Arshad Shaikh looks into the claims of an economic recovery and checks how inflation is acting as a dampener to supply, demand and the animal spirits

Celebrated American economist, Milton Friedman once said, “Inflation is taxation without legislation”. In simple terms, inflation is a persistent rise in the general price level. Some economists call it ‘too much money chasing too few goods’. It reduces the purchasing power of the consumer; hence its direct impact on aggregate demand. Consequently, supply too has to optimise itself towards this new situation and hence inflation leads to an overall dampening of the economy.

After Covid, the Indian economy was undoubtedly on the recovery path; however, with inflation raising its ugly head, policymakers and the government are now confronted with the classical economic challenge of navigating the economy towards sustainable growth without runaway inflation. Some of the data on the inflation front is quite worrisome.

The road to economic prosperity for developing economies is fraught with obstacles like inflation that are not easy to surmount. Inflation is a “political hot potato” and tends to aid anti-incumbency, thus making governments extremely sensitive to price rises especially when it comes to daily household consumption goods like oil and vegetables. It affects everyone yet very few understand its reasons and possible solutions for surmounting it. Let us look at various perspectives on inflation and the pros and cons of various approaches to tame this menace.


Two terms are frequently used during TV debates on inflation and the economy. One is headline inflation and the other core inflation. Headline inflation is the raw inflation that is reported through the Consumer Price Index (CPI). The CPI measures the price changes from the perspective of the retail buyer. It is measured by tracking prices of transportation, food, beverages, cigarettes, alcohol, clothing, footwear, housing, etc.

There is another index called the Wholesale Price Index (WPI) that measures price rise from the perspective of the producer and tracks inflation for goods sold and traded in bulk by wholesale businesses. The WPI consists of primary articles (raw form), fuel and power and manufactured goods. Earlier inflation in India was measured through the WPI but since 2014, headline inflation is measured through the CPI.

Core inflation is the price increase in all goods except those experiencing regular price volatility like fuel and food products. Core inflation (as it discounts fuel and food price changes) helps policy-makers make better decisions related to controlling inflation. The latest data shows that core inflation (at 6%) has overtaken headline inflation (at around 4%). Since core inflation does not contain volatile items like fuel and food, it tends to be sticky (takes a long time to change).


Economics literature proposes various types of inflation, which assists our understanding of this phenomenon. The first type is known as ‘Demand-Pull Inflation’. This occurs when there is an inflationary gap in the economy when the aggregate demand for goods and services cannot be matched by aggregate supply at full employment.

Aggregate demand is the sum of consumption plus investment plus government spending plus the trade balance (total exports minus imports). Therefore, the imbalance between aggregate demand and supply can be due to any one of the components that make up aggregate demand usually excessive government spending through expansionary fiscal policy (tax cuts and spending on infrastructure projects) and expansionary monetary policy (increased money supply through low interest rates).

The other type of inflation called ‘Cost-Pull Inflation’ or ‘Supply Side Inflation’ is caused by ‘shocks’ in oil prices, farm prices, import prices or wage-push. It is said that cost-pull inflation also brings about a fall in GDP. This combination of falling GDP with high inflation is called stagflation. As far as demand-pull inflation is concerned, two prominent economists hold different views. The Keynesian view is that excess demand is a result of the autonomous increase in expenditure on investment or consumption, or increase in government expenditure on goods and services. Thus, the increase in aggregate expenditure or demand occurs independent of any increase in the supply of money. However, Milton Friedman, the main proponent of the monetarist view, said, “Inflation is always and everywhere a monetary phenomenon and can be produced only by a more rapid increase in the quantity of money than in output”.

There is a third theory called the “Structuralist Theory of Inflation” that says that the increased government spending or money supply are not the main reasons behind price rise, rather, it depends on the various structural features of the economy. This theory is applicable to developing and emerging economies like India. The structuralists say that there are various sectoral constraints or bottlenecks. These give rise to sectoral imbalances that leads to inflation.


The conventional ways of controlling demand-pull inflation are through fiscal policy, monetary policy and other measures. One important way of reducing inflation is to reduce the fiscal deficit. It means that the gap between government revenue (through taxation) and government expenditure (on its own functioning, defence, welfare schemes and infrastructure) should be minimised. Fiscal deficit is financed by government borrowing from the RBI (our central bank) against the issuing of government securities (tradeable loans). This government borrowing without raising taxes results in an increase in money supply and the aggregate demand causing inflationary pressure on the economy.

India’s fiscal deficit is 6.8% of GDP or about 15 lakh crores. The other method of controlling price rise is by tightening the monetary policy. Repo rate is the interest rate at which the RBI lends money to commercial banks for a short period. A hike in repo rate is cascaded to the credit market and borrowing becomes more expensive. The cost of loans (interest rates) goes up and aggregate consumer expenditure goes down. To compensate for the increased cost of borrowing and decline in credit offtake, banks entice consumers with higher rates of interest on deposits, thereby increasing savings and further reduction in spending leading to lower aggregate demand.

The increase in repo rate leading to decline in credit growth is subject to the working of this monetary transmission mechanism. This money-tightening tool to control inflation works if banks do not have liquid reserves. If they have sufficient reserves, they will not raise interest rates and the cost of credit will remain the same. The easiest way to tame inflation is to follow the golden mean. Strike a balance between your needs and available resources. Produce only as much as you consume. Excessive production without corresponding demand results in losses and job losses. Excess and artificial demand (created by an interest-based financial system) leads to demand-pull inflation.

Muslims have been termed as an “Ummat-e-Wasat” (justly balanced community) that avoids extremes and leads a way of life that adopts the ‘golden mean’ in all aspects of life, including economy. The Qur’ān describes them thus – “They are those who, when they spend, are neither extravagant nor miserly, but follow a middle way between them” (Surah Furqan: 67). The key to taming inflation is achieving balance or equilibrium.

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