What is Inflation, Measurement, Types and Effects of Inflation

One of the favourite topics from Indian Economy in Prelims and Mains is Inflation. Since inflation affects every citizen of the country, however rich or poor, it is a crucial determinant of a country’s economic and social progress. No wonder, your inflation-related concepts should be clear. In this post, we will discuss the definition of Inflation, how it is determined and list the different types of inflation. Then we discuss the effects of inflation since questions are often asked in Prelims on the effects of inflation on different economic segments.

This is the first post on inflation. You can also learn about common inflation terms and inflation management.

Note: If you would like to attempt practice questions on Inflation, take a look at the Test Series course

Definition of Inflation

The simplest definition is Inflation is “a rise in the general level of prices”. By the term general, we mean if the price of one good has gone up it is not inflation, it is inflation only if the prices of most goods have gone up. The opposite of inflation is deflation which means a fall in the general level of prices.

How is Inflation Measured in India

In India, inflation is measured on two price indices, viz, wholesale price index (WPI) and consumer price index (CPI). WPI measures price rise or inflation at the level of seller or retailer who buy commodities in bulk or ‘whole sale’. CPI is also called retail inflation since it measures inflation at the retail or consumer level. In India, WPI is the basis for determining the inflation of the economy.

About Wholesale Price Index (WPI)

WPI is measured on weekly basis. The first index of wholesale prices commenced in India for the week January 10, 1942. The base year of WPI is revised periodically. Till date, 5 revisions have take place. The current WPI base year is 2004-05 based on prices of 670 commodities.

[thrive_text_block color=”orange” headline=””]Recently, a Working Group was set up under chairmanship of Prof. Abhijit Sen to recommend new series of WPI. The committee recommendations have been accepted by the govt. [/thrive_text_block]

For determining WPI, commodities are divided into three categories – Primary Articles (102 items), Fuel & Power (19 items), and Manufactured Products (555 items). As you can see, the weight assigned to manufacturing is highest at 82% followed by primary articles like fruits and vegetables.

About Consumer Price Index (CPI)

Unlike WPI, there is not a single measure of CPI. In India, four CPI indices are used to determine inflation at the consumer level. These are: CPI-IW (Industrial Worker), CPI-UNME (Urban Non-Manual Employees), CPI-AL (Agricultural Labourers), and CPI-RL (Rural Labourers).

Unlike the WPI, the new series of CPI based on recommendations of Abhijit Sen committee assigns the highest weight to primary articles like food, beverages and tobacco (49%).

Causes of Inflation

There are two main causes of inflation: cost push and demand pull.

Cost-Push Inflation occurs when general prices of commodities increases due to increase in production cost. Demand-Pull Inflation is the result of mismatch between demand and supply. Either the demand increases over the same level of supply or the supply decreases with the same level of demand.

Types of Inflation

Inflation may be classified into three main categories.

Low Inflation

Such inflation is slow and on predictable lines which might be called small or gradual. It is sometimes also called ‘creeping inflation‘. For example monthly inflation that increases in single digits like 2.3%, 2.8%, 3.2%, 3.5% etc.

Galloping Inflation

This is very high inflation running in double or triple digits like 20%, 100% or 200% a year. Such kind of inflation was observed in certain Latin American countries like Argentina.

Hyper Inflation

This form of inflation is ‘large and accelerating‘ which might have annual rates in million or even trillion. Such rate of inflation was recently observed in Zimbabwe. In such inflation not only range of increase is very large but the increase takes place in a very short span of time and prices shoot up overnight.

Effects of Inflation

Inflation has multi-dimensional effects on an economy. Effects of inflation on different sectors and segments is explained below.

On Creditors and Debtors

Inflation redistributes wealth from creditors to debtors i.e. lenders suffer and borrowers benefit from inflation. This is true assuming that salaries would also increase due to price rise. This results in repaying the same amount of money with extra money at hand due to wage hike or increase in Dearness Allowance (DA for government employees).

On Aggregate Demand

Rising prices usually results in higher demand as it comparatively lower supply. However if inflation results from higher input costs (cost-push), aggregate may demand may or may not increase comparative to price rise.

On Investment

Inflation increases the investment in an economy in the short run as it encourages producers to expand or increase production. Also, in the short run, higher the inflation lower is the cost of loan.

On Saving

In the short run, rising prices encourages people to deposit cash in hand with banks as money loses value so holding it does not much sense. However in the long run, rising prices depletes the saving rate in an economy.

On Exchange Rate

Rising prices generally leads to depreciation of the currency which implies that the currency loses its exchange value in front of a foreign currency. But this is relative to the pressure on the foreign currency against which the exchange rate is compared. For instance, from 2013 till mid-2014, even though there was relatively high inflation in India, still it did not lose much value vis-a-vis the US dollar since the dollar was also under inflationary pressure.

On Export

With inflation, exportable items of an economy gain competitive prices in the world market. This boost a country’s exports. This happens since value of currency falls so it makes it cheaper for importing countries to buy the exporting countries produce.

On Imports

Inflation gives an economy advantage of lower imports and import-substitution as foreign goods become costlier.

On Wages

Inflation increases the nominal or face value of the wages while its real value falls. Simply put, even though wages may increase to offset inflation the actual value of money falls.

Recommended Book and Mock Tests

I suggest you go through Indian Economy by Ramesh Singh for understanding Inflation topic in more detail and also to prepare other basic topics related to economy.

Recommended Books for IAS

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  1. very useful . Thank you .Please update some more current related topics in same way. Because it helps to understand the topics

  2. Thanks sir, it helped me to understand this topic.
    If you update some more topics, It would be helpful for me and the students like me.. 🙂

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