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UNIT IV

INFLATION, DEFLATION AND


LESSON 8:
UNEMPLOYMENT
INFLATION , DEFLATION AND
REFLATION

Hello students now lets take a look at a very interesting topic the value of money. It also adversely affects the course
BUSINESS ECONOMY II

that is Inflation of economic planning and programming both at macro and


micro levels.
Objective of the module
In short, most of such harmful effects are indirectly by the
Meaning and Explanation
menace of , inflation and deflation. Inflation implies declining
Demand and cost Inflation value of money: Deflation implies rising value of money. We
Introduction shall therefore, discuss these topics in details in this chapter.
If money is to serve its good purpose its value must remain Meaning of Inflation
stable. Changes in value of money lead to harmful conse- Inflation is commonly understood as a situation of substantial
quences in the economy at large. and rapid general increase in the level of prices and consequent
Some broad effects of changes in value of money are traced deterioration in the value of money over a period of time.
below: The behaviour of general prices is measured through price
1. Price fluctuations implies that the value of money is indices. The trend of price indices reveals the course of inflation
unstable. This adversely affect the confidence in money fails or deflation in the economy. As Lerner says, a price rise which is
to serve as a good store of value. unforeseen and uncorrected is inflationary.
2. Even as a means of payments it looses its growth. It may Thus, inflation is statistically measured in terms of percentage
also become a source of peril and confusion. Since prices of increase in the price index, as a rate per cent per unit of time -
all goods do not change in the same order, the relative price usually a year or a month.
structure is distorted. When prices of necessaries tend to Usually, the wholesale price index (WPI) numbers are used to
rise while those of luxuries may be falling, there is regressive measure inflation. Alternatively, the consumer price index (CPI)
effect, as the poor consumers suffer, while the rich are or the cost of living index number can be adopted in measuring
benefited while spending their money. the rate of inflation.
3. Price variations in product and factor markets are not A Few Definitions
uniform. Thus, thecost-functions and revenues in different Inflation is like an elephant to the blind men. Different
categories of production differ. As a result, profitability of economists have defined inflation differently. We may, thus,
firms and industry tend to differ. Marginal productivity of enlist a few important definitions of inflation as under which
different factors in different uses never tend to identical would give us a comprehensive idea about this intricate
when the value of money fluctuates in segregated manner. problem.
This obstructs the optimal utilisation of resources. This
Harry Johnson defines inflation as a substained rise in prices.
may also cause maladjustment and wastefulness in the
eXploitation of countrys productive resources. Crowther, similarly defines inflation as a state in which the
value of money is falling, i.e., prices are rising.2
4. When value of money changes incoherently in different
types of real and financial assets, assets portfolio The common feature of inflation is a price rise, the degree of
management becomes a difficult task. It also distorts the which may be measured by price indices.
pattern of wealth distribution and position of the wealth Edward Shapiro, puts it thus: Recognising the ambiguities our
holders. Say, for instance, when share prices fall but real words contain, we will define inflation simply as a persistent
estate prices rises,then person who has invested in shares is and appreciable rise in the general level of prices.3
a looser while person occupying a real estate of the same Prof. Samuelson puts it thus: Inflation occurs when the
amount is a gainer. general level of price and costs is rising.Authors like Throp and
Such changes in different values of wealth due to unstable value Quandt, however, opine that it is of great help to defme
of money distorts the pattern of income distribution. Conse- inflation in terms of observable phenomenon and for this
quently, savings and investment may be adversely affected. It reason the process of rising prices should be considered as
also disturb business expectations and business planning. inflationary.
Business risks would be high when value of money in not There are, at least, two distinct views on the concept of
stable. inflation. To some economists, inflation is a pure monetary
5. Effects of rising prices in general- inflation effects - are also phenomenon, while to others, it is a postfull employment
different from the effects of falling prices in general - the phenomenon.
deflation effects. Especially, tempo of growth process and
economic development is disturbed -due to instability in

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Inflation As A Pure Monetary Phenomenon operating in the economy or because the economy has already

BUSINESS ECONOMY II
Monetarists, in general, regard inflation as a purely monetary reached the full employment level.
phenomenon. It is held that when money supply exceeds the In Keynes view, thus, rising prices in all situations cannot be
normal absorbing capacity of the economy, it leads to persis- termed as inflation. In a condition of under-employment,
tently rising prices. In other words, when there is overexpansion when an increase in money supply and rising prices are accompa-
of money supply and too much money chasing too few goods, nied by the expansion of output and employment, but
inflation occurs. Milton Friedman, puts thus, Inflation is when1here are bottlenecks in the economy, an increase in money
always and everywhere a monetary phenomenon. supply may cause cost and prices to rise more than the expan-
Goldenweiser goes on to state that Inflation occurs when the sion of output and employment. This may be termed as
volume of money activity bidding forr goods and services semi-inflation or reflation till the ceiling of full employ-
increases faster than the available supply of goods, when the ment is reached. Once full employment level is reached, the
growth of national income in money units is greater than its entire increase in money supply is reflected simply by the rising
growth in physical units. prices - the real inflation.
The monetarists view, in fact, is a corollary to the quantity Incidentally, Keynes mentions the following four related terms
theory of money. Other things being equal, if money supply while discussing the concept of inflation:
increases, there is inflation or a rise in prices.
1. Reflation,
This evidently follows from the Fisherian equation:
2. Inflation,
MV =P T
3. Disinflation, and
Assuming
4. Deflation.
V and T to be constant,
Using a trade cycle model (as in Figure 1) we may clarify these
P rises directly in proportion to the increase in money supply terms as under:
(M).
1. Reflation. It is a situation of rising prices, deliberately
Economists such as Milton Friedman, Hawtrey and undertaken to relieve a depression. With rising prices,
Goldenweiser who looked upon inflation as a purely monetary employment, output and income also increase till the
phenomenon, firmly believed in the quantity theory of money. economy reaches the full employment ceiling.
But the theory failed to explain the phenomenon of hyper-
In the below diagram, the FF line represents the full employ-
inflation, where the rise in the prices may cause an increase in the
ment ceiling and represents the normal path. In the beginning
money supply which, in turn, may cause a further rise in prices.
when the economy is at a point of below full employment
In fact, the phenomenon of money and prices chasing each
equilibrium, an increase in money supply leads the economy to
other in a vicious spiral is so indivisible that it is not very easy to
move on the path ofAB. However, till the economy reaches the
determine which is the cause and which is the effect in the
pointB, price rise is accompanied by the expansion of employ-
dynamic process of inflation. Moreover, the quantity theory is
ment and output. The situation is, thus, described as
quite misleading and confusing if one were to analyse a
semi-inflation or reflation.
situation of depression, in which the government resorts to the
usual fiscal and monetary techniques to counteract the evils of
depression, and the result is both an increase in money supply
and a rise in prices.
Inflation As A Post-full Employment Phenomenon
Although inflation by its nature is commonly conceived as a
monetary phenomenon, a group of economists, including
Pigou and Keynes, regarded inflation as a phenomenon of full
employment. In particular, the Keynesian theory of inflation is
based on the concept of full employment. In the Keynesian
view, rising prices in all situations cannot be termed inflation. In
a situation of underemployment, when an increase in money fig. 1: The Model of a Trade Cycle
supply and rising prices are accompanied by an expansion of Inflation. It occurs when prices rise after the stage of full
output and employment, inflation does not occur. Sometimes, employment is reached in the economy, with no corresponding
due to bottlenecks in the economy, an increase in money supply rise in employment and output. The following are the main
may cause costs and prices to rise more than the expansion of characteristics of inflation:
output and employment. This is known as semi-inflation or
Inflation is a long-term operating dynamic process.
bottleneck inflation. Once full-employment level is reached, the
entire increase in money supply is reflected by rising prices-a case Inflation is a process of persistently ris.ing price level.
of a true inflation. Inflationary price rise is persistent and is irreversible within a
Inflation occurs in a situation where there is an increase in short time; thus, it should be distinguished from a price
demand expressed through more money spending but no rise which may occur temporarily, due to short-term scarcity
corresponding increase in production either due to bottlenecks or during a cyclical upswing.

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11.251 49
A cyclical movement is not inflation. Inflation is a rising ployment and stagnation in the rate of growth. To describe this
BUSINESS ECONOMY II

trend in the price level. situation, Professor Samuelson has coined a new term,
Inflation is endogenous to the economic system. stagflation. As Samuelson says, Stagflation involves inflation-
ary rises in prices and wages at the same time so that people are
Inflation is fostered by the interaction of a multitude of
unable to find jobs and firms are unable to find customers for
economic factors. (g) Inflation, in a real sense, is a post-full
what their plants can produce.In short, stagflation refers to a
employment phenomenon. (h) By and large, inflation is also a
situation of recession and rising unemployment accompanied
monetary phenomenon. It is usually characterised by an
by a rising price level.flats, etc. are much high and fascinating
overflow of money and credit. In fact, the root causeof
than the rate of returns on shares, and bonds in an inflationary
inflation is the expansion of money supply beyond the normal
economy.
absorbing capacity of the economy.
9. Interest rates in the unaccounted and unorganised sectors
In Figure 1, the economys path up to BC is inflationary,
tend to be higher than the organised sectors of the money
Disinflation. When prices are falling due to anti-inflationary
market.
measures adopted by the authorities, with no corresponding
decline in the existing level of employment, output and 10. Labour unrest, strikes, lock-outs, etc. are common.
income, the result is disinflation. Organised labour force successfully resists any reduction in
real wages and pushes up the money-wages, thereby
When acute inflation afflicts the community, disinflation is
accelerating the process of cost-plish inflation.
adopted as a cure. Disinflation is said to take place when
deliberate attempts are made to curtail expenditure of all sorts 11. In an inflationary economy, the government is trapped in
to lower prices and money incomes for the benefit of the the cob-web of ever increasing public expenditure, larger
community. budgets, higher taxes, larger public debts, huge deficit
financing and a large number of controls, which, in turn,
In Figure 1, the path CD represents disinflation.
encourage black money and dual accounting system,
Deflation: It is a condition of falling prices accompanied by a blackmarketing, smuggling and other antisocial activities on
decreasing level of employment, outpUt and income. Deflation account of the deterioration of the communitys morals in
is just the opposite of inflation. Deflation occurs when the total general caused by the inflationary impact.
expenditure of the community is not equal to the existing
In short, an economy is inflationary because it is inflationary.
prices. Consequently, the value of money goes up and prices
There tends tobe a vicious circle of inflation when it is curbed
fall. However, each and every fall in price cannot be called
immediately. In the long period, the state of unchecked
deflation. The process of reversing inflation without either
inflation becomes a built-in feature of the economy and people
creating unemployment or reducing output is called
expect the rate of inflation to accelerate further.
disinflation and not deflation.Deflation is an under-
employment phenomenon. In Fig. I, the path DEG shows Students now lets try to understand inflation in a different way
deflation. Meaning of Inflations
Contemporary Views on Inflation Different economists have offered different definitions of the
For all practical purposes, Emile James defined inflation as a term inflation. In fact, there is a plethora of defInitions on the
self-perpetuatingand irreversible upward movement of prices, subject. Inflation in the popular mind is generally associated
caused by an excess of demand over capacity to supply. Here, with rapidly rising prices which cause a decline in the purchasing
Prof. James points ab oUt that excess demand may be demand power of money. Prof. Hawtrey defines inflation as the issue
for investment as well as for consumer goods. The phrase of too much currency. Prof. Kemmerer has defined inflation as
capacity to supply in the definition stresses that any increase in too much currency in relation to the physical volume of
demand, at a given moment, constitutes a call for an increase in business being done. Prof. Coulbourn has defined inflation as
production. If the productive apparatus can meet the challenge, too much money. chasing too few goods. These definitions
there will be no inflation. Inflation can come aboUt only if given by Hawtrey, Kemmerer, and Coulbourn belong to the
expansion in production or supply is held back by some same category. They seek to establish cause and effect relation-
obstacle, such as full employment of resources or occasionally, ship between supply of money and the price level. According to
by some constraints, and market imperfections. In this sense, these definitions, the rise in the pricelevel is caused by an
the term inflation is also applicable to an economy when a increase in the supply of money. The increase in the supply of
rise in the price level may not lead to increased output beyond a money is the cause, the rise in the price-level is the effect.
certain stage due to the existence of bottlenecks, even. though But the above cause and effect relationship between supply of
the stage of full employment is not attained. Briefly then, apart money and the price-level was reversed in Germany after the
from price rise, the existence of excess demand is regarded as an First World War. The rise in the price-level, instead of being the
essential characteristic of inflation. result, was actually the cause of the expansion of money supply
It is generally believed that inflation is accompanied by growth in Germany in .the post-war period. In other words, it was the
in employment. rise in prices which caused the expansion of money supply in
Germany. It is in this context that Prof. Einzig has drawn a
However, in recent years, the world has been experiencing a
distinction between money inflation and price inflation.
situation in which the price level has been continuously rising
but simultaneously there has been a rise in the rate of unem-

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50 11.251
-According to him, money inflation is the first stage of inflation during the war, or during the planning period, or during a

BUSINESS ECONOMY II
in which the excess of money supply over business require- period of technological improvements.
ments pushes up the price-level. Price inflation is the second There is, however, no fundamental difference between the two
stage of inflation when the rising price-level necessitates a rapid approaches. The excess demand can become effective only
expansion of the supply of money. During price inflation, the through an increased supply of money. The increased supply of
prices rise with such rapidity that even the money supply cannot money is thus the causal factor of inflation. Ultimately, there is
keep pace with them. The stage of inflation is referred to as no basic difference between the quantity theory of money
hyper-inflation. To our mind, Einzigs definition of inflation approach and the excess demand approach. The excess demand
appears to be the best because it fully explains the phenomenon approach is, however, more popular than the quantity theory of
of inflation. In the words of Einzig, Inflation is that state of money approach.
disequilibrium in which an expansion of purchasing power
The above explanation of excess demand approach highlights
tends to cause or is the effect of an increase in the price-leveL
the various factors that cause the emergence of excess demand
An analysis of this definition reveals the fact that the rise in the
in the economy. The emergence of excess demand in the
price-level is not only the result but also the cause of the
economy can be attributed to two main factors:
expansion of money supply.
i. Increase in the demand for goods and services, and
But recently, Prof. Keynes has linked up the concept of inflation
with the phenomenon of full employment. According to ii. Decrease in the supply of goods and services. The factors
Keynes, an inflationary rise in the price-level cannot take place causing an increase in demand include increase in public
before the point of full employment. An expansion of money expenditure, increase in private expenditure, increase in
supply will not lead to a rise in the price-level so long as there exports, reduction in taxation and repayment of past
are unemployed resources in the economy. The price-level will internal debts. The factors causing a decrease in supply
rise only after the point of full employment has been reached. include such things as shortage of supplies of factors of
According to Keynes, the rise in the price-level after the point of production, hoarding by traders and consumers, etc.
full employment is true inflation. Demand Inflation and Cost Inflation
Approaches to the Theory of Inflation Broadly speaking, there are two main causes of inflation: (I) an
There are two main approaches to the theory of inflation: increase in effective demand, and (ii) an increase in production
cost. The former gives rise to demand inflation while the latter
i. The Quantity Theory of Money Approach, and
leads to cost inflation.
ii. The Excess Demand Approach.
Demand-Pull Inflation
i. The Quantity Theory of Money Approach Demand-pull inflation is caused by an increase in the aggregate
According to this approach, it is the increase in the quantity of effective demand for goods and services in the economy. The
money which causes an inflationary rise in the price-level. This effective demand increases due to increased money incomes of
approach looks upon inflation as a purely monetary phenom- the factors of production consequent upon increased invest-
enon. It has been subjected to criticism in recent years: ment in the economy. This demand inflation is marked by a
a. This approach does not adequately explain the considerable rise in commodity and factor prices in the
phenomenon of hyper-inflation which took place in economy. This type of inflation generally arises in thePost-war
Germany in the post-war period. It was the rise in the price- period when people rush up to give vent to their pent-up
level which caused an increase in the supply of money there. demand for goods and services. The demand inflation can be
b. This approach is not applicable to an economy which tackled by the government by curtailing unnecessary demand
suffers from depression and unemployment. through the adoption of monetary and fiscal measures.
An expansion of money in such an economy may not necessar- Cost-Push Inflation
ily result in an inflationary rise in the price-level. An expansion The cost-push inflation is caused by an increase in production
of money supply in such an economy, instead of raising the costs. It is generally caused by two factors: (a) an increase in
price-level, will go to increase output and employment. wages, and (b) an increase in the profit-margins of the
entrepreneurs. The increase in wages may be caused by a
ii. Thee Excess Demand Approach
monopolistic labour union through pressure tactics. This
This approach has been developed in recent years by the
attempt on the part of the trade unions to push up wages
Cambridge economists, particularly Keynes. According to them,
invariably causes cost inflation in the economy. Cost inflation is
Just as the price of any good is determined by the demand for
also caused by an organized attempt on the part of the
and the supply of it, so also the general price-level is determined
industrialists to push up their profit margins. But the profits-
by the total demand for and total supply of the group of
push elements are not so important in causing inflation as the
goods concerned. Thus, according to this approach, inflation is
wage-push elements are. Powerful trade unions get the wages
that situation in which the total demand for goods exceeds the
pushed up even without an equivalent increase in the productiv-
total supply of goods at current prices. The sole cause of
ity of the workers. Under these circumstances, the increase in
inflation, according to this approach, is the existence of a
wages cannot but result in an increase in prices. When cost
persistent excess demand in the economy. This phenomenon
inflation arises in one particular industry, it soon spreads to the
of excess demand can arise in a number of situations, such as,
other factors of economy as well, the reason being that the

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11.251 51
various sectors of the economy are closely linked with each deftnition depends upon the net disposable income of the
BUSINESS ECONOMY II

other. community. The net disposable income of the community, in


It should be noted that demand inflation and cost inflation are its own turn, is arrived at by subtracting taxation and saving out
not mutually exclusive concepts. Demand inflation, when it of the total money income. Net disposable income = total
once starts, may soon land the economy into cost inflation. An money income taxation saving. Anticipated total expenditure of
increase in the prices of consumer goods is invariably accompa- the community is determined by tbe aggregate consumption,
nied by the demand for higher wages on the part of the investment and government outlays. Thus,total anticipated
workers. The prices of raw materials may also. register a rise expenditure = C + I + G (where, C represents consumption
under the impact of demand inflation. An increase in wages expenditure, I denotes investment expenditure, and G shows
and the prices of raw materials will naturally lead to the government outlays on goods and services).
emergence of cost inflation in, the economy. It is, thus, difficult The real output, on the other hand, is determined by the
to demarcate the line between demand inflation and cost conditions of employment, plus the technological basis of the
inflation. Of the two types of inflations, cost inflation is much economy. The inflationary gap is a situation where the antici-
more difficult to control than demand inflation.. Demand pated expenditure (i.e., the demand for output) exceeds the
inflation can be tackled by adopting various types of monetary available output at pre-inflation prices. It is measured by the
and fiscal measures to mop up surplus purchasing power from difference between the net disposable income on the one hand
the hands of the public, but cost inflation cannot be so easily and the available output on the other.
controlled through monetary and ftscal measures. Any attempt The inflationary gap may develop in the economy like this. To
to cut down wages by the authorities will be met by stiff start with, there is an increase either in private investment or in
resistance on the part of the workers. government outlays. This has the result of raising the money
Students in some lessons I have introduced exercise for practice income of the community to higher levels, but the real output
to enable you to answer in a structural manner.I hope it will of goods and services does not increase because the economy is
help you all. already operating at the point of full employment. The failure
of the economy to raise its output in response to the increase in
Exercise for Practice
the money income results in the emergence of the inflationary
Ex. 1. gap. The inflationary gap is, thus, the result of excess demand
Distinguish between cost-push and demand-pull inflation. in the economy. In other words, the inflationary gap is equal to
Why is it difficult to separate the one from the other? net disposable income minus real output of goods and
services. The inflationary gap has been explained in the Table
Hints:
below which represents the state of affairs in an imaginary
you may point out that it is often difftcult to separate demand-
wartime economy
pull inflation from cost-push inflation. Demand-pull inflation,
when it starts, soon lands the economy into cost-push infla- TABLE (In croses of Rupees)
tion. Demand inflation results in a steep rise in the prices of
Demand side Supply Side
consumer goods. The workers agitate and through concerted
Total Money Income .300 Gross National Product
action get their wages raised. This soon results in increases in
production costs or in cost-push inflation. For a detailed Minus Taxes 50 (at per inflation prices) .270
treatment of this aspect,.} Total Disposal Income ..250 Minus War Expenditure .90

the Keynesian Theory of Inflationary Gap. Minus Saving 50 Available Output for

Inflationary Gap arises when money expands more than in Net Disposable Income 250 Civilian Consumption
proportion to income-earning activity. Explain and suggest the (at pre-inflation prices) .180
necessary measures to bridge any such gap in a developing Hence,Inflationary Gap =200-180 = Rs. 20 crore
economy.
The above Table relates to a wartime economy. There is a clear
Inflationary Gap inflationary gap of Rs. 20 crore in the economy. So long as this
Real inflation, according to Keynes, comes into being only if inflationary gap continues to exist, the price-level shall go on
monetary expansion continues even beyond the point of full rising upwards. But if somehow this inflationary gap of Rs. 20
employment. Then every additional expansion of money Crore is wiped out, there shall be no inflation at all. The
supply shall exert its full effect on prices, raising them to higher government can reduce a part of this inflationary gap by cutting
and higher levels. Keynes tried to explain the phenomenon of down disposable income through taxes. The whole of the gap
inflation in terms of his well-known concept of inflationary gap cannot be wiped out through taxation, because in that case there
in his famous pamphlet entitled How to Pay for the War? The is bound to be tax:resistance and popular unrest. So it is
Keynesian concept of inflationary gap represents the technique advisable to remove the inflationaryc-gap through taxes as well
of statistically measuring the pressure of inflation in the as induced savings. Yet another way to reduce or narrow down
economy. The inflationary gap for the economy, as a whole, may the inflationary gap is to increase the supply of consumer
be deftned in the words of Prof. Kurihara, as an excess of goods. But in wartime, the scope for increasing the supply of
anticipated expenditure over available output at base prices. consumer goods for civilians is rather limited. So the only
The anticipated total expenditure referred to in the above methods available for narrowing down the inflationary gap

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52 11.251
during wartime are taxes and public borrowings. It should,

BUSINESS ECONOMY II
however, be remembered that the inflationary gap cannot be
completely wiped out during wartime.
Hence, the possibility of inflation is always there in a wartime
economy. The inflationary gap can also arise in a planned
economy where the anticipated expenditure may exceed the total
output of goods and services. Thus, whenever the amount of
disposable income exceeds the volume of output available, an
inflationary gap is bound to arise in the economy. If, on the
contrary, the volume of output exceeds the disposable money
income, then a deflationary gap is bound to emerge, giving rise
to a falling price-level in the economy.higher and higher levels.
Since the economy is already operating at the point of full
employment, the supply of money income increases more
rapidly than the output of goods and services in the economy.
With the expenditure increasing faster than the output of
goods and services, the prices will naturally rise to equate the
increased expenditure with the money value of output at a
higher price-level. The inflationary gap may, therefore, be
defined as the amount by which the monetary demand exceeds
the value of current output at existing .prices. In order to keep
prices constant, the output should be increased by an amount
that is sufficient to absorb the excess demand caused by the
increased government expenditure. The price-level can remain
constant only if the output of goods and services increases
from OMI to OM2. This amount of output is equal to the
excess demand P1N1 caused by the increased government
expenditure. The inflationary gap of P1N1-in the diagram can be
wiped out only if the output of goods and services increases by
M1M2
The concept of inflationary gap is a very useful concept in
economic analysis. It not only measures statistically the pres-
sures of inflation in the economy, it also highlights the nature
and the extent of anti-inflationary measures, both fiscal and
monetary, which the government can adopt to cure the
economy of the malady of inflation. /
The Shrinking Dollar
Inflation: definition
A rise in the general price level
Note that this does not mean that all prices are rising.
Deflation, the opposite of inflation, is a decrease in the
general price level.

Notes -

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