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INFLATION

MEANING

Inflation is often defined in terms of its

supposed causes. Inflation exists when

money supply exceeds available goods and

services.

Inflation may be defined as ‘a sustained

upward trend in the general level of prices’

and not the price of only one or two goods.

 (^) (iii) Deficit-induced inflation:  (^) The budget of the government reflects a deficit when expenditure exceeds revenue. To meet this gap, the government may ask the central bank to print additional money. Since pumping of additional money is required to meet the budget deficit, any price rise may the be called the deficit-induced inflation.  (^) (iv) Demand-pull inflation:  (^) An increase in aggregate demand over the available output leads to a rise in the price level. Such inflation is called demand-pull in flation (henceforth DPI). But why does aggregate demand rise? Classical economists attribute this rise in aggregate demand to money supply. If the supply of money in an economy exceeds the available goods and services, DPI appears. It has been described by Coulborn as a situation of “too much money chasing too few goods.”

 (i) Creeping or Mild Inflation:

 If the speed of upward thrust in prices is slow but small then

we have creeping inflation. What speed of annual price rise is a

creeping one has not been stated by the economists. To some,

a creeping or mild inflation is one when annual price rise varies

between 2 p.c. and 3 p.c. If a rate of price rise is kept at this

level, it is considered to be helpful for economic development.

Others argue that if annual price rise goes slightly beyond 3

p.c. mark, still then it is considered to be of no danger.

 (ii) Walking Inflation:

 If the rate of annual price increase lies between 3 p.c. and 4

p.c., then we have a situation of walking inflation. When mild

inflation is allowed to fan out, walking inflation appears. These

two types of inflation may be described as ‘moderate inflation’.

B. On the Basis of Speed or Intensity:

(iii) Galloping and Hyperinflation:

Walking inflation may be converted into

running inflation. Running inflation is danger

ous. If it is not controlled, it may ulti mately

be converted to galloping or hyperinflation.

It is an extreme form of inflation when an

economy gets shattered.”Inflation in the

double or triple digit range of 20, 100 or

200 p.c. a year is labelled “galloping

inflation”.

 There are two theoretical approaches to the DPI—one is classical and other is the Keynesian.  (^) According to classical economists or monetarists, inflation is caused by an increase in money supply which leads to a rightward shift in negative sloping aggregate demand curve. Given a situation of full employment, classi cists maintained that a change in money supply brings about an equiproportionate change in price level.  (^) That is why monetarists argue that inflation is always and everywhere a monetary phenomenon. Keynesians do not find any link between money supply and price level causing an upward shift in aggregate demand. (i) Demand-Pull Inflation Theory

According to Keynesians, aggregate

demand may rise due to a rise in consumer

demand or investment demand or govern

ment expenditure or net exports or the com

bination of these four components of

aggreate demand. Given full employment,

such increase in aggregate demand leads to

an upward pressure in prices. Such a

situation is called DPI.

This can be explained graphically

KEYNESIAN APPROACH



DPI originates in the monetary sector. Monetarists’

argument that “only money matters” is based on

the assumption that at or near full employment

excessive money supply will increase aggregate

demand and will, thus, cause inflation.



An increase in nominal money supply shifts

aggregate demand curve rightward. This enables

people to hold excess cash bal ances. Spending of

excess cash balances by them causes price level

to rise. Price level will continue to rise until

aggregate demand equals aggregate supply.

(ii) Causes of Demand-Pull Inflation:

 (^) Keynesians argue that inflation originates in the non- monetary sector or the real sector. Aggregate demand may rise if there is an increase in consumption expenditure following a tax cut. There may be an autonomous increase in business investment or government expenditure. Government expenditure is inflationary if the needed money is procured by the government by printing additional money.  (^) In brief, increase in aggregate demand i.e., increase in (C + I

• G + X – M) causes price level to rise. However, aggregate demand may rise following an increase in money supply gen erated by the printing of additional money (classical argument) which drives prices upward. Thus, money plays a vital role. That is why Milton Friedman argues that inflation is always and everywhere a monetary phenomenon.



CPI arises due to the increase in cost of produc tion.

Cost of production may rise due to a rise in cost of

raw materials or increase in wages.



However, wage increase may lead to an in crease in

productivity of workers. If this hap pens, then the

AS curve will shift to the right- ward not leftward—

direction. We assume here that productivity does

not change in spite of an increase in wages.



Such increases in costs are passed on to

consumers by firms by raising the prices of the

products. Rising wages lead to rising costs. Rising

costs lead to rising prices.

(iii) Cost-Push Inflation Theory:

This can be demonstrated graphically where AS 1 is the initial aggregate supply curve. Below the full employment stage this AS curve is positive sloping and at full employment stage it becomes perfectly inelastic. Intersection point (E 1 ) of AD 1 and AS 1 curves determine the price level (OP 1 ). Now there is a leftward shift of aggregate supply curve to AS 2. With no change in aggregate demand, this causes price level to rise to OP 2 and output to fall to OY 2. With the reduction in output, employment in the economy declines or unemployment rises. Further shift in AS curve to AS 3 results in a higher price level (OP 3 ) and a lower volume of aggregate output (OY 3 ). Thus,

 Fiscal policy changes, such as increase in tax rates also leads to an upward pressure in cost of production.  Finally, production setbacks may result in decreases in output. Natural disaster, gradual exhaustion of natural resources, work stop pages, electric power cuts, etc., may cause ag gregate output to decline.  In the midst of this output reduction, artificial scarcity of any goods created by traders and hoarders just simply ignite the situation.

Inefficiency, corruption, mismanagement of

the economy may also be the other

reasons. Thus, inflation is caused by the

interplay of various factors.