What is inflation? Effects of inflation on an economy.

We all are living in a Democratic country. We should know about, What is inflation? Effects of inflation on an economy.

What is INFLATION ?

The primary meaning of inflation in economics is a “rise in the price level of a particular economy over a given period of time”.

Whenever there is an increase in the price level of the economy. It means that for the exchange of one unit of currency, now the consumer will get less amount of goods and services than before.

That means inflation leads to relatively less purchasing power with the customer having the same amount of money.  If not controlled by the central bank or RBI, Inflation could turn into hyperinflation wherein the price of commodities rise frequently, making the economy unstable thereby decreasing the value of one unit of currency.

Types of Inflation

If we talk about the types of inflation, generally we do study the major two types of inflation

Cost-Push Inflation

Cost-push inflation is defined as a type of inflation where the price in the economy rises due to an increase in the per-unit cost of production due to a decrease in the aggregate supply of goods and services in an economy.

i.e., If there is an increase in the cost of factors of production (example- land, labour, raw material, etc.), then the aggregate supply of goods and services would decrease and further the price level of a commodity in an economy will increase.

Demand-Pull Inflation

Demand-pull inflation is defined as a type of inflation where the price in the economy rises due to an increase in the aggregate demand for goods and services in an economy.

Aggregate demand in an economy could be increased by increased government spending, increase in demand of households, etc. That is when the overall demand for a particular product increases then the price for the same commodity also increases because the quantity supplied is the same as that before.

Measures to control inflation in an economy

Quantitative measures

  • Bank rate or discount rate– it is the rate at which the Reserve Bank of India(RBI) or central bank gives loan to the commercial banks. While inflation RBI increases the bank rate due to which there would be less amount of fund left with general public for personal consumption.
  • Repo rate – it is the rate at which RBI advances credit to the commercial banks for short against the government bonds. Short period may be up to 7-14 days.
  • Reserve ratios – reserve ratios include cash reserve ratio(CRR) and statutory liquidity ratio(SLR). CRR is the amount which is kept with Reserve Bank of India in the form of liquid cash by the commercial banks out of the total deposits. SLR is the reserve which is kept by commercial bank in the form of liquid cash with themselves in certain proportions of the total deposits.

Qualitative measures

  • Margin requirement– the difference between the value of security and the loan given against it is known as margin requirement. For example – if the loan amount 15 lakh security is 10 lakh rupees it means  the margin requirement is 33.3%
  • Moral suasion The central bank holds workshops, meetings, seminars, etc., with the head of commercial banks to persuade them to follow according to the situation prevailing in the economy.
  • Selective credit control– Now, there can be rationing of credit or quota may be fixed for various sectors of the economy.

Effects of inflation on an economy.

  1. Stability of an economy– Inflation causes the state of unrest or instability in an economy due to continuous change in price of a commodity.
  2. Real and nominal value of money- Inflation reduces the real as well as nominal value of the money that is with the same amount of money now the customer will be able to buy comparative less quantity of particular goods.
  3. Cost of factors of production– Inflation also increases the per unit cost of production thereby decreasing the quantity supplied of goods and services into the market.
  4. Measures from Reserve Bank of India– Frequent rise in price level of the commodities in an economy make the central bank RBI to interrupt in between, in order to stabilize the severe economic crisis.