Inflation: meaning, measurement, causes, effects and remedies
Inflation is a sustained rise in the general price level. It is measured with a consumer price index and caused by excess demand, rising costs or money growth.
Meaning and types
Inflation is a sustained rise in the general price level, so each rupee buys less. A one-off rise in a single price is not inflation. By speed, economists speak of creeping (low and steady), galloping (high and rising) and hyperinflation (extremely fast, money loses value rapidly). Deflation is a sustained fall in the price level; disinflation is a fall in the rate of inflation (prices still rising, but more slowly). Sri Lanka experienced very high inflation in 2022, during the economic crisis, followed by a sharp slowdown in inflation as the crisis eased.
Worked example 1: building a price index
A simple basket for a household contains 20 kg of rice, 30 coconuts and 20 bus trips. Base-year prices: rice Rs. 200/kg, coconut Rs. 100, bus trip Rs. 100. Current prices: rice Rs. 220, coconut Rs. 130, bus trip Rs. 125. Find the price index. If the index rises to 126 next year, what is that year's inflation rate?
- Base-year cost: rice 20 × 200 = 4,000; coconuts 30 × 100 = 3,000; bus 20 × 100 = 2,000. Total = Rs. 9,000.
- Current cost: rice 20 × 220 = 4,400; coconuts 30 × 130 = 3,900; bus 20 × 125 = 2,500. Total = Rs. 10,800.
- Price index = 10,800 ÷ 9,000 × 100 = 120. Prices have risen 20% since the base year.
- Next year's inflation = (126 − 120) ÷ 120 × 100 = 6 ÷ 120 × 100 = 5%.
Index = 120 (20% above the base year). Inflation the following year = 5%.
Causes of inflation
| Type | What happens | Example |
|---|---|---|
| Demand-pull | Aggregate demand grows faster than the economy can produce: 'too much money chasing too few goods' | A credit boom or large budget deficits near full capacity |
| Cost-push | Higher production costs push prices up; SRAS shifts left | Rising world fuel prices, higher electricity tariffs, wage rises above productivity |
| Imported inflation and depreciation | A weaker rupee makes imported goods and inputs dearer | Fuel, medicines, machinery and food imports |
| Built-in (wage-price spiral) | Workers demand higher wages to keep up with prices; firms raise prices to cover wages | Expectations of continuing inflation |
| Monetary | The money supply grows much faster than output, often to finance government deficits | Central bank financing of the budget |
Effects of inflation
| Group or area | Effect |
|---|---|
| Fixed-income earners and pensioners | Lose: their real income falls |
| Savers and lenders | Lose if interest rates are below inflation (negative real interest) |
| Borrowers | Gain: they repay loans with money worth less |
| Businesses | Uncertainty makes planning and investment harder; frequent price changes (menu costs) |
| Exporters | Lose competitiveness if domestic prices rise faster than abroad (unless the rupee weakens) |
| Economy as a whole | Redistribution from savers to borrowers; social unrest when essentials become unaffordable |
Worked example 2: real wages
A worker's monthly wage rises by 10% in a year in which the price level rises by 20%. What happens to her real wage?
- Wage index = 110 (base 100). Price index = 120 (base 100).
- Real wage index = 110 ÷ 120 × 100 = 91.67.
- Change = 91.67 − 100 = −8.33%.
Her real wage falls by about 8.33%, even though her money wage rose by 10%.
Remedies for inflation
- Monetary policy: raise the policy interest rate, absorb excess money, slow credit growth.
- Fiscal policy: reduce the budget deficit by cutting spending or raising revenue; avoid central bank financing of the budget.
- Supply-side measures: raise productivity, improve agriculture and storage, ease supply bottlenecks.
- Exchange rate stability: build foreign reserves to reduce imported inflation.
- Anchoring expectations: a credible central bank target helps stop the wage-price spiral.
Firm-level strategies to combat inflation
- Control costs: cut waste, save energy, improve productivity per worker.
- Manage suppliers: long-term contracts, bulk buying, and finding local substitutes for imported inputs.
- Hedge currency risk: use forward contracts for import payments.
- Price smartly: smaller pack sizes, staged price rises, value packs, and price-adjustment clauses in long contracts.
- Manage working capital: tighter stock control, faster collection from customers, careful cash flow planning.
- Protect staff: link pay rises to productivity so wages keep up without a wage-price spiral.
During 2022's very high inflation, Sri Lankan consumer firms used smaller pack sizes, staged price rises and local raw materials to stay affordable, while exporters such as apparel makers protected margins by pricing in foreign currency. These are firm-level strategies to combat inflation.
Short answer: “Define inflation and name Sri Lanka's main consumer price indices.” A sustained rise in the general price level. Sri Lanka uses the Colombo Consumer Price Index (CCPI) and the National Consumer Price Index (NCPI), compiled by the Department of Census and Statistics.
Structured question: “Calculate a price index from a basket of goods and the inflation rate between two years.” Index = current cost of basket ÷ base cost × 100 (e.g. 10,800 ÷ 9,000 × 100 = 120); inflation = change in index ÷ old index × 100 (126 vs 120 = 5%).
Essay: “Explain the causes and effects of inflation and suggest remedies, including strategies firms can use.” Define and measure inflation, explain demand-pull, cost-push, imported and monetary causes, analyse effects on groups, and discuss monetary, fiscal and supply-side remedies plus firm-level strategies.
Inflation causes: D-C-M (Demand-pull, Cost-push, Money). Losers: fixed incomes and savers; winners: borrowers. Real wage = money wage ÷ price index.