Inflation

Inflation is a sustained (continuing) rise in the general price level of an economy over a period of time. The key words are "sustained" (a one-off rise is not inflation) and "general" (the average of all prices, not just one good). When prices rise, the purchasing power of money falls — the same money buys fewer goods than before. The rate of inflation is measured by a price index such as the CPI or the WPI.

Inflation is classified by its speed:

• Creeping inflation — a slow, mild rise (low single-digit). It is generally considered harmless or even mildly good for growth.
• Galloping (running) inflation — a rapid rise (high, often double or triple digit). It seriously harms the economy.
• Hyperinflation — an extremely rapid, out-of-control rise where money loses its value almost daily. It can destroy a currency.

The opposite situations are also named: deflation (a sustained fall in the general price level), disinflation (a slowing of the inflation rate, prices still rising but more slowly), and stagflation (the difficult case of high inflation together with stagnation/unemployment). So inflation is essentially about money losing value as prices rise, and its severity ranges from a gentle creep to a destructive hyperinflation.

Inflation has two broad causes, named after the side of the market that pushes prices up:

• Demand-pull inflation — caused by too much demand. When aggregate demand exceeds the economy's capacity to produce (an inflationary gap), buyers compete for limited goods and pull prices up. Causes include a rise in money supply, higher government spending, easy credit, or rising incomes — in short, "too much money chasing too few goods."
• Cost-push inflation — caused by rising costs of production. When the cost of inputs goes up — higher wages, dearer raw materials, higher oil prices, or new taxes — producers raise their prices to cover the cost, pushing the price level up even without extra demand.

The effects of inflation fall unevenly on different groups, so inflation redistributes income:

• Who loses: people on fixed incomes (pensioners, salaried workers), lenders/creditors (they are repaid in money worth less), and savers holding cash. Their real income and savings shrink.
• Who gains: borrowers/debtors (they repay in cheaper money), businessmen and traders (prices and profits rise), and those holding real assets (land, gold) whose value rises.

Mild inflation may even encourage production, but high inflation harms the economy: it discourages saving, creates uncertainty, hurts the poor most, and can make exports less competitive. This uneven impact is why governments work hard to keep inflation low and stable.

Because high inflation harms the economy, the government and the central bank use several measures to control it, grouped into three kinds.

• Monetary measures (by the RBI) — the central bank reduces the money supply and credit to curb demand. It raises the repo rate, the CRR and the SLR, and sells government securities (open market operations). Costlier and scarcer credit reduces spending, cooling demand-pull inflation. This is contractionary monetary policy.
• Fiscal measures (by the government) — the government reduces aggregate demand through its budget: it cuts public spending and/or raises taxes, and tries to reduce the budget deficit. Lower government spending and higher taxes leave less money to be spent, reducing demand.
• Supply-side / other measures — since inflation also comes from a shortage of goods, the government tries to increase supply: importing scarce goods, releasing buffer stocks of food, improving production and distribution, and controlling hoarding and black-marketing. Administrative measures like a public distribution system (ration shops) and price controls also help protect the poor.

The right cure depends on the cause: demand-pull inflation is best fought by reducing demand (tight monetary and fiscal policy), while cost-push inflation is best fought by easing costs and raising supply. In practice, governments use a combination. Keeping inflation low and stable — without choking growth — is one of the central goals of macroeconomic policy, completing our study of how the whole economy is managed.