Causes of Inflation

In the long run inflation is generally believed to be a monetary phenomenon while in the short-run and medium term it is influenced by the relative elasticity of wages, prices and interest rates.

A great deal of economic literature concerns the question of what causes inflation and what effect it has. There are different schools of thought as to what causes inflation. However, inflation in the economy will occur due to two factors, i.e., increase in effective demand and increase in production cost. The inflation caused by the increase in demand is known as demand-pull inflation and on the other hand, the inflation caused by the increase in cost of production is known as cost-push inflation. There are many other factors within these two reasons which are explained below.

  • Demand-pull Inflation

Demand-pull inflation caused by increase in aggregate demand due to increased private and government spending, etc. Demand-pull inflation is constructive to a faster rate of economic growth since the excess demand and favorable market conditions will stimulate investment and expansion. The demand-pull inflation occurs when the aggregate demand exceeds the available supply of goods and Services in existence. The process of demand-pull inflation is when the supply of money increases, rate of interest falls. This increases the investment which increases money income. As a result, the expenditure on consumption goods and investment expenditure increases. Due to this, demand increases than supply and the demand-pull inflation occurs. This can be illustrated with the help of figure;

In the figure given above, ‘AS’ is the given aggregate supply curve of the economy and each aggregate demand curve (AD0 to AD4) Shows the level of aggregate demand associated with the rising levels of money income in the economy when aggregate demand increases from AD0 to AD2, output as well as prices increase. But as the level of full employment is reached at Qf and the supply curve becomes perfectly inelastic, increases in income beyond AD2 lead to what Keynes termed “true inflation”. The rise in prices upto P2 is called “bottleneck inflation”, which is due to imbalances, shortages and rising costs in the economy as the level of full employment is approached. Beyond the point E, the aggregate supply function is assumed to be vertical and prices are rising directly due to increases in the level of money income.

According to this concept, the inflation occurs when the demand further increases after reaching the state of full employment. In such situation aggregate demand will be more than the aggregate supply because after the state of full employment supply won’t increase despite the increase in demand. Thus, price of goods will increase. This is known as demand-pull inflation.

Causes of demand-pull inflation

Demand-pull inflation caused by the following factors:

(i) Increase in the quantity of money:

The demand for goods increases rapidly when the quantity of money increases rapidly in the economy. So, increase in demand due to increase, in the quantity of money creates the ‘demand-pull inflation’.

(ii) Increase in public expenditure:

            In modern time, the government spends more than revenue due to the increase in government activities. This creates fiscal deficit. Some part of the deficit is met by the government by printing new notes on account of this the expansion of money increases and inflation occurs.

(iii) Reduction in taxation:

            If the government reduces taxes, households are left with more disposable income in their pockets. This leads to increase consumer spending. Thus, increasing aggregate demand and eventually causing demand-pull inflation.

(iv) Shortage of goods and services:

The price level increases when the supply of goods and services is lower in relation to demand. The production and supply decrease due to the scarcity of factors of production, hoarding by businessmen, natural calamity, scarcity of raw-materials, etc.

(v) Redistribution of income:

Redistribution of income will increase the demand for goods and services. This is because increase in the income of the people will increase their propensity to consume. Increase in consumption will increase the demand which will lead to increase in price and the ‘demand-pull inflation’ will be resulted.

  • Cost-Push Inflation

Cost-push inflation is also called “supply shock inflation”, caused by drops in aggregate supply due to increased prices of inputs, for example. Take for instance a sudden decrease in the supply of oil which would increase oil prices. Producers for whom oil is a part of their costs could then pass this on to consumers in the form of increased prices.

Inflation is also caused by increase in the cost of production. As a result of increase in the cost of production, the aggregate supply declines in relation to existing demand of goods and services. Thus, the inflation that occurs due to the pressure of cost is called cost-push inflation. Cost-push inflation can be illustrated with the help of figure:

 

In above given diagram, aggregate output is shown on the horizontal axis and price level is shown on the vertical axis, ‘AS’ is the aggregate supply curve and ‘AD’ is the aggregate demand curve. Let us suppose that the economy is in equilibrium at the full employment level at the point where output is Q0. The corresponding price level is P0. Now, let us further suppose that there is an upward shift of costs of production from the position of AS0 to AS1. If the money income remains at the same level equilibrium output will fall to Q1 and the price level will rise to P1. Similarly, if the supply function assumes the position AS2, output will diminish to Q2 and prices will be pushed up to P2. This rise in the price level is commonly known as cost push inflation.

The causes of cost push inflation are explained as follows:

(1) Wage- Induced inflation (wage-push Inflation) :

Wage- induced inflation caused by the use of bargaining power of trade unions in raising per unit wage costs. Where trade unions have strong bargaining power, even when the worker’s productivity does not rise, they are able to get wage rates pushed up. Such pushes will lead to autonomous shift in the cost of production even if aggregate demand and level of income remain unchanged. When wages are increased without any corresponding rise in productivity, the resultant upward shift in the aggregate supply function will lead to cost-push inflation.

(2) Profit-induced inflation (profit-push inflation):

Another cause of cost-push inflation is the profit-push. It can occur only under imperfectly competitive markets. Where the monopolists and the oligopolists raise prices of their products more than the increase in cost, this may lead to cost-push inflation.

(3) International Reasons (Supply-Shock inflation): 

Every country of the world will have some kind of business or economic relationship with other countries. The countries like Nepal are dependent on foreign countries for construction materials, raw materials, every including consumer goods. Hence, if the prices of these goods increase in foreign countries, the price in Nepal also automatically increase. If the inflation occurs due to price raised by foreign countries such as the price of petroleum by OPEC, it is know as ‘supply-shock’ inflation.

 

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