Inflation passes through three stages. In the first stage the rise in price is slow and gradual. In this stage it is easier to check the inflationary rise in the price of goods and services. But if inflation is not effectively checked in the first stage then it enters the second stage. In second stage inflation becomes a serious headache for the government. The prices of goods and services start rising much more rapidly then before. It not possible to eliminate inflation completely but if the government takes effective steps, it may be possible to prevent a further rise in price level. In the third stage, prices of goods and services now start rising almost every minute and it becomes impossible for the government to check them.
These can be illustrated by an example , in first stage price rise in a proportion is less than the supply of money. If the supply of money increases by 10%, the price rise by 5% or even less than that . In the second stage, the prices rise exactly in the same proportion in which the supply of money increases. In other words, if the supply of money is increased by 10% the price rise also goes by 10%. In the third stage, the price rise in a much greater proportion than the increase in the supply of money. In other words, if the supply of money is 10% price level may rise by 15% or even more.
The three stages of inflation are described below:
1. Pre-full Employment Stage
The rise in price level in the first stage is less than proportionate to the increase in the supply of money. Let us suppose the supply of money increases by 10%. As, a result, there will be immediate rise in the price level. Consequently, the production of goods and services receive stimulus. As a result of increase in output of goods and services, the price level will come down. But if the supply of money is again increased by 10%, the price level will rise up, giving encouragement to the production of goods and services in the economy. In this way if there is continuous increase in the supply of money, a stage will come when the output of goods and services may not increase in the same proportion in which the supply of money increases. The reason being that with the expansion of production, the supply of the factors of production goes on declining.
2. Full Employment Stage
If the supply of money continues to increase without any interruption, then after some time production will cease to increase, or in other words, production will become stagnant. The reason being that all productive resources are already fully employed. Extra resources are not available for a further expansion of production. Hence, the further expansion of production comes to an end. Since production becomes constant, the price level now starts increasing in the same proportion in which the supply of money increases.
3. Post-full Employment Stage
If the supply of money continues to increase even after the time of full employment, then for some time the price level will increase in the same proportion in which supply of money increases. But after that the supply of money increases so much that the public loses confidence in it and the increase in the price level is much more than the increase in supply of money. For example, if the supply of money is 10%, then the price level increases by 20%, 30% or even 40%. In such a situation, it becomes difficult, to check the rise in the price level. This is the final stage of inflation. In this stage, the prices rise so high that money exchange comes to be replaced by commodity exchange in due course of time