Tuesday, 9 July 2013

Inflation: Meaning, types, and theories

What is Inflation? Meaning


Inflation refers to a continuous rise in general price level which reduces the value of money or purchasing power over a period of time.
Inflation Meaning Definition Features Terms
Statistically speaking, inflation is measured in terms of a percentage rise in the price index (i.e. percentage rate per unit time) usually for an annum (a year) or for 30-31 days (a month).

square Definition of Inflation


According to Crowther,
"Inflation is a state in which the value of money is failing i.e. the prices are rising."
According to Coulbourn,
"Inflation is too much of money chasing too few goods."


square Features of Inflation


The characteristics or features of inflation are as follows :-
  1. Inflation involves a process of the persistent rise in prices. It involves rising trend in price level.
  2. Inflation is a state of disequilibrium.
  3. Inflation is scarcity oriented.
  4. Inflation is dynamic in nature.
  5. Inflationary price rise is persistent and irreversible.
  6. Inflation is caused by excess demand in relation to supply of all types of goods and services.
  7. Inflation is a purely monetary phenomenon.
  8. Inflation is a post full employment phenomenon.
  9. Inflation is a long-term process.

square Terms Related to Inflation


The important terms related to inflation are as follows :-
  1. Deflation : Deflation is a condition of falling prices. It is just the opposite of inflation. In deflation, the value of money goes up and prices fall down. Deflation brings a depression phase of business in the economy.
  2. Disinflation : Disinflation refers to lowering of prices through anti-inflationary measures without causing unemployment and reduction in output.
  3. Reflation : Reflation is a situation of rising prices intentionally adopted to ease the depression phase of the economy. In reflation, along with rising prices, the employment, output and income also increase until the economy reaches the stage of full employment.
  4. Stagflation : Paul Samuelson describes Stagflation as the paradox of rising prices with increasing rate of unemployment.
  5. Stagnation : Stagnation in the rate of economic growth which may be a slow or no economic growth at all.
  6. Statflation : The term 'Statflation' was coined by Dr. P.R. Brahmananda to describe the inflationary situation of India. According to Brahmananda, Rising prices in the middle of a recession is known as Statflation.
Types of Inflation in Economics
This article briefly explains different types of inflation in economics with examples, wherever necessary. Following article is also supplemented with a hierarchical diagram (given below this paragraph) to help readers summarize and quickly assimilate various types of inflation. Click on the following diagram (figure) listing different types of inflation to get a zoomed preview of it.
types of inflation

square 1. Types of Inflation on Coverage


Types of inflation on the basis of coverage and scope point of view:-
  1. Comprehensive Inflation : When the prices of all commodities rise throughout the economy it is known as Comprehensive Inflation. Another name for comprehensive inflation is Economy Wide Inflation.
  2. Sporadic Inflation : When prices of only few commodities in few regions (areas) rise, it is known as Sporadic Inflation. It is sectional in nature. For example, rise in food prices due to bad monsoon (winds bringing seasonal rains in India).


square 2. Types of Inflation on Time of Occurrence


Types of inflation on the basis of time (period) of occurrence:-
  1. War-Time Inflation : Inflation that takes place during the period of a war-like situation is known as War-Time inflation. During a war, scare productive resources are all diverted and prioritized to produce military goods and equipments. This overall result in very limited supply or extreme shortage (low availability) of resources (raw materials) to produce essential commodities. Production and supply of basic goods slow down and can no longer meet the soaring demand from people. Consequently, prices of essential goods keep on rising in the market resulting in War-Time Inflation.
  2. Post-War Inflation : Inflation that takes place soon after a war is known as Post-War Inflation. After the war, government controls are relaxed, resulting in a faster hike in prices than what experienced during the war.
  3. Peace-Time Inflation : When prices rise during a normal period of peace, it is known as Peace-Time Inflation. It is due to huge government expenditure or spending on capital projects of a long gestation (development) period.

square 3. Types of Inflation on Government Reaction


Types of inflation on basis of Government's reaction or its degree of control:-
  1. Open Inflation : When government does not attempt to restrict inflation, it is known as Open Inflation. In a free market economy, where prices are allowed to take its own course, open inflation occurs.
  2. Suppressed Inflation : When government prevents price rise through price controls, rationing, etc., it is known as Suppressed Inflation. It is also referred as Repressed Inflation. However, when government controls are removed, Suppressed inflation becomes Open Inflation. Suppressed Inflation leads to corruption, black marketing, artificial scarcity, etc.

square 4. Types of Inflation on Rising Prices


Types of inflation on the basis of rising prices or rate of inflation:-
  1. Creeping Inflation : When prices are gently rising, it is referred as Creeping Inflation. It is the mildest form of inflation and also known as a Mild Inflation or Low Inflation. According to R.P. Kent, when prices rise by not more than (upto) 3% per annum (year), it is called Creeping Inflation.
  2. Chronic Inflation : If creeping inflation persist (continues to increase) for a longer period of time then it is often called as Chronic or Secular Inflation. Chronic Creeping Inflation can be either Continuous (which remains consistent without any downward movement) or Intermittent (which occurs at regular intervals). It is called chronic because if an inflation rate continues to grow for a longer period without any downturn, then it possibly leads to Hyperinflation.
  3. Walking Inflation : When the rate of rising prices is more than the Creeping Inflation, it is known as Walking Inflation. When prices rise by more than 3% but less than 10% per annum (i.e between 3% and 10% per annum), it is called as Walking Inflation. According to some economists, walking inflation must be taken seriously as it gives a cautionary signal for the occurrence of Running inflation. Furthermore, if walking inflation is not checked in due time it can eventually result in Galloping inflation.
  4. Moderate Inflation : Prof. Samuelson clubbed together concept of Crepping and Walking inflation into Moderate Inflation. When prices rise by less than 10% per annum (single digit inflation rate), it is known as Moderate Inflation. According to Prof. Samuelson, it is a stable inflation and not a serious economic problem.
  5. Running Inflation : A rapid acceleration in the rate of rising prices is referred as Running Inflation. When prices rise by more than 10% per annum, running inflation occurs. Though economists have not suggested a fixed range for measuring running inflation, we may consider price rise between 10% to 20% per annum (double digit inflation rate) as a running inflation.
  6. Galloping Inflation : According to Prof. Samuelson, if prices rise by double or triple digit inflation rates like 30% or 400% or 999% per annum, then the situation can be termed as Galloping Inflation. When prices rise by more than 20% but less than 1000% per annum (i.e. between 20% to 1000% per annum), galloping inflation occurs. It is also referred as Jumping inflation. India has been witnessing galloping inflation since the second five year plan period.
  7. Hyperinflation : Hyperinflation refers to a situation where the prices rise at an alarming high rate. The prices rise so fast that it becomes very difficult to measure its magnitude. However, in quantitative terms, when prices rise above 1000% per annum (quadruple or four digit inflation rate), it is termed as Hyperinflation. During a worst case scenario of hyperinflation, value of national currency (money) of an affected country reduces almost to zero. Paper money becomes worthless and people start trading either in gold and silver or sometimes even use the old barter system of commerce. Two worst examples of hyperinflation recorded in world history are of those experienced by Hungary in year 1946 and Zimbabwe during 2004-2009 under Robert Mugabe's regime.

square 5. Types of Inflation on Causes


Types of inflation on the basis of different causes:-
  1. Deficit Inflation : Deficit inflation takes place due to deficit financing.
  2. Credit Inflation : Credit inflation takes place due to excessive bank credit or money supply in the economy.
  3. Scarcity Inflation : Scarcity inflation occurs due to hoarding. Hoarding is an excess accumulation of basic commodities by unscrupulous traders and black marketers. It is practised to create an artificial shortage of essential goods like food grains, kerosene, etc. with an intension to sell them only at higher prices to make huge profits during scarcity inflation. Though hoarding is an unfair trade practice and a punishable criminal offence still some crooked merchants often get themselves engaged in it.
  4. Profit Inflation : When entrepreneurs are interested in boosting their profit margins, prices rise.
  5. Pricing Power Inflation : It is often referred as Administered Price inflation. It occurs when industries and business houses increase the price of their goods and services with an objective to boost their profit margins. It does not occur during a financial crisis and economic depression, and is not seen when there is a downturn in the economy. As Oligopolies have the ability to set prices of their goods and services it is also called as Oligopolistic Inflation.
  6. Tax Inflation : Due to rise in indirect taxes, sellers charge high price to the consumers.
  7. Wage Inflation : If the rise in wages in not accompanied by a rise in output, prices rise.
  8. Build-In Inflation : Vicious cycle of Build-in inflation is induced by adaptive expectations of workers or employees who try to keep their wages or salaries high in anticipation of inflation. Employers and Organisations raise the prices of their respective goods and services in anticipation of the workers or employees' demands. This overall builds a vicious cycle of rising wages followed by an increase in general prices of commodities. This cycle, if continues, keeps on accumulating inflation at each round turn and thereby results into what is called as Build-in inflation.
  9. Development Inflation : During the process of development of economy, incomes increases, causing an increase in demand and rise in prices.
  10. Fiscal Inflation : It occurs due to excess government expenditure or spending when there is a budget deficit.
  11. Population Inflation : Prices rise due to a rapid increase in population.
  12. Foreign Trade Induced Inflation : It is divided into two categories, viz., (a) Export-Boom Inflation, and (b) Import Price-Hike Inflation.
  13. Export-Boom Inflation : Considerable increase in exports may cause a shortage at home (within exporting country) and results in price rise (within exporting country). This is known as Export-Boom Inflation.
  14. Import Price-Hike Inflation : If a country imports goods from a foreign country, and the prices of imported goods increases due to inflation abroad, then the prices of domestic products using imported goods also rises. This is known as Import Price-Hike Inflation. For e.g. India imports oil from Iran at $100 per barrel. Oil prices in the international market suddenly increases to $150 per barrel. Now India to continue its oil imports from Iran has to pay $50 more per barrel to get the same amount of crude oil. When the imported expensive oil reaches India, the indian consumers also have to pay more and bear the economic burden. Manufacturing and transportation costs also increase due to hike in oil prices. This, consequently, results in a rise in the prices of domestic goods being manufactured and transported. It is the end-consumer in India, who finally pays and experiences the ultimate pinch of Import Price-Hike Inflation. If the oil prices in the international market fall down then the import price-hike inflation also slows down, and vice-versa.
  15. Sectoral Inflation : It occurs when there is a rise in the prices of goods and services produced by certain sector of the industries. For instance, if prices of crude oil increases then it will also affect all other sectors (like aviation, road transportation, etc.) which are directly related to the oil industry. For e.g. If oil prices are hiked, air ticket fares and road transportation cost will increase.
  16. Demand-Pull Inflation : Inflation which arises due to various factors like rising income, exploding population, etc., leads to aggregate demand and exceeds aggregate supply, and tends to raise prices of goods and services. This is known as Demand-Pull or Excess Demand Inflation.
  17. Cost-Push Inflation : When prices rise due to growing cost of production of goods and services, it is known as Cost-Push (Supply-side) Inflation. For e.g. If wages of workers are raised then the unit cost of production also increases. As a result, the prices of end-products or end-services being produced and supplied are consequently hiked.

square 6. Types of Inflation on Expectation


Types of inflation on the basis of expectation or predictability:-
  1. Anticipated Inflation : If the rate of inflation corresponds to what the majority of people are expecting or predicting, then is called Anticipated Inflation. It is also referred as Expected Inflation.
  2. Unanticipated Inflation : If the rate of inflation corresponds to what the majority of people are not expecting or predicting, then is called Unanticipated Inflation. It is also referred as Unexpected Inflation.

square 1. Types of Inflation on Coverage


Types of inflation on the basis of coverage and scope point of view:-
  1. Comprehensive Inflation : When the prices of all commodities rise throughout the economy it is known as Comprehensive Inflation. Another name for comprehensive inflation is Economy Wide Inflation.
  2. Sporadic Inflation : When prices of only few commodities in few regions (areas) rise, it is known as Sporadic Inflation. It is sectional in nature. For example, rise in food prices due to bad monsoon (winds bringing seasonal rains in India).


square 2. Types of Inflation on Time of Occurrence


Types of inflation on the basis of time (period) of occurrence:-
  1. War-Time Inflation : Inflation that takes place during the period of a war-like situation is known as War-Time inflation. During a war, scare productive resources are all diverted and prioritized to produce military goods and equipments. This overall result in very limited supply or extreme shortage (low availability) of resources (raw materials) to produce essential commodities. Production and supply of basic goods slow down and can no longer meet the soaring demand from people. Consequently, prices of essential goods keep on rising in the market resulting in War-Time Inflation.
  2. Post-War Inflation : Inflation that takes place soon after a war is known as Post-War Inflation. After the war, government controls are relaxed, resulting in a faster hike in prices than what experienced during the war.
  3. Peace-Time Inflation : When prices rise during a normal period of peace, it is known as Peace-Time Inflation. It is due to huge government expenditure or spending on capital projects of a long gestation (development) period.

square 3. Types of Inflation on Government Reaction


Types of inflation on basis of Government's reaction or its degree of control:-
  1. Open Inflation : When government does not attempt to restrict inflation, it is known as Open Inflation. In a free market economy, where prices are allowed to take its own course, open inflation occurs.
  2. Suppressed Inflation : When government prevents price rise through price controls, rationing, etc., it is known as Suppressed Inflation. It is also referred as Repressed Inflation. However, when government controls are removed, Suppressed inflation becomes Open Inflation. Suppressed Inflation leads to corruption, black marketing, artificial scarcity, etc.

square 4. Types of Inflation on Rising Prices


Types of inflation on the basis of rising prices or rate of inflation:-
  1. Creeping Inflation : When prices are gently rising, it is referred as Creeping Inflation. It is the mildest form of inflation and also known as a Mild Inflation or Low Inflation. According to R.P. Kent, when prices rise by not more than (upto) 3% per annum (year), it is called Creeping Inflation.
  2. Chronic Inflation : If creeping inflation persist (continues to increase) for a longer period of time then it is often called as Chronic or Secular Inflation. Chronic Creeping Inflation can be either Continuous (which remains consistent without any downward movement) or Intermittent (which occurs at regular intervals). It is called chronic because if an inflation rate continues to grow for a longer period without any downturn, then it possibly leads to Hyperinflation.
  3. Walking Inflation : When the rate of rising prices is more than the Creeping Inflation, it is known as Walking Inflation. When prices rise by more than 3% but less than 10% per annum (i.e between 3% and 10% per annum), it is called as Walking Inflation. According to some economists, walking inflation must be taken seriously as it gives a cautionary signal for the occurrence of Running inflation. Furthermore, if walking inflation is not checked in due time it can eventually result in Galloping inflation.
  4. Moderate Inflation : Prof. Samuelson clubbed together concept of Crepping and Walking inflation into Moderate Inflation. When prices rise by less than 10% per annum (single digit inflation rate), it is known as Moderate Inflation. According to Prof. Samuelson, it is a stable inflation and not a serious economic problem.
  5. Running Inflation : A rapid acceleration in the rate of rising prices is referred as Running Inflation. When prices rise by more than 10% per annum, running inflation occurs. Though economists have not suggested a fixed range for measuring running inflation, we may consider price rise between 10% to 20% per annum (double digit inflation rate) as a running inflation.
  6. Galloping Inflation : According to Prof. Samuelson, if prices rise by double or triple digit inflation rates like 30% or 400% or 999% per annum, then the situation can be termed as Galloping Inflation. When prices rise by more than 20% but less than 1000% per annum (i.e. between 20% to 1000% per annum), galloping inflation occurs. It is also referred as Jumping inflation. India has been witnessing galloping inflation since the second five year plan period.
  7. Hyperinflation : Hyperinflation refers to a situation where the prices rise at an alarming high rate. The prices rise so fast that it becomes very difficult to measure its magnitude. However, in quantitative terms, when prices rise above 1000% per annum (quadruple or four digit inflation rate), it is termed as Hyperinflation. During a worst case scenario of hyperinflation, value of national currency (money) of an affected country reduces almost to zero. Paper money becomes worthless and people start trading either in gold and silver or sometimes even use the old barter system of commerce. Two worst examples of hyperinflation recorded in world history are of those experienced by Hungary in year 1946 and Zimbabwe during 2004-2009 under Robert Mugabe's regime.

square 5. Types of Inflation on Causes


Types of inflation on the basis of different causes:-
  1. Deficit Inflation : Deficit inflation takes place due to deficit financing.
  2. Credit Inflation : Credit inflation takes place due to excessive bank credit or money supply in the economy.
  3. Scarcity Inflation : Scarcity inflation occurs due to hoarding. Hoarding is an excess accumulation of basic commodities by unscrupulous traders and black marketers. It is practised to create an artificial shortage of essential goods like food grains, kerosene, etc. with an intension to sell them only at higher prices to make huge profits during scarcity inflation. Though hoarding is an unfair trade practice and a punishable criminal offence still some crooked merchants often get themselves engaged in it.
  4. Profit Inflation : When entrepreneurs are interested in boosting their profit margins, prices rise.
  5. Pricing Power Inflation : It is often referred as Administered Price inflation. It occurs when industries and business houses increase the price of their goods and services with an objective to boost their profit margins. It does not occur during a financial crisis and economic depression, and is not seen when there is a downturn in the economy. As Oligopolies have the ability to set prices of their goods and services it is also called as Oligopolistic Inflation.
  6. Tax Inflation : Due to rise in indirect taxes, sellers charge high price to the consumers.
  7. Wage Inflation : If the rise in wages in not accompanied by a rise in output, prices rise.
  8. Build-In Inflation : Vicious cycle of Build-in inflation is induced by adaptive expectations of workers or employees who try to keep their wages or salaries high in anticipation of inflation. Employers and Organisations raise the prices of their respective goods and services in anticipation of the workers or employees' demands. This overall builds a vicious cycle of rising wages followed by an increase in general prices of commodities. This cycle, if continues, keeps on accumulating inflation at each round turn and thereby results into what is called as Build-in inflation.
  9. Development Inflation : During the process of development of economy, incomes increases, causing an increase in demand and rise in prices.
  10. Fiscal Inflation : It occurs due to excess government expenditure or spending when there is a budget deficit.
  11. Population Inflation : Prices rise due to a rapid increase in population.
  12. Foreign Trade Induced Inflation : It is divided into two categories, viz., (a) Export-Boom Inflation, and (b) Import Price-Hike Inflation.
  13. Export-Boom Inflation : Considerable increase in exports may cause a shortage at home (within exporting country) and results in price rise (within exporting country). This is known as Export-Boom Inflation.
  14. Import Price-Hike Inflation : If a country imports goods from a foreign country, and the prices of imported goods increases due to inflation abroad, then the prices of domestic products using imported goods also rises. This is known as Import Price-Hike Inflation. For e.g. India imports oil from Iran at $100 per barrel. Oil prices in the international market suddenly increases to $150 per barrel. Now India to continue its oil imports from Iran has to pay $50 more per barrel to get the same amount of crude oil. When the imported expensive oil reaches India, the indian consumers also have to pay more and bear the economic burden. Manufacturing and transportation costs also increase due to hike in oil prices. This, consequently, results in a rise in the prices of domestic goods being manufactured and transported. It is the end-consumer in India, who finally pays and experiences the ultimate pinch of Import Price-Hike Inflation. If the oil prices in the international market fall down then the import price-hike inflation also slows down, and vice-versa.
  15. Sectoral Inflation : It occurs when there is a rise in the prices of goods and services produced by certain sector of the industries. For instance, if prices of crude oil increases then it will also affect all other sectors (like aviation, road transportation, etc.) which are directly related to the oil industry. For e.g. If oil prices are hiked, air ticket fares and road transportation cost will increase.
  16. Demand-Pull Inflation : Inflation which arises due to various factors like rising income, exploding population, etc., leads to aggregate demand and exceeds aggregate supply, and tends to raise prices of goods and services. This is known as Demand-Pull or Excess Demand Inflation.
  17. Cost-Push Inflation : When prices rise due to growing cost of production of goods and services, it is known as Cost-Push (Supply-side) Inflation. For e.g. If wages of workers are raised then the unit cost of production also increases. As a result, the prices of end-products or end-services being produced and supplied are consequently hiked.

square 6. Types of Inflation on Expectation


Types of inflation on the basis of expectation or predictability:-
  1. Anticipated Inflation : If the rate of inflation corresponds to what the majority of people are expecting or predicting, then is called Anticipated Inflation. It is also referred as Expected Inflation.
  2. Unanticipated Inflation : If the rate of inflation corresponds to what the majority of people are not expecting or predicting, then is called Unanticipated Inflation. It is also referred as Unexpected Inflation.


types of inflation

square 1. Types of Inflation on Coverage


Types of inflation on the basis of coverage and scope point of view:-
  1. Comprehensive Inflation : When the prices of all commodities rise throughout the economy it is known as Comprehensive Inflation. Another name for comprehensive inflation is Economy Wide Inflation.
  2. Sporadic Inflation : When prices of only few commodities in few regions (areas) rise, it is known as Sporadic Inflation. It is sectional in nature. For example, rise in food prices due to bad monsoon (winds bringing seasonal rains in India).


square 2. Types of Inflation on Time of Occurrence


Types of inflation on the basis of time (period) of occurrence:-
  1. War-Time Inflation : Inflation that takes place during the period of a war-like situation is known as War-Time inflation. During a war, scare productive resources are all diverted and prioritized to produce military goods and equipments. This overall result in very limited supply or extreme shortage (low availability) of resources (raw materials) to produce essential commodities. Production and supply of basic goods slow down and can no longer meet the soaring demand from people. Consequently, prices of essential goods keep on rising in the market resulting in War-Time Inflation.
  2. Post-War Inflation : Inflation that takes place soon after a war is known as Post-War Inflation. After the war, government controls are relaxed, resulting in a faster hike in prices than what experienced during the war.
  3. Peace-Time Inflation : When prices rise during a normal period of peace, it is known as Peace-Time Inflation. It is due to huge government expenditure or spending on capital projects of a long gestation (development) period.

square 3. Types of Inflation on Government Reaction


Types of inflation on basis of Government's reaction or its degree of control:-
  1. Open Inflation : When government does not attempt to restrict inflation, it is known as Open Inflation. In a free market economy, where prices are allowed to take its own course, open inflation occurs.
  2. Suppressed Inflation : When government prevents price rise through price controls, rationing, etc., it is known as Suppressed Inflation. It is also referred as Repressed Inflation. However, when government controls are removed, Suppressed inflation becomes Open Inflation. Suppressed Inflation leads to corruption, black marketing, artificial scarcity, etc.

square 4. Types of Inflation on Rising Prices


Types of inflation on the basis of rising prices or rate of inflation:-
  1. Creeping Inflation : When prices are gently rising, it is referred as Creeping Inflation. It is the mildest form of inflation and also known as a Mild Inflation or Low Inflation. According to R.P. Kent, when prices rise by not more than (upto) 3% per annum (year), it is called Creeping Inflation.
  2. Chronic Inflation : If creeping inflation persist (continues to increase) for a longer period of time then it is often called as Chronic or Secular Inflation. Chronic Creeping Inflation can be either Continuous (which remains consistent without any downward movement) or Intermittent (which occurs at regular intervals). It is called chronic because if an inflation rate continues to grow for a longer period without any downturn, then it possibly leads to Hyperinflation.
  3. Walking Inflation : When the rate of rising prices is more than the Creeping Inflation, it is known as Walking Inflation. When prices rise by more than 3% but less than 10% per annum (i.e between 3% and 10% per annum), it is called as Walking Inflation. According to some economists, walking inflation must be taken seriously as it gives a cautionary signal for the occurrence of Running inflation. Furthermore, if walking inflation is not checked in due time it can eventually result in Galloping inflation.
  4. Moderate Inflation : Prof. Samuelson clubbed together concept of Crepping and Walking inflation into Moderate Inflation. When prices rise by less than 10% per annum (single digit inflation rate), it is known as Moderate Inflation. According to Prof. Samuelson, it is a stable inflation and not a serious economic problem.
  5. Running Inflation : A rapid acceleration in the rate of rising prices is referred as Running Inflation. When prices rise by more than 10% per annum, running inflation occurs. Though economists have not suggested a fixed range for measuring running inflation, we may consider price rise between 10% to 20% per annum (double digit inflation rate) as a running inflation.
  6. Galloping Inflation : According to Prof. Samuelson, if prices rise by double or triple digit inflation rates like 30% or 400% or 999% per annum, then the situation can be termed as Galloping Inflation. When prices rise by more than 20% but less than 1000% per annum (i.e. between 20% to 1000% per annum), galloping inflation occurs. It is also referred as Jumping inflation. India has been witnessing galloping inflation since the second five year plan period.
  7. Hyperinflation : Hyperinflation refers to a situation where the prices rise at an alarming high rate. The prices rise so fast that it becomes very difficult to measure its magnitude. However, in quantitative terms, when prices rise above 1000% per annum (quadruple or four digit inflation rate), it is termed as Hyperinflation. During a worst case scenario of hyperinflation, value of national currency (money) of an affected country reduces almost to zero. Paper money becomes worthless and people start trading either in gold and silver or sometimes even use the old barter system of commerce. Two worst examples of hyperinflation recorded in world history are of those experienced by Hungary in year 1946 and Zimbabwe during 2004-2009 under Robert Mugabe's regime.

square 5. Types of Inflation on Causes


Types of inflation on the basis of different causes:-
  1. Deficit Inflation : Deficit inflation takes place due to deficit financing.
  2. Credit Inflation : Credit inflation takes place due to excessive bank credit or money supply in the economy.
  3. Scarcity Inflation : Scarcity inflation occurs due to hoarding. Hoarding is an excess accumulation of basic commodities by unscrupulous traders and black marketers. It is practised to create an artificial shortage of essential goods like food grains, kerosene, etc. with an intension to sell them only at higher prices to make huge profits during scarcity inflation. Though hoarding is an unfair trade practice and a punishable criminal offence still some crooked merchants often get themselves engaged in it.
  4. Profit Inflation : When entrepreneurs are interested in boosting their profit margins, prices rise.
  5. Pricing Power Inflation : It is often referred as Administered Price inflation. It occurs when industries and business houses increase the price of their goods and services with an objective to boost their profit margins. It does not occur during a financial crisis and economic depression, and is not seen when there is a downturn in the economy. As Oligopolies have the ability to set prices of their goods and services it is also called as Oligopolistic Inflation.
  6. Tax Inflation : Due to rise in indirect taxes, sellers charge high price to the consumers.
  7. Wage Inflation : If the rise in wages in not accompanied by a rise in output, prices rise.
  8. Build-In Inflation : Vicious cycle of Build-in inflation is induced by adaptive expectations of workers or employees who try to keep their wages or salaries high in anticipation of inflation. Employers and Organisations raise the prices of their respective goods and services in anticipation of the workers or employees' demands. This overall builds a vicious cycle of rising wages followed by an increase in general prices of commodities. This cycle, if continues, keeps on accumulating inflation at each round turn and thereby results into what is called as Build-in inflation.
  9. Development Inflation : During the process of development of economy, incomes increases, causing an increase in demand and rise in prices.
  10. Fiscal Inflation : It occurs due to excess government expenditure or spending when there is a budget deficit.
  11. Population Inflation : Prices rise due to a rapid increase in population.
  12. Foreign Trade Induced Inflation : It is divided into two categories, viz., (a) Export-Boom Inflation, and (b) Import Price-Hike Inflation.
  13. Export-Boom Inflation : Considerable increase in exports may cause a shortage at home (within exporting country) and results in price rise (within exporting country). This is known as Export-Boom Inflation.
  14. Import Price-Hike Inflation : If a country imports goods from a foreign country, and the prices of imported goods increases due to inflation abroad, then the prices of domestic products using imported goods also rises. This is known as Import Price-Hike Inflation. For e.g. India imports oil from Iran at $100 per barrel. Oil prices in the international market suddenly increases to $150 per barrel. Now India to continue its oil imports from Iran has to pay $50 more per barrel to get the same amount of crude oil. When the imported expensive oil reaches India, the indian consumers also have to pay more and bear the economic burden. Manufacturing and transportation costs also increase due to hike in oil prices. This, consequently, results in a rise in the prices of domestic goods being manufactured and transported. It is the end-consumer in India, who finally pays and experiences the ultimate pinch of Import Price-Hike Inflation. If the oil prices in the international market fall down then the import price-hike inflation also slows down, and vice-versa.
  15. Sectoral Inflation : It occurs when there is a rise in the prices of goods and services produced by certain sector of the industries. For instance, if prices of crude oil increases then it will also affect all other sectors (like aviation, road transportation, etc.) which are directly related to the oil industry. For e.g. If oil prices are hiked, air ticket fares and road transportation cost will increase.
  16. Demand-Pull Inflation : Inflation which arises due to various factors like rising income, exploding population, etc., leads to aggregate demand and exceeds aggregate supply, and tends to raise prices of goods and services. This is known as Demand-Pull or Excess Demand Inflation.
  17. Cost-Push Inflation : When prices rise due to growing cost of production of goods and services, it is known as Cost-Push (Supply-side) Inflation. For e.g. If wages of workers are raised then the unit cost of production also increases. As a result, the prices of end-products or end-services being produced and supplied are consequently hiked.

square 6. Types of Inflation on Expectation


Types of inflation on the basis of expectation or predictability:-
  1. Anticipated Inflation : If the rate of inflation corresponds to what the majority of people are expecting or predicting, then is called Anticipated Inflation. It is also referred as Expected Inflation.
  2. Unanticipated Inflation : If the rate of inflation corresponds to what the majority of people are not expecting or predicting, then is called Unanticipated Inflation. It is also referred as Unexpected Inflation.

    Cause of inflation

    inflation in the economy will occur when effective demand and production cost increase excessively. in other words, inflation will occur when there is an excessive increase in effective demand and production cost in the economy. that is, disequilibrium created in the economy when aggregate demand is excessively higher than the aggregate supply is known as inflation. the main cause for the increase in the aggregate demand is the increase in monetary income or increase in the quantity of money. therefore, there are mainly two causes for inflation. they are:
    1. increase in money income
    demand for goods and services increase as monetary income increases. but if production does not increase in proportion with the increase in demand, then disequilibrium will be creased. due to such disequilibrium, price of goods and services will increase. main cause for the increase in money income are as follows:
    (a) monetary and credit policy of government
    monetary expansion will occur when the government undertakes the policy of spending excessive quantity of money. failure of proper control in such a situation will create inflation. similarly, bank rate policy of the central bank and open market operations will influence the quantity of credit. low interest rate will increase the demand for credit resulting the increase in the credit expansion. similarly. if securities sold through the central bank in the open market are purchased by the people then quantity of money will increase in the society. so, due to monetary policy of the government and the central bank, the credit as well as the income of the people will increase. this will result disequilibrium in production and income creating inflation in the economy.
    (b) deficit financing
    the budget in which income is less than the expenditure indicated in the public budget is known as deficit budget. that is, if government expenditure is more than income then to meet or fulfill such expenditures the government will issue excessive quantity of money through the central bank. in such a situation, the government taken loan from the central bank. thus taken loan when spent in various sectors will increase the monetary expansion. this will increase the money income of the people and the situation of inflation will arise in the economy.
    (c) credit policy of commercial bank
    if demand for credit increase excessively, then only small part of the deposits deposited by the deposits will be kept in the cash-fund by the commercial banks. this will increase the credit expansion of the commercial banks excessively. due to excessive increase in credit expansion, more quantity of money will be in use in the society. increase in the use of money in the society will create the state of inflation.
    (d)increase in the velocity of circulation of money
    due to increase in the propensity to consume of the people, the personal expenditure will increase. as a result of this, the saving of the people will decrease and the velocity of the circulation of money will increase. due to increase in the velocity of circulation of money, the demand will increase and supply will decrease.as a result, there will be an excessive increase in the price of goods and services, and inflation will be encouraged.
    (e)financial mismanagement
    due to failure of proper financial management by the government, the tax won't be collected properly, while sometimes the government will reduce the tax for various reasons. as a result of this, the quantity of unaccounted money will increase with the people and demand for goods and services. the price of the goods and services will also increase resulting inflation in the economy.
    (f) export promotion policy
    every developing country's trade will be in as unbalanced state. to solve this problem the government will undertake export promotion policy and will discourage imports. for this , the government will evaluated the domestic currency. as a result of this domestic goods will be cheaper in the international market of foreign countries, the quantity of goods in the country will be less relative to the demand for the goods. as a result of the disequilibrium between demand and supply , the price will increase creating inflation in the economy.
    (g) increase in unproductive expenditure
    the excessive expenditure of the government in various wars and internal defence or construction of various infrastructures of development such as, health, education, transportation, communication sectors etc. will increase the money income of the public. but the production of consumption goods of the public will be less compared to the increase in income. this will also increase demand excessively and inflation will be resulted.
    2. decrease in production
    due to various reason the production in the country will decrease. as a result of decrease in production. disequilibrium will be created between demand, supply and inflation will be resulted. the causes for decrease in production are as follows:
    (a) nature causes
    nature calamities that occur at different times, such as , floods, landslides, earthquakes, drought,etc. decrease agricultural production. that is these natural calamities affect badly the countries based on agriculture. in other words the countries whose economy is dependent upon agriculture will be badly affected by the natural calamities. along with the decrease in the agriculture product this will also result in scarcity if raw materials required for the industries required for the industries based on agriculture will increase. in such a situation, despite the constant money income, due to natural causes the production will decrease and inflation will be resulted.
    (b) law of diminishing returns
    the returns of land are not always in proportion. sometimes the law if increasing returns is applicable and sometimes the law of diminishing returns is applicable. if the law of diminishing returns is applicable, then low production will be resulted through high production cost. as a result of high production cost the price of the goods will increase and inflation will occur. when production is less in proportion to productions cost, inflation will be created.
    (c) lack of raw materials
    lack of raw materials required for production will decrease the production. due to decrease in production, disequilibrium will emerge between demand and supply resulting in the increase price of goods. this will lead to inflation.
    (d) techniques of production
    the quantity of production is also affected by the techniques of production. if the production technique is very old, then production will decrease instead of increasing. if modern and scientific methods of production are not used, then production will decrease with the increase in price. this will lead to inflation.
    (e) trade and taxation policy of the government
    if excessive tax is levied on the production of goods by the government , then the price of the produced goods will also increase. due to increase in price the demand will decrease and this will result in the decrease in production. in addition to this, if the government undertakes the export promotion policy and encourages export, then the quantity of goods in the country will be less. that is , there will be a shortage of goods in the domestic market. due to this shortage the price of goods will increase. thus,trade and taxation policy of the government will also create the state of inflation.
    (f) industrial disputation
    due to various disputations in the industrial sector of a country, such as, strike by lab ours, conflict between trade union and industrialist, instability in the country,etc. will force the industries and factories to be closed down. closing down of factories and industries will decrease the production and increase the price. this increase in price will create the state of inflation.
    (g) increase in population
    if the population of a county increases more rapidly than the increase in production, then there will arise a state of disequilibrium between demand and supply. the demand will be more than the supply and as a result the price will increase which will be the cause of inflation.
    (h) structure of production
    if disequilibrium arises in the structure of production, then in such a situation also inflation will occur. due to production of other goods in greater quantity than the daily consumption goods of the public the price of the daily consumption goods will increase. so , decrease in the production of consumption goods will increase the price of such goods leading the way to inflation.
    due to these various reasons when the state of disequilibrium arises between the quantity of money and credit and the quantity of available output, then the state of inflation will occur. but this does not mean that the state of inflation will always occur due to increase in the quantity of money or decrease in the quantity of production inflation is the result of the state of disequilibrium between these two . increase in the quantity of money or monetary will result the "cost push inflation".

    Effect of inflation

    inflation affects the different sectors of the economy differently. in general, effects of inflation seem to be negative. but if the rate of inflation is low, then this provides some motion to the economy. this sort of motion increase the employment and leads the economy towards development and prosperity. but, when the rate of inflation is high, then this will affect the economy negatively. this will hinder the capital formation as well as create the black market and artificial scarcity with decrease in the quantity of goods. if the income of people increases in proportion to the increase in the price of goods, then this is not regarded as harmful. but if the price and income do not increase proportionately in the economy, then this will affect different sectors of the society differently. the sector having fixed income will be affected more than the other sectors, thus, effects of inflation can be explained more clearly by dividing them into two part. they are :
    1. economic effects
    2. non-economic effects

    1. economic effects of inflation
    economy is deeply affected by inflation. the economic effects of inflation can be divided into two parts. they are:
    i. effects on production
    creeping inflation has positive effect in the economy because in the beginning the increase n price is very small. in such situation, due to small increase in the cost of production, the profit also increases by a small scale. this affects the economy positively. when hyper inflation occurs in the economy, then due to uncertainly there will be negative effect in production. therefore, hyper inflation is harmful to the economy. the negative effects on production can explained as follows:
    (1) disrupts in price system: inflation will disrupt the price system which will increase slowly. as a result if this the factors won't be mobilized properly.
    (2) discourage to foreign capital: inflation not only decrease the saving of domestic capital, it also result in the devaluation of money . as a result, there won't be profit for the foreign investors and this will discourage the foreign capital investment.
    (3) reduction in capital accumulation: inflation badly affects saving and capital formation because high price needs to be paid for the goods when price increase. as a result there won't be any saving and sources of investment will be closed.
    (4) encourages hoarding: when prices increase people will increase the stock to create artificial scarcity in order to earn more profits. from this , the businessmen specially the black marketers will make excessive profits. due to fear of further increase in price people will start hoarding more goods and this will increase the price even more.
    (5) encouragement to speculation activities: inflation encourages speculation activities withe further increase in prices. businessmen instead of producing proper goods for earning profits, shift to easy and fast profit making activities.
    (6) reduction in the volume of production: inflation reduces the volume if production in two ways. firstly, there won't be any capital formation due to lack of saving. secondly, due to uncertainty in the business, the producers are not ready to bear risks. therefore, there will reduction in the volume of production.
    (7) effects on the pattern of production: hyper inflation brings about the change in the pattern of production. due to inflation, income of some people will increase comprehensively while income of some other people will decrease. people with increased income will demand for luxury goods in greater quantity. therefore, production of luxury goods will increase and the production of necessary goods will decrease.
    (8) decrease in quality: in the state of inflation, the inflation of the sellers in the market will increase. as a result, to earn more profit, they will reduce the quality of the goods.
    ii.effects on distribution of wealth
    inflation badly affects on the distribution of wealth. when price increases in the economy, some class ofthe society will benefit and some class will face loss. in any society, there will be two classes of people. one having constant income and the other having variable income. if the inflation prevails for a long period then businessmen, industrialists and rich people will become even richer while the poor class and people with fixed income ( servicemen, teachers, people dependent on pension and some kind of rent) will become poorer facing even worse situations. so, effects of inflation on different people of the society are as follows:
    (1) debtor and creditor: when price increases, the debtor will benefit and the creditor will suffer loss. when price increases, then the value of money will decrease. the money returned by the debtor will be able to purchase less quantity of goods and services than before. what is clear from this is that, the value of money is more at the time if taking loan and the value of money is less at the time of returning the loan. therefore, debtor will have some sort of benefit and the creditor will have some loss during the time of inflation.
    (2) wage and salary earners
    daily wage earners and salary earners are affected more by inflation. there are mainly two reasons for this. firstly wage and salary do not increase in proportion to the increase in price. secondly, the gap between the increase in price and the increase in wage and salary will become even wider. in such a situation, labors and servicemen not associated with labor union will be affected more. that is . they will suffer more loss.
    (3) fixed income earner group: people dependent on fixed income, such as pension, house- rent and previous saving will be affected by inflation. thus is, inflation will harm the people having fixed income. but people having variable income, such as, industrialists, businessmen and share-holders will benefit from inflation . the income of such people will increase during the time of inflation.
    (4) business community: all types of business communities, such as producers businessmen, entrepreneurs, speculation group etc, earn profit deuing the time of inflation. to earn more profit in short period. they will increase the price of goods more than the increase in the cost of production of such goods. similarly , since the value of the assets of such people increase such communities will be in profit.
    (5) investors: investors are affected by inflation in two ways because there are two types of investors. the first type of investors are those having fixed income and the other type having variable income. investors with fixed income are those who earn income at a fixed rate as interest for providing their capital for investment. such a investors are not affected by the profit or loss in th business. in such situation excessive increase in the price of the goods will decrease the purchasing power. contrary to this, investors having variable income will benefit from inflation because they share the profits and losses of the industry,if profit is resulted, then their profit will also increase proportionally. since level of profit is more during the time of inflation , the income of the investors will also be more because they will get their shares.
    (6) farmers: normally, price of the goods is more than the cost of production during the time of inflation. for this reason the farmers are also benefited. but Small farmers won't be able to share this benefit. small farmers normally don't produce goods for selling in the markets. as a result, they will have to purchase some goods for consumption.
    2. non-economic effects of inflation
    due to excessive increase in demand during the time of inflation, the production and employment also increase. this will benefit the debtors, producers and business communities. but, this does not mean that the effects of inflation are always good. inflation harms the consumers, investors and creditors . as a result inflation also has various non-economic effects.
    " non -economic effects" means crisis in social, political and moral sectors. corruption, black market, bribery, etc. are resulted due to inflation. the government. so, the effect of inflation is economically unsound, politically dangerous and socially as well as morally disastrous. non-economic effects of inflation can be explained as follows:
    (1) social effects : inflation has various effects in the society. inflation makes rich people even richer and poor people even poorer. as a result of this , conflict starts between the rich class and the poor class.
    (2) moral effects : inflation negatively affects the morality of people. as a result of this, black market, bribery and corruption will increase in the society. this will provide protection to the speculation activities. with the objective of earning more profits businessmen will mix goods with inferior goods which will even reduce the quality of goods.
    (3) political effects: inflation not only has economic, social and moral effects but it also has political effect. during the time of inflation, people will be dissatisfied with the government. as a result, unhealthy competition will start in politics. opposition parties try to become ruling body by heavily criticizing the government and turning the people against the government. they try all means to remove the ruling government. the inflation of 1920 in Germany made Hitler a dictator

    Remedies or control of inflation

    since inflation has negative effect in the economy the government should control it. but control of inflation does not mean that the price is kept constant totally. excessive inflation will have serious social, political economic effects. therefore, for the equilibrium of the economy, the inflation has to be controlled. to control the rate of inflation the following measures can be undertaken:

    1.monetary measures

    2.fiscal measures

    3.direct measures

    1. monetary measures

    the inflation in the economy can be controlled by the monetary policy of the central bank. for the control of inflation, the central bank will undertake the following monetary measures:

    (1) increase in bank rate

    to control the inflation the central bank will increase the bank rate. this will increase the intertest rate for the loan provided by the bank. thus, increased interest the will decrease the demand for loans. decreasing the monetary expansion. this will control inflation to some extent.

    (2) open market operation

    for the control of inflation the central bank sells the government securities to the businessmen and public through open market operation. this will bring the money from the hands of businessmen and public to the hands of central bank. the quantity of money in the hands of businessmen and public will decrease and as a result inflaton will be controlled.

    (3) increase in the minimum cash reserve ratio

    central bank will increase the minimum cash reserve ratio of the commercial banks. so, commercial banks will have to deposit more amount of cash in the centeal bank. this will decrease the credit creation capacity of the commercial banks and as a result inflation will be controlled.

    (4) decrease in the credit facility

    if credit facilities and instalment facilities are given for the durable goods, such as televisions, cars, washing machines, refrigerators, etc. then demand for such goods will increase. to control inflation in such a situation, the central bank will increase the amount of first instalment. this will decrease the demand for such goods and as a result inflation will be controlled.

    (5) changes in the margin requirement of securities

    when inflation occurs in a country, then to control this the central bank will arrange a system for commercial banks to provide less amount of loan than the value to the securities. as a result of this , customers will get less amount of loan for the higher value of securities. this will decrease in the monetary-expansion and inflation will be controlled.
    2. fiscal measures
    to control the inflation that occurs in the economy, the government has to undertake fiscal measures along with the monetary measures. government can control inflation through different types of fiscal policies which can be explained as follows:
    (1) increase in the rate of taxation
    government has to increase the tax rate in various sectors of the economy. this will decrease the quantity of money in the hands of people of different sectors and as a result inflation will be controlled. in addition to this due to new taxes demand for goods will decrease and price increase will be checked.
    (2) balanced budget
    to control inflation, the government has to prepare balanced budget as far as possible. this is because to fulfill deficit budget the issuing of new notes will be required. as the issuing of new notes creares inflation it is conreolled by preparing balanced budget.
    (3) decrease in the government expenditure
    increase in the public expenditure by the government will increae the quantity of money in the hands of the public. this will increase in the demand for goods creating the state of inflation. so, there should be decrease in the government expenditure. this will decrease the demand and inflation will be controlled.
    (4)encouragement to saving
    government has to encourage saving and decrease consumption through different fiscal policies. this will decrease the demand and inflation will be controlled.
    (5) over valuation of money
    in the time of inflation demand for goods will increase excessively. to control this , the export of domestic goods to foreign countries should be checked. for this , the domestic currency should be over-valued. this will make the domestic goods expensive in the foreign markets. this will decrease the demand for domestic goods by customers of the foreign markets. that is, export from the domestic country to the foreign countries will decrease. as a result, domestic goods will be available in the domestic market at lower price and this will help in controlling inflation.

    3.direct measures
    to control inflation, in addition to monetary and fiscal policies the government can under table some other types of direct measures. with inflation by determining an appropriate wage rate. the wage of the labors should be determined on the basis of their productivity. this will also control inflation.
    (1) control of the wage rate
    due to high wage rate demand increase in the economy and as a result inflation will occur. in such a situation, the government can control inflating by determining an appropriate wage rate. the wage of the lab ours should be determined on the basis of their productivity, this will also control inflation.
    (2) increase in production
    if production increase in the same proportion as the increase in the quantity of money, then inflation won't occur in the economy. while increasing production, the government should encourage the production of necessity goods rather than the production if luxury goods. this will increase the production of necessary goods as per demand and the inflation will be controlled.
    (3) change in investment pattern
    during the time of inflation, income increase due to increase in the quantity of investment. but production of directly necessary goods won't increase. as a result of this, inflation will occur. in such a situation, the government should encourage investment in the production if direct consumption goods rather than in the construction of infrastructures of production.
    (4) direct control
    the government can control inflation by the direct control over the increase in price. in such a situation, the goods whose demand is more than the production, the government should supply those goods under "rationing". this will control the increase in demand for such goods and inflation will be controlled.

Theories of Inflation and its Economic Consequences

Since it’s specifically difficult to identify the reasons for or factors that contribute to inflation, many theories and concepts have been introduced for this purpose. Each theory tries to clarify the supply and demand factors that result in the creation of an inflationary situation.
The main theories of inflation are as follows,
  • Quantity Theory of Money
  • Keynesian Theory
  • Monetarism
  • Structuralism

Quantity Theory of Money

This refers to the identical or equal relationship between national income estimated at market prices and the velocity of circulation of the money supply. Based on this theory, there is a positive relationship between price levels and the money supply. This relationship is presented using the quantity equation (MV=PY) which was observed previously under the study on money supply.
MV = PY
Where: M is the stock of money in circulation
V is the velocity of circulation
P is the general price level
Y is the total income.
Accordingly there will be a proportionate positive relationship between the money supply and the price levels of a given economy. That is, when the money supply increases by a certain percentage the price levels will also increase by an equal percentage.
According to this theory it is believed that inflation is caused by an expansion in the money supply of a given economy. It is under the view that inflationary situations caused due to an increase in money supply which is not followed by or supported by an increase in output levels of an economy.

Keynesian Theory

The Keynesian view on inflation initially introduced in a book titled The General Theory of Employment, Interest and Money published in 1940.
According to Keynes an increase in general price levels or inflation is created by an increase in the aggregate demand which is over and above the increase in aggregate supply. If a given economy is at its full employment output level, an increase in government expenditure (G), an increase in private consumption (C) and an increase in private investment (I) will create an increase in aggregate demand; Leading towards an increase in general price levels.
Such an inflationary situation is created due to the fact that at optimum or full employment of output (maximum utilization of scarce resources) a given economy is unable to increase its output or aggregate supply in response to an increase in aggregate demand.

According to the graph, when the government uses monetary and fiscal policies to improve full employment of production levels, there will be an increase in aggregate demand level of the economy from AD0 toAD1 which would result in the creation of full employment level of equilibrium out put represented at the point E. If the aggregate demand level increases further from AD1 to AD2 the general price levels shall increase since the full employment of production level will remain unchanged at Yf. The output level will not change since all resources are fully employed at the point of Yf.
An Aggregate demand level over and above the full employment of production level will create an inflationary gap of EF. In addition, an aggregate demand below the full employment of production level will create deflationary gap of ED.

Monetarism

The monetarists theory states that when the money supply is increased in order to grow or increase production and employment, creating an inflationary situation within an economy.
A monetarist believes increases in the money supply will only influence or increase production and employment levels in the short run and not in the long run. Accordingly, there will be a positive relationship between inflation levels and money supply. The monetarists explain this relationship using the theory of natural rate of unemployment.
The theory of natural rate of unemployment suggests that there will be a level of equilibrium output, employment, and corresponding level of unemployment naturally decided based on features such as resources employment, technology used and the number of firms in the country etc, the unemployment level decided in this manner will be identified as natural rate of unemployment.
In the short run, expansionary monetary policies will result in the decline in the natural rate of unemployment and increase the production but the effectiveness of the expansionary policies will be limited in the long run and lead to an Inflationary situation.

Structuralism

This theory states that the main reason for inflation is the in-elasticity in the structures of the economy. This theory is mainly used to explain the nature and basis of inflation in developing countries. Originating in Latin America, this theory states that the inflation rates in developing countries are affected by the in-elasticity of the following reasons;
  • Production level and capacity
  • Capital formulation
  • Institutional framework
  • High in-elasticity in the agricultural sector
  • In-elasticity of the labour force and employment structures.

Economic Consequences

Unfavorable effects

  • Increase in the cost of living

An increase in the general price of goods and services will increase the cost of living and lead to a decrease in the living standards of fixed income earners. Such a situation can create many social, economical, and political problems within a given country.
  • Inefficiency in resource utilization

In situations of inflation the aggregate demand for goods and services will decrease due t the decrease in purchasing power of consumers. Accordingly, output levels will be affected by a decrease, resulting in an overall reduction of full employment or resource utilization within the economy. On the other, hand the production of essential goods can be limited or ignored ignored since many producers will try to purchase high priced goods with a greater increase in price levels of inflationary effect and profit.
  • Savings are discouraged

Savings will be discouraged since the real value of savings declines and the returns that could be received through other means of investment increases. This is because the inflation is high than the rate of interest received on the deposits or savings.
  • Fixed income earners will be at a disadvantage

Fixed income earners or parties who receive wages, rent and interest income on previously agreed, fixed term contracts are the parties that are the most adversely affected by inflation. They are unable to increase their income and the real value of money continually decreases leading to a decrease in real income of these parties.
  • Long-term investments will be discouraged

There will be low levels of domestic and foreign investments due to the economic and political instability created by high levels of persistent inflation within the economy. On the other hand, speculators and investors tend to invest more on real assets than financial assets, which will lead to low levels of fund formation for business activities and long-term investments
  • Increased Government spending

The governments current and capital expenditure will increase in time inflation, since the government income remains unchanged or decreases, the budget deficit expands further. the government needs to provide assistance in terms of fund transfers to low and fixed income earners and if the government finances such expenditure using borrowings from banking sources, further inflationary pressure will be created.
  • Inflation creates adverse effects on the Balance of Payment and Foreign Exchange Reserves of a country.
  • High levels of domestic inflation can over value the foreign exchange rates of a country resulting in unfavourable situations in international trade.

Favourable effects

  • The producers, businesses, and organizations will benefit  from inflation, since the price levels of goods and services will increase at a higher level that the cost of production, thereby increasing profits.
  • Debtors shall benefit at the expense of creditors as the real value of loan installments and interest rates falls in situations of inflation.
  • An inflationary situation can stimulate or assist in the process of achieving economic growth since producers are encouraged with the increase in profits, resulting in the expansion of business activities.

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