11 Inflation — Concept, Types, Measurement and Control
11.1 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 % annual rise in a price index covering most of what households buy is.
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 |
| A.C. Pigou | “Inflation exists when money income is expanding more than in proportion to increase in earning activity.” | Money income |
| Milton Friedman | “Inflation is always and everywhere a monetary phenomenon — too much money chasing too few goods.” | Monetary cause |
| Coulborn | “Too much money chasing too few goods.” | Demand-supply imbalance |
| Mankiw | “An increase in the overall level of prices in the economy.” | Price-level rise |
| RBI (India) | “A rise in the general price level over a period of time, measured as the rate of change of a price index.” | Index-based |
- Deflation — sustained fall in the general price level (negative inflation rate). Japan 1990s.
- Disinflation — slowing of the inflation rate (still positive but lower).
- Stagflation — high inflation + stagnation (high unemployment + low growth). Coined by Iain Macleod 1965; OECD 1970s oil shocks.
- Reflation — deliberate policy of raising prices after deflation.
11.2 Types of Inflation
11.2.1 By rate of price rise
| Type | Typical rate | Character | Example |
|---|---|---|---|
| Creeping | < 3 % annually | Mild, often considered desirable | Most developed economies |
| Walking | 3–10 % | Warning signal | Many emerging economies |
| Running / Galloping | 10–100 % p.a. | Serious; erodes savings | India late 1970s |
| Hyperinflation | Above 50 % per month (Cagan) | Catastrophic; money loses meaning | Weimar Germany 1923; Zimbabwe 2008; Venezuela 2018 |
The hyperinflation threshold of 50 % per month is from Phillip Cagan’s 1956 paper, The Monetary Dynamics of Hyperinflation.
11.2.2 By cause — Demand-pull vs Cost-push
| Dimension | Demand-pull | Cost-push (supply-side) |
|---|---|---|
| Cause | Aggregate Demand outpaces Aggregate Supply | AS curve shifts left (input costs rise) |
| Typical drivers | Money-supply expansion, deficit financing, consumption boom, fiscal stimulus | Wage push, profit push, raw-material shock, oil shock, currency depreciation |
| Friedman-Keynes connection | Keynesians + Monetarists both can explain | Most often associated with structuralists |
| Curve shift | AD ↑, AS unchanged | AS ↓, AD unchanged |
| Stagflation | Rare | Possible (e.g., 1973 oil shock) |
- Built-in inflation (also called wage-price spiral or inertial) — past inflation feeds expected inflation; expected inflation drives wage demands; wage rises drive further price rises.
- Imported / Exchange-rate inflation — domestic prices rise because the exchange rate depreciates, raising the rupee cost of imported goods.
11.2.3 By context
- Open inflation — prices rise freely; no government interference.
- Suppressed / Repressed inflation — prices held by controls (rationing, price ceilings); shortages emerge instead. War-time India / UK.
- Sectoral inflation — confined to one sector (e.g., food inflation in 2010 India).
- Headline vs Core inflation — Headline includes everything; Core excludes the volatile food and fuel components.
- Bottleneck inflation — supply-side constraints; common in fast-growing emerging economies.
11.3 Causes of Inflation
11.3.1 Demand-side causes
- Excess money supply — Friedman’s central claim.
- Deficit financing — government prints money to fund deficits.
- Population growth raising aggregate demand.
- Black money and unaccounted incomes raising demand.
- Increase in disposable income.
- Increase in government expenditure.
- Export surplus drawing goods out of the country.
- Fall in personal direct tax raising consumption.
- Cheap money policy — low interest rates.
11.3.2 Supply-side / Cost-push causes
- Wage push by powerful unions.
- Profit push by oligopolistic firms.
- Increase in indirect tax (GST, excise) raising prices.
- Increase in raw material / input prices — global oil, metals.
- Crop failure / drought raising food prices.
- Hoarding by middlemen.
- Black-marketing and adulteration.
- Imported inflation through depreciation.
- Strikes, lockouts, natural disasters disrupting supply.
11.4 Theories of Inflation
11.4.1 Quantity Theory of Money — Fisher (1911)
Irving Fisher’s equation of exchange:
\[MV = PT\]
Where M = money supply, V = velocity of circulation, P = price level, T = volume of transactions. With V and T assumed roughly constant in the short run, an increase in M produces a proportionate increase in P.
11.4.2 Cambridge Cash-balance Approach — Marshall, Pigou
The Cambridge version emphasises the demand for money (cash balances people wish to hold):
\[M = k P Y\]
Where k = proportion of nominal income held as cash, Y = real income. Inflation results when k falls (people want to hold less cash) faster than M and Y change.
11.4.3 Keynesian Theory
J.M. Keynes (How to Pay for the War, 1940) distinguished inflation that occurs before full employment (mild, output also rises) and the inflationary gap — excess AD over AS at full employment, which raises only prices.
11.4.4 Monetarist Theory — Friedman
Friedman’s k% rule — central bank should grow money supply at a constant rate equal to long-run real growth. Friedman’s 1976 Nobel-Prize-winning work crystallised the modern monetarist view that inflation is always and everywhere a monetary phenomenon.
11.4.5 Phillips Curve
In 1958, William Phillips (LSE) plotted UK wage inflation against unemployment 1861–1957 and found a stable inverse relationship. The original Phillips curve:
- Short-run Phillips curve — downward-sloping; trade-off between inflation and unemployment.
- Long-run Phillips curve (Friedman-Phelps, 1968) — vertical at the Natural Rate of Unemployment (NRU) / NAIRU. No long-run trade-off.
- Stagflation of 1970s broke the simple Phillips curve and brought expectations-augmented versions to prominence.
11.4.6 Expectations-Augmented Phillips Curve
Edmund Phelps (1967) and Milton Friedman (1968) added expected inflation to the curve. The current inflation rate depends on actual unemployment relative to the natural rate and on expected inflation. If expectations are rational (Lucas, 1972), even short-run trade-offs vanish.
11.5 Effects of Inflation
| Who gains | Who loses |
|---|---|
| Borrowers (pay back in cheaper money) | Lenders / creditors (receive cheaper money) |
| Equity holders (corporate profits rise with inflation) | Bondholders / fixed-income earners |
| Producers / traders (rising prices on existing stock) | Wage / salary earners (real wage falls) |
| Speculators / hoarders | Pensioners (fixed income) |
| Government (real value of debt falls — inflation tax) | Money-holders (real value of cash falls) |
The inflation tax is the loss in real value of money holdings caused by inflation. The government benefits because the real value of its outstanding debt falls. Seigniorage = revenue earned by the government from issuing money.
- Allocative distortion — investment shifts to unproductive assets (gold, real estate) to hedge against inflation.
- Menu costs — costs of constantly changing prices.
- Shoe-leather costs — people make more trips to the bank to avoid holding cash.
- Tax distortions — bracket creep raises real tax burdens.
- Balance of payments deterioration — domestic prices rise faster than world prices, so imports rise, exports fall.
- Social discontent — political instability follows long bouts of high inflation.
- Mild inflation can stimulate growth — Keynes’s case.
11.6 Measurement of Inflation in India
11.6.1 The four indices
| Index | Full name | Base year | Coverage | Compiled by |
|---|---|---|---|---|
| WPI | Wholesale Price Index | 2011-12 | Wholesale prices of 697 items; manufacturing largest weight | Office of Economic Adviser, DPIIT |
| CPI (Combined) | Consumer Price Index — combines rural + urban | 2012 | Retail prices; food has largest weight (~46 %) | NSO (MoSPI) |
| CPI-IW | CPI for Industrial Workers | 2016 | Retail basket of industrial workers | Labour Bureau |
| CPI-AL / CPI-RL | CPI for Agricultural / Rural Labourers | 1986-87 | Retail basket of agricultural / rural labourers | Labour Bureau |
- WPI measures wholesale transactions of goods only (no services). Base year 2011-12.
- CPI measures retail prices of goods and services as a typical household buys them. Base year 2012.
- CPI is the headline inflation gauge in India since 2014 — switched on the recommendation of the Urjit Patel Committee (2014). Earlier (and in many older texts), WPI was the headline.
- CPI Food and Beverages (~46 % weight) drive most of headline movements.
11.6.2 Inflation rate formula
\[\text{Inflation rate (year t)} = \frac{\text{Index}_t - \text{Index}_{t-1}}{\text{Index}_{t-1}} \times 100\]
11.6.3 The CPI basket — six groups
- Food and Beverages
- Pan, Tobacco and Intoxicants
- Clothing and Footwear
- Housing
- Fuel and Light
- Miscellaneous (transport, communication, recreation, health, education, personal care)
11.7 Inflation Targeting in India
In June 2016, India formally adopted a Flexible Inflation Targeting (FIT) framework:
- Target: CPI-Combined inflation at 4 % ± 2 % (i.e., 2 % to 6 %).
- Decision body: Six-member Monetary Policy Committee (MPC) — 3 RBI members + 3 government-appointed external members.
- Frequency: MPC meets at least 4 times a year and decides the policy repo rate.
- Statutory basis: Section 45ZB of the RBI Act, after the 2016 amendment (Finance Act).
- Originating committee: Urjit Patel Expert Committee (2014).
Inflation targeting was first practised by New Zealand (1990), then Canada (1991), UK (1992). The concept was theoretically developed by Lars Svensson and Bennett McCallum.
11.8 Control / Measures Against Inflation
| Family | Specific measures |
|---|---|
| Monetary measures | Raise repo rate; raise CRR / SLR; OMO (sell securities to absorb liquidity); moral suasion; selective credit control |
| Fiscal measures | Cut government spending; raise direct taxes; reduce subsidies; cut deficit financing |
| Trade measures | Reduce import tariffs on essentials; restrict exports of scarce goods; rupee appreciation |
| Administered prices | Public Distribution System (PDS); buffer stocks (FCI); essential commodities Act |
| Income / wage policy | Wage freeze; productivity-linked pay; restraint on dividends |
| Other | Encourage savings; raise interest rate on deposits; structural reforms to raise supply |
11.8.1 Monetary policy instruments — RBI
| Instrument | What it is | Effect of raising it |
|---|---|---|
| Repo rate | Rate at which RBI lends short-term to commercial banks | Tightens liquidity, raises lending rates |
| Reverse Repo rate | Rate RBI pays to absorb funds from banks | Encourages banks to park funds with RBI |
| CRR (Cash Reserve Ratio) | % of deposits banks must keep with RBI as cash | Tightens lending capacity |
| SLR (Statutory Liquidity Ratio) | % of deposits banks must keep in approved securities | Tightens lending capacity |
| Bank Rate | Long-term rate at which RBI lends to banks | Penal rate; signals tight policy |
| OMO (Open Market Operations) | RBI buys / sells government securities | Sale absorbs liquidity (anti-inflationary) |
| MSF (Marginal Standing Facility) | Overnight lending against SLR securities | Ceiling on overnight rate |
| LAF (Liquidity Adjustment Facility) | Daily liquidity management via repo/reverse repo | Smooths short-term liquidity |
11.9 Practice Questions
"Inflation is always and everywhere a monetary phenomenon" — the statement is attributed to:
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Cagan's textbook threshold for hyperinflation is an inflation rate of at least:
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Stagflation refers to:
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A sharp rise in global crude-oil prices that raises domestic prices in India is best classified as:
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Irving Fisher's equation of exchange MV = PT implies that, with V and T constant, a doubling of M will:
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The original Phillips Curve (1958) shows the relationship between:
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According to Friedman and Phelps (1968), the long-run Phillips Curve is:
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During inflation, which of the following typically *gains*?
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India's *headline* inflation measure since 2014 is:
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The current base year of WPI in India is:
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India's Consumer Price Index (Combined) is compiled and released by:
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India's flexible inflation-targeting mandate sets a CPI target of:
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The Monetary Policy Committee (MPC) of India has how many members?
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An increase in the repo rate by RBI is most likely to:
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Cash Reserve Ratio (CRR) is the proportion of bank deposits that banks must hold as:
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A *fall* in the general price level over time is called:
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"Core inflation" typically excludes:
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The Urjit Patel Committee (2014) recommended:
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Inflation targeting was first formally adopted by which country?
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Match the concept with its author / origin:
| (i) | Equation of exchange MV = PT | (a) | Phillips |
| (ii) | Phillips Curve | (b) | Cagan |
| (iii) | 50 % per month hyperinflation threshold | (c) | Fisher |
| (iv) | Natural rate of unemployment | (d) | Friedman-Phelps |
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11.9.1 Advanced Format Questions
A: Demand-pull inflation arises when AD exceeds AS.
R: Cost-push inflation arises from supply-side shocks.
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A: India's headline retail inflation is measured by CPI(C).
R: RBI's inflation targeting framework (since 2016) uses CPI(C) with 4 ± 2% band.
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Types of inflation: (i) Creeping. (ii) Walking. (iii) Galloping. (iv) Hyperinflation.
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CPI rose from 150 to 165. Inflation rate is:
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11.10 Quick Recall
- Definitions: Crowther (falling money value), Pigou (money-income expansion), Friedman (“always and everywhere a monetary phenomenon”), Coulborn (“too much money chasing too few goods”).
- Related concepts: Deflation (negative) · Disinflation (slowing) · Stagflation (inflation + stagnation) · Reflation.
- By severity: Creeping (<3 %) · Walking (3–10 %) · Galloping (10–100 %) · Hyperinflation (Cagan: > 50 %/month).
- By cause: Demand-pull (AD ↑) vs Cost-push (AS ↓ / wage / oil shock). Built-in (wage-price spiral); Imported (depreciation).
- By context: Open vs Suppressed · Headline vs Core (excludes food & fuel).
- Theories: Fisher MV = PT · Cambridge cash-balance M = kPY · Keynes inflationary gap · Friedman monetarist + k% rule · Phillips curve (1958) · Friedman-Phelps long-run vertical at NRU/NAIRU (1968).
- Effects — gainers (borrowers, equity, producers, government [inflation tax]) vs losers (creditors, bondholders, fixed-income earners).
- India indices: WPI (base 2011-12, DPIIT Economic Adviser, wholesale, 697 items) · CPI-Combined (base 2012, NSO, retail, headline since 2014) · CPI-IW · CPI-AL.
- Inflation Targeting (India) — 4 % ± 2 % CPI; 6-member MPC; statutory since 2016 amendment of RBI Act; Urjit Patel Committee 2014. First adopter: New Zealand 1990.
- Control toolkit: Monetary (Repo, CRR, SLR, OMO, MSF, LAF, Bank Rate) · Fiscal (cut spending, raise direct tax) · Trade (lower import duties, restrict exports) · Administered (PDS, buffer stock) · Income policy.