Inflation definition, types

Inflation, in very simple terms, denotes a persistent rise in the general price level. There is ambiguity about the rate of price increase.

Rate of price increase beyond a certain mark with or without objective basis may be considered appreciable (i.e. perceptible but not necessarily requiring adjustment by different agents or inflicting some adverse impact) or excessive (i.e. having the potential to inflict harmful effects).

But there is no consensus about a specific percentage rate of price rise. After living many years with 8% - 16% annual inflation rate, 2% or 3% annual rise in general price level may not be considered inflationary by a society.

The minimum rate of general price rise which qualifies to be accepted as inflation may itself rise over the years if the society continues to experience increasingly high rate of inflation as years pass by.

The next question is what should be the length of time span during which general price level is observed to rise persistently. If we agree about length of time span we may quite frequently have inflation in one period but deflation in another period.

Besides, we may not have relevant macro-level data for smaller time periods like fortnights or weeks in most of the countries. Controversy as to whether a state of rising prices be called inflation or not does not arise when we have double digit or higher annual rate of price increase sustained over a period of at lest one year.

Such states, most of the economists will agree, are inflationary states. Admitting some amount of ambiguity we define inflation as a persistent and appreciable rise in the general price level with the following clarifying note:

(1) most of the prices must have sustained rise at lest over a period of one year, and

(2) general price level must rise at an annual rate of 5% or more. There are still two other problems with this somewhat blunt definition of inflation:

(a) it does not say what should be the measure of inflation. The Consumer Price Index, The Producer Price Index and The GDP Implicit Deflator all cover a wide variety of goods and services and hence, qualify as measures for inflation and

(b) the above definition does not cover the so called suppressed or repressed inflation as they are notional and not observable. During war time markets may be substantially replaced by wage and price controls and rationing. Had the general price level not been controlled there could have been persistent and appreciable rise in the general price level.

The existence of black market and rising prices in that market may bear testimony in support of that conjecture.

Rate of inflation in year t may be worked out using the following expression: Rate of inflation in year t = (general price level in year t - general price level in year t-1) 100. A price index is a measure of general price level and is a weighted average of the prices of a number of goods and services. The most important and frequently used price indexes are the consumer Price Index (CPI) the GDP Implicit Deflator and the Producer Price Index (PPI).

PPI is similar to CPI in construction. It however measures the prices of large number of goods (and not services) at the level of their first commercial transaction. This index is widely used by businesses. Prices are either wholesale prices or farmgate prices. Both CPI and PPI use fixed quantity weights for prices.

Unlike the CPI or the PPI, GDP Implicit Deflator uses variable weights for prices. This deflator is primarily used to get a measure of growth of real output over time. This covers final goods and services and considers all sectors of the economy. This deflator for a particular year is obtained by dividing the nominal GDP of that year by the real GDP of the same year. Hence is the use of the adjective, implicit. Real GDP of that year is obtained by multiplying the quantities of final goods and services produced in that year by the corresponding retail prices that prevailed in predetermined base year. Such products are then added up to obtain Real GDP (or GDP in base year prices). We can use any of the above price indices to find rate of inflation in the following manner: Rate of inflation in year, t = {(Price Index in year t - Price Index in year t-1)/(Price Index in year t-1)}  100%. All those indices do not consider the change of quality and introduction of new commodities. The first two indices are over estimates when people substitute relatively inexpensive goods and services for relatively expensive ones. Further more, problems arise when those indices differ widely among themselves and/ or move in opposite direction. For instance PPI may rise at an annual rate of only 3% while for CPI the rate is 8%. Such a situation probably suggest a poor or declining state of market integration. But when all the indices rise at high rates (say at double digit rate) the economy clearly suffers the brunt of inflation.

On the basis of annual rate of increase sustained rises in prices are sometimes called creeping (less than 5%), walking inflation (5-10)%, trotting (two digit rates but less than 50%) and galloping or hyper inflation (more than 50% to 3 or 4 digit rates). The following three types of inflation are very often mentioned.

Moderate Inflation: This denotes single digit annual inflation rates. Prices rise predictably and people trust money. Long term contracts are kept in terms of money during moderate inflation. 

Galloping Inflation: This type of inflation denotes two or three digit percentage annual rise of general price level. When such inflation occurs for a pretty long time most contracts are adjusted to price increases or accounts are kept in terms of a stable foreign currency. Preference for money holding greatly diminishes. Financial markets wither away as capital flows abroad. Even then economies experiencing galloping inflation are found to survive in many instances. 

Hyper Inflation: Such inflation denote annual price rise at a rate of more than 1000%. Real demand for money falls drastically, relative prices become highly unstable causing serious distortion. A profound change in income distribution occurs and a moral and an economic disequilibriam take place. Economies are reported to have survived or even prospered during a period of hyper inflation.

An important distinction in effects in inflation occurs in an economy when it shifts from unanticipated inflation to anticipated inflation. If people had become accustomed to stable general price level or creeping inflation and then all on a sudden face double digit inflation, they cannot readily adjust their behaviour in the changed circumstances. Such an inflation is called Unanticipated Inflation.

When general price rises and the rate at which it would rise are anticipated people can better adjust with the process to mitigate the adverse effects of inflation. Such an inflation is called Anticipated Inflation. Such a phenomenon is observed in societies where prices keep rising at more or less constant rate for a pretty long time even though growth rate of prices may be a double digit number.