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Causes of Inflation:
a. Demand Pull Inflation
Inflation caused due to excessive demand is termed as demand pull inflation. It exists in the economy when overall price of goods and services increase due to increase in aggregate demand, but the
aggregate supply remains the same.
When the economy is at full employment, it is not possible to produce goods and services any further because the available resources have been optimally utilized. In this case, the supply of commodities is limited, but the demand is increasing. Consequently, the price of the commodity rise and leads to
inflation.
In the diagram, the horizontal line shows quantity (AD & AS), whereas the vertical line shows price. As shown in the figure, aggregate demand (AD1) intersects aggregate supply (AS) at point A where, the equilibrium price level is P1 and the quantity is Q1. When the aggregate demand increases, the initial AD1 curve shifts rightwards to AD2 and AD3 which intersects the initial AS curve at point B and C in which the new equilibrium price level are P2 and P3 respectively.
The increase in price from P1 to P2 and P3 is known as semi inflation. The price rise from P1 to P2 and P3 is because of the rise in aggregate demand for goods and services at a given supply situation. Corresponding to the P3 level of price level, the economy has reached full employment level. So, the aggregate supply curve (AS) becomes vertical.
Further rise in AD to AD4 increases the price to P4 but there is no increase in output since, the economy is at full employment. Such increase in price is known as inflation. As shown in the diagram, the price continues to rise if the aggregate demand keeps increasing.
Causes of Demand Pull Inflation
Some of the factors contributing to demand pull inflation are explained below:
1. Increase in money supply
When the central monetary authority of the country supplies more money, interest rates decline which leads to more investment and leads to increase in income. Subsequently, demand increases, resulting in price rise.
2. Increase in government expenditure
Increase in government expenditure raises the income level of the people. Increase in income increases the expenditure (demand) of the households and shifts the demand curve upwards. But, at the given level of output, the growing needs of people cannot be met, which leads to an increase in general prices of commodities.
3. Increase in private expenditure
Total private expenditure has two components:consumption and investment. An increase in consumption directly leads to an upward shift in demand curve. Similarly, increased investment leads to more job opportunities and hence higher income level which also increases the aggregate demand. Consequently, the price level rises.
4. Reduction in taxes
Reduction in direct taxes lead to higher level of disposable income which increases the aggregate demand of households and individuals. At a fixed level of supply, a higher demand leads to inflation.
5. Increase in net exports
Increase in net export means more inflow of foreign currency which increases the income level of people. This leads to an increase in aggregate demand. But, at a given level of output, price levels rise as the demand is high but supply is limited. Similarly, more export and less import may result in shortage of commodities in the domestic market. As a result, demand increases but supply remains same, so prices rise.
6. Deficit financing
When governmental expenses are in excess to its revenue, deficit of balance occurs. In order to level of deficit balance, government prints more money as a solution, which leads to inflation. Such situation occurs during war or internal conflicts.
b. Cost Push Inflation
Inflation caused due to an increase in the cost of production is known as cost push inflation. When manufacturing firms face higher production costs, they usually raise the price of their products to maintain their profit margins which causes cost push inflation.
Cost push inflation occurs when at a given demand level, aggregate supply declines due to increase in production costs such as labor wages or cost of raw materials. This causes the supply to decrease, consequently, increasing the price of commodities. Therefore, it is also known as supply side inflation.
The concept of cost push inflation can be explained with the diagram below:
In the diagram, vertical axis represents price level and horizontal axis represents quantity level. At the beginning, aggregate demand curve (AD) intersects aggregate supply curve (AS) at point A, where the equilibrium price level and quantity are P1 and Q1 respectively. As the supply falls short and the supply curve shifts leftward from AS1 to AS2, the equilibrium level is restored at point B where the price is higher rises to P2.
If aggregate supply declines further, AS curve shifts to AS3 thereby causing a rise in price to P3. The rise in price levels from P1 to P2 and P3 is cost push inflation.
Thus, the figure shows that a decrease in aggregate supply of commodities in relation to demand leads to inflation, but at the same time reduces the output level in the economy.
Causes of Cost Push Inflation
The major factors leading to cost push inflation are described below:
1. Increase in wage rate
When the increase in wage rate is greater than the level of labor productivity, it leads to inflation. Although general rise in wage does not lead to inflation, the presence of labor unions, wages generally exceed productivity causing inflation.
2. Increase in input prices or interest rates
The rise in prices of factors of input such as raw materials, electricity, water supply, oil, etc. leads to rise in price of goods and services. Similarly, increase in interest rates raise the cost of capital, ultimately leading to inflation.
3. Increase in profit margin
When manufacturing firms increase their profit margin per unit of output, with no increase in cost of production or demand of the commodity in the market, prices rise rapidly causing inflation.
4. Indirect taxation or removal of subsidies
Increase in indirect taxes like VAT, excise duty, custom duty, etc. directly increases prices of commodities. Likewise, removal of government subsidies also leads to higher payment of subsidized goods.
5. Depreciation of currency
If the domestic currency is devalued against foreign currency, the prices of imported goods increase. If the economy is predominated by imports, it will have greater impact on the domestic price movement, leading to higher inflation.
6. Supply shock
Factors such as natural calamities, power shortage, crop failures, strikes, etc. also cause shortage in the supply of goods and services, which leads to inflation in the economy.
c. Mixed Demand Pull Cost push inflation
Economists believe that in an economy actual inflationary process contains some elements of both demand pull inflation and cost push inflation. They state that both the forces operate simultaneously and independently in an inflationary process. Thus, mixed inflation is when change in price level is a result of change in both aggregate demand and aggregate supply functions.
But, economists also argue that both demand pull and cost push inflations do not occur simultaneously. The inflationary process may begin with either excess of demand or an increase in costs of production.
When inflation begins with excess demand with no cost push forces, prices rise and consequently leads to rise in wage rates (rise in cost of production). Here, wages do not increases because of cost push inflation but because of rise in prices. This is because, when the price of commodities increase, individuals would want a raise in their income in order to keep up with the economy. Thus, mixed inflation takes place.
On the other hand, when inflationary process starts with cost push inflation, prices rise but output declines. Subsequently, problem of unemployment occurs in the economy. In order to avoid economic recession, government adopts expansionary monetary and fiscal policies. Increase in government’s expenditures give rise to employment opportunities which further increases income level and purchasing power of people. As a result, demand for commodities increase, causing a price rise and thus, leading to demand pull inflation.
The diagram below clearly explains the concept of mix inflation:
As seen in the diagram, forces that affect aggregate demand and aggregate supply simultaneously affect each other. The initial point of equilibrium is E0 where, aggregate demand curve ADo intersects aggregate supply curve AS0, and the equilibrium price is P0 and output is Y0.
Suppose, wage rates rise due to the activities of the trade union. Rise in wage shifts the AS curve to AS1 and the new equilibrium point is E1. At this point, the higher price level is at P1 and the reduced level of output is at Y1. This is cost push inflation.
As the government takes measures to increase employment level in the economy, income level rises and causes a shift in the demand curve from AD0 to AD1. The new equilibrium point is E2 where the rise in price is P2. This is demand pull inflation resulted due to cost push inflation.
Taking another economic scenario, suppose government expenditures increase in the economy, which increases the level of income of the people. This shifts the AD curve from AD0 to AD1. The new equilibrium point with higher price level (P1) and output (Y1) is point E1. This is demand pull inflation.
When prices rise, real income of workers fall. So, workers demand more wages to keep up with the increasing prices. This causes the aggregate supply curve AS to shift from AS0 to AS1. The new point of equilibrium is E2 where price rose to P2 and output declined to Y0. Consequently, demand pull inflation gave rise to cost push inflation.
Thus, demand pull and cost push inflations operate simultaneously in the economy and cause a sustained rise in prices from P0 to P2.
Effects of Inflation
1. Effects of Inflation on Output and Employment
Inflation has unfavorable effect on production and employment particularly when there are unemployed resources in the economy. In the short-run, effects of inflation on output and employment depend on whether the initial force is cost-push or demand pull. Demand pull force shifts the demand curve-up resulting a rise in price level as well as output and employment. Cost push lead to the rise in price level but decrease in output and employment.
2. Effect of Income on Distribution of Income and Wealth
Effect of inflation is different for different group of income earners. Flexibility income group such as businessmen, traders gain during inflation due to increasement in profits of arising from increasement of price. Fixed income group such as workers, salary men are the losers during inflation but sometimes they are not affected when their wages are increased according to the inflation.
3. Other Effects:
a. Disrupts the smoothly going price mechanisms and creates uncertainities in the economy.
b. Raises the cost of holding money
c. Creates socio-political unrests.
d. People do not trust the government
e. Encourages black marketing, hoarding, corruption, etc.
f. Affects the pattern of production.
Some parts are Adopted from: https://www.businesstopia.net/economics/macro/causes-inflation,
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