Causes of Inflation - Macroeconomics | Macro Economics - B Com PDF Download

Causes of Inflation:

Inflation is mainly caused by excess demand/ or decline in aggregate supply or output. Former leads to a rightward shift of the aggregate demand curve while the latter causes aggregate supply curve to shift left­ward. Former is called demand-pull inflation (DPI), and the latter is called cost-push infla­tion (CPI). Before describing the factors, that lead to a rise in aggregate demand and a de­cline in aggregate supply, we like to explain “demand-pull” and “cost-push” theories of inflation.

(i) Demand-Pull Inflation Theory:

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, classi­cists 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.

According to Keynesians, aggregate demand may rise due to a rise in consumer demand or investment demand or govern­ment expenditure or net exports or the com­bination 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.

Just like the price of a commodity, the level of prices is determined by the interaction of aggregate demand and aggregate supply. In Fig. 4.3, aggregate demand curve is negative sloping while aggregate supply curve before the full employment stage is positive sloping and becomes vertical after the full employ­ment stage is reached. AD₁ is the initial aggregate demand curve that intersects the aggregate supply curve AS at point E₁.

The price level, thus, determined is OP₁. As ag­gregate demand curve shifts to AD₂, price level rises to OP₂. Thus, an increase in aggre­gate demand at the full employment stage leads to an increase in price level only, rather than the level of output. However, how much price level will rise following an increase in aggregate demand depends on the slope of the AS curve.

(ii) Causes of Demand-Pull Inflation:

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 bal­ances. Spending of excess cash balances by them causes price level to rise. Price level will continue to rise until aggregate demand equals aggregate supply.

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 gen­erated 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.

There are other reasons that may push ag­gregate demand and, hence, price level up­wards. For instance, growth of population stimulates aggregate demand. Higher export earnings increase the purchasing power of the exporting countries. Additional purchasing power means additional aggregate demand. Purchasing power and, hence, aggregate de­mand may also go up if government repays public debt.

Again, there is a tendency on the part of the holders of black money to spend more on conspicuous consumption goods. Such tendency fuels inflationary fire. Thus, DPI is caused by a variety of factors.

(iii) Cost-Push Inflation Theory:

In addition to aggregate demand, aggregate supply also generates inflationary process. As inflation is caused by a leftward shift of the aggregate supply, we call it CPI. CPI is usu­ally associated with non-monetary factors. CPI arises due to the increase in cost of produc­tion. 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 in­crease in productivity of workers. If this hap­pens, 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. And, rising prices again prompt trade unions to demand higher wages. Thus, an inflationary wage-price spiral starts. This causes aggregate supply curve to shift leftward.

This can be demonstrated graphically where AS₁ 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 (E₁) of AD₁ and AS₁ curves determine the price level (OP₁). Now there is a leftward shift of aggregate supply curve to AS₂. With no change in aggregate demand, this causes price level to rise to OP₂ and output to fall to OY₂. With the reduction in output, employment in the economy de­clines or unemployment rises. Further shift in AS curve to AS₃ results in a higher price level (OP₃) and a lower volume of aggregate out­put (OY₃). Thus, CPI may arise even below the full employment (Y_F) stage.

(iv) Causes of Cost-Push Inflation:

It is the cost factors that pull the prices up­ward. One of the important causes of price rise is the rise in price of raw materials. For in­stance, by an administrative order the govern­ment may hike the price of petrol or diesel or freight rate. Firms buy these inputs now at a higher price. This leads to an upward pres­sure on cost of production.

Not only this, CPI is often imported from outside the economy. Increase in the price of petrol by OPEC com­pels the government to increase the price of petrol and diesel. These two important raw materials are needed by every sector, espe­cially the transport sector. As a result, trans­port costs go up resulting in higher general price level.

Again, CPI may be induced by wage-push inflation or profit-push inflation. Trade unions demand higher money wages as a compen­sation against inflationary price rise. If in­crease in money wages exceed labour produc­tivity, aggregate supply will shift upward and leftward. Firms often exercise power by push­ing prices up independently of consumer de­mand to expand their profit margins.

Fiscal policy changes, such as increase in tax rates also leads to an upward pressure in cost of production. For instance, an overall in­crease in excise tax of mass consumption goods is definitely inflationary. That is why govern­ment is then accused of causing inflation.

Finally, production setbacks may result in decreases in output. Natural disaster, gradual exhaustion of natural resources, work stop­pages, electric power cuts, etc., may cause ag­gregate 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. A particular factor cannot be held responsible for any inflationary price rise.