Inflation: Types and causes

Demand-pull inflation arises when spending power grows faster than the supply of goods. A large pay revision for government employees puts more income in households' hands and lifts consumption demand, which pulls prices up if supply does not keep pace. The other three are supply-side shocks: crop damage reduces supply, dearer coal raises the cost of electricity, and a weaker rupee raises the cost of imports. In each of those, prices rise because costs rise or supply shrinks, not because buyers have more money.

Irving Fisher's equation of exchange, MV = PT, says that money spent (money stock × the number of times each unit changes hands) equals the value of transactions (price level × volume of transactions). If V and T are held constant, P moves in proportion to M, so doubling M doubles P. This is the logic behind the monetarist view that sustained inflation is 'too much money chasing too few goods' and behind the conclusion that financing deficits by creating new money is the most inflationary route.

All three statements are correct. Demand-pull inflation comes from aggregate demand outrunning supply; while there is slack, extra demand also draws idle capacity into use, so output rises along with prices, and near full capacity the effect falls mostly on prices. Cost- push inflation comes from the supply side (dearer oil, wages, raw materials or indirect taxes): the aggregate supply curve shifts left, prices go up and output falls, the stagflation-like case. In a wage-price spiral, workers seek higher wages to keep up with prices, firms pass the higher wage bill on, and the loop continues only if money and credit expand to finance it.

All four raise the cost of producing or supplying goods. A weaker rupee makes imports dearer in rupee terms (imported inflation), and India imports most of its crude oil, edible oils and many inputs. Higher global crude prices raise fuel, freight and fertiliser costs across the economy. Wage rises beyond productivity growth raise unit labour costs, which firms pass on in prices. Higher indirect taxes such as excise on diesel raise the delivered price of fuel and, through transport costs, of almost everything else. Each shifts aggregate supply to the left rather than adding to demand.

Statements 1 and 2 are correct. Indian food prices are highly sensitive to the monsoon, heat waves and unseasonal rain, which hit perishable vegetables and pulses hardest. Over the longer term, dietary diversification with rising incomes raises demand for protein foods faster than supply, a structural driver the Economic Survey has repeatedly highlighted. Statement 3 is wrong: in the CPI 2024 series released by MoSPI on 12 February 2026, food and beverages has a combined weight of 36.75 per cent (down from 45.86 per cent in the 2012 series) but remains the largest of the 12 divisions; housing, water, electricity, gas and other fuels comes next at about 17.67 per cent.

The output gap is actual output minus potential output (the level the economy can sustain without accelerating inflation). When it is positive, the economy is running above capacity: firms work overtime, labour markets tighten and costs rise, so prices tend to accelerate. This is demand-side inflationary pressure. A negative gap means slack (idle capacity, unemployment above its natural rate) and disinflationary pressure. The RBI's monetary policy statements regularly refer to the output gap when judging whether growth is adding to inflation.

Both statements are correct and Statement-II explains Statement-I. The exchange- rate pass-through works mainly through import prices: when the rupee weakens, every dollar of imported crude oil, edible oil, fertiliser, coal, electronics and gold costs more rupees. These costs feed into fuel prices, transport, manufactured goods and, with a lag, the wider CPI basket. The size of the pass-through depends on how much of the cost is absorbed by firms or by taxes, but the direction is clear: depreciation is a source of imported inflation, which is why the RBI watches the rupee closely when inflation is already high.

Statements 1 and 2 are correct. The structuralist view, developed by Latin American economists and widely applied to India, traces inflation to rigidities in the real economy: an inelastic food supply, infrastructure and foreign-exchange bottlenecks, and skewed distribution. The monetarist view, associated with Milton Friedman, says that inflation is always and everywhere a monetary phenomenon. Statement 3 reverses the structuralist position: precisely because the causes lie in supply constraints, structuralists argue that monetary squeezing alone cannot cure inflation without hurting growth; they prescribe supply- side and structural reforms.

Statements 1, 2 and 4 are correct (d). Statement 1 is right: the e-rupee (Central Bank Digital Currency, pilots since 2022) is legal tender issued by the RBI in line with its monetary policy. Statement 2 is right: like a currency note, it is a liability on the RBI's balance sheet. Statement 4 is right: it can be swapped one-to-one for bank deposits and cash. Statement 3 is wrong: like any currency, it loses value with inflation; nothing in its design protects it.

Notice the difference from crypto: Bitcoin has no issuer and its price swings, while the e-rupee is just a digital form of the rupee. The RBI runs both a retail (e₹-R) and a wholesale (e₹-W) version, and has added offline and programmable features.

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Statements 1 and 3 are correct (c). Statement 1 is right: NEER (Nominal Effective Exchange Rate) is a weighted average of the rupee against a basket of trading partners' currencies; a rise means the rupee has appreciated. Statement 2 is wrong: REER adjusts NEER for inflation differences. A rising REER means Indian goods are getting dearer abroad, so competitiveness falls, not improves. Statement 3 is right: if India's inflation runs higher than its partners', REER rises even when NEER does not, so the two drift apart.

Notice that the RBI publishes NEER and REER on 40-currency and 6-currency baskets. A REER above 100 suggests the rupee is overvalued against the base year.

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Statements 2 and 3 are correct (b). Statement 1 is wrong: to fight high inflation, the RBI sells government securities through open market operations, pulling money out of the system; buying them would add money. Statement 2 is right: to stop the rupee falling fast, the RBI sells dollars from its forex reserves, which raises the supply of dollars. Statement 3 is right: when US or EU interest rates fall, foreign money flows into India and the rupee tends to rise, so the RBI buys dollars to smooth this and add to reserves.

Notice sterilisation: when the RBI buys dollars it releases rupees, so it may sell bonds to soak them up. India's forex reserves crossed $700 billion in 2024.

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Statements 1 and 2 are correct (a). In an Inflation-Indexed Bond, the principal, and so the interest, is adjusted for inflation. Statement 2 is right: this protects the investor's real return from uncertain inflation. Statement 1 is right: because of this cover, investors accept a lower coupon, which saves the government money on its borrowing. Statement 3 is wrong: there is no tax break; interest and capital gains on IIBs are taxable like any other bond.

Notice that India's IIBs of 2013 were linked to the WPI, and later ones to the CPI, but they drew little interest. Other countries' versions include the US TIPS. The Sovereign Gold Bond (2015) offered a different hedge, linked to gold prices.

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The Reserve Bank of India controls inflation (d). The RBI Act, 1934, amended in 2016, says the primary objective of monetary policy is price stability while keeping growth in mind. The government sets a CPI inflation target of 4%, with a band of 2–6%, and the six-member Monetary Policy Committee sets the repo rate to meet it. Option (a) is wrong: the Department of Consumer Affairs tracks prices of essentials and runs consumer protection. Option (b) is wrong: the Expenditure Management Commission (2014) only advised on government spending. Option (c) is wrong: the FSDC, chaired by the Finance Minister, looks after financial stability, not inflation.

Notice that if inflation stays outside the band for three quarters in a row, the RBI must explain it in writing to the government.

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All three influence Indian bond yields (d). A bond yield is the return investors demand for holding a bond; it moves opposite to the bond's price. Item 1 is right: if the US Federal Reserve raises rates, US bonds pay more, foreign investors sell Indian bonds, and Indian yields rise. Item 2 is right: RBI moves on the repo rate, and its bond purchases through open market operations, move yields directly. Item 3 is right: higher inflation and higher short-term rates make investors ask for a higher return on long bonds.

Notice that Indian government bonds joined JP Morgan's emerging market bond index in 2024, which drew foreign inflows. The 10-year G-Sec yield is India's benchmark interest rate.

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