensions. Similarly the renter class consisting of interest and rent receivers get fixed payments. The same is the case with the holders of fixed interest bearing securities, debentures and deposits. All such persons lose because they receive fixed payments, while the value of money continues to fall with rising prices. Among these groups, the recipients of transfer payments belong to the lower income group and the renter class to the upper income group. Inflation redistributes income from these two groups towards the middle group comprising traders and businessmen.
(5) Equality Holders or Investors. Persons who hold shares or stocks of companies gain during inflation. For when prices are rising, business activities expand which increase profits of companies. As profits increase, dividends on equities also increase at a faster rate than prices. But those who invest in debentures, securities, bonds, etc. which carry a fixed interest rate lose during inflation because they receive a fixed sum while the purchasing power is falling.
(6) Businessman. Business of all types, such as producers, traders and real estate holders gain during periods of rising prices. Take producers first. When prices are rising, the value of their inventories (goods in stock) rise in the same proportion. So they profit more than they sell they stored commodities. The same is the case with traders in the short run. But producers profit more in another way. Their costs do not rise in the extent of the rise in the prices of their goods. This is because prices of raw materials and other inputs and wages do not rise immediately to the level of price rise. The holders of real estates also profit during inflation because the prices of landed property increase much faster than the general price level.
(7) Agriculturists. Agriculturists are of three types, landlords, peasant proprietors, and landless agricultural workers. Landlords lose during rising prices because they get fixed rents. But peasant proprietors who own and cultivate their farms gain. Prices of farm products increase more than the cost of production. For prices of inputs and land revenue do not rise to the same extent as the rise in the prices of farm products. On the other hand, the landless agricultural workers are hit hard by rising prices. Their wages are not raised by the farm owners, because trade unionism is absent among them. But the prices of consumer goods rise rapidly. So landless agricultural workers are losers.
(8) Government. Government as a debtor gains at the expense of households who are its principal creditors. This is because interest rates on government bonds are fixed and not raised to offset expected rise in prices. The government, in turn, levies less taxes to service and retire its debt. With inflation, even the real value of taxes is reduced. Thus redistribution of wealth in favour of the government accrues as a benefit to the tax-payers. Since the tax payers of the government are high income groups, they are also the creditors of the government because it is they who hold government bonds. As creditors, the real value of their assets declines and as tax payers, the real value of their liabilities also declines during the inflation. The extent to which they will be gainers or losers on the whole is a very complicated conclusion.
Conclusion. Thus inflation redistributes income from wage earners and fixed income groups to profit recipients, and from creditors to debtors. In so far as wealth distributions are concerned, the very poor and the very rich are more likely to lose than middle income groups. This is because the poor hold what little wealth they have in monetary forms and have few debts, whereas the very rich hold a substantial part of their wealth in bonds are likely to be heavily in debt and hold some wealth in common stock as well as in real estate.
2. Effect on Production
When prices start rising products is encouraged. Producers earn wind-fall profits in the future. They invest more in anticipation of higher profits in the future. This tends to increase the employment, production and income. But this is only possible up to the full level employment. Further increase in investment beyond this level will lead to severe inflationary pressures within the economy because prices rise more than production as the resources are fully employed. So inflation adversely affects production after the level of full employment. The adverse effects of inflation on production are discussed below.
(1) Misallocation of Resources. Inflation causes misallocation of resources when producers divert resources from the production of essential to non-essential goods from which they expect higher profits.
(2) Changes in the System of Transactions. Inflation leads to changes in transactions pattern of producers. They hold a smaller stock of real money holdings against unexpected contingencies than before. They devote more time and attention to converting money into inventories or other financial or real assets. It means that time and energy are diverted from the production of goods and services and some resources are used wastefully.
(3) Reduction in Production. Inflation adversely affects the volume of production because the expectation of rising prices along with rising costs of inputs bring uncertainty. This reduces production.
(4) Fall in Quality. Continuous rise in prices creates a sellers’ market. In such a situation, produce and sell sub-standard commodities in order to earn higher profits. They also indulge in adulteration of commodities.
(5 )Hoarding and Black-marketing. To profit more from rising prices, producers hoard stocks of their commodities. Consequently, an artificial scarcity of commodities is created in the market. Then the producers sell their products in the black market which increase inflationary pressures.
(6) Reduction in Saving. When prices rise rapidly, the propensity to save declines because more money is needed to buy goods and services than before. Reduced saving adversely affects investment and capital formation. As a result, production is hindered.
(7) Hinders Foreign Capital. Inflation hinders the inflow of foreign capital because the rising cost of materials and other inputs makes foreign investment less profitable.
(8) Encourages speculation. Rapidly rising prices create uncertainty among producers who indulge in speculative activities in order to make quick profits. Instead of engaging themselves in productive activities, they speculate in various types of raw materials required in production.
3. Other Effects
Inflation leads to number of other effects which are discussed as under.
(1) Government. Inflation affects the government in various ways. It helps the government in financing its activities through inflationary finance. As the money income of the people increases, government collects that in the form of taxes on incomes and commodities. So the revenues of the government expenses also increase with rising production costs of public projects and enterprises and increase in administrative expenses as prices and wage rise. On the whole, the government gains under inflation for rising wages and profits spread an illusion of propensity within the country.
(2) Balance of Payments. Inflation involves the sacrificing of the advantages of international specialization and division of labour. It affects adversely the balance of payments of country. When prices rise more rapidly in the home country than in foreign countries, domestic products become costlier compared to foreign products. This tends to increase imports and reduce exports, thereby making the balance of payments unfavourable for the country. This happens only when the country follows a fixed exchange rate policy. But there is no adverse impact on the balance of payments if the country is on the flexible exchange rate system.
(3) Exchange rate. When prices rise more rapidly in the home country than in foreign countries, it lowers the exchange rate in relation to foreign currencies.
(4) Collapse of the Monetary System. If hyperinflation persists and the value of money continues to fall many times in a day, it ultimately leads to the collapse of the monetary system, as happened in Germany after the World War II.
(5) Social. Inflation is socially harmful. By widening the gulf between rich and the poor, rising prices create discontentment among the masses. Pressed by the rising cost of living, workers resort to strikes which lead to loss in production. Lured by profit, people resort to hoarding, black-marketing, adulteration, manufacture of substandard commodities, speculation, etc. Corruption spreads in every walk of life. All this reduces the efficiency of the economy.
(6) Political. Rising prices also encourage agitations and protests by political parties opposed to the government. And if they gather momentum and become unhandy they may bring the downfall of the government. Many government have been sacrificed at the alter of inflation.
Measures of Inflation:
CPI (The Consumer Price Index)
WPI (Whole Sale Price Index) or PPI (Producer Price Index)