INFLATION

Inflation Inflation is a significant and persistent increase in the price level –significant – more than 1 percent per year –persistent – there is difference between sustained and episodic increases in prices moderate inflation - on the level of 1 to 3 percent per year hyperinflation – price increases more than 50 percent per month

1. Cost-push inflation Cost push inflation is inflation caused by an increase in prices of inputs like labour, raw material, etc. The increased price of the factors of production leads to a decreased supply of these goods. While the demand remains constant, the prices of commodities increase causing a rise in the overall price level. This is in essence cost push inflation. Description: In this case, the overall price level increases due to higher costs of production which reflects in terms of increased prices of goods and commodities which majorly use these inputs. This is inflation triggered from supply side i.e. because of less supply. (The opposite effect of this is called demand pull inflation where higher demand triggers inflation.) Apart from rise in prices of inputs, there could be other factors leading to supply side inflation such as natural disasters or depletion of natural resources, monopoly, government regulation or taxation, change in exchange rates, etc. Generally, cost push inflation may occur in case of an inelastic demand curve where the demand cannot be easily adjusted according to rising prices.

AS’ AS AD PRICES REAL DEMAND AND OUTPUT E’ E p’ p

Reasons for cost-push inflations and supply shocks: rising labor costs due to increased labor union power: when unemployment is low, wages will have risen more then they otherwise would have; hence, wages and prices will be higher when unemployment is low and output is high; increased mark-ups of prices resulting from a decline in competition, depreciation of domestic currency which increased prices of imported goods

Demand-pull inflation Demand curve shifts upward, from D to D’ and prices rise. Such shifts could be due to increase in: the average propensity to consume, the marginal efficiency of investment,government expenditures, export, and the money supply. The aggregate demand curve also shifts upward if taxes, imports or the demand for money decrease AD = C + I +G + (E – X)

AS AD PRICES REAL DEMAND AND OUTPUT E’ E p’ p AD’

Demand-pull inflation is asserted to arise when aggregate demand in an economy outpaces aggregate supply. It involves inflation rising as real gross domestic product rises and unemployment falls, as the economy moves along the Phillips curve. This is commonly described as "too much money chasing too few goods". More accurately, it should be described as involving "too much money spent chasing too few goods", since only money that is spent on goods and services can cause inflation. This would not be expected to persist over time due to increases in supply, unless the economy is already at a full employment level. Milton Friedman in his highly influential work „A Monetary History of the United States” asserted that inflation is always and everywhere a monetary phenomenon. The term demand-pull inflation is mostly associated with Keynesian economics. According to Keynesian theory, the more firms will employ people, the more people are employed, and the higher aggregate demand will become. This greater demand will make firms employ more people in order to output more.