The term ‘inflation’ is used in many senses and it is difficult to give a generally accepted, precise and scientific definition of the term. Popularly, inflation refers to a rise in price level.
Read More:
- Definition of Inflation and it’s Types
- Causes and Effects of Inflation
- The Stages of Inflation
- Keynesian View of Inflation
- Effects of Inflation on Different Groups of Society
We can distinguish between two kinds of inflation on the basis of their causes, viz., demand-pull and cost-push inflation.
Demand-Pull Inflation
The most common cause for inflation is the pressure of ever-rising demand on a stagnant or less rapidly increasing supply of goods and services. The expansion in aggregate demand may be due to rapidly increasing private investment or expanding government expenditure for war or economic development. At a time when demand is expanding and exerting pressure on prices, attempts are made to expand production. However, this may not be possible either due to non- availability of employed resources or shortages of transport, power, capital and equipment. Expansion in aggregate demand, after the level of full employment, results into rise in the price level. In a developing economy like India, resources are used for growth, for creating fixed assets and production of consumer goods. Necessarily, large expenditure will create. large money income and large demand but without a corresponding increase in supply of real output.
In the above diagram, an increase in aggregate demand (AD) from AD1 to AD2 leads to a rise in the general price level (P) from P1 to P2. Aggregate demand could increase due to an increase in any of its components. For instance, when households are more optimistic about the economic outlook, they will expect their income to rise and hence increase consumption expenditure. Consumption expenditure may also rise due to other factors such as an increase in the wealth of households. A fall in interest rates will lead to more profitable planned investments resulting in an increase in investment expenditure. Investment expenditure may also rise due to other factors such as stronger business sentiment. When the economy is in a recession, the government may increase expenditure on goods and services to steer the economy back onto the path of expansion. An increase in foreign income will lead to an increase in net exports.
We should emphasize here the role played by deficit financing and increase in money supply on the level of prices in a developing country. Often, the government of a developing country resorts to deficit spending to finance economic development i.e., borrowing from the central bank and commercial banks, which, in turn, leads to increase in money supply in the country. This exerts a strong pressure on the level of prices. An increase in foreign demand for the exports of a country may also raise the price level in a country. Expansion in foreign demand and consequent expansion in exports will raise income of the people. This will push up demand for goods and services within a country. In case the additional money income is used to buy imports or is hoarded then it will not have inflationary effect in the country. Thus, inflationary pressure is built by increasing aggregate demand in excess of the available resources. The increase in aggregate demand can be due to increase in government expenditure or increase in private investment and private consumption or release of pent up demand of consumers immediately after a war or increase in exports and so on. Deficit financing and increase in money supply further aggregate the situation by boosting demand still further. In all these cases, inflation is the result of demand-pull factors. It must be emphasized here that demand-pull inflation cannot be sustained unless there is increase in money supply.
Cost-Push Inflation
In certain circumstances, prices are pushed up by wage increases, forced upon the economy by labor leaders under the threat of strike. Costs can also be raised by manufacturers through a system of fixing a higher margin of profit. The common man generally blames profiteers, speculators, hoards and others for pushing up the costs and prices. Again, the government is responsible for raising the costs by imposing new taxes and continuously raising the tax rates of existing commodity. Therefore, rising rates of commodity taxes, in a sellers market, will enable the producers to raise the prices by the full amount of taxes. Under conditions of rising prices, business and industrial units find it easy to pass on the burden of higher wages to the consumers by raising the prices. Thus rise in wages, profit margin and taxation are responsible for cost-push inflation.
In the above diagram, a decrease in aggregate supply (AS) from AS1 to AS2 leads to a rise in the general price level (P) from P1 to P2. The cost of production in the economy may rise independently of demand due to several reasons. For instance, workers will bargain for higher wages when they expect prices to rise or when the labour market is tight. The prices of imported intermediate goods will rise when the exchange rate of domestic currency falls or when there is inflation in other economies. If the government increases indirect taxes such as the goods and services tax or if oil prices rise, the cost of production in the economy will rise. For instance, the sharp rise in oil prices in the early 1970s led to a huge rise in the cost of production in the world.
In periods when wages, prices and aggregate demand are all rising and creating an inflationary situation, it is difficult to find out active and passive factor. In many cases, it is neither demand-pull inflation nor cost-push inflation, but it is a combination of both. However, it is possible and often useful to separate the dominant factors. If aggregate demand is responsible for the inflationary situation, it may persist so long as excess demand persists and in the extreme case, it may develop into hyper-inflation come though cost-push inflation. On the other hand, cost-push inflation cannot persist for long, unless there is increase in aggregate demand. On the other hand, if wages and prices continue to rise even when demand ceases to grow, we have cost-push inflation.