Inflation

The Problem of Inflation is as old as market system Opens in new window. Persistent inflation is perhaps the second most serious macroeconomic problem confronting the world economy today — second only to hunger and poverty in the ‘third world’.

What then is Inflation?

In a broad sense of the term, inflation means a considerable and persistent rise in the general price level over a period of time.

However, there is no universally acceptable definition of inflation. Most definitions of inflation in the literature are a matter of opinion on price rise and its causes.

Let us look at some widely quoted economists views of inflation and their implications.

  • According to Pigou, “Inflation exists when money income is expanding more than in proportion to increase in earning activity.”
  • To Coulborn, inflation is a situation of “too much money chasing too few goods.”
  • According to Kemmerer, “Inflation is … too much currency in relation to physical volume of business.”
  • Crowther defined inflation as, “a state in which the value of money is falling, that is, prices are rising.”

The general drawback of these definitions is that they tell the cause of inflation rather than telling what inflation is. The definitions of this orientation do not capture the full implications of the inflationary situation.

Let’s consider some recent and more appropriate definitions of inflation.

  • According to Ackley, “inflation is a persistent and appreciable rise in the general level or average of prices.”
  • Harry G. Johnson defines inflation as “a sustained rise in prices.”
  • According to Samuelson, “Inflation denotes a rise in the general level of prices”.

The modern economists seem to agree that inflation means a ‘persistent’ and ‘appreciable’ increase in the general level of prices.

Nevertheless, the terms ‘persistent’ and ‘appreciable’ and other terms like “sustained,” “considerable,” “continuing,” and “prolonged” used in other definitions of inflation are not precisely defined.

In practice, however, the term persistent implies that the price level continues to rise and does not respond to anti-inflationary policies.

The term appreciable is more ambiguous because it does not specify as to what rate of increase in the price level is to be considered as ‘appreciable’ or ‘considerable’ — 5%, 10%, 30% per month or per annum or what?

There is no specific answer to this question, nor can there be any because economic conditions, desirability of inflation, ability of the economy to absorb or tolerate inflation and effects of inflation vary from country to country and from time to time.

What Rate of Price Rise is Inflation?

If one goes by the definition of inflation given by some modern economists, any rise in the general price level is not inflation. In their opinion, only a persistent, prolonged and sustained and a considerable and appreciable rise in the general price level can be called inflation.

Though the terms persistent, prolonged and sustained are not defined precisely, it implies that if price rise is not persistent, prolonged or sustained, it is not inflation whatever the rate of rise in the general price level.

Nor do the economists specify what rate of price rise is considerable or appreciable — 1%, 5%, 10%, 20% or what? They do not provide a specific answer to this question too. It may thus be concluded that modern economists do not provide a definite answer to the question as to what rate of increase in price rise is inflation.

However, if one goes by Samuelson-Nordhaus definition of inflation, a rise in the general level of prices is inflation. It means that any rise in the general price level over and above the base-year level is inflation.

This is the concept of inflation which is generally used in the analysis of price behavior Opens in new window.

For instance, the rate of price rise in India during April – May 2009 was below 1% and had gone down to 0.13% in the last week of May 2009 — the lowest in 30 years. This almost zero rate of rise in the general price was called inflation in public report. This is the practice, in fact, in all other countries and adopted also by the international organizations like World Bank Opens in new window and IMF Opens in new window.

This should not mean, however, modern economists’ perception of inflation is meaningless and impracticable. If one looks at their approach carefully, one finds that their approach is policy oriented and they have an important and useful point of view.

Inflation upto a certain level is advantageous and desirable as it is conducive to economic growth and employment.

But beyond this level, inflation is harmful and often proves disastrous to the economy.

Besides, it creates many social and political problems. Therefore, when inflation rate crosses its desirable limit, it has to be controlled. But, an anti-inflationary policy and inflation control measures have to be devised very carefully or else it may do more harm than good to the economy.

For this purpose, the policy-makers have to ensure

Since economic conditions of different countries and their ability to absorb inflation vary from country to country and, within a country, from time to time, it is not justifiable to specify a rate of price rise to be called inflation.

Each country has to find for itself the desirable rate of inflation at different points of time and to formulate policy measures accordingly to control inflation.

Measuring Inflation by PIN

There are two common methods of measuring inflation:

  1. percentage change in Price Index Numbers (PIN), and
  2. change in GNP Deflator.

In this post we consider the first method. The following formula is used for measuring the rate of inflation through the change in the PIN.

Rate of Inflation = PINt – PINt – 1 x 100
                                        PINt –1

where PINt is the price index number in the year selected for measuring inflation and PINt –1 is the price index number in the preceding year.

The two widely used PINs are Wholesale Price Index (WPI), also called Producer Price Index (PPI), and Consumer Price Index (CPI). WPI is used to measure the general rate of inflation and CPI is used to measure the change in the cost of living.

In order to illustrate the measurement of inflation, let us use price index numbers in India in the early 1990s. The WPI (1999–2000 = 100) for all commodities increased from 134.6 in 2005–06 to 141.9 in 2006–07. The rate of inflation between 2005–06 and 2006–07 can be obtained by using the above formula as follows.

Rate of Inflation = 141.9 – 134.6 x 100
                                          134.6

= 5.4 percent

The annual average rate of inflation over a period of time (say 5, 10 or 20 years) is computed by taking average of the annual rates of inflation.

Inflation, Disinflation and Deflation

It’s important to understand the difference between inflation and disinflation and between inflation and deflation.

  • Inflation refers to persistent increase in the general price level.
  • Disinflation means decline in the rate of inflation.
  • Deflation means fall in the general price level below the base-year level.

The conceptual difference between these terms is illustrated below with hypothetical price data.

Measuring Inflation, Disinflation and Deflation
(Base year = 2000–01)
YearPrice Index
Number (PIN)
% Change in
Price (Year-to-Year)
Nature of
Price Change
2000-01100
2001-0211010Inflation (10%)
2002-031054.5Disinflation (5.5%)
2003-04100(-) 5.0Disinflation (5.0%)
2004-051000.0Zero Rate of Inflation
2004-0595 - 5.0Deflation

As can be seen from the above table, when PIN rises from 100 in base-year 2000-01 to 110 in year 2001-02, it means there 10% inflation.

When PIN decreases from 110 in year 2001-02 to 105 in year 2002-03, inflation rate on year-to-year basis has declined from 10% to 4.5% but still remains above the base-year level. This is the situation of disinflation—the fall in the rate of inflation.

When PIN declines below the base-year PIN = 100, this means deflation. Thus, deflation means that the price level has gone down below the base-year price level.