What is inflation and its causes

Inflation is a process in which there is continuous increase in the general price level and the money is continuously losing its value. In the words of Gardner Ackley, “Inflation may be defined as a persistent and appreciable rise in general level or average of prices”. It may here be noted that rising general level of prices does not mean that prices of all goods are necessarily rising. Even during inflation, the prices of some goods may remain relatively constant and a few others actually falling.

Inflation also does not mean that prices of goods rise evenly or proportionately. Inflation is a continued upward movement in the general (average) level of prices. In words Milton Friedman, “By inflation is meant a steady and sustained rise in the prices.” 

Demand Pull Inflation

Demand pull inflation is also known as aggregate demand inflation. According to J. M. Keynes, demand pull inflation occurs from excess demand for output. When aggregate demand increases faster than aggregate supply of goods and services, the prices of goods tend to rise. Such a situation where aggregate demand persistently exceeds aggregate supply of goods at current prices so that the price level is pulled up is known as inflation.

   

Aggregate Demand Rise Sources

The economists are not in agreement about the causes that attribute rises in aggregate demand. Monetarists are of the view that rises in aggregate demand are solely and mainly due to increase in the supply of money at a faster rate than real output. They firmly believe that if money supply increases beyond that amount which households and firms want to hold, there will be increase in aggregate demand. This excess increase in aggregate demand for goods and services, due to higher spending, will pull the prices upward.

J. M. Keynes and his associates regard demand pull inflation as a non monetary phenomenon. According to them, there may be one or more than one causes leading to persistent upward shifts in the aggregate demand. For-example, domestic consumers may purchase more goods and services for consumption purposes due to increase in their wealth. Business firms may invest more due to higher profit expectations or fall in interest rates. The rise in aggregate demand can also be due to increases in government expenditure. The foreign residents demand for the country’s goods can also shift the aggregate demand upward or all the factors combining together shift the price level upward.

Cost Push Inflation

The second major cause of inflation is the increase in the cost of production of goods. The cost push inflation describe a situation where the process of rising prices is initiated and sustained by rising costs which push up the general price level. Cost push inflation thus occurs when the prices are forced upward by increases in the cost of factors of production and not by excess demand. It is inflation from the supply side of the economy. It is associated with leftward upward shifts in the aggregate supply curve. The major sources of cost push inflation are as under.

   

Increase in money wage rates

The wages push inflation occurs when strong labor unions manage to press for wage increases in excess of labor productivity.  Unit cost of production is thereby raised. The rise in costs of production exerts pressure on sellers to increase prices of goods so as to get profit margin.

Profit push inflation

If the producers of certain commodities have monopoly or near monopoly power in the market, they fix up higher profit margins arbitrarily without any increase in other elements of cost. When a few powerful firms increase the profit margins, the smaller firms also tend to mark up their profit margins. The higher profit margins, thus, inflate the price level.

Material push inflation

If there is increase in the prices of some basic materials such as gas, steel, chemicals, oil etc which are used directly or indirectly in almost all industries, it causes an increase in the cost of production and hence in the general price level.

Higher taxes

If the government levies new taxes and raises the rates of old taxes, the producers generally shift the burden of taxes on to the consumers. The increases in the selling prices of the commodities push up the inflationary trend in the economy.

Rise in import price

If the prices of imported goods increase, it also increases the inflation rate.