Inflation, Meaning, Types, Causes, Measures, Impacts

Inflation is the sustained increase in the general price level of goods and services in an economy over a period. It reflects the decrease in purchasing power, meaning each currency unit buys fewer goods and services. As inflation rises, each unit of currency buys fewer goods and services, effectively decreasing the purchasing power of money.

Economists typically measure inflation as an annual percentage change in a price index, such as the Consumer Price Index (CPI) or the Gross Domestic Product (GDP) deflator.

What is Inflation?

Inflation is a gradual loss of purchasing power that results in a significant increase in the prices of goods and services over time. The inflation rate is calculated by averaging the price increases of a basket of selected goods and services over a year. High inflation means that prices are rising rapidly, whereas low inflation means that prices are rising more slowly. 

• Deflation: Inflation can be distinguished from deflation, which occurs when prices fall while purchasing power rises.

Inflation Types

Inflation is categorised based on the rate and causes of price increases. By rate, it includes creeping, walking, galloping, and hyperinflation. By causes, it comprises demand-pull, cost-push, structural, and protein inflation.

Types of Inflation Based on Rate

Inflation is categorised by the rate at which prices increase. Based on rate, inflation can be classified as creeping inflation, walking inflation (Trotting Inflation), galloping inflation (Hopping or Running Inflation), or hyperinflation.

• Creeping Inflation (Mild or Low Inflation): A gradual increase in prices, usually less than 3% annually, which is considered manageable and may positively stimulate demand and investment.
• Walking Inflation (Trotting Inflation): Prices increase at a moderate pace, generally around 3% to 10% per year. If unchecked, it can lead to economic overheating.
• Galloping Inflation (Hopping or Running Inflation): This inflation occurs when prices increase rapidly at double—or triple-digit annual rates, between 10% and 50%. It disrupts economic stability and can severely affect consumer purchasing power.
• Hyperinflation: An extreme form of inflation where prices rise over 50% monthly. Hyperinflation can decimate a currency’s value, as seen historically in Zimbabwe and Germany’s Weimar Republic.

Types of Inflation Based on Causes

Inflation can stem from various economic factors, including increased demand, higher production costs, structural issues, or supply constraints in specific sectors. Understanding these causes helps in crafting effective inflation control strategies.

• Demand-Pull Inflation: Demand-pull inflation occurs when an increase in the supply of money and credit causes overall demand for goods and services to rise faster than the economy's production capacity. This increases demand, which leads to price increases.
• Cost-Push Inflation: Cost-push inflation is caused by an increase in prices for inputs used in the production process. When more money and credit are channelled into commodity or other asset markets, prices for all types of intermediate goods rise. This is especially evident when a negative economic shock disrupts the supply of key commodities.
• Built-in Inflation: Built-in inflation is associated with adaptive expectations, which hold that current inflation rates will persist in the future. People may expect the price of goods and services to continue rising at a similar rate in the future.
• Structural Inflation: Structural inflation occurs due to economic issues such as rigid supply chains or monopolistic market structures, leading to periodic price hikes in specific sectors.
• Protein Inflation: Specifically related to the food sector, protein inflation refers to price increases in protein-rich food products like pulses, eggs, and meat, often due to demand shifts or supply constraints.

Inflation Causes

Inflation arises from demand-pull factors, cost-push factors, supply shocks, increased money supply, wage-price spirals, inflation expectations, and certain fiscal policies. These elements collectively drive price increases, impacting purchasing power.

• Demand-Pull Factors: When demand for goods and services exceeds supply, prices increase. This often happens when there is an influx of cash or credit in the economy, stimulating purchasing beyond the economy’s capacity.
• Cost-Push Factors: Rising production costs can also cause inflation. When the costs of inputs like raw materials and labour increase, companies pass these costs on to consumers through higher prices.
• Supply Shocks: Sudden disruptions to supply, such as natural disasters, conflicts, or pandemics, can significantly reduce the availability of critical goods. 
  • For example, supply chain issues during COVID-19 led to price spikes across sectors.
• Increased Money Supply: A significant increase in the money supply can drive inflation, as more cash circulating in the economy fuels higher demand. With too much money chasing too few goods, prices tend to rise.
• Wage-Price Spirals: When workers demand higher wages to cope with rising prices, businesses often raise prices to cover these increased labour costs. This cycle, known as the wage-price spiral, can fuel sustained inflation.
• Inflation Expectations: When people expect inflation to persist, they may demand higher wages and buy goods now to avoid future price increases, reinforcing inflation. Central banks aim to keep these expectations stable to control inflation.
• Fiscal Policies: Government policies like tax cuts or increased public spending can raise overall demand, leading to inflation if the economy is already operating at full capacity and supply cannot keep pace.

Measures of Inflation 

Inflation is measured using indices that track price changes in a basket of goods and services over time. A price index is a statistical measure that reflects changes in this average price level relative to a base year. In India, inflation is primarily tracked using two main price indices: the Wholesale Price Index (WPI) and the Consumer Price Index (CPI). Globally, another widely used measure of inflation is the GDP Deflator.

Wholesale Price Index (WPI)

The Wholesale Price Index (WPI) measures and tracks price changes in the wholesale market, focusing on goods traded between companies. It excludes services and is calculated monthly, representing a broad view of inflation at the wholesale level. In India, it is published by the Office of Economic Adviser, Department for Promotion of Industry and Internal Trade, with base year 2011-12.

Consumer Price Index (CPI)

The Consumer Price Index (CPI) tracks changes in the cost of a typical basket of goods and services over time, reflecting the overall shift in consumer prices. It is a key inflation measure monitored closely by policymakers, financial markets, businesses, and consumers alike. Unlike WPI, it includes services. The Central Statistics Office of the Ministry of Statistics and Programme Implementation publishes it.

Producer Price Index (PPI)

The Producer Price Index (PPI) measures price changes from the perspective of producers, capturing input cost changes across manufacturing and production sectors. While PPI does not account for consumer prices, it provides insight into cost pressures that may eventually impact retail prices.

GDP Deflator

The GDP Deflator measures price level changes across the entire economy, covering both goods and services produced domestically. It reflects the overall inflation rate by comparing the ratio of nominal GDP to real GDP. Unlike the Consumer Price Index (CPI), the GDP deflator allows for comparisons across multiple periods without relying on a fixed base year or a set basket of goods. 

• The GDP Deflator value is calculated using the formula: GDP deflator = (Nominal GDP / Real GDP) * 100.

Inflation Impacts

Inflation impacts various aspects of the economy, from reducing purchasing power and increasing interest rates to widening income inequality and affecting investment returns. It also hampers export competitiveness and raises business costs, complicating economic planning.

• Reduced Purchasing Power: Inflation erodes the purchasing power of money, meaning consumers can buy fewer goods and services with the same income, ultimately affecting their quality of life and standard of living.
• Increased Interest Rates: To control inflation, central banks often raise interest rates, making borrowing more expensive for individuals and businesses, which can slow down economic growth and investment activities.
• Income Inequality: Inflation impacts income groups unevenly. Lower-income households feel the pinch more as a larger portion of their income goes toward essentials, widening the gap between socioeconomic classes.
• Investment Returns: Inflation diminishes real returns on investments, especially fixed-income assets, as the actual purchasing power of returns is reduced, potentially discouraging savings and long-term investment.
• Export Competitiveness: Rising domestic prices make exports less competitive internationally, as foreign buyers may seek cheaper alternatives elsewhere, potentially harming industries that rely on exports for revenue.
• Business Costs and Planning: Inflation raises operational costs for businesses, especially in materials and labour, leading to challenges in pricing and long-term planning as businesses struggle to maintain profit margins.

Measures to Control Inflation

Measures to control inflation include adjusting interest rates, reducing government spending, boosting supply efficiency, and employing exchange rate policies, price controls, and subsidies to stabilise prices and maintain economic stability.

• Monetary Policy Measures: The Monetary Policy Committee is entrusted with fixing the benchmark policy rate required to contain inflation within the specified target level.
• As per the revised monetary policy framework, the Government has fixed the inflation target of 4% with a tolerance level of +/—2 per cent.
• RBI may also use qualitative control methods, such as raising margins on loans for commodities that traders tend to speculate on and hoard.
• The Reserve Bank of India may also resort to other operations, such as Open Market Operations, to remove liquidity from the market by selling government securities and bonds.
• Fiscal Measures: The government can take two routes to bring down prices through this method. It can cut down its spending on various schemes, projects etc. It can increase taxes (either directly or indirectly).
• Supply-Side Policies: These aim to increase production efficiency. By improving infrastructure, encouraging innovation, and removing regulatory barriers, supply-side policies help reduce production costs, thereby controlling cost-push inflation.
• Exchange Rate Policy: A strong currency can reduce import prices, making goods and services cheaper. Governments may intervene in the foreign exchange market to stabilise the currency, indirectly controlling inflation through lower import costs.
• Price Controls and Subsidies: Temporary price controls on essential goods can help limit inflation. Governments may also provide subsidies to reduce the cost of essential products like food and fuel, stabilising prices in the short term.
• Targeted Interventions: In cases of specific inflationary pressures, such as food inflation, governments may release buffer stocks or modify import policies to ensure adequate supply, addressing price rises in critical sectors.

Inflation UPSC PYQs

Question 1: Do you agree with the view that steady GDP growth and low inflation have left the Indian economy in good shape? Give reasons in support of your arguments. (UPSC Mains 2019)

Question 2: Consider the following statements: (UPSC Prelims 2020)

1. The weightage of food in Consumer Price Index (CPI) is higher than that in Wholesale Price Index (WPI).
2. The WPI does not capture changes in the prices of services, which CPI does.
3. Reserve Bank of India has now adopted WPI as its key measure of inflation and to decide on changing the key policy rates.

Which of the statements given above is/are correct?

(a) 1 and 2 only 

(b) 2 only 

(c) 3 only

(d) 1, 2 and 3

Ans: (a)

Question 3: If the RBI decides to adopt an expansionist monetary policy, which of the following would it not do? (UPSC Prelims 2020)

1. Cut and optimize the Statutory Liquidity Ratio
2. Increase the Marginal Standing Facility Rate
3. Cut the Bank Rate and Repo Rate

Select the correct answer using the code given below:

(a) 1 and 2 only 

(b) 2 only 

(c) 1 and 3 only

(d) 1, 2 and 3

Ans: (b)

Question 4: The lowering of Bank Rate by the Reserve Bank of India leads to (UPSC Prelims 2011)

(a) More liquidity in the market

(b) Less liquidity in the market

(c) No change in the liquidity in the market

(d) Mobilization of more deposits by commercial banks

Ans: (a)

Inflation FAQs

Q1. What do you mean by inflation?

Ans. Inflation is a sustained increase in the general price level of goods and services in an economy over time, resulting in decreased money's purchasing power.

Q2. What is India's inflation rate?

Ans. Retail inflation in India increased to 6.21% in October, up from 5.49% in September 2024, driven by rising food prices. 

Q3. Which causes inflation?

Ans. Inflation can be caused by increased production costs, higher consumer demand, expansionary monetary policies, supply chain disruptions, or rising wages pushing up prices.

Q4. What are three types of inflation?

Ans. The three main types of inflation are demand-pull inflation (excess demand), cost-push inflation (rising production costs), and built-in inflation (wage-price spiral)

Q5. Is inflation good or bad?

Ans. Moderate inflation (2-3%) can stimulate economic growth, but high inflation erodes purchasing power, creates uncertainty, and harms savers. Overall, the effects are mixed.