Inflation
- Inflation is a sustained rise in the general price level. This unit covers the meaning and types of inflation (demand-pull, cost-push, built-in)
- measurement through the Consumer Price Index (CPI)
- causes, effects, and anti-inflationary measures
- the Phillips curve linking inflation and unemployment
- the concepts of deflation and stagflation.
In this chapter
Meaning and Types of Inflation
Inflation is a sustained increase in the general price level of goods and services over time. When the general price level rises, each unit of currency buys fewer goods and services — so inflation reduces the purchasing power of money. The inflation rate is the percentage change in the price level from one period to the next, usually measured year-over-year.
Inflation rate formula
Types of Inflation
| Type | Cause | Key Feature |
|---|---|---|
| Demand-pull | AD > AS — too much money chasing too few goods | Prices rise because demand outstrips supply |
| Cost-push | Rising input costs (wages, raw materials, oil) | Prices rise because supply shifts left |
| Built-in (wage-price spiral) | Workers expect inflation and demand higher wages | Self-perpetuating — expectations drive actual inflation |
| Creeping | Low, steady (< 3% per year) | Considered healthy for economic growth |
| Galloping | High (10%–100% per year) | Serious economic disruption |
| Hyperinflation | Extremely high (> 50% per month) | Money becomes worthless — e.g., Zimbabwe, Venezuela |
Measurement: Consumer Price Index (CPI)
The Consumer Price Index (CPI) is the most common measure of inflation. It tracks the cost of a fixed basket of goods and services that a typical urban household buys each month. The basket includes food, housing, clothing, transport, health, education, and other items. The CPI is calculated as: CPI = (cost of basket in current year ÷ cost of basket in base year) × 100. The inflation rate is then the percentage change in CPI from one year to the next. In Nepal, the Nepal Rastra Bank publishes CPI data monthly, with weights based on the household survey.
CPI and inflation rate calculation
Hypothetical CPI Basket and Cost
| Item | Quantity | Base year price (Rs) | Current price (Rs) | Base cost | Current cost |
|---|---|---|---|---|---|
| Rice (kg) | 20 | 60 | 80 | 1,200 | 1,600 |
| Vegetables (kg) | 15 | 50 | 70 | 750 | 1,050 |
| Clothing (m) | 5 | 200 | 250 | 1,000 | 1,250 |
| Transport (trips) | 30 | 30 | 40 | 900 | 1,200 |
| Total | 3,850 | 5,100 |
Real-Life Example: Nepal's CPI
Nepal's CPI basket has 464 items grouped into 12 categories. Food and beverages carry the largest weight (about 44%), followed by housing and utilities (about 28%), and clothing and footwear (about 6%). In FY 2022/23, Nepal's inflation was about 7.7% — driven mainly by rising food prices (especially vegetables and cooking oil), higher fuel prices, and the depreciation of the Nepali rupee against the US dollar, which made imports more expensive.
Demand-Pull vs Cost-Push Inflation
Demand-pull inflation occurs when aggregate demand exceeds aggregate supply at the current price level — "too much money chasing too few goods." Causes: increase in money supply, government spending, consumer confidence, or exports. The AD curve shifts right, raising both output and prices (in the short run). Cost-push inflation occurs when production costs rise, shifting the aggregate supply curve left. Causes: higher wages, oil price shocks, raw material costs, or a depreciating currency (which raises import costs). Output falls while prices rise — a worse combination called stagflation.
Effects of Inflation
Effects on Different Groups
- Redistributes wealth: borrowers gain (repay with cheaper money), lenders and savers lose. Fixed-income earners (pensioners) lose.
- Reduces purchasing power: each rupee buys less — hurts the poor disproportionately.
- Hurts exporters: domestic prices rise, exports become less competitive. Helps importers if currency doesn't adjust.
- Distorts price signals: businesses can't tell if a price rise means higher demand or just inflation.
- Menu costs: firms must constantly change prices, print new menus, update catalogues.
- Shoe-leather costs: people hold less cash and visit banks more often, wasting time.
- Tax distortions: nominal income rises push people into higher tax brackets even though real income hasn't changed ("bracket creep").
The Phillips Curve
The Phillips curve, named after New Zealand economist A.W. Phillips (1958), shows an inverse relationship between inflation and unemployment in the short run. When unemployment is low, inflation is high (because tight labour markets push up wages, which push up prices). When unemployment is high, inflation is low. The curve suggests a policy trade-off: governments can reduce unemployment by accepting higher inflation, or reduce inflation by accepting higher unemployment. In the long run, however, the Phillips curve is vertical at the natural rate of unemployment — there is no trade-off. Attempts to push unemployment below the natural rate only accelerate inflation (the accelerationist hypothesis, associated with Milton Friedman and Edmund Phelps).
Deflation and Stagflation
Deflation is a sustained fall in the general price level (negative inflation). While it sounds good for consumers, deflation can be dangerous — it discourages spending (why buy today if it'll be cheaper tomorrow?), increases the real burden of debt, and can lead to a deflationary spiral of falling demand, falling output, and falling employment. Japan has experienced deflation for much of the past 30 years. Stagflation is the combination of stagnation (high unemployment, low output) and inflation (rising prices) — the worst of both worlds. It was a major problem in the 1970s when oil price shocks caused cost-push inflation while simultaneously causing recession. Stagflation disproved the simple Phillips curve trade-off.
Anti-Inflationary Measures
Governments and central banks use both monetary policy (raising interest rates, reducing money supply, raising reserve requirements) and fiscal policy (cutting government spending, raising taxes) to fight demand-pull inflation. For cost-push inflation, supply-side measures help: reducing import duties, improving infrastructure, increasing agricultural productivity, and stabilising exchange rates. Income policies (wage-price guidelines) can address built-in inflation. The challenge: contractionary policies that reduce inflation also tend to raise unemployment — the Phillips curve trade-off.
Practice Problem
A household buys the following basket in the base year and current year: 20 kg rice (base Rs 60/kg, current Rs 80/kg); 10 kg vegetables (base Rs 50/kg, current Rs 75/kg); 5 litres cooking oil (base Rs 150/litre, current Rs 220/litre). (a) Calculate the cost of the basket in the base year and the current year. (b) Calculate the CPI (base year = 100). (c) Calculate the inflation rate.
Friedman's Expectations-Augmented Phillips Curve
Milton Friedman (1968) and Edmund Phelps independently argued that the short-run Phillips curve trade-off is an illusion. They introduced adaptive expectations — workers base their wage demands on past inflation, not current. In the short run, there is a trade-off because workers are fooled by unexpected inflation (they accept lower real wages, firms hire more). But in the long run, workers adjust their expectations — the Phillips curve becomes vertical at the natural rate of unemployment. Attempts to push unemployment below the natural rate only accelerate inflation — the accelerationist hypothesis. This means there is no permanent trade-off between inflation and unemployment.
Short-Run vs Long-Run Phillips Curve
| Feature | Short-Run PC | Long-Run PC |
|---|---|---|
| Shape | Downward sloping | Vertical at natural rate |
| Trade-off | Yes (inflation ↔ unemployment) | No trade-off |
| Expectations | Fixed (adaptive, past-based) | Adjusted (correct) |
| Policy implication | Can reduce U by accepting higher π | Cannot reduce U below natural rate |
Effects of Inflation on Different Groups
Winners and Losers from Inflation
| Group | Effect of Inflation | Why? |
|---|---|---|
| Debtors/Borrowers | Gain ↑ | Repay with cheaper money |
| Creditors/Lenders | Lose ↓ | Repaid in money worth less |
| Fixed wage earners | Lose ↓ | Real wage falls |
| Business owners | Gain ↑ (if prices rise faster than costs) | Profit margins expand |
| Pensioners | Lose ↓ | Fixed income buys less |
| Speculators in real estate/gold | Gain ↑ | Asset prices rise with inflation |
| Exporters | Lose ↓ (if currency doesn't depreciate) | Domestic costs rise, competitiveness falls |
Real-Life Example: Nepal's Inflation Drivers
Nepal's inflation is heavily influenced by: (1) India — since 60% of trade is with India and the rupee is pegged to INR, Indian inflation transmits directly; (2) Fuel prices — Nepal imports all petroleum; when global oil rises, transport costs push up all prices; (3) Food supply — agricultural shocks (droughts, floods) cause food price spikes (food has 44% weight in CPI); (4) Exchange rate — depreciation against USD makes imports from third countries costlier. In FY 2022/23, Nepal's 7.7% inflation was driven mainly by food (9.5%) and transport (12%) price rises.
Stagflation: The Worst Case
Stagflation = stagnation (high unemployment, low growth) + inflation (rising prices). It is the worst of both worlds — the economy suffers from recession AND inflation simultaneously. The 1970s oil crisis caused stagflation worldwide: oil prices quadrupled → production costs rose (cost-push inflation) → firms cut output and laid off workers (recession). The simple Phillips curve could not explain this — it predicted that high unemployment should mean low inflation. Stagflation led to the development of the expectations-augmented Phillips curve and supply-side economics.
Key Terms and Definitions
- Inflation: Sustained rise in the general price level — महंगी: सामान्य मूल्य स्तरमा दिगो वृद्धि।
- CPI: Consumer Price Index — cost of a fixed basket of goods — CPI: उपभोक्ता मूल्य सूचकांक।
- Demand-pull inflation: AD exceeds AS — "too much money chasing too few goods" — माग-आकर्षित महंगी।
- Cost-push inflation: Rising input costs shift AS left — लागत-धक्का महंगी।
- Phillips curve: Short-run inverse relationship between inflation and unemployment — फिलिप्स वक्र।
- Natural rate of unemployment: Frictional + structural unemployment — प्राकृतिक बेरोजगारी दर।
- Stagflation: Stagnation + inflation simultaneously — स्ट्यागफ्लेसन: स्थगन + महंगी।
- Deflation: Sustained fall in the general price level — अपस्फीति: सामान्य मूल्य स्तरमा दिगो पतन।
- Disinflation: Reduction in the inflation rate (prices still rising, but slower) — अन्तःस्फीति: महंगी दरमा कमी।
- Hyperinflation: Extremely high inflation (>50% per month) — अतिमहंगी: अत्यधिक उच्च महंगी।
- GDP deflator: Measure of price level = (Nominal GDP ÷ Real GDP) × 100 — GDP डिफ्लेटर।
- Menu costs: Costs of changing prices during inflation — मेनु लागत: महंगीमा मूल्य परिवर्तनको लागत।
Practice Problem
An economy has a natural rate of unemployment of 5%. The short-run Phillips curve is π = π^e − 0.5(u − 5%), where π is actual inflation, π^e is expected inflation, and u is actual unemployment. Initially, π^e = 3% and the economy is at the natural rate. (a) What is the actual inflation rate? (b) If the central bank surprises everyone by pushing unemployment to 3% (below natural rate), what is the actual inflation? (c) After one year, expectations adjust to the new actual inflation (π^e becomes the new π). What is the new actual inflation at u = 3%? (d) What happens if the central bank tries to keep u = 3% forever?