What is inflation and its types? How to control inflation rate | Price, Price Level, and Price Index

Inflation is the increase in prices of goods and services in an economy over a period of time. When there is inflation, the value of your money decreases because you have to spend more money to buy the same ear of corn. This is important for economists to study inflation to see if an economy is unstable or stable. There will always be people who offer measurements of inflation in a variety of terminology, and there are many categories of inflation based on rate, causes, and effects – creeping inflation or mild inflation, galloping inflation, and hyperinflation, to show the change in price for a good or service over time. Inflation can fall into demand-pull inflation, which occurs when demand for a good exceeds the supply or the other type is cost-pulled inflation, which when the production costs of goods rise, producers raise their prices acoss the board. It is very important to control inflation to ensure the health of any economy. Mostly because, if inflation goes unabated, it disrupts the stability of an economy, diminishes purchasing power, and creates chaos in uncertainty. Government, banks, and central banks have a variety of tools available to control inflation. These include adjusting interest rates, control money supply, regulating fiscal policies by lending money privately or publicly, and managing public expenditures.

What is Inflation?

Inflation is the rate of increase of prices for goods and services in an economy over a period of time. During periods of inflation, each unit of currency will purchase fewer goods and services, leading to a decline in the purchasing power of money. Inflation is generally measured by the Consumer Price Index (CPI) or the Producer Price Index (PPI).

Types of Inflation:

Demand-Pull Inflation:

Demand-pull inflation is the simplest type of inflation. It occurs when total demand for goods and services in an economy increases faster than the economy’s ability to produce them. Imagine a scenario of too many dollars chasing too few goods. The problem of rising demand “pulls up” the overall price level because consumers and businesses compete to buy a limited amount of goods and services.

• For Example, if everyone now has more money to spend and wishes to buy a new car, but the car companies cannot make them any faster, then the car dealerships will raise their prices, simply because they can—people are willing to pay the price to ensure they get one. This happening across many parts of the economy will create inflation throughout the economy.

Cost-Push Inflation:

Cost-push inflation happens when the economy is experiencing overall rising prices because of the increased cost of production. In this case, the cost for companies to produce or provide their goods/services just became more expensive, and companies will pass on the higher costs to consumers via higher prices. The “push” is coming from the supply side in the economy.

• For Example, if oil prices increase significantly, the transportation and manufacturing costs are impacted by several businesses. In order to maintain profitability, an airline will pass their fuel cost to passengers through higher ticket prices. Alternatively, if they have implemented a higher minimum wage, this can add to their labour costs which lead them to push prices up on the services they sell.

Built-In (Wage-Push) Inflation:

Built-in inflation, sometimes called wage-push inflation, is a feedback loop where inflation creates inflation. In built-in inflation, the expectation of inflation creates an inflationary dynamic. It starts when workers notice that the price of living is high, and demand higher wages to accommodate for inflation and the decline of purchasing power. If employers agree to these wage increases, then the labour cost rises. To maintain profit margins businesses will offload the increase to consumers by raising the price of every item they sell. The problem for workers is that now the price of living has once again climbed, and workers are entitled to wage increases in the next contract negotiations. It becomes a continuous feedback loop where wages and prices chase one another.

• For Example, if prices rose 5%, a union can ask for and negotiate 5% raise for its workers at the factory. The factory would now be paying more in wages, then they would raise the product price by 5% to account for the additional wages. This then is now the reason for other workers to request their raise and so forth.

Hyperinflation:

Hyperinflation is a high and rapidly escalating price rise that is out of control, and destroys the value of money. It involves something much stronger than high inflation, it is the complete loss of confidence in money where prices can double in hours or days. This usually occurs when governments engage in massive money printing or deficit spending to pay for the tons of spending they are doing (which jumps the money supply) completely overwhelming the available goods to be purchased.

• A classic example is Germany in the 1920s, when people needed wheelbarrows of cash to buy one loaf of bread. Money became so worthless it was cheaper to wallpaper a house with banknotes or burn them in a fire than it was to spend them. In this situation, the normal economy collapses, and people end up often bartering again for basic necessities, as currency has failed its most basic functions of store of value and a medium of exchange.

Stagflation:

Stagflation refers to a rare and problematic economic condition that combines the worst aspects of a recession and inflation: it has stagnant economic growth and high unemployment like a recession, and high prices associated with inflation. Stagflation creates a challenging situation for policymakers because the usual treatment for a recession, which is to increase spending and lower interest rates, will only make the inflation much worse. Similarly, the usual cure for inflation is to lower spending and raise interest rates, which is what leads to recession and higher unemployment.

• One famous example occurred in the 1970s in many Western countries when a rapid increase in oil prices sharply raised costs of production and transportation (cost push inflation) and cause prices to sharply rise. At the same time, the rising costs of energy crippled businesses, rate factories closed, economic output stalled (stagnation), and unemployment rose. The public suffers immensely from stagflation, as they find themselves suffering from both a weak economy AND a high cost of living.

Creeping, Walking, and Galloping Inflation:

Economists often use these terms in reference to the speed or intensity of inflation and relate inflation to varying speeds of movement. Creeping inflation is the low and controllable rise in prices, typically in the range of 1-3% per year. Creeping inflation is often viewed as a positive sign for a growing economy since an increase in prices encourages spending and investing.

• For example, if we experienced a year in which inflation was at 2%, then a product that cost $100 this year would cost $102 next year. The increase is small enough, and follows a predictable pattern, that people hardly pay attention to the small increases.

Walking inflation is a moderate concern, which would mean inflation was in the range of 3-10% a year. When inflation is at this level, while people may notice prices rising, it is not at such alarming rates to trigger hoarding of goods which can trigger further inflation.

• For example, last year’s $100 product may cost $107 next year. Surely, even even if this price concern was coming from a limited amount of descriptors in price floors or what people pay for products, it isn’t so severe that people and economic agents overreact.

Galloping inflation rate is a severe, destructive inflation is typically in the range of over 10% per annum to nearly 100% or greater. Money is losing value, wages cannot keep pace, and people spend their incomes as fast as they can because they want to acquire and spend their income on tangible assets in case prices increase even further. In a case of galloping inflation.

• For example, the previous example good worth $100 may cost $150 or even a much larger number of dollars within a single year. The rapid change confuses people and economists, and the chaos squeezes the limits of uncertainty.

Price, Price level and Price Index

• Price: The amount of money paid for a single, specific item, like a loaf of bread or a cup of coffee.
• Price Level: The Price Level is not a single number but a conceptual measure of the average of all current prices for a large basket of goods and services across the entire economy at a given time. It represents how expensive life is in general.
• Price Index: The Price Index (e.g., the Consumer Price Index or CPI) is the actual statistical tool used to measure changes in the Price Level over time. By tracking how the cost of a standard basket of goods changes, the Price Index calculates the inflation rate, providing a precise percentage that tells us if prices are rising or falling.

How to Control Inflation Rate

Regulating the inflation rate is fundamentally the role of a country’s central bank (the Federal Reserve in the US; European Central Bank in the EU) through monetary policy. The primary tool of a central bank is to increase interest rates. Increasing rates will constrain borrowing financing costs for people and businesses. As spending and investments slow, the demand for goods and services declines, in turn directing less money toward upward price movement, resulting in controlled inflation. Additionally, governments can use fiscal policy to achieve the same effect by taking money out of the economy by cutting their own spending or raising taxes.

Monetary Policy (Targeting Price Level Stability):

• Raise Interest Rates: Central banks (e.g., Federal Reserve, RBI) increase interest rates to reduce borrowing and consumer spending, which lowers demand for goods and services. This slows the rise in individual prices and stabilizes the price level.
  • Impact on Price Index: A slower rise in CPI as demand-driven price increases ease.
  • Example: In 2022-2023, the U.S. Federal Reserve raised rates to curb CPI growth from 9.1% to around 3%.
• Reduce Money Supply: By selling government bonds (open market operations), central banks reduce the money available for spending, curbing demand-pull inflation.
  • Impact on Price Index: Less money chasing goods slows the increase in CPI or PPI.
  • Example: Tightening money supply to prevent excessive price rises in consumer goods.

Fiscal Policy (Reducing Demand Pressure on Prices):

• Cut Government Spending: Lower public expenditure reduces aggregate demand, easing pressure on prices of goods and services.
  • Impact on Price Index: Lower demand reduces the rate of CPI growth.
  • Example: Reducing infrastructure spending to cool an overheated economy.
• Raise Taxes: Increased tax rates will decrease disposable income decreases consumers’ ability to spend on goods and services which leads to decreases in individual prices.
  • Impact on Price Index: Decrease in CPI growth, leading to slower growth due to decreased consumer demand.
  • Example: Raising either income taxes or sales taxes to help decrease excessive spending.

Inflation Targeting (Guiding Price Index Expectations):

• Central banks fix an inflation rate (4% for RBI in India) as a target of that inflation rates and adjust a policy to ensure the price index growth remains within that area.
  • Impact on Price Index: Anchors CPI growth away from runaway price increases.
  • Example: RBI’s monetary policy committee will keep CPI inflation within a band of 2-6%.

Conclusion

Inflation indicates the rise of prices of goods and services and can be caused by demand, cost push causes, or wage price spirals. Inflation is measured by indices that track price levels over time, such as the Consumer Price Index (CPI). Inflation can be controlled through monetary tightening, fiscal discipline, or supply-side measures. Programs must be evaluated in terms of growth and stability. If you would like further information about current inflation trends, or certain actions in particular, I can search the web or analyze pertinent data if required.

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