Inflation - Causes, Types and Measurements

Inflation

  • Inflation is defined as the rise in the price level of goods and services in an economy over time. It is important to note that the price of goods and services implies a basket of goods and services, if the price of one product has gone up, it can not be termed as inflation.
  • Inflation is also defined as a situation where the Value of Money or the Purchasing Power of Money decreases with an increase in the price level of Goods and Services.
Illustration 1: Mr Mehta used to buy his monthly Groceries for Rs. 5000 in January 2019. After one year in January 2020, the same Groceries billed up to Rs. 6200 and Mr Mehta had to include
additional Rs. 1200 in his expenses, this can be interpreted in two ways:
  1. Price of Groceries increased in 1 Year
  2. Purchasing Power of Rs. 5000 Decreased in 1 Year
This is a case of Inflation wherein the price of Goods and Services (Groceries) has gone up over a period (1 Year).

Illustration 2: Due to an upcoming Festival, the price of Milk increased by Rs. 10 per litre in October 2020 but came to its original price in a week.
  • This situation cannot be termed as Inflation because the change is the price is temporary for a few days. Inflation is followed by a price rise which continues over a period and not for a few days.
  • Inflation is expressed in percentage terms which can either be positive or negative, a positive value shows that inflation has increased over the period and negative value shows that inflation has decreased over the period. The negative inflation is also known as Deflation.

Cause of Inflation

Inflation denotes a rise in price levels, hence, to find the cause of inflation we need to find the cause of Price Rise. Price levels are determined by the Equilibrium between Supply and Demand Curves as shown in the figure below:
In the figure above the Initial, Supply is  Sand its corresponding Demand is  D1. The intersection of  Sand  D1 is the equilibrium point that corresponds to Price  P1. Let us consider the following scenarios:
  1. Demand Increases from Dto D2, and the supply remains constant at S:
    • If the Demand Increases at constant Supplies, there will be a shortage of Supplies that will lead to the increased price of commodities, the Equilibrium point will shift upwards and the new Price level becomes P2. If the demand increases further the price level will again continue to rise upwards.
  2. Supply Decreases from Sto S2, and the demand remains constant at D1:
    • If the Supply Decreases at constant Demand, there will be a shortage of Supplies that will lead to the increased price of commodities, the Equilibrium point will shift upwards and the new Price level becomes P2. If the demand increases further the price level will again continue to rise upwards.
  3. Demand Dand Supply S1 remain constant but the price level goes up:
    • If the cost of Production i.e. Labour, Raw Materials, etc. becomes costly then the cost of final goods increases without any change in Demand or Supply.

Demand-Pull Inflation: 

  • If the price level of goods and services increases due to an increase in Demand and/or reduction in supplies, it is known as Demand-Pull Inflation. In the above explanation, I and II are scenarios of Demand-Pull Inflation.

Cost-Push Inflation: 

  • If the price level of goods and services increases due to an increase in the cost of Production (Demand and Supply are constant), it is known as Cost-Push Inflation. In the above explanation, III is the scenario of cost-push Inflation.

Measuring Inflation

  • Inflation is defined as a change in price levels of goods and services over a period, the change in price levels is measured by measuring the value of price index over a period. CPI (Consumer Price Index) and WPI (Wholesale Price Index) is used for measuring inflation, let us see each of them.

I. Consumer Price Index (CPI)

  • CPI measures the weighted average of prices of a basket of goods and services which are of primary consumer needs. It is calculated by taking price changes for each item in the predetermined basket of goods and averaging them based on their relative weight in the whole basket. CPI measures changes in price from the purchasers’ perspective.
  • CPI of a fixed year (knows as Base year) is taken for reference to calculate inflation using the following formula.

Inflation  =  CPI-  CPI1 × 100%
CPI1     
Where,
CPI= CPI of the base or reference year
CPI= Current CPI

Illustration 3: The CPI of the base year 2004-2005 is 108 and for current FY is 270, calculate the inflation.
Inflation = [(270 – 108) / 108] * 100%
Inflation = 1.5 *100% = 150%

Let us see the following Illustrations to understand.

II. Wholesale Price Index (WPI) or the Purchaser Price Index (PPI)

  • WPI is like CPI except for the fact that the price levels used are at Wholesale Level or Producer Levels. WPI is an index of prices paid by retailers for goods and services. It monitors the price changes made by manufacturers and wholesalers before the products reach the final consumers. The calculation of Inflation using WPI is the same as CPI, in the formula the CPI is replaced by WPI.
Inflation  =  WPI-  WPI1 × 100%
WPI1     

III. GDP Deflator

  • GDP Deflator is the ratio between GDP at Current Prices (Nominal GDP) and GDP at Constant Prices (Real GDP). Measurement of GDP Deflator gives an idea of factor level rise in Inflation e.g. if the GDP Deflator is 3 it implies that the GDP inflation has Increased 3 times.
GDP Deflator  = Nominal (Current Price)GDP × 100%
Real (Constant Price)GDP     
Let us summarise the methods used to calculate Inflation.
  • The formula to calculate the Inflation can also be used to calculate the Purchasing Power of Currency, let us see an Illustration below to understand this.
Illustration 4: Calculate the Purchasing power of Rs. 100 in 2019-2020 if the CPI of the base year is 204.5 and CPI of Current Year in 526.50.
  • Inflation = (526.50-204.50)/204.50 * 100 % = (322/204.5) * 100% = 157.46%
  • This implies that inflation has increased by 157.46% and a commodity worth Rs. 100 in base year will now cost Rs. 157.46

Types of Inflation

  1. Open Inflation: This type of inflation is purely based on market forces of supply and demand without the interference of any regulation.
  2. Suppressed Inflation: This is just the opposite of Open inflation wherein the regulatory controls are exercised by the Government to control price levels and inflation.
  3. Low/Creeping Inflation: This type of inflation is small, predictable, and grows gradually over time. The range of increase of such inflation is a single digit.
  4. Galloping/Hopping/Jumping/Running/Runway Inflation: This type of inflation is unpredictable and very high with very little or no chances to reduce, galloping inflation may range in two or three digits.
  5. Hyper Inflation: This type of inflation is very large and accelerating i.e. grows very rapidly with time (e.g. overnight). Hyperinflation is influenced more by political changes rather than economic changes.
  6. Bottleneck/Structural Inflation: This type of inflation is caused by a Sudden fall in supplies, demand to be constant. This can happen due to supply-side hazards like fire, earthquake, tsunami, etc. 
  7. Stagflation: This type of inflation is characterized by high inflation and unemployment simultaneously.
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