10 Inflation
10.1 What is Inflation?
Inflation is a sustained rise in the general price level of goods and services in an economy over a period of time. The two key words are sustained and general. A one-off seasonal spike in onion prices is not inflation. A 6 per cent annual rise in the price of “everything” — a price index covering most of what households buy — is.
Mankiw defines inflation as “an increase in the overall level of prices in the economy” and the inflation rate as “the percentage change in some measure of the price level from the previous year” (mankiw2020?). Dwivedi defines it more sharply as “a sustained and substantial increase in the general level of prices accompanied by a fall in the value of money” (dwivedi2015?).
When prices rise, the purchasing power of money falls. ₹100 today buys less than ₹100 bought a year ago. Inflation and the value of money move in opposite directions — they are two ways of saying the same thing.
| Author / source | Definition | What it foregrounds |
|---|---|---|
| Crowther | “A state in which the value of money is falling, i.e., prices are rising.” | Falling money value |
| Pigou | “Inflation exists when money income is expanding more than in proportion to increase in earning activity.” | Money income |
| Friedman | “Always and everywhere a monetary phenomenon — too much money chasing too few goods.” | Monetary cause |
10.2 Types of Inflation
10.2.1 By rate of price rise
| Type | Typical rate | Character | Example |
|---|---|---|---|
| Creeping | < 3 per cent annually | Mild, often considered desirable | Most developed economies |
| Walking | 3–10 per cent | Warning signal | Many emerging economies |
| Running / Galloping | 10–100 per cent | Serious; erodes savings | India in the late 1970s |
| Hyperinflation | Above 50 per cent per month (Cagan) | Catastrophic; money loses meaning | Weimar Germany 1923; Zimbabwe 2008; Venezuela 2018 |
The hyperinflation threshold of 50 per cent per month is from Phillip Cagan’s 1956 paper (cagan1956?).
10.2.2 By cause
| Type | Trigger | Mechanism |
|---|---|---|
| Demand-pull | Aggregate demand exceeds aggregate supply | “Too much money chasing too few goods” — Keynes; Friedman |
| Cost-push | Costs of production rise (wages, raw materials, energy) | Firms pass higher costs into prices |
| Structural | Bottlenecks, supply rigidities in developing economies | Sectoral mismatch — agriculture cannot keep up |
| Imported | Higher prices of imported goods (oil, gold) | Currency depreciation amplifies the effect |
| Built-in / wage-price spiral | Workers demand higher wages because prices rose; firms raise prices because wages rose | Self-reinforcing |
10.2.3 By government response
- Open inflation — prices are allowed to rise; the government does not intervene.
- Suppressed inflation — price controls and rationing keep measured prices stable, but shortages and black markets emerge.
- Stagflation — inflation and high unemployment / stagnant growth occur together. The 1970s OPEC shock is the classic case.
10.3 Demand-Pull Inflation
Aggregate demand outruns aggregate supply at full employment. The standard sources:
- Government deficit financing — printing money to fund expenditure.
- Easy monetary policy — low interest rates, abundant credit.
- Rise in private investment or consumer spending.
- Rise in exports relative to imports.
The Keynesian view sees demand-pull as the primary mechanism. Friedman’s monetarist view re-cast it: every demand-pull inflation has a monetary root because demand cannot persist without money to pay for it.
10.4 Cost-Push Inflation
Inflation triggered by an autonomous rise in the cost of production. Three streams:
- Wage-push. Strong unions secure wage increases that exceed productivity growth.
- Profit-push. Oligopolistic firms raise margins.
- Supply-shock. A jump in the price of a major input — most often oil — pushes costs up across the economy.
Cost-push is harder to control with conventional monetary tools because tightening money to curb prices also slows output.
10.5 Measuring Inflation
Inflation is measured by price indices. The two that matter most in India are the Consumer Price Index (CPI) and the Wholesale Price Index (WPI).
| Feature | CPI | WPI |
|---|---|---|
| Compiled by | National Statistical Office (NSO) / MoSPI | Office of the Economic Adviser, Ministry of Commerce & Industry |
| Coverage | Final retail prices paid by consumers | Wholesale transactions of goods only |
| Includes services | Yes | No |
| Base year (current) | 2012 (CPI–Combined) | 2011-12 |
| Used for | RBI’s monetary policy target since 2014 | Producer-side price tracking; deflator for some macro series |
10.5.1 The headline measure for monetary policy
Since the Monetary Policy Framework Agreement of February 2015, the RBI’s nominal anchor is CPI Combined inflation (rbi2015?). The current target is 4 per cent ± 2 per cent — so the inflation tolerance band is 2–6 per cent. The Monetary Policy Committee (MPC), formed in 2016, sets the policy repo rate to keep CPI inflation near the target.
10.5.2 Other price indices
- GDP deflator — covers every component of GDP; broadest measure (computed implicitly from national income data).
- Producer Price Index (PPI) — used in the US and many countries; conceptually closer to WPI but covers services too. India is moving towards a PPI but does not yet publish it as the headline.
- Core inflation — CPI excluding food and fuel, the most volatile components. Used to read the underlying trend.
10.6 Effects of Inflation
| Effect | Beneficiaries | Losers |
|---|---|---|
| On debtors and creditors | Debtors — they repay in cheaper money | Creditors / lenders / fixed-income earners |
| On producers and traders | Producers — selling prices rise faster than costs in the short run | Salaried employees with sticky wages |
| On savings | Holders of real assets (gold, real estate) | Holders of cash and fixed-rate financial assets |
| On exports and imports | Imports become relatively attractive | Exporters lose price competitiveness |
| On the economy at large | Mild inflation can grease the wheels | High inflation distorts decisions, encourages hoarding, hurts the poor |
The poor are typically the most affected — they hold their wealth in cash, spend a high share of income on food, and cannot easily switch to inflation-linked instruments.
10.7 Phillips Curve
A.W. Phillips’s 1958 finding of an inverse relation between unemployment and the rate of change of money wages — extended to inflation — became the Phillips curve (phillips1958?). The simple form: low unemployment is associated with high inflation, and vice versa.
The 1970s stagflation broke the simple curve. Friedman and Phelps’s expectations-augmented Phillips curve introduced expected inflation and the natural rate of unemployment; in the long run, the curve is vertical at the natural rate, and there is no permanent trade-off (friedman1968?).
10.8 Control of Inflation
Three families of measures:
| Family | Instrument | Tightening tool |
|---|---|---|
| Monetary | Repo rate, CRR, SLR, OMO, MSF | Raise repo and CRR; sell government securities |
| Fiscal | Tax, expenditure, public borrowing | Raise taxes; cut public spending; reduce deficit |
| Direct / Administrative | Price controls, rationing, subsidy targeting, anti-hoarding laws, wage controls | Cap or freeze prices of essentials |
The 1991 reforms shifted India away from heavy direct controls toward indirect monetary and fiscal levers. Since 2015, monetary policy is the lead instrument, anchored on CPI inflation.
10.9 Practice Questions
Inflation is best described as:
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"Inflation is always and everywhere a monetary phenomenon." This view is most strongly associated with:
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Phillip Cagan's classical threshold for hyperinflation is:
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Stagflation refers to the simultaneous occurrence of:
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RBI's monetary policy target since 2015 is anchored on:
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Inflation tends to benefit:
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The original Phillips curve (1958) describes the relationship between:
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To curb demand-pull inflation, the RBI is most likely to:
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- Inflation = sustained, general rise in the price level. Money’s value falls.
- By rate: creeping (<3%), walking (3–10%), running/galloping (10–100%), hyperinflation (>50%/month — Cagan).
- By cause: demand-pull, cost-push, structural, imported, built-in. Special case: stagflation (inflation + stagnation).
- Friedman: inflation is “always and everywhere a monetary phenomenon”.
- India: CPI Combined is the policy anchor; target 4 ± 2 per cent since 2015. WPI compiled by Office of Economic Adviser.
- Effects: borrowers gain, lenders lose; cash holders and fixed-income earners hit hardest; the poor disproportionately so.
- Phillips curve: short-run inflation-unemployment trade-off; long run vertical at the natural rate (Friedman–Phelps).
- Control: monetary (repo, CRR, OMO), fiscal (tax, expenditure), direct (price control, rationing).