What is Inflation?
Inflation is the pace at which a currency's value declines and as a result, the general level of costs for goods and services rises. Although the price fluctuations of individual goods can easily be calculated over time human interests reach well beyond one or two such products. To live a comfortable life, individuals need a wide and diversified range of goods as well as a host of services. They include goods such as food grains, metal and fuel, electricity and transportation utilities, and services such as healthcare, entertainment, and labour.
Inflation attempts to calculate the aggregate effect of price increases on a diversified range of products and services and enables the rise in the price level of goods and services in an economy to be measured at a single value over a while. Prices increase as a currency loses value, and it buys fewer goods and services. The general cost of living for the general population is influenced by this loss of buying power, which inevitably leads to a deceleration of economic development.
Causes of Inflation:
In an economy, different factors can push prices or inflation. Inflation usually results from an increase in the cost of production or a rise in demand for goods and services.
Cost-Push Inflation:
Cost-push inflation happens when prices, such as raw materials and wages rise because of rises in production costs. Demand for products remains constant, although the supply of goods decreases as a result of higher production costs. As a consequence, in the form of higher prices for finished products, the additional costs of production are passed on to customers. As they are big manufacturing inputs, one of the indicators of potential cost-push inflation can be seen in rising commodity prices such as oil and metals.
For instance, if the price of copper increases, businesses that produce their products using copper may raise the prices of their goods. If the demand for the commodity is independent of the demand for copper, the higher cost of raw materials would be passed on to customers by the enterprise. Without any change in demand for the goods purchased, the effect is higher prices for customers. Prices can also be pushed higher by natural disasters. For instance, if a hurricane kills a crop such as maize, as maize is used in many goods, prices will increase in the economy.
Cost-Push Inflation Examples
Most commonly cost-push inflation occurs in the sectors of natural gas and oil prices. Gasoline and natural gas are used by almost everyone to fuel their automobiles or heat their home. Crude oil is used in refineries for the manufacturing of gasoline and other fuels. High levels of natural gas are also used by electric power suppliers for the manufacturing of electricity. The reduction in the supply of oil due to change in global policies, creation of warlike conditions or occurrence of natural disasters. These reductions in the supply of oil will ultimately increase the price of gasoline. In this case, the demand for the product remains the same but the raw material available for manufacturing the product is not available due to which the price of the product increases.
Demand-Pull Inflation:
Demand-pull inflation can be exacerbated by high demand from customers for a product or service. Prices rise as there is an increase in demand for commodities throughout an economy, and demand-pull inflation is the result. When unemployment is low, consumer morale appears to be high and wages rise, leading to more spending. Economic expansion has a direct effect on an economy's level of consumer spending, which can contribute to a strong demand for goods and services. As the demand for a specific product or service rises, the supply available decreases. When fewer goods are available, customers are willing to pay more to get the item, as illustrated in the supply and demand economic theory. Owing to demand-pull inflation, the consequence is higher prices.
Companies, especially if they produce common goods, often play a role in inflation. A business can boost prices simply because the additional amount is willing to be charged by customers. Corporations often openly increase prices because the commodity for sale is something that customers, such as oil and gas, require for daily life. Nevertheless, it is customer demand that gives businesses the power to boost costs.
Demand-Pull Inflation Example
The most recent example of demand-pull inflation was seen during the coronavirus pandemic when the global economy was completely shut down in March 2020. The global economy moved towards recovery when the availability of vaccines increased and the pace of vaccination also increased exponentially. This recovery of the global economy is increasing the demand for goods and services which were otherwise not available for the complete year. The increased demand of such products like food, household items and fuel lead to an increase in the prices of the product. The rise in the rate of employment post COVID has also led to rise in the prices of fuel, air tickets and hotel rooms. The low interest rate on properties have also made people buy new houses which has led to an increased demand for copper. Thus, as the global economy has opened up, customers are in favour of spending money but the factories don't have enough raw material to supply the products at a rate at which the demand of the product is increasing.
Effects of Inflation:
A Decrease in Purchasing Power: The first effect of inflation is just another way of stating what it is. Inflation is a decrease in the currency's purchasing power due to an economy-wide increase in prices. The average price of a cup of coffee in living memory was one dime.
Encouraging Spending, Investing: Buying now rather than later, is a predictable response to declining purchasing power. Cash will only lose value, so it is better to get your shopping out of the way and stock up on things that are not likely to lose value.
Raises the Cost of Borrowing: Companies and individuals can borrow cheaply to start a business, earn a degree, hire new workers, or buy a shiny new boat if interest rates are low. In other words, spending and investment are encouraged by low rates, which in turn generally stoke inflation.
Reduces Unemployment: There is some evidence that unemployment can be driven down by inflation. Wages tend to be sticky, which means that in reaction to economic changes, they adjust slowly.
Increases Growth: Inflation discourages saving unless there is an attentive central bank on hand to drive up interest rates because the buying power of deposits erodes over time. The prospect provides an opportunity for customers and companies to spend or invest.
Weakens of Strengthen Currency: A slumping exchange rate is generally associated with high inflation, but this is usually a case of the weakened currency contributing to inflation, not the other way around.
Remedies of Inflation:
There are three ways by which Inflation can be controlled:
Monetary Policy: which is controlled by the Central Bank Of the country
Operation of Open Market: Inflation requires the Central Bank to reduce the cash.
Interest Rate: During the time of Inflation, the interest rate should be increased. An increase in Interest Rate will result in discouragement of consumption and investment.
Fiscal Policy: Which is controlled by the government via instruments, taxes and expenditure of the government.
Direct/Physical Control:
Price Pegging: The government will decide the floor and ceiling price so that values will not increase rapidly.
Encourage Saving: The government raises the contribution to the employee’s Provident Funds.
Price Tagging: Every product needs to be labelled to prevent producers from charging to consumers.
FAQs on Inflation: Meaning and Causes
1. What is inflation in economics, and what are its two primary causes?
In economics, inflation refers to the sustained increase in the general price level of goods and services in an economy over a period of time. As prices rise, the purchasing power of currency falls. The two primary causes of inflation are:
- Demand-Pull Inflation: This occurs when the total demand for goods and services in an economy exceeds the total supply. It's often described as "too much money chasing too few goods."
- Cost-Push Inflation: This is caused by an increase in the costs of production, such as raw materials or wages. Producers pass these higher costs onto consumers in the form of higher prices.
2. What is demand-pull inflation and what are its main drivers?
Demand-pull inflation arises when aggregate demand in an economy outpaces aggregate supply. This increase in demand pulls prices up. Key drivers for demand-pull inflation as per the CBSE syllabus for 2025-26 include:
- Increased Money Supply: When the central bank injects more money into the economy, consumers and businesses have more to spend, increasing demand.
- Rising Government Expenditure: Increased government spending on infrastructure or social programs boosts overall demand.
- Growth in Population: A rapidly growing population increases the demand for essential goods and services.
- Expansion of Credit: Easier access to loans and credit encourages more spending by consumers and more investment by firms.
3. What is cost-push inflation and what factors typically trigger it?
Cost-push inflation is triggered by a decrease in the aggregate supply of goods and services, which stems from an increase in the cost of production. This forces producers to raise prices to maintain their profit margins. Common factors include:
- Increase in Wages: Higher wages for labour, not matched by productivity gains, increase production costs.
- Rise in Raw Material Prices: An increase in the price of essential inputs, like crude oil or steel, makes manufacturing more expensive.
- Natural Disasters or Production Disruptions: Events like floods or strikes can reduce supply and push prices higher.
- Higher Taxes: An increase in indirect taxes, such as GST, can lead to higher final prices for consumers.
4. What are the different types of inflation based on the rate of price increase?
Inflation can be classified into different types based on its severity or rate. The main types are:
- Creeping Inflation: A slow and mild rate of inflation, typically in the low single digits (e.g., 2-3% per year). It is often considered healthy for economic growth.
- Walking or Trotting Inflation: A moderate rate of inflation, usually between 3-10% annually. It serves as a warning sign for the economy to take control measures.
- Galloping Inflation: A very high rate of inflation, running into double or triple digits (e.g., 20%, 100% per year). It can destabilise an economy quickly.
- Hyperinflation: An extreme and out-of-control rate of inflation, where prices increase at an astronomical pace (e.g., over 50% per month). It can lead to a complete collapse of the monetary system.
5. How does a high rate of inflation impact different groups in society, like borrowers and lenders?
A high rate of inflation has different effects on various groups. For instance, borrowers generally benefit from unanticipated inflation because they repay their loans with money that is worth less than the money they originally borrowed. Conversely, lenders (or creditors) are negatively impacted because the real value of the money they receive back is lower than what they lent. Similarly, individuals on fixed incomes, like pensioners, suffer as their purchasing power erodes, while those with variable incomes or assets like real estate may be better protected.
6. What is the fundamental difference between inflation and deflation?
The fundamental difference lies in the direction of price movements. Inflation is a sustained increase in the general price level, leading to a decrease in the purchasing power of money. In contrast, deflation is a sustained decrease in the general price level, which increases the purchasing power of money. While moderate inflation can be a sign of a growing economy, deflation is often associated with economic stagnation, as falling prices can lead to reduced consumer spending and business investment.
7. Why might a government or central bank aim for a small, positive rate of inflation rather than zero inflation?
Most central banks, including the Reserve Bank of India, aim for a small, positive rate of inflation (e.g., 2-4%) instead of zero for several strategic reasons. A low level of inflation can encourage spending and investment, as consumers and businesses are motivated to buy now rather than later when prices might be higher. It also makes it easier for wages and prices to adjust and provides the central bank with a buffer against deflation, which is generally considered more harmful to an economy.
8. What are the main policy measures used to control inflation in an economy?
Governments and central banks use a combination of policies to control inflation. The primary measures include:
- Monetary Policy: Implemented by the central bank, this involves increasing interest rates to make borrowing more expensive, thus reducing spending and investment. The central bank can also sell government securities (Open Market Operations) to reduce the money supply.
- Fiscal Policy: Managed by the government, this involves reducing government spending or increasing taxes. Both actions help decrease aggregate demand in the economy.
- Supply-Side Policies: These are long-term measures aimed at increasing the economy's productive capacity, such as investing in infrastructure or promoting policies that enhance efficiency, which helps to combat cost-push inflation.
