INFLATION

Inflation refers to a rise in the general price level and a corresponding fall in the value of money over a period of time. It is a state in which the value of money is falling i.e. prices are rising.

Formula:
Rate of inflation= (price level of year t- price level of year (t-1))/ price level of year (t-1)*100

THREE STRAINS OF INFLATION:

Low inflation: Here prices rise slowly and predictably. It is single digit annual inflation rate. Galloping inflation: It is the Inflation is of double or triple digit range. Once it is enriched serious economic distortions arises. Hyperinflation: no good can be said at the market economy in which prices are increasing a million or even a trillion percent per year.

ANTICIPATED AND UN-ANTICIPATED INFLATION:

Anticipated inflation is the inflation which is to be expected by the people.The effect is less here,since people would have been prepared. Un-anticipated inflation is inflation that occurs unexpectedly which leads to worse effects.

IMPACT OF INFLATION:
As the result of diverging relative prices, two definite effects of inflation are 1. A re-distribution of income and wealth among different groups. 2. Distortions in the relative prices and output of different goods, or sometimes in output and employment for the economy as the whole.

Impact of inflation on income and wealth distribution:

The major distribution of inflation arises from differences in assets and liabilities that people hold. E.g. Suppose if a person borrows one lakh rupees to buy a car, the fixed interest will be Rs.1000 per month. Suddenly a great inflation doubles the wages and incomes, the nominal interest will be still Rs.1000 per month but the real value of the car is halved. The great inflation has increased the wealth by cutting the real value of the debts. But when inflation slows and the economy turns sour the interest will be very burdensome and many people go bankrupted. I.e. when unexpected inflation occurs the money paid back by a lender will worth much less than the money lended. Inflation increases the interest rate. When inflation increases to new rate there will be no further re-distribution of income and wealth once the interest rates have been adapted to new inflation rates. Generally the people who live on monthly wages will lose from inflations whereas people of daily wages will gain from inflation. An anticipated inflation re-distributes the wealth from creditors to debtors, helping borrowers and hurting lenders.

Impact of inflation on economic efficiency:

In addition to redistributing incomes, inflation affects the real economy in two specific areas : it can harm economic efficiency, and it can affect total Output. Inflation impairs economic efficiency because it distorts prices and price signals. In a low - inflation economy, if the market price of a good rises, both buyers and sellers know that there has been an actual change in the supply and/ or demand conditions for that good, and they can react appropriately.

By contrast, in a high- inflation economy it's much harder to distinguish between charges in relative prices and changes in the overall price level.

 Inflation also distorts the use of money. Currency is money that bears a zero nominal interest rate. If the inflation rate rises from 0 to 10 percent annually, the real interest rate on currency falls from 0 to -10 percent per year. As a result of which people devote real resources to reducing their money holdings during inflationary times. There is also menu costs of inflation in addition to the distortion on prices and money value. The idea behind menu costs is that when prices are changed , firms must spend real resources adjusting their prices. For instance, restaurants reprint their menus, mail-order firms reprint their catalogs, cities adjust parking meters etc.

TYPES OF INFLATION
The two different types of inflation include: Cost push inflation Demand pull inflation

COST PUSH INFLATION :

Cost Push Inflation occurs when prices are pushed up by rising costs to producers who compete with each other for increasingly scarce resources. The increased costs are passed onto consumers. Three types: - Wage-price spiral - Profit-push inflation - Supply-side shocks Wage-price spiral Rising wages force companies to increase prices. Blamed on labor unions or shortage of workers. Not a problem since early 1980s.

Profit-push inflation In many industries, there are only a small number of companies. Easy for them to raise prices to protect their profit margins. Supply-side shocks Dramatic and unexpected increases in the prices of key materials, such as oil or energy in general.

DEMAND PULL INFLATION :

Inflation initiated by an increase in aggregate demand is called is called demand-pull inflation. In fig 2 and fig 3 the inflation begins with a shift of the aggregate demand schedule from AD0 to AD1, which causes the price level to increase from P0 to P1. Output also increases from Y0 to Y1. If the economy is operating on the steep portion of the AS curve at the time of the increase in aggregate demand, as in fig 3, most of the effect will be an increase in the price level instead of an increase in output. If the economy is operating on the flat portion of the AS curve, as in fig 2, most of the effect will be an increase in output instead of an increase in the price level. Note that, in the long run the initial increase in the price level will cause the AS curve to shift to the left as input prices (costs) respond to the increase in output prices. If the long run AS curve is vertical, as depicted in fig 1, the increase in costs will shift the short run AS curve (AS0) to the left to AS1, pushing the price level even higher, to P2. If the long run AS curve is vertical, a shift in aggregate demand from AD0 to AD1 will result, in the long run, in no increase in output and a price-level increases from P0 to P2.

Fig 1 Fig 2

Fig 3