Inflation Samir K Mahajan

CAUSES OF INFLATION Broadly speaking there are two school of thought regarding the possible causes of inflation. o Demand-pull inflation theory o Cost-push inflation theory

According to Demand-pull theory, price rises when aggregate demand (AD) in an economy exceeds aggregate supply (AS) of goods and services at full employment level. The demand- pull theorists point out that inflation might be caused, in the first place, by an increase in in the quantity of money, when the economy is operating at full-employment. As the quantity of money increases, the rate of interest will fall and consequently investment will increase. The increase in investment expenditure will increase the income of various factors of production. As a result, aggregate consumption expenditure will increase leading to an increase in effective demand. With economy already operating at the level of full-employment, this will immediately raise prices, and inflationary forces may emerge. Thus, when general monetary demand rises faster than the general supply, it pulls up prices (both commodity as well as factor prices). In figure, curves AD, AD1, and AD2 represents aggregate demand curves. The AS curve represent the aggregate supply function which slopes upward and becomes vertical straight line at point F indicating that the economy has reached full- employment. DEMAND-PULL INFLATION

Hence real output tend to be fixed or inelastic at point. Assuming that AD1 curve intersects with AS curve at point F, the real output or income is Y at full-employment and price level is P. when there is an increase in aggregate demand there would be an upward shift in aggregate demand curve such as from AD to AD1, or to AD2. The aggregate supply being inelastic, the price level then to rise from P to P1 and then to P2. There are many reasons which causes demand-pull inflation. Some of them are as follows are as follows: o Increase in autonomous investment in firms o Increase in government spending or public expenditure o A quick increase in consumption or MPC o A sudden increase in exports which might lead to a huge under-valuation of your currency o Excessive monetary growth – when they is too much money in the system chasing too few goods. The ‘price’ of a good will thus increase DEMAND-PULL INFLATION

Output or real income 0 Price level F YfYf AS AD 1 AD 2 AD P P1P1 P2P2

COST-PUSH INFLATION Cost-push inflation occurs due to rising production costs. As production costs rises, the businessman raises the prices of their product in order to maintain their profit margins. Thus, cost push inflation is determined by supply side factors and can lead to lower economic growth and often causes a fall in living standards, though it often proves to be temporary. Higher costs shift a firm’s supply curve upwards and lead to an increase in price. The phenomenon of cost-push inflation is graphically illustrated as under. In figure, AD curve represents the aggregate demand curve. The AS, AS 1, AS 2 curves represents the aggregate supply function. AS curve becomes vertical or inelastic at point F which is the full-employment equilibrium point. The full-employment level of income is OY which can be maintained at price level P. Now if we begin with the price level P, F is the point of intersection AD and AS. If there is an increase in cost of production, the aggregate supply curve will shift upward from AS to AS 1, and consequently, the new equilibrium points will be A with real output OY 1 at higher price level P 1. In figure, AD curve represents the aggregate demand curve. The AS, AS 1, AS 2 curves represents the aggregate supply function. AS curve becomes vertical or inelastic at point F which is the full-employment equilibrium point. The full-employment level of income is OY which can be maintained at price level P.

Now if we begin with the price level P, F is the point of intersection AD and AS. If there is an increase in cost of production, the aggregate supply curve will shift upward from AS to AS 1, and consequently, the new equilibrium points will be A with real output OY 1 at higher price level P 1. A further rise in cost of production will cause shift in supply curve to AS 2 which will intersect with AD curve at point B and consequently price level will rise to P 2,real output will fall to OY 2, Clearly the level of real output at A and B equilibrium points is less than full employment level. This means that with increase in cost of production, price level will rise cause fall in real output and rise in unemployment. There are many reasons for cost-push inflation: Rising prices of raw materials: Rising cost raw materials especially strategic raw materials like fuels etc. increase the, transportation cost, manufacturing cost and consequently cost of production and prices would rise would rise. Rising labour costs: Wages are one of the main costs facing firms. Rising wages will push up prices as firms have to pay higher costs (higher wages may also cause rising demand) caused by increase in wage. Wages are on the rise due to increasing pressure from trade unions and labour unions to raise wages. Higher indirect taxes: Higher indirect taxes imposed by the government on goods and services specially on essential commodities increase the cost of production and price. Imported Inflation: Devaluation will increase the domestic price of imports. Therefore, after devaluation we often get an increase in inflation due to rising cost of imports. Profit-push: when there are monopolies in the product market, monopoly firms would raise the price of the product in order to reap more profit. Consequently prices rise.

CONSEQUENCES OF INFLATION High inflation rate may result in the following adverse effects on the economy: Greater uncertainty: There may be greater uncertainty for both firms and households. Firms will postpone their investment due to uncertainty in the market. This will result in negative implications on the economic growth in the economy. Redistributive effects: High rate of inflation will adversely affect people who have constant incomes, such as retired people, students, and dependents. Moreover, rise in prices of essential commodities (food & clothing) will affect the poor segment of the society as they spend a major part of their income on these good. This will lead to increased inequality in the economy. Less saving: High rate of inflation will have an adverse effect on the savings in the economy. As people spend more to sustain their present standard of living, less is being saved. This will result in less loanable funds being available to firms for investment. Business community: Entrepreneurs and businessman welcomes inflation as the stand to profit when price is rising. They find that the value of their inventories and stock of goods is rising in money terms.

Debtor and creditor: Debtors generally gain and creditors loose lose during inflation. Gain accrues to a borrowers when he repays loans when value of money has fallen due to inflation. Thus a borrowers pay less in real terms when he repays his loans during inflation. The creditor on the other hand is a loser since he receives less in real terms. Damage to export competitiveness: High rate of inflation will hit hard the export industry in the economy. The cost of production will rise and the exports will become less competitive in the international market. Thus, inflation has an adverse effect on the balance of payments. Social unrest: High rate of inflation leads to social unrest in the economy. There is increase dissatisfaction in among the workers as they demand higher wages to sustain their present living standard. Moreover, high rate of inflation leads to a general feeling of discomfort for the household as their purchasing power is consistently falling. Interest rates: The Central Bank might use monetary tools to control high inflation rate by increasing interest rates. This will increase the cost of borrowing and will have a negative effect on both consumption and investment. CONSEQUENCES OF INFLATION contd.

MEASURES TO CONTROL INFLATION The anti-inflationary measures are broadly classified into three categories MONETARY MEASURES: Monetary policy refer to polices adopted by monetary authorities aim at reducing and absorbing excess supply of money in an economy. the central bank of the country may exercise various quantitative and qualitative techniques of credit control to check inflation. The following are some of the anti-inflationary monetary measures: o The volume of currency money may be reduced either by withdrawing a part of the notes already issued or by avoiding large scale issue of notes. o Restrictions on bank credits by setting higher cash reserve ratio o Increasing bank rate and other interest rates o Sale of Government securities in the open market by central bank. o Prescribing a higher margin that bank and other lenders must maintain for the loans granted by them against stocks and shares. o Regulation of consumers credit o Rationing of credit etc 6.

MEASURES TO CONTROL INFLATION contd. FISCAL MEASURES: Fiscal measure to control inflation relates to government policy with respect to its receipts and expenditure. The following are some of the important anti-inflationary fiscal measures: o Reduction in the volume of public expenditure. o Rise in the levels of taxes, introduction of new taxes and bringing more people under the coverage of taxes. o More internal borrowings by public authorities o Postponing the repayment of debt to people o Control on the volume of deficit financing o Preparation of a surplus budget o Incentive to savings o Tariffs should be reduced to increase imports and thus allow a part of the increased domestic money income to leak out o Inducing wage earners to buy voluntarily government bonds and securities

MEASURES TO CONTROL INFLATION contd. DIRECT OR ADMINISTRATIVE MEAURE: Direct controls refer to the regulatory or administrative measures taken by the government directly with an objective of controlling rise in prices. Some of them are as follows: o Expansion in the volume of domestic output so as to meet the ever increasing rise in the demand for them o Direct control of prices and introduction of rationing o Control of speculative and gambling activities o Wage -profit freeze by adopting appropriate wage-profit policy o Control of population because if population is controlled, it is possible to keep a check on demand for goods and services o Exhortations: Exhortations implies authoritative persuasions, publicity campaigns, national saving campaign, requests to trade union to volunteer resisting demand for rise in wages, to companies to restrict dividend distributions and to management to increase productivity and output.