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?

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.

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.

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.

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.

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

• that inflation rate is high enough to prove harmful to the economy and the society before they deploy measures to quell it, and
• that inflation persists over a long period of time and it is not an intermittent rise-and-fall affair of a seasonal affair or supply-shock kind of inflation, e.g., oil supply shock of 1970s causing global inflation.

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.

where PIN_t is the price index number in the year selected for measuring inflation and PIN_{t –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.

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.

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

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.