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YASH CLASSES

FYB.COM SEM-II

INFLATION
Q - 1 GIVE THE DEFINITION OF INFLATION AND EXPLAIN ITS NATURE.
CONCEPT AND DEFINITION OF INFLATION : Usually when we think of inflation, we take of rising prices and the resultant fall in the value of money. But it cannot be believed that rising prices always indicate inflation. Sometime prices are rising due to non-monetary factors, like supply inelasticitys, declining output due to diminishing return, oligopolitic tendencies in the market etc. Similarity, in spite of stable prices, there may be inflation. This happens when prices are tried to maintain artificially by control and rationing. Thus, rising prices are not necessary and sufficient condition for inflation to exist. In this situation, it is very difficult to give precise and acceptable definition of inflation. (1) Crowther: "Inflation is a situation in which the value of money is falling, meaning thereby that prices are rising." (2) Pigou : "When monetary income are increasing more in proportion to income gaining activities, inflation exists." (3) Crameror: "Inflation means too much money and bank deposits i.e., excessive money in relation to physical volume of trade." (4) Friedman: "Inflation means steady and continuous ride in price. Inflation is purely monetary phenomenon. (5) Keynes: "After full employment equilibrium when aggregate demand is greater than aggregate supply inflation comes into existence, and it is perfect inflation."

(1) There is continuous increase in prices, and in the long run also process of inflation continuous and so fit is dynamitic. (2) It is not necessary that prices always rise in inflation, but when aggregate demand is in excess of aggregate supply inflation may come into existence.

CHARACTERISTICS OF INFLATION:

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(3) Inflation is purely monetary phenomenon. However, before full employment equilibrium, when output, income and employment increase along with money supply prices may not rise, but after full employment there is proportionate increase in prices due increase in money supply. Thus, true inflation exists after full employment. (4) The inflation which comes into existence due to interactions of economic factors is fundamentally economic phenomenon, because in this situation inflation is self-propelling.

TYPE OF INFLATION:
There are different types of inflation in view of different approaches to inflation. However, different types of inflation are not independent of one another. For the sake of convenience, types of inflation can be divided on the basis of (1) speed of price increase (2) different process (3) coverage (4) nature (5) causes. Let us understand each type of inflation:

(1) Types of inflation on the basis of speed of prices increase

There are four types of inflation on the basis of speed of rising prices. (a) Mild inflation (b) Creeping inflation (c) Runaway inflation (d) Hyper inflation. In mild inflation, during long run prices rise very slowly, whereas in hyper inflation, the speed of price rise is very fast. But in run-away and hyper inflation, during short run price rise is very sharp. However, it is very difficult to draw a dividing line between different types of inflation. Usually, economists differentiate different types of inflation on the basis of percentage rise in prices annually. If the prices rise annually 1 to 1.5%, it is mild inflation, if there is 3% rise in prices annually, it is creeping inflation, if there is 10% rise in prices it is run-away inflation and if there is 100% rise in prices it is hyper inflation. Some economists favour mild dose of inflation as it

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helps increasing employment output and income. But it has been argued that with the process of time mild inflation turns into creeping, run-away and finally into hyper inflation. About the severity of hyper inflation one citizen notes that earlier we were marketing with money in our pockets and purchasing commodities in the basket, but now we go for marketing with money in baskets and purchase only few commodities. (2) Types of inflation on the basis of different process : On the basis of process of inflation, there are three types of inflation (a) Deficit induced inflation (b) Wage-induced inflation and (c) Profit induced inflation. (a) Deficit Induce Inflation : When the deficit in the Government budget, arising out of planned expenditure, war expenditure or expenditure due to natural calamities are financed by over-drafts from the central bank of financed by printing new money, this type of inflation takes place. Because of this inflation, effective supply of money increases, which in turn increases demand for commodities but output does not increases immediately and so the imbalance between demand and supply gives rise to this type of inflation. This is also called development induced inflation. (b) Wage Induced Inflation: When the price are rising in the economy due to some reason, the real income of the laborers decline. Laborers would try to compensate this loss of income by demanding higher wages; and with the backing of trade unions, they would succeed in getting higher wages. But the cost of production would go up, as wage cost is the major cost in production cost. The producers will increases the prices of their products, which would give rise to demand for higher wages. Thus a vicious circle of wage price spiral would come into existence. (c) Profit Induced Inflation: Usually in the situation of inflation, there would be considerable increase in prices. But many times due to monopolistic elements in the market, the monopolist will produce output loss than optimum and so the

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profit of the entrepreneur would go up but consumer will have to pay higher prices. This type of inflation is called profit induced inflation. (3) Type of inflation on the basis of spread of inflation: On the basis of spread of inflation, there are two types of inflation (a) comprehensive inflation and (b) sporadic or partial inflation. When in the economy prices of all commodities in all sectors are rising , it is called comprehensive inflation, whereas in partial inflation prices of one or group of commodities are increasing. For example, prices of food grains in draught situation, or prices of petroleum products during oil crisis are the example of partial inflation. (4) Types of inflation on the basis of nature of inflation: On the basis of nature of inflation there are two types (i) open inflation and (ii) suppressed inflation. Prof. Milton Friedman states that when in the economy inflationary forces are active and Government allows prices to increases freely, without controlling them , open inflation comes into existence. After first world war this type of inflation was existing in West Germany, Australia and Russia. This type of inflation ultimately turns into galloping inflation. On the contrary, government instead of allowing prices to increase freely, tries to control prices artificially by monetary and physical control, like dear money policy, price control, distribution of scarce commodities, exchange control etc. suppressed inflation comes into existence. This type of suppressed inflation creates problems like artificial scarcity, corruption, back marketing due to failure of distribution policy. Because of these evils of suppressed inflation, Prof. Friedman favours open inflation. (5) Structural Inflation: Prof. Shultz has given explanation of this type of inflation. This inflation exists in underdeveloped countries. Because of unused resources on the one hand and insufficient supply of goods we find co-existence of increasing prices. The structure of underdeveloped countries itself gives

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rise to inflation.

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(6) Types of Inflation based on causes of inflation : There are two types of inflation: (a) Demand pull inflation and (b) cost-push inflation. (a) Demand Pull Inflation : When total demand of different commodities are greater than total supply of commodities prices increase due to pressure of demand. This type of inflation is called demand-pull inflation. In this inflation it is found that "too many money chose too few goods." Thus price increase due to imbalances between demand and supply, and as the demand increases, the price of commodities also increase. Before full employment, with the increase in prices, supply of commodities also increase to some extent, but after full-employment level the supply curve of commodities becomes perfectly elastic, and therefore, money income only increases prices and not supply of goods. Keynes believes that the inflation after full-employment is true or full inflation and that in demand pull inflation in the beginning prices of consumer goods increase. (b) Cost Push Inflation: Demand pull inflation takes into account forces of demand, whereas cost-push inflation considers only forces of supply i.e. cost of production. Before 1950, Keynes and other economists gave importance to effective demand for the explanation of inflation. But after 1950, because of trade union's policy of wage increase and monopoly and oligopolistic situation in production, increase in cost of production became important factor for explaining inflation. Wage induced inflation and profit induced inflation are the example of cost-push inflation. Q - 2 WHAT ARE THE MAIN EFFECTS OF INFLATION ON ECONOMIC DEVELOPMENT? The effects of inflation can be discussed under two sub-heads (i) effects on production, and (ii) effects on distribution.

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EFFECTS ON PRODUCTION:

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The phenomenon of inflation produces a very deep impact on the production of wealth in the economy. It is this hyperinflation which has harmful consequences for the economy. In fact, hyperinflation disrupts the smooth functioning of the economy. This type of inflation has the following adverse effects on the productive activities of the country: (1) Since hyperinflation results in a serious depreciation of the value of money, it discourages savings on the part of the public. With reduced saving, the process of capital accumulation suffers a serious setback. (2) If the value of money undergoes considerable depreciation, this may even drive out the foreign capital already invested in the country. (3) With reduced capital accumulation, the investment will suffer a serious setback which may have an adverse effect on the volume of production in the country. (4) The volume of production will not only decline on account of the slowing down of capital accumulation, it may also decline on account of business uncertainty which may discourage entrepreneurs and businessmen from taking business risk in production. (5) The pattern of production in the economy may also undergo changes under the impact of runaway inflation. This type of inflation may result in the diversion of productive resources from the essential goods industries to the luxury goods industries, creating further shortages of consumer goods for the common man. (6) Since runaway inflation results in a seller's market, it may lead to a serious deterioration in the quality of goods produced in the economy.

EFFECTS ON DISTRIBUTION:
Inflation produces a deep impact on the distribution of income and wealth in society. Businessmen, traders, merchants, and speculators reap rich harvests on account of windfall profits accruing to them as a result of the inflationary rise in prices. Price under the pressure of inflation rise much more than the production costs. There is always a time lag between the rise in production costs and the rise in the price

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level. This time lag brings rich profits to the business classes. Moreover, the stocks and inventories of businessmen invariably go up in value because of the constantly rising price level under the impact of inflation. The business classes, thus make all around gains during a period of inflation. The fact of the matter is that the flexible income groups, such as, businessmen, merchants and traders are always the gainers in a period of inflation while the fixed income groups, such as, workers, salaried employees, teachers, pensioners, etc. are always the losers on account of the inflationary rise in prices. Inflation is always unjust. Inflation throws the economic burden on the shoulders of those sections of the community who are the least able to bear it. 4 > EFFECTS ON VARIOUS GROUPS OF SOCIETY: (1) Debtors and Creditors : During inflation, debtors are generally the gainers while the creditors are the losers. The reason is that the debtors had borrowed when the purchasing power of money was high and now return the loan when the purchasing power of money is low due to rising prices. In other words, the debtors while repaying their debts return less purchasing power to the creditors than what they had actually borrowed. Since the creditors receive less in real terms, they are the losers during inflation. (2) Wage and Salary Earners: Wage and salary earners mostly suffer during inflation because wages and salaries generally do not rise in the same proportion in which the cost of living rises. Then there is the time lag between the rise in the cost of living and the rise in wages and salaries. If the workers and salary earners are well-organized into powerful trade unions, they may not suffer much during inflation, but if they are unorganized or ill-organised, as they generally are, they may suffer much as their wages and salaries may not increase at all or may not increase in the proportion in which the cost of living increases. (3) Fixed income group: The fixed income groups are the hardest hit during inflation because their incomes, being fixed , do not bear any relationship with the rising cost of living. Persons who live on past savings, pensioners, interest and rent receivers suffer most during inflation as their incomes

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remain fixed while the prices soar high. Inflation, it is said, is also a killer of older, retired people, who, with the advent of winter, find their pension inadequate to buy fuels with their existing fixed pensions. (4) Entrepreneurs : Inflation is a boon to the entrepreneurs whether they be manufacturers, traders, merchants or businessmen, because it serve as a tonic for business enterprise. They experience windfall gains as the prices of their inventories (stocks) suddenly go up. They also gain because their costs do not go up as rapidly as the prices of their products. The costs of labour, raw materials and equipment, etc. do not catch up with the rise in prices of products. Inflation converts the entrepreneurs into 'profiteers' who put the community to ransom through their profiteering and hoarding activities. (5) Investors: Investors are generally of two types : (i) investors in equities (shares), and (ii) investors in fixed interest yielding bonds and debentures. Inflation bestows favours on the former and is rather harsh on the latter. Dividends on equities increase with the increase in prices and corporate earning and as such, the investors in equities are favourably affected. Incomes from bonds and debentures, however, remain fixed and as such, investors in them are adversely affected. The small middle-class investors generally invest in fixed interest yielding bonds and securities and therefore, have much to lose during inflation. Frequently, they find their saving largely, if not completely, wiped out as a result of the depreciation in the value of money. The rich class investors, on the other hand, invest in equities on which the dividends go up during inflation and are thus beneficially affected. (6) Farmers: Farmers are generally the gainers during inflation. The prices of farm products go up while the costs incurred by them (the farmers) do not go up to the same extent. Further, there is generally a time lag between the rise in prices and the increase in costs. Moreover, the farmers are generally debtors and can repay their debts during inflation in terms of less purchasing power. It should, however, be remembered that small farmers do not gains as much from high prices as the big farmers do, because the farmer do not

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have a considerable surplus to dispose of in the market.

Q - 3 EXAMINE THE EFFECTIVENESS OF MONETARY AND FISCAL POLICY FOR CONTROLLING INFLATION. INTORDUCTION : We have seen that inflation is a social evil and its evil effect touches each class of society to greater or lesser extent. Hence its control becomes necessary. It is intended to discuss in what follows the stabilization policy to free the economy from evil effects of inflation. CONTROL OF INFLATION: As we known the fundamental cause of inflation is the imbalance between, demand and supply. At the prevailing prices when monetary demand for goods is more than the supply of goods inflation comes into existence. Therefore, to control inflation, the availability of supply of goods should be more than the demand for goods and so output should be increased, or if the supply of goods cannot be increased, demand for goods should be controlled. We know that the output of commodities cannot be increased in short run inflation can be controlled only by controlling demand. In this context, for the control of inflation policy of demand management is very important. The policy of demand management for the control of inflation includes (a) monetary policy (b) fiscal policy and (c) administrative policy. (A) Monetary Policy : By necessary changes in the supply of money in the economy tries to control the demand for commodities by increasing the cool of availability of credit. This type of monetary policy is called dear money policy. Central bank by adopting dear money policy tries to control the demand for commodities by putting restriction on credit control of commercial banks. There are two instruments of monetary policy (i) measures of quantitative credit control and (ii) measures of

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qualitative or selective credit control. In measures of qualitative credit control, there are three instruments : bank rate policy, open market operation, changes in reserve ratio. Commercial banks also increase their lending rates following increases in bank rate by central bank. This will have adverse effect on investment and have psychological effect on the economy. Increases in bank rate gives warning to businessman, producers and entrepreneurs to decrease in investment. Similarity by selling government securities and increasing reserve ratio, the credit creation capacity of commercial banks is considerably reduced. The second important measure of credit control is qualitative credit control. By resorting to policy of qualitative credit control bank tries to check speculative and boarding activities in the selective sectors of the economy through changes in margin, credit rationing and moral persuasion. Thus, with the help of quantitative and qualitative credit control, central bank implements monetary policy. But there are limitations of monetary policy. Limitation of Monetary Policy: (1) Rate of interest increases following increase in the bank rate. But because of inflation, if the investment is profitable and profit is higher than interest cost, bank rate policy does not succeed in controlling demand through control of investment. (2) Policy of open market operation does not succeed in inflation, because of underdeveloped nature of government securities and central bank does not sale the securities in proportion to the demand for it. (3) The effectiveness of monetary policy reduces in the developing countries because of lack of integrated money market. (B) Fiscal Policy : As a supplementary policy to monetary policy, fiscal policy also holds an important place as antiinflationary policy. Fiscal policy includes taxation, public expenditure and policy of public debt. During inflation, if we can estimate inflationary gap fiscal policy becomes effective; the expenditure can be curtailed in proportion to 'inflationary gap'. Prof. Kurihara states that Inflationary arising out of

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uncontrolled private expenditure can be controlled to certain extent by cutting government expenditure. During the period of inflation, government should cut the purchasing power of the people by increasing direct and indirect taxes, by loans from the people by the policy of public debt. Government by reducing their expenditure and by achieving deficit financing should go for balance budget. (C) Administrative policy : Inflation can be effectively controlled by judiciously following administrative, monetary and fiscal policy. This is called 'Package Deal Policy'. IN administrative policy are included price control and rationing, wage, freezz, income policy and import licence policy. (i) Price control and rationing : In inflation, when the supply of essential commodities is less in relation to its demand or when scarcity of essential commodities arises, government undertakes and distributes the essential commodities through rationing and price control. But due to the inefficiency of administrative machinery many times these measures lead to hoarding, black marketing and corruption. (ii) Income policy : When the demand for commodities increases following increase in income wages of the people, price of the commodities increase. Usually this happens in wage induced inflation. Robert Leafman, notes that the origin of the changes in the value of money is to be found in the changes in the income of the people and therefore, apparently to check the value of money, the control of monetary income of the people is necessary." In this context, for controlling inflation through controlling demand, government implements s income policy by freezing wages. (iii) Licensing Policy: Government resorts to the licensing policy in inflation to discourage hoarding, speculative activities and investment in non-essential commodities. In international trade also policy of import licensing is included for controlling imports of non-essential goods. At the end it can be said inflation is multi-headed monster, therefore, against the fight of inflation, instead of using a single weapon many weapons should be used to fight it out. However, in the long run the only measure to control inflation is to increase production in every sector.

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