Inflation and deflation: meaning, types, causes, effects and control

1. Meaning and definitions

Inflation is a sustained rise in the general price level, or, what is the same thing, a continuing fall in the value of money. A once-for-all rise in the price of one commodity is not inflation.

• Crowther: inflation is “a state in which the value of money is falling, that is, prices are rising.”
• Coulborn: “too much money chasing too few goods.”
• Keynes: true inflation begins only after full employment; before that, more spending raises output as well as prices (semi-inflation or bottleneck inflation).
• Friedman: “inflation is always and everywhere a monetary phenomenon.”

In India inflation is measured by the CPI (combined) for monetary policy and by the WPI for producer prices. Under section 45ZA of the RBI Act, 1934 the Central Government fixes an inflation target in terms of CPI for five years at a time; the target adopted in 2016 is 4 per cent with a tolerance band of 2 to 6 per cent.

2. Types of inflation

(a) By speed

• Creeping: mild, about 2–3 per cent a year; regarded as helpful to growth.
• Walking: moderate, under 10 per cent; a warning signal.
• Running: 10 to 20 per cent or more; hurts fixed-income groups badly.
• Galloping or hyperinflation: prices rise by hundreds or thousands of per cent; money loses its functions (Germany 1923, Zimbabwe 2008).

(b) By cause

• Demand-pull: aggregate demand exceeds aggregate supply at full employment.
• Cost-push: rising costs (wage-push, profit-push, supply shocks such as oil prices) push prices up.
• Deficit-induced: government deficits financed by borrowing from the central bank (monetisation).
• Imported: rising world prices or a depreciating currency raise import costs.
• Structural: supply bottlenecks in agriculture, infrastructure and markets in a developing economy.

(c) By other criteria

• Open and suppressed: prices rise freely, or are held down by controls and rationing (and reappear as black markets).
• Partial and full (Keynes): before and after full employment.
• Stagflation: inflation together with stagnant output and high unemployment, as in the oil shocks of the 1970s.
• Core and headline: headline inflation includes food and fuel; core excludes them.

3. Causes of inflation

(a) Demand-side (demand-pull) factors

1. Increase in money supply and bank credit.
2. Deficit financing by the government.
3. Increase in public expenditure, especially unproductive and defence spending.
4. Rise in disposable income: tax cuts, higher wages, remittances.
5. Population growth, raising demand for food and housing.
6. Black money, spent on conspicuous consumption and real estate.
7. Exports, which reduce domestic supply while adding to income.

(b) Supply-side (cost-push) factors

1. Fall in agricultural output through failed monsoons.
2. Rising wages without matching productivity (trade union pressure).
3. Rising input costs: oil, power, raw materials, imported inputs.
4. Hoarding and speculation by traders.
5. Indirect taxes on goods, which raise prices directly.
6. Industrial disputes and infrastructure bottlenecks that cut output.
7. Monopoly pricing (profit-push).

4. Effects of inflation

(a) On production

Mild inflation stimulates production: profits rise because prices rise ahead of costs, and businesses invest. Severe inflation hurts production: it discourages saving, diverts resources to speculation, hoarding and luxury goods, distorts the price signals on which planning depends, and makes long-term contracts uncertain.

(b) On distribution

Inflation is therefore called a “regressive tax”: it transfers income from the poor and the middle class to the rich.

(c) Other effects

• Balance of payments: exports become dearer and imports cheaper, so the trade deficit widens and the currency weakens.
• Saving and capital formation fall because the real return on saving falls.
• Social and political: unrest, strikes, corruption and loss of faith in government.

5. Control of inflation

• Monetary measures (by the RBI): raising the repo rate and bank rate, raising the CRR and SLR, selling securities in open market operations, and selective credit controls on speculative lending. These are explained in the note on credit control and monetary policy.
• Fiscal measures: cutting unproductive public expenditure, raising direct taxes, reducing the fiscal deficit, public borrowing from the people rather than from the central bank, and encouraging saving.
• Other measures: raising output (especially of food), imports of scarce goods, buffer stocks and public distribution, price controls and action against hoarding (the Essential Commodities Act, 1955), and wage policy linking wages to productivity.

6. Deflation

Deflation is a sustained fall in the general price level accompanied by falling output, income and employment. Crowther: a state in which the value of money is rising, that is, prices are falling. The classic case is the Great Depression of 1929–33. A fall in the rate of inflation (prices still rising, but more slowly) is disinflation, not deflation.

Causes. Contraction of money supply and credit; a fall in investment and consumer demand; over-production; heavy taxation or cuts in public spending; excessive saving (Keynes’ paradox of thrift); and a fall in exports.

Effects. Prices fall faster than costs, so profits disappear; firms cut output and workers lose jobs; creditors and fixed-income earners gain in real terms but the debtor and the producer suffer; the real burden of debt rises; investment collapses and the economy can sink into a depression. Keynes regarded deflation as worse than inflation: inflation is unjust, but deflation is inexpedient, because it causes unemployment.

Remedies. Cheap money policy (lower interest rates, lower reserve ratios, purchase of securities by the central bank); higher public expenditure on public works and deficit budgets; tax cuts to raise demand; and support prices for farmers.

How this is examined

For “causes of inflation”, divide into demand-pull and cost-push and give six or seven points under each, with Indian examples (monsoon failure, oil prices). For “effects”, use production, distribution (the gainers and losers table) and balance of payments. Six-mark notes on “types of inflation” need the speed and cause classifications only; for “deflation” give meaning, causes, effects and remedies in four short paragraphs.