Effects and Control of Inflation

  • Post last modified:22/04/2022
  • Reading time:23 mins read

The future of the governments and the political parties depend on how they tackle the problem of inflation. Many aspects of our everyday activities are in some way influenced by the level of and changes in the rate on inflation.

A high rate of inflation makes the life of the poor very miserable. During mild inflation, consumers generally cut their spending on luxurious goods, corporate profits increases sharply due to the increase in price and they build up new inventories. Also in government sector, the tax collected from indirect tax also rises. It also affects the income distribution of the economy.

Before discussing the effects of inflation on different classes of the economy, this section will discuss the concepts of anticipated and unanticipated inflation.

Anticipated Inflation

If the people know that in the coming time period the rate of inflation is going to increase, this inflation is known as anticipated inflation. If rate of inflation is anticipated, people take steps to make suitable adjustment in their contracts to avoid the adverse effects which inflation could bring to them.

For instance, a worker correctly anticipates that in the coming year the rate of inflation will be 15 per cent. Suppose, his income in the existing year is ₹10,000, then he can make a contract with his employer to increase the wage by 15 percent in next year, so he will get ₹11,500 in the next year. This way he will not be affected by the rise in the inflation rate.

Unanticipated Inflation

Suppose, a worker is not able to anticipate the inflation rate, it means in next year he will also get the same wage, i.e., 10,000. However, in real term, his real income was decreased by 15 percent, due to the increase in the rate of inflation.


Effects of Inflation

We can divide the effects of inflation into six parts, as given below:

  1. Effects of Inflation on Producers and Traders Class
  2. Effects of Inflation on Investor’s Class
  3. Effects of Inflation on Labourers and other Fixed Income Groups
  4. Effects of Inflation on Consumer Class
  5. Effects of Inflation on Debtors and Creditors Class
  6. Other Effects of Inflation

Effects of Inflation on Producers and Traders Class

From the view point of producers and traders, inflation is always very useful, in the period of inflation they earn much profit and soon they became financially strong. There are many reasons for this such as follows:

  • In the period of inflation, the cost of production and price both increase, but the rate of increase in price is much higher than the increase in the cost of production. That’s why a lower cost of production producer charges a higher price and earns a higher rate of profit.

  • In the period of inflation, the demand is much higher even at a higher price; the result is same as above, a higher rate of profit.

  • In the period of inflation the liquidity increases. That’s why people can purchase more, so the demand of the consumer increases. The producer can sell all the goods easily even at a higher price.

Effects of Inflation on Investor’s Class

Here, the meaning of investor class is those people who invest their capital in the industry. On the basis of investment, investor class can be divided into two parts, (i) investors of fixed income and (ii) investors of variable income.

Investors of Fixed Income

Those investors received fixed return from their investment, like investment in the debentures; they receive a fixed income for their investment. In the period of inflation this type of investors are in loss, because their real income decreases.

Investors of Variable Income

The incomes of the investors of variable income depend on the change in the value of money and on the business. They usually invest into the shares of a company. Because they earn in the period of inflation and they earn their share through increase in the price of the share.

Effects of Inflation on Labourers and other Fixed Income Groups

Generally, this sector includes the service sector; the persons who sell their services like, agricultural labour, industrial worker, teachers all come under this group. Because they belong to fixed income group, it means in the period of inflation the purchasing power of this group decreased.

It is also true that they can have more new job offers in the period of inflation, and the employers also pay the dearness allowances for this inflation, but that dearness allowance cannot off-set the inflation, that’s why the labourer’s do the strikes.

Effects of Inflation on Consumer Class

Every person in this world is a consumer. No matter he is a producer or the supplier of the factors of production. From the view point of a consumer inflation is always bad.

Effects of Inflation on Debtors and Creditors Class

In the period of inflation the purchasing power of the money decrease. That’s why the real burden of the tax decreases. In other words, in the period of inflation the payment of debt is not a tough task; in this period the debtor is in a better position than the creditor.

For example, you lend ₹20,000 to a person at a rate of 5 percent per annum, after one year you will receive ₹21,000. However, if there will be 4 percent rate of inflation then your 4 percent of income will be offset by the rise in prices, and effectively you will get only 1 percent real rate of interest.

Other Effects of Inflation

The following are the other effects of inflation:

  • Unequal distribution of wealth: Because of the inflation, there can be a centralization of the economic power, producers and the traders earn a higher profit and persons who belong to the fixed income group have to bear the loss. As a result, there will be unequal distribution of income and wealth.

  • Increase in taxation: In the period of taxation, governments generally revise the old taxes and it also implements new taxes, to decrease the purchasing power of the consumers.

  • Increase in immorality: This effect can be understand with the help of some definitions. According to Michael Levy; many people lose their health and happiness trying to accumulate money and that makes it most expensive thing on earth.

Effect of Inflation on Growth of Banking Sector

In the period of inflation, the monetary income of the people increase very fast. Hence, the insurance and the banking sector have changed completely.

Effect of Inflation on Balance of Payment (BOP)

Because of the inflation the balance of payment of any country can be adverse. Inflation leads to an increase in the price level, it affects the export very badly on the other hand it attracts the imports. As a result the balance of payment became negative or in other words adverse.

Adverse Effect on Savings

In the time period of inflation, the purchasing power of the consumers decrease, they have to pay more for the same amount of commodities. That’s why they have to decrease the amount of savings. In other words, inflation affects the rate of savings adversely.


Control of Inflation

With the help of above discussion, you can conclude that the inflation is very bad from the view point of economy, it can affect the economic and social structure of the economy adversely. There are several measures to check the inflation; some of them are as follows:

Monetary Measures

In monetary measures the government of a country tries to control the inflation through the central bank of that country. The central bank follows a strict monetary policy, through which central bank takes the excess money supply from the economy.

Instruments of Money Control

There are many instruments to control the money supply in the economy. Some of the main instruments of money control are as follows:

  • Open market operation: The term open market operation means the purchase and sale of government securities by the RBI from and to the public and also from and to the banks. When there is a situation of inflation in the economy, that time government can sell the government securities to the public and also to the bank to soak the excess liquidity interms of excess money supply from the economy.


    As you know that because of excess money supply, price of the goods and services increase, because of increase in demand for goods and services. With the sale of government securities to the public and to the bank, government takes back the excess money supply from the economy. Through this process government can check the inflation by using this instrument of money control.


    On the other hand, if there is a recession in economy. In this situation, the government can correct the situation by purchasing the government securities from the public and from the banks. In a recession, aggregate demand for goods and services decrease and because of this the production also decrease and consequently employment.


    To correct the condition of unemployment, decrease in aggregate demand of goods and services government purchase the government securities from the public and from the banks. By the help of this process, the government injects liquidity into the economy, and it corrects the situation of recession. In most the developing countries open market operation is regarded as the most efficient instrument of the monetary policy.


  • Variation in reserve requirement: Banks have to keep certain proportion of their assets in the form of cash. It is for two reasons. The first reason of holding the cash is to meet their daily transactions and the second reason of holding the cash reserve is statutory reserve requirement.

    Balance with the RBI is known as reserve requirement. This reserve requirement is known as CRR. According to the RBI Act 1956, the RBI can impose the CRR between 3 to 15 per cent on their net demand and time liabilities.

    The working of CRR can be explained with the help of two conditions of the economy. In the condition of inflation, when there is an excess money supply in the economy, RBI increases the CRR. With the increase in CRR, the lending power of the commercial banks decrease, the availability of the credit to the public also decrease.


    On the other hand, if there is a condition of recession in the economy. In this condition RBI decreases the CRR, so that the lending power of the commercial banks increase, and also the availability of credit to the public. By increasing and decreasing the rate of the CRR, RBI can affect the availability of the credit to the public.

    Bankratepolicy: The instrument of bank rate also plays a crucial role in money control. Bank rate is a rate at which RBI should be prepares to buy or rediscount eligible bills of exchange and other commercial papers. The bill market in India is not well developed in comparison with other developed countries, that’s why RBI has to makes advances to banks mainly in other forms.

  • Working of bank rate: An increase in the bank rate raises the cost of borrowed reserves by the commercial banks, and subsequently the commercial banks increase the PLR (prime lending rate), which discourages the public to take loans from banks. By increasing bank rate, RBI can decrease the money supply in the economy.


    On the other hand, a decrease in bank rate decreases the cost of borrowed reserves by the commercial banks, and subsequently the commercial banks decrease the PLR. Hence, people can avail loans at a lower interest rate. By decreasing the bank rate, RBI can increase the money supply in to the economy.

  • Statutory liquidity ratio: Statutory liquidity ratio is another instrument of money control. According to this instrument each and every commercial bank has to require statutory to maintain a minimum proportion of their daily total demand and time liabilities in the form of liquid assets.

Moral Suasion

Moral suasion is a combination of persuasion and pressures. The central bank of any country is always in a position to use this on commercial banks. In this instrument, the bank uses discussions, letters and speeches. The RBI issues letters to banks making clear its policy and urging banks to fall in line.

Selective Credit

Control Normally selective credit-control is used in western countries. The working of this instrument is very simple; the availability of bank finance for purchasing and holding some commodities is restricted. In India, the holding of food grains, agricultural raw material and other essential commodities is restricted to control the undue rise in their prices.

Fiscal Measures

The fiscal policy is prepared by the union finance minister. The first goal of the fiscal policy is to increase tax revenue as well as non-tax revenue. On the other hand, the other goals of fiscal policy are to maintain public services like food, shelter, safe drinking water, to bridge the gap between rich and poor, to control the money in circulation, full employment and to increase the rate of saving and rate of investment.

The fiscal policy is a projected balance sheet of the nation or a country. It is a study of allocation of the resources and generating those resources. The Finance Minister implements the fiscal policy through the budget. The budget is a future statement of revenue and expenditure of the state or a nation. According to Harvey and Johnson changes in government expenditure and taxation are designed to influence the patterns and level of activity.

With the help of fiscal policy, a government tries to bridge the gap in income levels, which affects the development of the country. With the equal distribution of income and wealth, a country can perform well in all the sectors. According to Otto Eckstein, changes in taxes and expenditure which aim at short-run goals of full employment, price level and stability.

Objectives of Fiscal Policy

The major objectives of the fiscal policy are as follows:

  • To finance various developmental projects, mobilization of resources is needed
  • To get the maximum utilization of the available resources
  • To get full employment
  • To decrease regional disparities
  • To control the inflationary pressure in the economy
  • To reduce the per centage of below poverty line (BPL) population
  • To increase the rate of capital formation with the increasing rate of saving and investment

Aspects of Fiscal Policy

There are mainly four aspects of fiscal policy, which are as follows:

  • Taxation policy: Taxation policy plays a vital role in the collection of revenue for the government in any country. Government can impose a direct tax and indirect tax. Direct tax is the tax in which impact and incidence of tax burden are on the individual person. In other words, he or she cannot shift the tax burden to others. In indirect tax, shifting of tax burden is possible.

    The main objectives of the tax policy are as follows:
    • To mobilize idle resources
    • To bridge the gap between rich and poor
    • To check the inflation by adopting an anti-inflationary taxation policy
    • Public expenditure policy
    • Public debt policy
    • Deficit financing policy

  • Public expenditure policy: In developing countries fiscal policy has a vital role in the economic development of the countries. After collecting the revenue from the public, government engages in public expenditure, which can be developmental or non-developmental expenditure.

    Developmental expenditures are generally related with developmental activities like roads, hospitals, bridges, infrastructure, railway. Non-developmental expenditures are generally related with maintenance of law and order, defence and so on.

  • Public debt policy: Mostly in developing countries, people have a low axable capacity. They cannot afford a higher rate of tax imposed by the government. To finance the developmental projects governments take loans from the public. It is known as public debt.

    Public debt helps the government in two ways, firstly it soaks the excess liquidity from the market that creates the inflationary pressure, and secondly it helps the government in financing the developmental projects, which are necessary for the economic development of the country. This debt can be internal or external. Government can also take the loan from the external resources like, World Bank, IMF, IDA etc.

  • Deficit financing policy: When the government expenditure exceeds the government revenue, this condition is known as deficit, and to finance that deficit government apply this policy. In this policy government can take the loan from the central bank in the form of issuing the fresh currency to finance the deficit.

    In the developing countries, where the taxable capacity, as well as rate of saving and the rate of investment are low, deficit financing policy is very useful for the economic development of those countries.

  • Increase in taxation: With an increase in the taxation, the disposable income of the consumers decreased, now because the purchasing power of the consumer decreased they can purchase a lesser amount of goods. Both the taxes have the adverse effect on purchasing power, direct tax and indirect tax.

    Direct tax decreased the disposable income of the consumer and on the other hand, indirect tax increased the prices of the commodities. Thus, by increasing the rate of tax, government can control the inflation.

  • Decrease in the public expenditure: In the period of inflation, the government should decrease the amount of public expenditure, so that the velocity of the money decreased. The main policy in the period of inflation should be decrease in the unproductive expenditure.

  • Increase in public debt: In the period of inflation, the government should take the public debt in larger amount. It affects the inflation in two ways, first it reduces the purchasing power of the consumers and secondly, after collecting the debt from the public, government can invest that into the manufacturing process, so that the output of the economy increased. With an increment in the output government can control the inflation.

  • Balanced budget policy: In the period of inflation, government should follow the balanced budget policy. Government should not prepare the deficit budget in the inflation, because it leads to the inflation.

  • Control over consumption: In the period of inflation, thegovernmentshould control the consumption, especially unproductive and demonstration expenditure.

  • Encouragement to savings: In the period of inflation, government should encourage saving, it can be through launching of new saving schemes. Government should also increase the deposit rates.

  • Overvaluation: In the period of inflation, government can also overvaluate the value of the currency, through over valuation will cause exports to decrease and imports to increase.

  • Control over investment: You have seen that in the period of inflation, investment increased in a larger amount. Because of this the profit as well as the inflation both increases. Banks and other financial institutions also provide the loan easily in this time period, the government should control it.

    Some other measures to curb inflation are as follows:
    • Increase in production: The best and the most convenient way to control inflation is to increase the amount of production. In the time period of inflation, the agriculture and the industrial sectors should be promoted through tax relief and subsidy.

    • Proper use of tariffs and quotas: In the time period of inflation, imports should be promoted and on the other hand, exports should be minimized through proper use of tariffs and quotas.

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