Causes and Effects of Inflation

By inflation one generally means rise in prices. To be more correct inflation is persistent rise in the general price level rather than a once-for-all rise in it, while deflation is persistent falling price. A situation is described as inflationary when either the prices or the supply of money are rising, but in practice both will rise together. These days economies of all countries whether underdeveloped, developing as well developed suffers from inflation. Inflation or persistent rising prices are major problem today in world. Because of many reasons, first, the rate of inflation these years are much high than experienced earlier periods. Second, Inflation in these years coexists with high rate of unemployment, which is a new phenomenon and made it difficult to control inflation.

An inflationary situation is where there is ‘too much money chasing too few goods’. As products/services are scarce in relation to the money available in the hands of buyers, prices of the products/services rise to adjust for the larger quantum of money chasing them.

Causes of Inflation

1. Over- Expansion of Money Supply: Many a times a remarkable degree of correlation between the increase in money and rise in the price level may be observed. The Central Bank (India’s RBI) should maintain a balance between money supply and production and supply of goods and services in the economy. Money supply exceeds the availability of goods and services in the economy, it would lead to inflation.
2. Increase in Population: Increase in population leads to increased demand for goods and services. If supply of commodities are short, increased demand will lead to increase in price and inflation.
3. Expansion of Bank Credit: Rapid expansion of bank credit is also responsible for the inflationary trend in a country.
4. Deficit Financing: Deficit financing means spending more than revenue. In this case government of India accepts more amount of money from the Reserve Bank India (RBI) to spend for undertaking public projects and only the government of India can practice deficit financing in India. The high doses of deficit financing which may cause reckless spending, may also contribute to the growth of the inflationary spiral in a country.
5. High Indirect Taxes: Incidence of high commodity taxation. Prices tend to rise on account of high excise duties imposed by the Government on raw materials and essentials.
6. Black Money: It is widely condemned that black money in the hands of tax evaders and black marketers as an important source of inflation in a country. Black money encourages lavish spending, which causes excess demand and a rise in prices.
7. Poor Performance of Farm Sector: If agricultural production especially food grains production is very low, it would lead to shortage of food grains, will lead to inflation.
8. High Administrative Pricing
9. Other reasons are capital bottleneck, entrepreneurial bottlenecks, infrastructural bottlenecks and foreign exchange bottlenecks.

Effects of Inflation

1. Effects of Inflation on Business Community: Inflation is welcomed by entrepreneurs and businessmen because they stand to profit by rising prices. They find that the value of their inventories and stock of goods is rising in money terms. They also find that prices are rising faster than the costs of production, so that their profit is greatly enhanced.
2. Fixed Income Groups: Inflation hits wage-earners and salaried people very hard. Although wage-earners, by the grace of trade unions, can chase galloping prices, they seldom win the race. Since wages do not rise at the same rate and at the same time as the general price level, the cost of living index rises, and the real income of the wage earner decreases.
3. Farmers: Farmers usually gain during inflation, because they can get better prices for their harvest during inflation.
4. Investors: Those who invest in debentures and fixed-interest bearing securities, bonds, etc, lose during inflation. However, investors in equities benefit because more dividend is yielded on account of high profit made by joint-stock companies during inflation.
5. Inflation will lead to deterioration of gross domestic savings and less capital formation in the economy and less long term economic growth rate of the economy.