Inflation – Concepts, Types, Causes & Effects

UPSC Economics Smart-Prep Module • GS III + Prelims + Optional Support

1. What is Inflation?

In everyday language, people call any rise in prices “inflation”. But in economics, inflation means a persistent and general rise in the overall price level of goods and services over a period of time, not just an increase in the price of one or two commodities.

If the price of onions goes up sharply but other prices remain stable, that is not inflation; it is a relative price change. Inflation is when the purchasing power of money falls because on average, most prices are rising together. In India, we usually measure it using the Consumer Price Index (CPI) and sometimes the Wholesale Price Index (WPI).

Mild inflation is often seen as healthy for growth (it encourages production and spending), but high or volatile inflation harms planning, investment, savings, and income distribution. For UPSC, always emphasise: “general, persistent, and sustained rise in prices”.

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2. Measuring Inflation – WPI, CPI, GDP Deflator

Inflation is not measured by just looking at a few prices; instead, we construct a price index using a representative “basket” of goods and services. The percentage change in this index over time gives the rate of inflation.

A. Key Price Indices in India

• Wholesale Price Index (WPI) – tracks prices at the wholesale / producer level, historically used as India’s headline inflation indicator.
• Consumer Price Index (CPI-Combined) – tracks retail prices faced by consumers; now the main index for RBI’s inflation targeting framework.
• CPI-AL, CPI-RL, CPI-IW – sub-indices for agricultural labourers, rural labourers, industrial workers, etc.
• GDP Deflator – ratio of nominal GDP to real GDP; covers the broadest set of goods and services, but is available with a lag.

graph TB
  A[Measurement of Inflation]:::root
  B[Price Indexes]:::node

  A --> B
  B --> C[WPI]:::node2
  B --> D[CPI]:::node2
  B --> E[GDP Deflator]:::node2

  C --> C1[Wholesale prices]:::note
  D --> D1[Retail consumer prices]:::note
  E --> E1[Price level for entire GDP]:::note

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3. Types of Inflation – By Speed & Visibility

Inflation can be classified by its speed (how fast prices are rising) and by whether it is visible or suppressed. This helps in understanding the seriousness of the problem and the policy response needed.

A. By Rate (Speed of Inflation)

• Creeping (Mild) Inflation – prices rise slowly (e.g., 2–3% per year); often considered healthy and compatible with growth.
• Walking / Moderate Inflation – prices rise in single digits, but faster than creeping; may start to hurt fixed-income groups.
• Running / Galloping Inflation – double-digit inflation; erodes purchasing power rapidly, causes serious macroeconomic distortions.
• Hyperinflation – extremely high inflation (hundreds or thousands of percent); money almost loses its function (e.g., Germany 1920s, Zimbabwe, etc.).

B. By Visibility

• Open Inflation – prices are allowed to rise freely according to market forces; inflation is transparent and visible.
• Suppressed Inflation – government uses price controls, rationing, subsidies to artificially hold prices down; excess demand shows up as shortages, black markets.

graph TB
  A[Types of Inflation]:::root --> B[By Rate]:::node
  A --> C[By Visibility]:::node

  B --> B1[Creeping]:::node2
  B --> B2[Moderate / Galloping]:::node2
  B --> B3[Hyperinflation]:::node2

  C --> C1[Open Inflation]:::note
  C --> C2[Suppressed Inflation]:::note

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4. Types of Inflation – By Cause (Demand-Pull, Cost-Push, Structural)

A very important classification (often asked in UPSC) is by cause. Broadly, we distinguish between: demand-pull inflation, cost-push inflation, and structural inflation.

A. Demand-Pull Inflation

Occurs when aggregate demand (AD) exceeds aggregate supply (AS) at full employment level. “Too much money chasing too few goods.” Sources of demand-pull inflation include:

• Rapid growth in money supply
• High government expenditure (deficit spending)
• Credit-fuelled private investment and consumption
• Export booms or external demand surges

B. Cost-Push Inflation

Occurs when the cost of production rises and producers raise prices to maintain profit margins, even if demand is not booming. Key sources:

• Increase in wages without matching productivity
• Rising energy and fuel prices
• Increase in import costs due to currency depreciation
• Higher indirect taxes or regulatory costs

C. Structural Inflation

Particularly relevant for developing economies like India, where inflation arises from structural bottlenecks:

• Rigidities in agricultural supply – low productivity, inadequate storage, fragmented markets
• Inadequate infrastructure (transport, power, logistics)
• Slow response of supply to rising demand →

graph TB
  A[Inflation by Cause]:::root --> B[Demand-Pull]:::node
  A --> C[Cost-Push]:::node
  A --> D[Structural]:::node

  B --> B1[Excess demand]:::note
  B --> B2[High money supply, deficit spending]:::note

  C --> C1[Higher wages, fuel, taxes]:::note
  C --> C2[Imported input costs]:::note

  D --> D1[Agricultural bottlenecks]:::note
  D --> D2[Infrastructure constraints]:::note

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5. Key Drivers of Inflation in India – Food, Fuel, Imported & Expectations

In India, inflation is often driven by a mix of food supply shocks, fuel price movements, imported inflation, and expectations. Understanding these helps in writing mains answers with a contemporary flavour.

A. Food Inflation

• Dependence on monsoon and weather → volatility in cereal, pulses, vegetable prices
• Supply chain issues (storage, transport, middlemen)
• Rising demand for protein-rich food (milk, eggs, meat) with slow supply response

B. Fuel & Energy Inflation

• High dependence on imported crude oil
• Pass-through of global oil prices to domestic fuel
• Fuel costs feed into transport, electricity, fertilisers, and thus into core inflation

C. Imported Inflation

• Global commodity price rise (oil, metals, fertilisers)
• Depreciation of the rupee making imports costlier
• External shocks (wars, supply disruptions, global crises)

D. Inflationary Expectations

• If firms and workers expect inflation to continue, they raise prices and demand higher wages
• This can create a wage–price spiral – expectation-driven inflation

graph TB
  A[Inflation in India]:::root --> B[Food Inflation]:::node
  A --> C[Fuel / Energy]:::node
  A --> D[Imported Inflation]:::node
  A --> E[Expectations]:::node

  B --> B1[Monsoon, supply chain, agri bottlenecks]:::note
  C --> C1[Global crude oil, transport costs]:::note
  D --> D1[Global prices + Rupee depreciation]:::note
  E --> E1[Wage-price spiral]:::note

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6. Effects of Inflation – Who Gains, Who Loses?

Inflation does not affect everyone equally. It redistributes income and wealth between different groups in society. Some gain from inflation, while others are clearly hurt.

A. General Macro Effects

• On Growth – Mild inflation may stimulate production; high or volatile inflation reduces investment and long-term growth.
• On Savings & Investment – If interest rates are lower than inflation, real return on savings becomes negative → people shift to gold, real estate, etc.
• On Balance of Payments – Higher domestic inflation makes exports less competitive and encourages imports → can worsen trade deficit.
• On Uncertainty – High inflation increases uncertainty, hurts long-term contracts and planning.

B. Who Gains from Inflation?

• Debtors – They repay old loans in money that has less purchasing power; real burden of debt falls (if interest rates do not fully adjust).
• Owners of Real Assets – People holding real estate, land, stocks, commodities may see the value of their assets rise with inflation.
• Governments with Debt – If a government has borrowed at fixed interest rates, moderate inflation reduces the real value of its outstanding debt.
• Some Businesses – Firms that can easily raise prices faster than their costs may see higher nominal profits in the short run.

C. Who Loses from Inflation?

• Creditors / Lenders – They receive repayment in money that has less value than when they lent it; real return falls if interest is not inflation-indexed.
• Fixed-Income Groups – Salaried employees, pensioners, and wage earners whose incomes do not rise with prices lose purchasing power.
• Savers in Cash / Fixed Deposits – If nominal interest < inflation rate, real interest is negative.
• Poor Households – Spend a large share of income on food and fuel; inflation in these items hits them disproportionately.

graph TB
  A[Inflation]:::root --> B[Winners]:::node
  A --> C[Losers]:::node

  B --> B1[Debtors]:::node2
  B --> B2[Owners of real assets]:::node2
  B --> B3[Government with fixed-rate debt]:::node2

  C --> C1[Creditors / Lenders]:::note
  C --> C2[Fixed-income earners]:::note
  C --> C3[Savers in deposits]:::note
  C --> C4[Poor households]:::note

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Inflation – Concepts, Policy, Curves & Summary (Block 2)

UPSC Economics Smart-Prep Module • GS III + Prelims + Optional Support

7. Phillips Curve – Inflation vs Unemployment

The Phillips Curve shows a short-run trade-off between inflation and unemployment. In the long run, however, unemployment returns to its “natural rate” regardless of inflation.

Short-Run Phillips Curve

• Higher inflation → lower unemployment
• Lower inflation → higher unemployment
• Driven by wage expectations

Long-Run Phillips Curve

• Vertical at the natural rate of unemployment
• No trade-off between inflation and unemployment

graph TB
  A[Phillips Curve]:::root
  A --> B[Short Run]:::node
  A --> C[Long Run]:::node

  B --> B1[Inverse relation]:::node2
  B --> B2[Lower unemployment with higher inflation]:::note

  C --> C1[Vertical curve]:::node2
  C --> C2[No trade-off in long run]:::note

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8. Stagflation – High Inflation + High Unemployment

Stagflation contradicts the Phillips Curve because both inflation and unemployment rise together. It usually results from negative supply shocks, such as oil price spikes.

graph TB
  A[Stagflation]:::root
  A --> B[High Inflation]:::node2
  A --> C[High Unemployment]:::node2
  A --> D[Low Growth]:::node2

  B --> X[Often cost-push]:::note
  C --> Y[Demand slowdown]:::note
  D --> Z[Weak productivity]:::note

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9. Core vs Headline Inflation

UPSC LOVES asking this difference. Headline inflation includes all items, while core inflation excludes food & fuel.

Headline Inflation

• Includes food + fuel
• Volatile
• Affected by monsoon, crude oil, supply shocks

Core Inflation

• Excludes food + fuel
• Sticky, stable
• Used by RBI for policy decisions

graph TB
  A[Inflation Types]:::root
  A --> B[Headline Inflation]:::node
  A --> C[Core Inflation]:::node
  A --> D[Imported Inflation]:::node
  A --> E[Bottleneck Inflation]:::node

  B --> B1[Includes food + fuel]:::note
  C --> C1[Excludes food + fuel]:::note
  D --> D1[Driven by global prices]:::note
  E --> E1[Caused by supply blockages]:::note

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10. Inflation Control – Monetary, Fiscal & Supply Measures

A. Monetary Measures (RBI)

• Repo ↑ → borrowing cost ↑ → demand ↓
• CRR / SLR adjustments
• Open Market Operations

B. Fiscal Measures

• Reduce fiscal deficit
• Control govt expenditure
• Rationalise subsidies

C. Supply-Side Measures

• Boost food output
• Improve logistics, cold chains
• Reduce import duties temporarily

graph TB
  A[Inflation Control]:::root
  A --> B[Monetary Policy]:::node
  A --> C[Fiscal Policy]:::node
  A --> D[Supply Measures]:::node

  B --> B1[Repo ↑, CRR ↑]:::note
  C --> C1[Reduce deficit]:::note
  D --> D1[Increase supply]:::note

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11. RBI Inflation Targeting – 4% ± 2%

India follows a Flexible Inflation Targeting (FIT) system. The target is set by the Government in consultation with the RBI.

• Target: 4% CPI
• Band: 2% to 6%
• Failure: CPI above 6% for 3 quarters

graph TB
  A[Inflation Targeting]:::root
  A --> B[Target: 4%]:::node
  A --> C[Band: 2%-6%]:::node
  A --> D[MPC Decision]:::node

  B --> B1[Price stability]:::note
  C --> C1[Upper & lower limits]:::note
  D --> D1[Bi-monthly policy]:::note

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12. Summary Table

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13. Master Diagram – All Inflation Concepts

graph TB
  A[Inflation]:::root
  A --> B[Measurement]:::node
  A --> C[Types]:::node
  A --> D[Effects]:::node
  A --> E[Policy Tools]:::node

  B --> B1[CPI, WPI, Deflator]:::note
  C --> C1[Demand, Cost, Structural]:::note
  D --> D1[Winners & Losers]:::note
  E --> E1[Monetary + Fiscal + Supply]:::note

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