Inflation refers to a sustained increase in the general price level of goods and services in an economy over a period of time. It results in the erosion of the purchasing power of money, meaning each unit of currency buys fewer goods and services than before. In India, the Primary measure for inflation is the Consumer Price Index (CPI), though the Wholesale Price Index (WPI) is also tracked for production-level price shifts.
Classification Based on Rate of Growth
Economists categorize inflation based on the speed at which prices rise, which dictates the nature of policy intervention required by the Reserve Bank of India (RBI).
- Creeping Inflation: Prices rise slowly, typically between 1% to 3% per annum. This is generally considered functional or even necessary for a growing economy as it encourages investment.
- Trotting or Walking Inflation: When prices rise by 3% to 10% annually. This serves as a warning signal for the government to implement fiscal and monetary controls to prevent it from spiraling.
- Galloping Inflation: Characterized by double or triple-digit increases (e.g., 20%, 100%, or 200%) within a year. It leads to serious economic distortions and loss of confidence in the currency.
- Hyperinflation: An extreme state where prices rise exceptionally fast, often exceeding 50% per month. Historical examples include Germany (1920s), Zimbabwe (2000s), and Venezuela (current era).
Classification Based on Causes
The root causes of inflation are generally divided into demand-side and supply-side factors.
Demand-Pull Inflation
This occurs when the aggregate demand for goods and services exceeds the aggregate supply at current prices (“too much money chasing too few goods”). Key drivers include:
- Increased government spending or fiscal stimulus.
- Reduction in direct taxes, increasing disposable income.
- Low interest rates leading to cheap consumer credit.
- Rapid population growth or increase in export demand.
Cost-Push Inflation
Also known as “Supply-shock inflation,” this is caused by a substantial increase in the cost of production. Key drivers include:
- Rise in global crude oil prices (imported inflation).
- Increase in Minimum Support Price (MSP) for crops.
- Hike in indirect taxes (like GST) or wages.
- Natural calamities or supply chain disruptions leading to scarcity.
Core vs. Headline Inflation
Understanding the components of inflation is vital for UPSC aspirants to grasp how the RBI formulates the Repo Rate.
| Feature | Headline Inflation | Core Inflation |
| Definition | Total inflation within an economy including all commodities. | Inflation excluding volatile sectors like Food and Fuel. |
| Volatility | High, as it reacts to seasonal crop failures or global oil shocks. | Low and stable; reflects the underlying trend of the economy. |
| Policy Utility | Used for the “Inflation Targeting” framework in India (4% +/- 2%). | Used to understand long-term price stability. |
Specific Economic Terms Related to Inflation
- Deflation: A persistent decrease in the general price level (negative inflation rate). It often leads to a recessionary spiral.
- Disinflation: A reduction in the rate of inflation (e.g., inflation falling from 8% to 5%). Prices are still rising, but at a slower pace.
- Stagflation: A unique situation where the economy faces high inflation, high unemployment, and stagnant economic growth simultaneously.
- Reflation: A deliberate attempt by the government or central bank to increase the money supply to pull the economy out of a recession.
- Skewflation: A price rise in one or a small group of commodities while others remain stable or fall (e.g., a sudden spike in onion prices while electronics become cheaper).
Important Indices and Facts for UPSC Prelims
- Inflation Targeting: The RBI’s Monetary Policy Committee (MPC) is legally mandated to maintain CPI inflation at 4% with a tolerance band of +/- 2%.
- WPI vs. CPI: WPI measures price changes at the factory gate and does not include services. CPI measures price changes at the retail level and includes services (Education, Health, etc.).
- Base Year: The current base year for CPI (Combined) is 2012, while the base year for WPI is 2011-12.
- Producer Price Index (PPI): Several committees have recommended moving from WPI to PPI to better capture price changes without the bias of indirect taxes and trade margins.
- The Phillips Curve: An economic concept stating an inverse relationship between inflation and unemployment (lower unemployment correlates with higher inflation).
The Effects of Inflation on Different Stakeholders
Inflation does not affect all sections of society equally.
- Debtors (Borrowers): Generally gain because they repay money that has less purchasing power than when they borrowed it.
- Creditors (Lenders): Generally lose as the real value of the money they receive back is lower.
- Bondholders: Lose value as rising inflation typically leads to higher interest rates, which lowers bond prices.
- Fixed Income Groups: Pensioners and salaried employees suffer as their real income declines unless indexed to inflation (e.g., Dearness Allowance).
- Investment: Moderate inflation encourages investment by making hoarding cash unattractive, whereas high inflation creates uncertainty and discourages long-term capital formation.