Inflation: Meaning, Causes and Effects Effects of Inflation

Inflation is a highly controversial term which has undergone modification since it was first defined by the neo-classical economists. They meant by it a galloping rise in prices as a result of the excessive increase in the quantity of money. They regarded it “as a destroying disease born out of lack of mon­etary control whose results undermined the rules of business, creating havoc in markets and financial ruin of even the prudent.”

But Keynes in his General Theory’ allayed all such fears. He did not believe like the neo-classicists that there was always full employment in the economy which resulted in hyper-inflation with increases in the quantity of money. According to him, there being underemployment in the economy, an increase in the money supply leads to increase in aggregate demand, output and employment.

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Starting from a depression, as the money supply increases, output at first rises proportionately. But as aggregate de­mand, output and employment rise further, diminishing returns start and certain bottlenecks appear and prices start rising. This process continues till the full employment level is reached. The rise in the price level during this period is known as bottleneck inflation or “semi-inflation”. If the money supply in­creases beyond the full employment level, output ceases to rise and the prices rise in proportion with the money supply. This is true inflation, according to Keynes.

Keynes’s analysis is subjected to two main drawbacks. First, it lays emphasis on demand as the cause of inflation, and neglects the cost side of inflation. Second, it ignores the possibility that a price rise may lead to further increase in aggregate demand which may, in turn, lead to further rise in prices.

However, the types of inflation during the Second World War, in the immediate post-war period, till the middle of the 1950s were on the Keynesian model based on his theory of excess demand. “In the latter 1950s, in the United States, unemployment was higher than it had been in the immediate post-war period, and yet prices still seemed to be rising, at the same time, the war time fears of postwar recession had belatedly been replaced by serious concern about the problem of inflation.

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The result was a prolonged debate…On the one side of the debate was the ‘cost-push’ school of thought, which maintained that there was no excess demand…On the other side was the “demand-pull” school…Later, in the United States, there developed a third school of thought, associated with the name of Charles Schultz, which advanced the sectoral ‘demand-shift theory’ of inflation… While the debate over cost-push versus demand- pull was raging in the United States, a new and very interesting approach to the problem of inflation and anti-inflationary policy was developed by A. W. Phillips.”

We shall study all theories mentioned here, besides Keynes’s theory of the inflationary gap. But before we analyse them, it is instructive to know about the meaning of inflation.

Contents

1. Meaning of Inflation

2. Demand-Pull Inflation

3. Cost-Push Inflation

4. The Inflationary Gap

5. Phillip Curve in Economics: The Relation between Unemployment and Inflation

6. Causes of Inflation

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7. Measures to Control Inflation

1. Monetary Measures
2. Fiscal Measures
3. Other Measures

8. Effects of Inflation

1. Effects on Redistribution of Income and Wealth
2. Effects on Production
3. Other Effects

1. Meaning of Inflation

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To the neo-classical and their followers at the University of Chicago, inflation is fundamentally a monetary phenomenon. In the words of Friedman, “Inflation is always and everywhere a monetary phenomenon…and can be produced only by a more rapid increase in the quantity of money than out­put.’” But economists do not agree that money supply alone is the cause of inflation.

As pointed out by Hicks, “Our present troubles are not of a monetary character.” Economists, therefore, define inflation in terms of a continuous rise in prices. Johnson defines “inflation as a sustained rise”4 in prices. Brooman defines it as “a continuing increase in the general price level.”5Shapiro also defines inflation in a similar vein “as a persistent and appreciable rise in the general level of prices.” Demberg and McDougall are more explicit when they write that “the term usually refers to a continuing rise in prices as measured by an index such as the consumer price index (CPI) or by the implicit price deflator for gross national product.”

However, it is essential to understand that a sustained rise in prices may be of various magni­tudes. Accordingly, different names have been given to inflation depending upon the rate of rise in prices.

1. Creeping Inflation:

When the rise in prices is very slow like that of a snail or creeper, it is called creeping inflation. In terms of speed, a sustained rise in prices of annual increase of less than 3 per cent per annum is characterised as creeping inflation. Such an increase in prices is regarded safe and essential for economic growth.

2. Walking or Trotting Inflation:

When prices rise moderately and the annual inflation rate is a single digit. In other words, the rate of rise in prices is in the intermediate range of 3 to 6 per cent per annum or less than 10 per cent. Inflation at this rate is a warning signal for the government to control it before it turns into running inflation.

3. Running Inflation:

When prices rise rapidly like the running of a horse at a rate or speed of 10 to 20 per cent per annum, it is called running inflation. Such an inflation affects the poor and middle classes adversely. Its control requires strong monetary and fiscal measures, otherwise it leads to hyperinflation.

4. Hyperinflation:

When prices rise very fast at double or triple digit rates from more than 20 to 100 per cent per annum or more, it is usually called runaway ox galloping inflation. It is also characterised as hyperinflation by certain economists. In reality, hyperinflation is a situation when the rate of inflation be­comes immeasurable and absolutely uncon­trollable. Prices rise many times every day. Such a situation brings a total collapse of mon­etary system because of the continuous fall in the purchasing power of money.

The speed with which prices tend to rise is illustrated in Figure 1. The curve С shows creeping inflation when within a period of ten years the price level has been shown to have risen by about 30 per cent. The curve W depicts walking inflation when the price level rises by more than 50 per cent during ten years. The curve R illustrates running inflation showing a rise of about 100 per cent in ten years. The steep curve H shows the path of hyperinflation when prices rise by more than 120 per cent in less than one year.

5. Semi-Inflation:

According to Keynes, so long as there are unemployed resources, the general price level will not rise as output increases. But a large increase in aggregate expenditure will face shortages of supplies of some factors which may not be substitutable. This may lead to increase in costs, and prices start rising. This is known as semi-inflation or bottleneck inflation because of the bottlenecks in supplies of some factors.

6. True Inflation:

According to Keynes, when the economy reaches the level of full employment, any increase in aggregate expenditure will raise the price level in the same proportion. This is because it is not possible to increase the supply of factors of production and hence of output after the level of full employment. This is called true inflation.

The Keynesian semi-inflation and true inflation situ­ations are illustrated in Figure.2.

Employment and price level are taken on vertical axis and aggregate expenditure on horizontal axis. FE is the full employment curve. When with the increase in aggregate expenditure, the price level rises slowly from A to the full employment level B, this is semi-inflation. But when the aggregate expenditure increases beyond point В the price level rises from В to T in proportion to the increase in aggregate expenditure. This is true inflation.

7. Open Inflation:

Inflation is open when “markets for goods or factors of production are al­lowed to function freely, setting prices of goods and factors without normal interference by the authori­ties. Thus open inflation is the result of the uninterrupted operation of the market mechanism. There are no checks or controls on the distribution of commodities by the government. Increase in demand and shortage of supplies persist which tend to lead to open inflation. Unchecked open inflation ultimately leads to hyperinflation.

8. Suppressed Inflation:

Men the government imposes physical and monetary controls to check open inflation, it is known as repressed or suppressed inflation. The market mechanism is not allowed to function normally by the use of licensing, price controls and rationing in order to suppress extensive rise in prices.

So long as such controls exist, the present demand is postponed and there is diversion of demand from controlled to uncontrolled commodities. But as soon as these controls are removed, there is open inflation. Moreover, suppressed inflation adversely affects the economy.

When the distribution of commodities is controlled, the prices of uncontrolled commodities rise very high. Suppressed infla­tion reduces the incentive to work because people do not get the commodities which they want to have. Controlled distribution of goods also leads to mal-allocation of resources. This results in the diversion of productive resources from essential to non-essential industries. Lastly, suppressed inflation leads to black marketing, corruption, hoarding and profiteering.

9. Stagflation:

Stagflation is a new term which has been added to economic literature in the 1970s. It is a paradoxical phenomenon where the economy expedience’s stagnation as well as inflation. The word stagflation is the combination of‘ stag’ plus ‘flation’ taking ‘stag’ from stagnation and ‘flation’ from inflation.

Stagflation is a situation when recession is accompanied by a high rate of inflation. It is, therefore, also called inflationary recession. The principal cause of this phenomenon has been excessive demand in commodity markets, thereby causing prices to rise, and at the same time the demand for labour is deficient, thereby creating unemployment in the economy.

Three factors have been responsible for the existence of stagflation in the advanced countries since 1972. First, rise in oil prices and other commodity prices along with adverse changes in the terms of trade, second, the steady and substantial growth of the labour force; and third, rigidities in the wage structure due to strong trade unions.

10. Mark-up Inflation:

The concept of mark-up inflation is closely related to the price-push problem. Modem labour organisations possess substantial monopoly power. They, therefore, set prices and wages on the basis of mark-up over costs and relative incomes. Firms possessing monopoly power have control over the prices charged by them. So they have administered prices which increase their profit margin. This sets off an inflationary rise in prices. Similarly, when strong trade unions are suc­cessful in raising the wages of workers, this contributes to inflation.

11. Ratchet Inflation:

A ratchet is a toothed wheel provided with a catch that prevents the ratchet wheel from moving backward. The same is the case under ratchet inflation when despite downward pressures in the economy, prices do not fall. In an economy having price, wage and cost inflations, aggregate demand falls below full employment level due to the deficiency of demand in some sectors of the economy.

But wage, cost and price structures are inflexible downward because large business firms and labour organisations possess monopoly power. Consequently, the fall in demand may not lower prices significantly. In such a situation, prices will have an upward ratchet effect, and this is known as “ratchet inflation.”

12. Sectoral Inflation:

Sectoral inflation arises initially out of excess demand in particular indus­tries. But it leads to a general price rise because prices do not fall in the deficient demand sectors.

13. Reflation:

Is a situation when prices are raised deliberately in order to encourage economic activity. When there is depression and prices fall abnormally low, the monetary authority adopts meas­ures to put more money in circulation so that prices rise. This is called reflation.

2. Demand-Pull Inflation

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Demand-Pull or excess demand inflation is a situation often described as “too much money chas­ing too few goods.” According to this theory, an excess of aggregate demand over aggregate supply will generate inflationary rise in prices. Its earliest explanation is to be found in the simple quantity theory of money.

The theory states that prices rise in proportion to the increase in the money supply. Given the full employment level of output, doubling the money supply will double the price level. So inflation proceeds at the same rate at which the money supply expands.

In this analysis, the aggregate supply is assumed to be fixed and there is always full employment in the economy. Naturally, when the money supply increases it creates more demand for goods but the supply of goods cannot be increased due to the full employment of resources. This leads to rise in prices.

Modem quantity theorists led by Friedman hold that “inflation is always and everywhere a mon­etary phenomenon. The higher the growth rate of the nominal money supply, the higher the rate of inflation. When the money supply increases, people spend more in relation to the available supply of goods and services. This bids prices up. Modem quantity theorists neither assume full employment as a normal situation nor a stable velocity of money. Still they regard inflation as the result of excessive increase in the money supply.

The quantity theory version of the demand-pull in­flation is illustrated in Figure 3. Suppose the money sup­ply is increased at a given price level OP as determined by the demand and supply curves D and S1 respec­tively. The initial full employment situation OYF at this price level is shown by the interaction of these curves at point E. Now with the increase in the quantity of money, the aggregate demand increase which shifts the demand curve D to D1 to the right. The aggregate supply being fixed, as shown by the vertical portion of the supply curve SS1 the D1 curve intersects it at point E1. This raises the price level to OP1.

The Keynesian theory on demand-pull inflation is based on the argument that so long as there are unem­ployed resources in the economy; an increase in invest­ment expenditure will lead to increase in employment, income and output. Once full employment is reached and bottlenecks appear, further increase in ex­penditure will lead to excess demand because output ceases to rise, thereby leading to inflation.

The Keynesian theory of demand -pull inflation is explained diagrammatically in Figure 3. Suppose the economy is in equilibrium at E where the SS1and D curves intersect with full employment income level OYF.The price level is OP. Now the government increases its expenditure. The increase in govern­ment expenditure implies an increase in aggregate demand which is shown by the upward shift of the D curve to D1 in the figure. This tends to raise the price level to OP1, as aggregate supply of output cannot be increased after the full employment level.

3. Cost-Push Inflation

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Cost-push inflation is caused by wage increases enforced by unions and profit increases by em­ployers. This type of inflation has not been a new phenomenon and was found even during the medieval period. But it was revived in the 1950s and again in the 1970s as the principal cause of inflation. It also came to be known as the “New Inflation.”

Cost-push inflation is caused by wage-push and profit-push to prices for the following reasons:

1. Rise in Wages:

The basis cause of cost-push inflation is the rise in money wages more rapidly than the productivity of labour. In advanced countries, trade unions are very powerful. They press employers to grant wage increases considerably in excess of increases in the productivity of labour, thereby raising the cost of production of commodities. Employers, in turn, raise prices of their prod­ucts.

Higher wages enable workers to buy as much as before, in spite of higher prices. On the other hand, the increase in prices induces unions to demand still higher wages. In this way, the wage-cost spiral continues, thereby leading to cost-push or wage-push inflation. Cost-push inflation may be fur­ther aggravated by upward adjustment of wages to compensate for rise in the cost of living index.

2. Sectoral Rise in Prices:

Again, a few sectors of the economy may be affected by money wage increases and prices of their products may be rising. In many cases, their production such as steel, raw materials, etc. are used as inputs for the production of commodities in other sectors. As a result, the production cost of other sectors will rise and thereby push up the prices of their products. Thus wage- push inflation in a few sectors of the economy may soon lead to inflationary rise in prices in the entire economy.

3. Rise in Prices of Imported Raw Materials:

An increase in the prices of imported raw materials may lead to cost-push inflation. Since raw materials are used as inputs by the manufacturers of the finished goods, they enter into the cost of production of the latter. Thus a continuous rise in the prices of raw materials tends to sets off a cost-price-wage spiral.

4. Profit-Push Inflation:

Oligopolist and monopolist firms raise the prices of their products to offset the rise in labour and production costs so as to earn higher profits. There being imperfect competition in the case of such firms, they are able to “administer prices” of their products. “In an economy in which so called administered prices abound there is at least the possi­bility that these prices may be administered upward faster than cost in an attempt to earn greater profits.

To the extent such a process is wide-spread profit-push inflation will result.” Profit-push inflation is, therefore, also called administered-price theory of inflation or price-push inflation or sellers’ inflation or market-power inflation. Cost-push inflation is illustrated in Figure 4. Where S1 S is the supply curve and D is the demand curve. Both intersect at E which is the full employment level OYF, and the price level OP is determined. Given the demand, as shown by the D curve, the supply curve S1 is shown to shift to S2as a result of cost-push factors. Consequently, it intersects the D curve at E1showing rise in the price level from OP to OP1 and fall in aggregate output from OYF to OY1level. Any further shift in the supply curve will shift and tend to raise the price level and decrease aggregate output further.

4. The Inflationary Gap

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In his pamphlet How to pay for the War published in 1940, Keynes explained the concept of the inflationary gap. It differs from his views on inflation given in his General Theory. In the General Theory, he started with underemployment equilibrium. But in How to Pay for the War, he began with a situation of full employment in the economy.

He defined an inflationary gap as an excess of planned expenditure over the available output at pre-inflation or base prices. According to Lipsey, “The inflation­ary gap is the amount by which aggregate expenditure would exceed aggregate output at the full em­ployment level of income.” The classical economists explained inflation as mainly due to increase in the quantity of money, given the level of full employment.

Keynes, on the other hand, ascribed it to the excess of expenditure over income at the full employment level. The larger the aggregate expenditure, the larger the gap and the more rapid the inflation. Given a constant average propensity to save, rising money incomes at full employment level would lead to an excess of demand over supply and to a consequent inflationary gap. Thus Keynes used the concept of the inflationary gap to show the main determinants that cause an inflationary rise of prices.

The inflationary gap is explained with the help of the following example:

Suppose the gross national product at pre-inflation prices is Rs. 200 crores. Of this Rs. 80 crores is spent by the government. Thus Rs. 120 (Rs. 200-80) crores worth of output is available to the public for consumption at pre-inflation prices. But the gross national income at current prices at full employ­ment level is Rs. 250 crores. Suppose the government taxes away Rs. 60 crores, leaving Rs. 190 crores as disposable income. Thus Rs. 190 crores is the amount to be spent on the available output worth Rs. 120 crores, thereby creating an inflationary gap of Rs. 70 crores.

This inflationary gap model is illustrated as under:

1. Gross national income at current prices	=	Rs. 250 Cr.
2. Taxes	=	Rs. 60 Cr.
3. Disposable income	=	Rs. 190 Cr.
4. GNP at pre-inflation prices	=	Rs. 200 Cr.
5. Government expenditure	=	Rs. 80 Cr.
6. Output available for consumption at pre-inflation prices	=	Rs. 120 Cr.
Inflationary gap (Item 3-6)	=	Rs. 70 Cr.

In reality, the entire disposable income of Rs. 190 crores is not spent and a part of it is saved. If, say 20 per cent (Rs, 38 crocs) of it is saved, then Rs. 152 crores (Rs. 190-Rs. 38 crores) would be left to create demand for goods worth Rs. 120 crores. Thus the actual inflationary gap would be Rs. 32 (Rs. 152— 120) crores instead of Rs. 70 crores.

The inflationary gap is shown diagrammatically in Figure 5 where OYF is the full employment level of income, 45° line represents aggregate supply AS and С + 1 + G line the desired level of consumption, invest­ment and government expenditure (or aggregate demand curve).

The economy’s aggregate demand curve (C + l +G) = AD intersects the 45° line (AS ) at point E at the income level OY1which is greater than the full employment income level OYF The amount by which aggregate demand (YFA) exceeds the aggregate supply (YFВ) at the full employment income level is the inflationary gap.

This is AB in the figure. The excess volume of total spending when resources are fully employed creates inflationary pressures. Thus the inflationary gap leads to inflationary pressures in the economy which are the result of excess aggre­gate demand.

How can the inflationary gap be wiped out?

The inflationary gap can be wiped out by increase in savings so that the aggregate demand is reduced. But this may lead to deflationary tendencies.

Another solution is to raise the value of available output to match the disposable income. As aggregate demand increases, businessmen hire more labour to expand output. But there being full employment at the current money age, they offer higher money wages to induce more workers to work for them.

As there is already full employment, the increase in money wages leads to proportionate rise in prices. Moreover, output cannot be increased during the short run because factors are already fully employed. So the inflationary gap can be closed by increasing taxes and reducing expenditure. Monetary policy can also be used to decrease the money stock. But Keynes was not in favour of monetary measures to control inflationary pressures within the economy.

It’s Importance:

Despite these criticisms the concept of inflationary gap has proved to be of much importance in explaining rising prices at full employment level and policy measures in controlling inflation. It tells that the rise in prices, once the level of full employment is attained, is due to excess demand generated by increased expenditures. But the output cannot be increased because all resources are fully employed in the economy. This leads to inflation. The larger the expenditure, the larger the gap and more rapid the inflation.

As a policy measure, it suggests reduction in aggregate demand to control inflation. For this, the best course is to have a surplus budget by raising taxes. It also favours saving incentives to reduce consumption expenditure.

“The analysis of the inflationary gap in terms of such aggregates as national income, investment outlays and consumption expenditures clearly reveals what determines public policy with respect to taxes, public expenditures, savings campaigns, credit control, wage adjustment—in short, all the conceivable anti-inflationary measures affecting the propensities to consume, to save’ and to invest which together determine the general price level.”

5. Phillip Curve in Economics: The Relation between Unemployment and Inflation

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The Phillips curve examines the relationship between the rate of unemployment and the rate of money wage changes. Known after the British economist A. W. Phillips who first identified it, it expresses an inverse relationship between the rate of unemployment and the rate of increase in money wages. Basing his analysis on data for the United Kingdom, Phillips derived the empirical relationship that when unemployment is high, the rate of increase in money wage rates is low.

This is because “workers are reluctant to offer their services at less than the prevailing rates when the demand for labour is low and unemployment is high so that wage rates fall very slowly.” On the other hand, when unemployment is low, the rate of increase in money wage rates is high. This is because, “when the demand for labour is high and there are very few unemployed we should expect employer to bid wage rates up quite rapidly.”

The second factor which influences this inverse relationship between money wage rate and unemployment is the nature of business activity. In a period of rising business activity when unemploy­ment falls with increasing demand for labour, the employers will bid up wages. Conversely, in a period of falling business activity when demand for labour is decreasing and unemployment is rising, employers will be reluctant to grant wage increases.

Rather, they will reduce wages. But workers and unions will be reluctant to accept wage cuts during such periods. Consequently, employers are forced to dismiss workers, thereby leading to high rates of unemployment. Thus when the labour market is depressed, a small reduction in wages would lead to large increase in unemployment. Phillips concluded on the basis of the above arguments that the relation between rates of unemployment and a change of money wages would be highly non-linear when shown on a diagram. Such a curve is called the Phillips curve.

The PC curve in Figure 6 is the Phillips curve which relates percentage change in money wage rate (W) on the vertical axis with the rate of unemployment (U).on the horizontal axis. The curve is convex to the origin which shows that the percentage change in money wages rises with decrease in the employment rate.

In the figure, when the money wage rate is 2 per cent, the un­employment rate is 3 per cent. But when the wage rate is high at 4 per cent, the unemployment rate is low at 2 per cent. Thus there is a trade-off be­tween the rate of change in money wage and the rate of unemployment. This means that when the wage rate is high the unemployment rate is low and vice versa.

The original Phillips curve was an observed statistical relation which was explained theoretically by Lipsey as resulting from the behaviour of labour market in disequilibrium through excess demand. Several economists have extended the Phillips analysis to the trade-off between the rate of unem­ployment and the rate of change in the level of prices or inflation rate by assuming that prices would change whenever wages rose more rapidly than labour productivity.

If the rate of increase in money wage rates is higher than the growth rate of labour productivity, prices will rise and vice versa. But prices do not rise if labour productivity increases at the same rate as money wage rates rise.

This trade-off between the inflation rate and unemployment rate is explained in Figure 6 where the inflation rate (p) is taken along with the rate of change in money wages (W). Suppose labour productivity rises by 2 per cent per year and if money wages also increase by 2 per cent, the price level would remain constant.

Thus point В on the PC curve corresponding to percentage change in money wages (M) and unemployment rate of 3 per cent (N) equals zero (O) per cent inflation rate (p) on the vertical axis. Now assume that the economy is operating at point B. If now, aggregate demand is increased, this lowers the unemployment rate to OT (2%) and raises the wage rate to OS (4%) per year.

If labour productivity continues to grow at 2 per cent per annum, the price level will also rise at the rate of 2 per cent per annum at OS in the figure. The economy operates at point C. With the movement of the economy from В to C, unemployment falls to T (2%). If points В and С are connected, they trace out a Phillips curve PC.

Thus money wages rate increase which is in excess of labour productivity leads to inflation. To keep wage increase to the level of labour productivity (OM) in order to avoid inflation, ON rate of unemployment will have to be tolerated.

The shape of the PC curve further suggests that when the unemployment rate is less than 5 ½ per cent (that is, to the left of point A), the demand for labour is more than the supply and this tends to increase money wage rates. On the other hand, when the unemployment rate is more than 5 ½ per cent (to the right of point A), the supply of labour is more than the demand which tends to lower wage rates. The implication is that the wage rates will be stable at the unemployment rate ОA which is equal to 5 ½ per cent per annum.

It is to be noted that PC is the “conventional” or original downward sloping Phillips curve which shows a stable and inverse relation between the rate of unemployment and the rate of change in wages.

Friedman’s View: The Long-Run Phillips Curve:

Economists have criticised and in certain cases modified the Phillips curve. They argue that the Phillips curve relates to the short run and it does not remain stable. It shifts with changes in expectations of inflation. In the long run, there is no trade-off between inflation and employment. These views have been expounded by Friedman and Phelps’ in what has come to be known as the “accelerationist” or the “adaptive expectations” hypothesis.

According to Friedman, there is no need to assume a stable downward sloping Phillips curve to explain the trade-off between inflation and unemployment. In fact, this relation is a short-run phenom­enon. But there are certain variables which cause the Phillips curve to shift over time and the most important of them is the expected rate of inflation. So long as there is discrepancy between the expected rate and the actual rate of inflation, the downward sloping Phillips curve will be found. But when this discrepancy is removed over the long run, the Phillips curve becomes vertical.

In order to explain this, Friedman introduces the concept of the natural rate of unemployment. In represents the rate of unemployment at which the economy normally settles because of its structural imperfections. It is the unemployment rate below which the inflation rate increases, and above which the inflation rate decreases. At this rate, there is neither a tendency for the inflation rate to increase or decrease.

Thus the natural rate of unemployment is defined as the rate of unemployment at which the actual rate of inflation equals the expected rate of inflation. It is thus an equilibrium rate of unemploy­ment towards which the economy moves in the long run. In the long run, the Phillips curve is a vertical line at the natural rate of unemployment.

This natural or equilibrium unemployment rate is not fixed for all times. Rather, it is determined by a number of structural characteristics of the labour and commodity markets within the economy. These may be minimum wage laws, inadequate employment information, deficiencies in manpower training, costs of labour mobility, and other market imperfections.

But what causes the Phillips curve to shift over time is the expected rate of inflation. This refers to the extent the labour correctly forecasts inflation and can adjust wages to the forecast. Suppose the economy is experiencing a mild rate of inflation of 2 per cent and a natural rate of unemployment (N) of 2 per cent. At point A on the short-run Phillips curve SPC1 in Figure 7, people expect this rate of inflation to continue in the future.

Now assume that the government adopts a monetary-fiscal programme to raise aggregate demand in order to lower unemployment from 3 to 2 per cent. The increase in aggregate demand will raise the rate of inflation to 4 per cent consistent with the unemployment rate of 2 per cent. When the actual inflation rate (4 per cent) is greater than the expected inflation rate (2 per cent), the economy moves from point A to В along the SPC1curve, and the unemployment rate temporarily falls to 2 per cent.

This is achieved because the labour has been deceived. It expected the inflation rate of 2 per cent and based their wage demands on this rate. But the workers eventually begin to realise that the actual rate of inflation is 4 per cent which now becomes their expected rate of inflation. Once this happens the short-run Phillips curve SPC1 shifts to the right to SPC2Now workers demand increase in money wages to meet the higher expected rate of inflation of 4 per cent.

They demand higher wages because they consider the present money wages to be inadequate in real terms. In other words, they want to keep up with higher prices and to eliminate fall in real wages. As a result, real labour costs will rise, firms will discharge workers and unemployment will rise from В (2%) to С (3%) with the shifting of the SPC1 curve to SPC2 At point C, the natural rate of unemployment is re-established at a higher rate of both the actual and expected inflation (4%).

If the government is determined to maintain the level of unemployment at 2 per cent, it can do so only at the cost of higher rates of inflation. From point C, unemployment once again can be reduced to 2 per cent via increase in aggregate demand along the SCP2 curve until we arrive at point D. With 2 per cent unemployment and 6 per cent inflation at point D, the expected rate of inflation for workers is 4 per cent.

As soon as they adjust their expectations to the new situation of 6 per cent inflation, the short-run Phillips curve shifts up again to SPC’3 and the unemployment will rise back to its natural level of 3 percent at point E. If points A, С and E are connected, they trace out a vertical long-run Phillips curve LPC at the natural rate of unemployment.

On this curve, there is no trade-off be­tween unemployment and inflation. Rather, any one of sev­eral rates of inflation at points A, С and E is compatible with the natural unemployment rate of 3 per cent. Any reduction in unemployment rate below its natural rate will be associated with an accelerating and ultimately explosive inflation. But this is only possible temporarily so long as workers overesti­mate or underestimate the inflation rate. In the long-run, the economy is bound to establish at the natural unemployment rate.

There is, therefore, no trade-off between unemploy­ment and inflation except in the short run. This is because inflationary expectations are revised according to what has happened to inflation in the past. So when the actual rate of inflation, say, rises to 4 per cent in Figure 7, workers continue to expect 2 per cent inflation for a while and only in the long run they revise their expectations upwards towards 4 per cent.

Since they adapt themselves to the expectations, it is called the adaptive expectations hypothesis. According to this hypothesis, the expected rate of inflation always lags behind the actual rate. But if the actual rate remains constant the expected rate would ultimately become equal to it. This leads to the conclusion that a short run trade-off exists between unemployment and inflation, but there is no long run trade-off between the two unless a continuously rising inflation rate is tolerated.

It’s Criticisms:

The accelerationist hypothesis of Friedman has been criticised on the following grounds:

1. The vertical long-run Phillips curve relates to the steady rate of inflation. But this is not a correct view because the economy is always passing through a series of disequilibrium positions with little tendency to approach a steady state. In such a situation, expectations may be disappointed year after year.

2. Friedman does not give a new theory of how expectations are formed that would be free from theoretical and statistical bias. This makes his position unclear.

3. The vertical long-run Phillips curve implies that all expectations are satisfied and that people correctly anticipate the future inflation rates. Critics point out that people do not anticipate inflation rates correctly, particularly when some prices are almost certain to rise faster than others. There are bound to be disequilibria between supply and demand caused by uncertainty about the future and that is bound to increase the rate of unemployment. Far from curing unemployment, a dose of inflation is likely to make it worse.

4. In one of his writings Friedman himself accepts the possibility that the long-run Phillips curve might not just be vertical, but could be positively sloped with increasing doses of inflation leading to increasing unemployment.

5. Some economists have argued that wage rates have not increased at a high rate of unemploy­ment.

6. It is believed that workers have a money illusion. They are more concerned with the increase in their money wage rates than real wage rates.

7. Some economists regard the natural rate of unemployment as a mere abstraction because Friedman has not tried to define it in concrete terms.

8. Saul Hyman has estimated that the long-run Phillips curve is not vertical but is negatively sloped. According to Hyman, the unemployment rate can be permanently reduced if we are prepared to accept an increase in inflation rate.

Tobin’s View:

James Tobin in his presidential address before the American Economic Association in 1971 proposed a compromise between the negatively sloping and the vertical Phillips curve. Tobin believes that there is a Phillips curve within limits. But as the economy expands and employment grows, the curve becomes even more fragile and vanishes until it becomes vertical at some critically low rate of unemployment.

Thus Tobin s Phillips curve is kinked-shaped, a part like a normal Phillips curve and the rest vertical, as shown in Figure 8. In the figure, Uc is the critical rate of unemployment at which the Phillips curve becomes vertical where there is no trade-off between un­employment and inflation. According to Tobin, the vertical portion of the curve is not due to increase in the demand for more wages but emerges from imperfections of the labour market.

At the Uc level, it is not possible to provide more employment because the job seekers have wrong skills or wrong age or sex or are in the wrong place. Regarding the normal portion of the Phillips curve which is negatively sloping, wages are sticky downward because labourers resist a decline in their relative wages.

For Tobin, there is a wage-change floor in excess supply situations. In the range of relatively high unemployment to the right of Uc in the figure, as aggregate demand and inflation increase and in­voluntary unemployment is reduced, wage-floor markets gradually diminish. When all sectors of the labour market are above the wage floor, the level of critically low rate of unemployment Uc is reached.

Solow’s View:

Like Tobin, Robert Solow does not believe that the Phillips curve is vertical at all rates of inflation. According to him, the curve is vertical at positive rates of inflation and is horizontal at negative rates of inflation, as shown in Figure 9. The basis of the Phillips curve LPC of the figure is that wages are sticky downward even in the face of heavy unemployment or deflation. But at a particular level of unemployment when the demand for labour increases, wages rise in the face of expected inflation. But since the Phillips curve LPC becomes vertical at that mini­mum level of unemployment, there is no trade-off between unemployment and inflation.

Conclusion:

The vertical Phillips curve has been accepted by the majority of economists. They agree that at unemployment rate of about 4 per cent, the Phillips curve becomes vertical and the trade-off between unemployment and inflation disappears. It is impossible to reduce unemploy­ment below this level because of market imperfections.

Policy Implications of the Phillips Curve:

The Phillips curve has important policy implications. It suggests the extent to which monetary and fiscal policies can be used to control inflation without high levels of unemployment. In other words, it provides a guideline to the authorities about the rate of inflation which can be tolerated with a given level of unemployment. For this purpose, it is important to know the exact position of the Phillips curve.

While explaining the natural rate of unemployment, Friedman pointed out that the only scope of public policy in influencing the level of unemployment lies in the short run in keeping with the position of the Phillips curve. He ruled out the possibility of influencing the long-run rate of unemployment because of the vertical Phillips curve.

According to him, the trade-off between unemployment and inflation does not exist and has never existed. However rapid the inflation might be, unemployment always tends to fall back to its natural rate which is not some irreducible minimum of unemployment. It can be lowered by removing obstacles in the labour market by reducing frictions.

Therefore, public policy should improve the institutional structure to make the labour market responsive to changing patterns of demand. Moreover, some level of unemployment must be accepted as natural because of the existence of large number of part-time workers, unemployment compensation and other institutional factors.

Another implication is that unemployment is not a fitting aim for monetary expansion, according to Friedman. Therefore, employment above the natural rate can be reached at the cost of accelerating inflation, if monetary policy is adopted.

In his words, “A little inflation will provide a boost at first—like a small dose of a drug for a new addict—but then it takes more and more inflation to provide the boost, just it takes a bigger and bigger dose of a drug to give a hardened addict a high.” Thus if the government wants to have a genuine full employment level at the natural rate, it must not use monetary policy to remove institutional restraints, restrictive practices, barriers to mobility, trade union coercion and simi­lar obstacles to both the workers and the employers.

But economists do not agree with Friedman. They suggest that it is possible to reduce the natural rate of unemployment through labour market policies, whereby labour market can be made more efficient. So the natural rate of unemployment can be reduced by shifting the long-run vertical Phillips curve to the left.

Johnson doubts about the applicability of the Phillips curve to the formulation of economic policy on two grounds. “On the one hand, the curve represents only a statistical description of the mechanics of adjustment in the labour market, resting on a simple model of economic dynamics with little general and well-tested monetary theory behind it.

On the other hand, it describes the behaviour of the labour market in a combination of periods of economic fluctuation and varying rates of inflation, conditions which presumably influenced the behaviour of the labour market itself, so that it may reasonably be doubted whether the curve would continue to hold its shape if an attempt were made by economic policy to pin the economy down to a point on it.”

6. Causes of Inflation

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Inflation is caused when the aggregate demand exceeds the aggregate supply of goods and services. We analyse the factors which lead to increase in demand and the shortage of supply.

Factors Affecting Demand:

Both Keynesians and monetarists believe that inflation is caused by increase in the aggregate demand.

They point towards the following factors which raise it.

1. Increase in Money Supply:

Inflation is caused by an increase in the supply of money which leads to increase in aggregate demand. The higher the growth rate of the nominal money supply, the higher is the rate of inflation. Modem quantity theorists do not believe that true inflation starts after the full employment level. This view is realistic because all advanced countries are faced with high levels of unemployment and high rates of inflation.

2. Increase in Disposable Income:

When the disposable income of the people increases, it raises their demand for goods and services. Disposable income may increase with the rise in national income or reduction in taxes or reduction in the saving of the people.

3. Increase in Public Expenditure:

Government activities have been expanding much with the result that government expenditure has also been increasing at a phenomenal rate, thereby raising aggregate demand for goods and services. Governments of both developed and developing countries are providing more facilities under public utilities and social services, and also nationalising industries and starting public enterprises with the result that they help in increasing aggregate demand.

4. Increase in Consumer Spending:

The demand for goods and services increases when consumer expenditure increases. Consumers may spend more due to conspicuous consumption or demonstration effect. They may also spend more whey they are given credit facilities to buy goods on hire-purchase and instalment basis.

5. Cheap Monetary Policy:

Cheap monetary policy or the policy of credit expansion also leads to increase in the money supply which raises the demand for goods and services in the economy. When credit expands, it raises the money income of the borrowers which, in turn, raises aggregate demand relative to supply, thereby leading to inflation. This is also known as credit-induced inflation.

6. Deficit Financing:

In order to meet its mounting expenses, the government resorts to deficit financing by borrowing from the public and even by printing more notes. This raises aggregate demand in relation to aggregate supply, thereby leading to inflationary rise in prices. This is also known as deficit-induced inflation.

7. Expansion of the Private Sector:

The expansion of the private sector also tends to raise the aggregate demand. For huge investments increase employment and income, thereby creating more demand for goods and services. But it takes time for the output to enter the market.

8. Black Money:

The existence of black money in all countries due to corruption, tax evasion etc. increases the aggregate demand. People spend such unearned money extravagantly, thereby creat­ing unnecessary demand for commodities. This tends to raise the price level further.

9. Repayment of Public Debt:

Whenever the government repays its past internal debt to the public, it leads to increase in the money supply with the public. This tends to raise the aggregate demand for goods and services.

10. Increase in Exports:

When the demand for domestically produced goods increases in for­eign countries, this raises the earnings of industries producing export commodities. These, in turn, create more demand for goods and services within the economy.

Factors Affecting Supply:

There are also certain factors which operate on the opposite side and tend to reduce the aggre­gate supply.

Some of the factors are as follows:

1. Shortage of Factors of Production:

One of the important causes affecting the supplies of goods is the shortage of such factors as labour, raw materials, power supply, capital, etc. They lead to excess capacity and reduction in industrial production.

2. Industrial Disputes:

In countries where trade unions are powerful, they also help in curtail­ing production. Trade unions resort to strikes and if they happen to be unreasonable from the employ­ers’ viewpoint’ and are prolonged, they force the employers to declare lock-outs. In both cases, industrial production falls, thereby reducing supplies of goods. If the unions succeed in raising money wages of their members to a very high level than the productivity of labour, this also tends to reduce production and supplies of goods.

3. Natural Calamities:

Drought or floods is a factor which adversely affects the supplies of agricultural products. The latter, in turn, create shortages of food products and raw materials, thereby helping inflationary pressures.

4. Artificial Scarcities:

Artificial scarcities are created by hoarders and speculators who indulge in black marketing. Thus they are instrumental in reducing supplies of goods and raising their prices.

5. Increase in Exports:

When the country produces more goods for export than for domestic consumption, this creates shortages of goods in the domestic market. This leads to inflation in the economy.

6. Lop-sided Production:

If the stress is on the production of comforts, luxuries, or basic products to the neglect of essential consumer goods in the country, this creates shortages of consumer goods. This again causes inflation.

7. Law of Diminishing Returns:

If industries in the country are using old machines and out­moded methods of production, the law of diminishing returns operates. This raises cost per unit of production, thereby raising the prices of products.

8. International Factors:

In modern times, inflation is a worldwide phenomenon. When prices rise in major industrial countries, their effects spread to almost all countries with which they have trade relations. Often the rise in the price of a basic raw material like petrol in the international market leads to rise in the price of all related commodities in a country.

7. Measures to Control Inflation

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We have studied above that inflation is caused by the failure of aggregate supply to equal the increase in aggregate demand. Inflation can, therefore, be controlled by increasing the supplies and reducing money incomes in order to control aggregate demand.

The various methods are usually grouped under three heads:

Monetary measures, fiscal measures and other measures.

1. Monetary Measures:

Monetary measures aim at reducing money incomes.

(a) Credit Control:

One of the important monetary measures is monetary policy. The central bank of the country adopts a number of methods to control the quantity and quality of credit. For this purpose, it raises the bank rates, sells securities in the open market, raises the reserved ratio, and adopts a number of selective credit control measures, such as raising margin requirements and regulating consumer credit.

Monetary policy may not be effective in controlling inflation, if inflation is due to cost-push factors. Monetary policy can only be helpful in controlling inflation due to demand-pull factors.

(b) Demonetisation of Currency:

However, one of the monetary measures is to demonetise currency of higher denominations. Such a measure is usually adopted when there is abundance of black money in the country.

(c) Issue of New Currency:

The most extreme monetary measure is the issue of new currency in place of the old currency. Under this system, one new note is exchanged for a number of notes of the old currency. The value of bank deposits is also fixed accordingly. Such a measure is adopted when there is an excessive issue of notes and there is hyperinflation in the country. It is a very effective measure. But is inequitable for it hurts the small depositors the most.

2. Fiscal Measures:

Monetary policy alone is incapable of controlling inflation. It should, therefore, be supplemented by fiscal measures. Fiscal measures are highly effective for controlling government expenditure, personal consumption expenditure, and private and public investment.

The principal fiscal measures are the following:

(a) Reduction in Unnecessary Expenditure:

The government should reduce unnecessary ex­penditure on non-development activities in order to curb inflation. This will also put a check on private expenditure which is dependent upon government demand for goods and services. But it is not easy to cut government expenditure. Though economy measures are always welcome but it becomes difficult to distinguish between essential and non-essential expenditure. Therefore, this measure should be supple­mented by taxation.

(b) Increase in Taxes:

To cut personal consumption expenditure, the rates of personal, corpo­rate and commodity taxes should be raised and even new taxes should be levied, but the rates of taxes should not be so high as to discourage saving, investment and production. Rather, the tax system should provide larger incentives to those who save, invest and produce more.

Further, to bring more revenue into the tax-net, the government should penalise the tax evaders by imposing heavy fines. Such mea­sures are bound to be effective in controlling inflation. To increase the supply of goods within the country, the government should reduce import duties and increase export duties.

(c) Increase in Savings:

Another measure is to increase savings on the part of the people. This will tend to reduce disposable income with the people, and hence personal consumption expenditure. But due to the rising cost of living, people are not in a position to save much voluntarily. Keynes, therefore, advocated compulsory savings or what he called ‘deferred payment’ where the saver gets his money back after some years.

For this purpose, the government should float public loans carrying high rates of interest, start saving schemes with prize money, or lottery for long periods, etc. It should also introduce compulsory provident fund, provident fund-cum-pension schemes, etc. compulsorily. All such measures to increase savings are likely to be effective in controlling inflation.

(d) Surplus Budgets:

An important measure is to adopt anti-inflationary budgetary policy. For this purpose, the government should give up deficit financing and instead have surplus budgets. It means collecting more in revenues and spending less.

(e) Public Debt:

At the same time, it should stop repayment of public debt and postpone it to some future date till inflationary pressures are controlled within the economy. Instead, the government should borrow more to reduce money supply with the public.

Like the monetary measures, fiscal measures alone cannot help in controlling inflation. They should be supplemented by monetary, non-monetary and non-fiscal measures.

3. Other Measures:

The other types of measures are those which aim at increasing aggregate supply and reducing aggregate demand directly:

(a) To Increase Production:

The following measures should be adopted to increase production:

(i) One of the foremost measures to control inflation is to increase the production of essential consumer goods like food, clothing, kerosene oil, sugar, vegetable oils, etc.

(ii) If there is need, raw materials for such products may be imported on preferential basis to increase the production of essential commodities.

(iii) Efforts should also be made to increase productivity. For this purpose, industrial peace should be maintained through agreements with trade unions, binding them not to resort to strikes for some time.

(iv) The policy of rationalisation of industries should be adopted as a long-term measure. Rationalisation increases productivity and production of industries through the use of brain, brawn and bullion.

(v) All possible help in the form of latest technology, raw materials, financial help, subsidies, etc. should be provided to different consumer goods sectors to increase production.

(b) Rational Wage Policy:

Another important measure is to adopt a rational wage and income policy. Under hyperinflation, there is a wage-price spiral. To control this, the government should freeze wages, incomes, profits, dividends, bonus, etc. But such a drastic measure can only be adopted for a short period and by antagonising both workers and industrialists. Therefore, the best course is to link increase in wages to increase in productivity. This will have a dual effect. It will control wages and at the same time increase productivity, and hence increase production of goods in the economy.

(c) Price Control:

Price control and rationing is another measure of direct control to check inflation. Price control means fixing an upper limit for the prices of essential consumer goods. They are the maximum prices fixed by law and anybody charging more than these prices is punished by law. But it is difficult to administer price control.

(d) Rationing:

Rationing aims at distributing consumption of scarce goods so as to make them available to a large number of consumers. It is applied to essential consumer goods such as wheat, rice, sugar, kerosene oil, etc. It is meant to stabilise the prices of necessaries and assure distributive justice. But it is very inconvenient for consumers because it leads to queues, artificial shortages, corruption and black marketing. Keynes did not favour rationing for it “involves a great deal of waste, both of resources and of employment.”

Conclusion:

From the various monetary, fiscal and other measures discussed above, it becomes clear that to control inflation, the government should adopt all measures simultaneously. Inflation is like a hydra-­headed monster which should be fought by using all the weapons at the command of the government.

8. Effects of Inflation

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Inflation affects different people differently. This is because of the fall in the value of money. When prices rise or the value of money falls, some groups of the society gain, some lose and some stand in between. Broadly speaking, there are two economic groups in every society, the fixed income group and the flexible income group.

People belonging to the first group lose and those belonging to the second group gain. The reason is that price movements in the case of different goods, services, assets, etc. are not uniform. When there is inflation, most prices are rising, but the rates of increase of individual prices differ much. Prices of some goods and services rise faster, of others slowly, and of still others remain unchanged. We discuss below the effects of inflation on redistribution of income and wealth, production, and on the society as a whole.

1. Effects on Redistribution of Income and Wealth:

There are two ways to measure the effects of inflation on the redistribution of income and wealth in a society. First, on the basis of the change in the real value of such factor incomes as wages, salaries, rents, interest, dividends and profits.

Second, on the basis of the size distribution of income over time as a result of inflation, i.e. whether the incomes of the rich have increased and that of the middle and poor classes have declined with inflation. Inflation brings about shifts in the distribution of real income from those whose money incomes are relatively inflexible to those whose money incomes are relatively flexible.

The poor and middle classes suffer because their wages and salaries are more or less fixed but the prices of commodities continue to rise. They become more impoverished. On the other hand, businessmen, industrialists, traders, reals estate holders, speculators, and others with variable incomes gain during rising prices.

The latter category of persons becomes rich at the cost of the former group. There is unjustified transfer of income and wealth from the poor to the rich. As a result, the rich roll in wealth and indulge in conspicuous consumption, while the poor and middle classes live in abject misery and poverty.

But which income group of society gains or losses from inflation depends on who anticipates inflation and who does not. Those who correctly anticipate inflation, they can adjust their present earnings, buying, borrowing, and lending activities against the loss of income and wealth due to infla­tion.

They, therefore, do not get hurt by the inflation. Failure to anticipate inflation correctly leads to redistribution of income and wealth. In practice, all persons are unable to anticipate and predict the rate of inflation correctly so that they cannot adjust their economic behaviour accordingly. As a result, some persons gain while others lose. The net result is redistribution of income and wealth.

The effects of inflation on different groups of society are discussed below:

(1) Debtors and Creditors:

During periods of rising prices, debtors gain and creditors lose. When prices rise, the value of money falls. Though debtors return the same amount of money, but they pay less in terms of goods and services. This is because the value of money is less than when they borrowed the money.

Thus the burden of the debt is reduced and debtors gain. On the other hand, creditors lose. Although they get back the same amount of money which they lent, they receive less in real terms because the value of money falls. Thus inflation brings about a redistribution of real wealth in favour of debtors at the cost of creditors.

(2) Salaried Persons:

Salaried workers such as clerks, teachers, and other white collar persons lose when there is inflation. The reason is that their salaries are slow to adjust when prices are rising.

(3) Wage Earners:

Wage earners may gain or lose depending upon the speed with which their wages adjust to rising prices. If their unions are strong, they may get their wages linked to the cost of living index. In this way, they may be able to protect themselves from the bad effects of inflation. But the problem is that there is often a time lag between the raising of wages by employees and the rise in prices.

So workers lose because by the time wages are raised, the cost of living index may have increased further. But where the unions have entered into contractual wages for a fixed period, the workers lose when prices continue to rise during the period of contract. On the whole, the wage earners are in the same position as the white collar persons.

(4) Fixed Income Group:

The recipients of transfer payments such as pensions, unemployment insurance, social security, etc. and recipients of interest and rent live on fixed incomes. Pensioners get fixed pensions. Similarly the rentier class consisting of interest and rent receivers get fixed payments. The same is the case with the holders of fixed interest bearing securities, debentures and deposits.

All such persons lose because they receive fixed payments, while the value of money continues to fall with rising prices. Among these groups, the recipients of transfer payments belong to the lower income group and the rentier class to the upper income group. Inflation redistributes income from these two groups towards the middle income group comprising traders and businessmen.

(5) Equity Holders or Investors:

Persons who hold shares or stocks of companies gain during inflation. For when prices are rising, business activities expand which increase profits of companies. As profits increase, dividends on equities also increase at a faster rate than prices. But those who invest in debentures, securities, bonds, etc. which carry a fixed interest rate lose during inflation because they receive a fixed sum while the purchasing power is falling.

(6) Businessmen:

Businessmen of all types, such as producers, traders and real estate holders gain during periods of rising prices. Take producers first. When prices are rising, the value of their inventories rise in the same proportion. So they profit more when they sell their stored commodities. The same is the case with traders in the short ran. But producers profit more in another way.

Their costs do not rise to the extent of the rise in the prices of their goods. This is because prices of raw materials and other inputs and wages do not rise immediately to the level of the price rise. The holders of real estate’s also profit during inflation because the prices of landed property increase much faster than the general price level.

(7) Agriculturists:

Agriculturists are of three types: landlords, peasant proprietors, and landless agricultural workers. Landlords lose during rising prices because they get fixed rents. But peasant proprietors who own and cultivate their farms gain. Prices of farm products increase more than the cost of production.

For prices of inputs and land revenue do not rise to the same extent as the rise in the prices of farm products. On the other hand, the landless agricultural workers are hit hard by rising prices. Their wages are not raised by the farm owners because trade unionism is absent among them. But the prices of consumer goods rise rapidly. So landless agricultural workers are losers.

(8) Government:

The government as a debtor gains at the expense of households who are its principal creditors. This is because interest rates on government bonds are fixed and are not raised to offset expected rise in prices. The government, in turn, levies less taxes to service and retire its debt. With inflation, even the real value of taxes in reduced. Thus redistribution of wealth in favour of the government accrues as a benefit to the tax-payers.

Since the tax-payers of the government are high- income groups, they are also the creditors of the government because it is they who hold government bonds. As creditors, the real value of their assets declines and as tax-payers, the real value of their liabilities also declines during inflation. The extent to which they will be gainers or losers on the whole is a very complicated calculation.

Conclusion:

Thus inflation redistributes income from wage earners and fixed income groups to profit recipients, and from creditors to debtors. In so far as wealth redistributions are concerned, the very poor and the very rich are more likely to lose than middle income groups.

This is because the poor hold what little wealth they have in monetary form and has few debts, whereas the very rich hold a substantial part of their wealth in bonds and have relatively few debts. On the other hand, the middle income groups are likely to be heavily in debt and hold some wealth in common stock as well as in real assets.

2. Effects on Production:

When prices start rising, production is encouraged. Producers earn wind-fall profits in the future. They invest more in anticipation of higher profits in the future. This tends to increase employment, production and income. But this is only possible up to the full employment level.

Further increase in investment beyond this level will lead to severe inflationary pressures within the economy because prices rise more than production as the resources are fully employed. So inflation adversely affects production after the level of full employment.

The adverse effects of inflation on production are discussed below:

(1) Misallocation of Resources:

Inflation causes misallocation of resources when producers divert resources from the production of essential to non-essential goods from which they expect higher profits.

(2) Changes in the System of Transactions:

Inflation leads to changes in transactions pattern of producers. They hold a smaller stock of real money holdings against unexpected contingencies than before. They devote more time and attention to converting money into inventories or other financial or real assets. It means that time and energy are diverted from the production of goods and services and some resources are used wastefully.

(3) Reduction in Production:

Inflation adversely affects the volume of production because the expectation of rising prices along with rising costs of inputs brings uncertainty. This reduces production.

(4) Fall in Quality:

Continuous rise in prices creates a seller’s market. In such a situation, producers produce and sell sub-standard commodities in order to earn higher profits. They also indulge in adulteration of commodities.

(5) Hoarding and Black-marketing:

To profit more from rising prices, producers hoard stocks of their commodities. Consequently, an artificial scarcity of commodities is created in the market. Then the producers sell their products in the black market which increase inflationary pressures.

(6) Reduction in Saving:

When prices rise rapidly, the propensity to save declines because more money is needed to buy goods and services than before. Reduced saving adversely affects investment and capital formation. As a result, production is hindered.

(7) Hinders Foreign Capital:

Inflation hinders the inflow of foreign capital because the rising costs of materials and other inputs make foreign investment less profitable.

(8) Encourages Speculation:

Rapidly rising prices create uncertainty among producers who indulge in speculative activities in order to make quick profits. Instead of engaging themselves in productive activities, they speculate in various types of raw materials required in production.

3. Other Effects:

Inflation leads to a number of other effects which are discussed as under:

(1) Government:

Inflation affects the government in various ways. It helps the government in financing its activities through inflationary finance. As the money income of the people increases, the government collects that in the form of taxes on incomes and commodities. So the revenues of the government increase during rising prices.

Moreover, the real burden of the public debt decreases when prices are rising. But the government expenses also increase with rising production costs of public projects and enterprises and increase in administrative expenses as prices and wages rise. On the whole, the government gains under inflation because rising wages and profits spread an illusion of prosperity within the country.

(2) Balance of Payments:

Inflation involves the sacrificing of the advantages of international specialisation and division of labour. It adversely affects the balance of payments of a country. When prices rise more rapidly in the home country than in foreign countries, domestic products become costlier compared to foreign products. This tends to increase imports and reduce exports, thereby making the balance of payments unfavourable for the country. This happens only when the country follows a fixed exchange rate policy. But there is no adverse impact on the balance of payments if the country is on the flexible exchange rate system.

(3) Exchange Rate:

When prices rise more rapidly in the home country than in foreign coun­tries, it lowers the exchange rate in relation to foreign currencies.

(4) Collapse of the Monetary System:

If hyperinflation persists and the value of money continues to fall many times in a day, it ultimately leads to the collapse of the monetary system, as happened in Germany after World War I.

(5) Social. Inflation is socially harmful:

By widening the gulf between the rich and the poor, rising prices create discontentment among the masses. Pressed by the rising cost of living, workers resort to strikes which lead to loss in production. Lured by profit, people resort to hoarding, black-marketing, adulteration, manufacture of substandard commodities, speculation, etc. Corruption spreads in every walk of life. All this reduces the efficiency of the economy.

(6) Political:

Rising prices also encourage agitations and protests by political parties opposed to the government. And if they gather momentum and become unhandy they may bring the downfall of the government. Many governments have been sacrificed at the alter of inflation.