ME/U5 Topic 4 Elementary Idea of Inflation
Inflation is often defined in terms of its supposed causes. Inflation exists when money supply exceeds available goods and services. Or inflation is attributed to budget deficit financing. A deficit budget may be financed by the additional money creation. But the situation of monetary expansion or budget deficit may not cause price level to rise.
Inflation may be defined as ‘a sustained upward trend in the general level of prices’ and not the price of only one or two goods. G. Ackley defined inflation as ‘a persistent and appreciable rise in the general level or average of prices’. In other words, inflation is a state of rising prices, but not high prices.
It is not high prices but rising price level that constitute inflation. It constitutes, thus, an overall increase in price level. It can, thus, be viewed as the devaluing of the worth of money. In other words, inflation reduces the purchasing power of money. A unit of money now buys less. Inflation can also be seen as a recurring phenomenon.
While measuring inflation, we take into account a large number of goods and services used by the people of a country and then calculate average increase in the prices of those goods and services over a period of time. A small rise in prices or a sudden rise in prices is not inflation since they may reflect the short term workings of the market
It is to be pointed out here that inflation is a state of disequilibrium when there occurs a sustained rise in price level. It is inflation if the prices of most goods go up. Such rate of increases in prices may be both slow and rapid. However, it is difficult to detect whether there is an upward trend in prices and whether this trend is sustained. That is why inflation is difficult to define in an unambiguous sense.
Types of Inflation
As the nature of inflation is not uniform in an economy for all the time, it is wise to distinguish between different types of inflation. Such analysis is useful to study the distributional and other effects of inflation as well as to recommend anti-inflationary policies. Inflation may be caused by a variety of factors. Its intensity or pace may be different at different times. It may also be classified in accordance with the reactions of the government toward inflation.
Thus, one may observe different types of inflation in the contemporary society:
- On the Basis of Causes
(i) Currency inflation
This type of inflation is caused by the printing of currency notes.
(ii) Credit inflation
Being profit-making institutions, commercial banks sanction more loans and advances to the public than what the economy needs. Such credit expansion leads to a rise in price level.
(iii) Deficit-induced inflation
The budget of the government reflects a deficit when expenditure exceeds revenue. To meet this gap, the government may ask the central bank to print additional money. Since pumping of additional money is required to meet the budget deficit, any price rise may the be called the deficit-induced inflation.
(iv) Demand-pull inflation
An increase in aggregate demand over the available output leads to a rise in the price level. Such inflation is called demand-pull inflation (henceforth DPI). But why does aggregate demand rise? Classical economists attribute this rise in aggregate demand to money supply. If the supply of money in an economy exceeds the available goods and services, DPI appears. It has been described by Coulborn as a situation of “too much money chasing too few goods.”
(v) Cost-push inflation
Inflation in an economy may arise from the overall increase in the cost of production. This type of inflation is known as cost-push inflation (henceforth CPI). Cost of production may rise due to an increase in the prices of raw materials, wages, etc. Often trade unions are blamed for wage rise since wage rate is not completely market-determinded. Higher wage means high cost of production. Prices of commodities are thereby increased.
A wage-price spiral comes into operation. But, at the same time, firms are to be blamed also for the price rise since they simply raise prices to expand their profit margins. Thus, we have two important variants of CPI wage-push inflation and profit-push inflation.
2. On the Basis of Speed or Intensity
(i) Creeping or Mild Inflation
If the speed of upward thrust in prices is slow but small then we have creeping inflation. What speed of annual price rise is a creeping one has not been stated by the economists. To some, a creeping or mild inflation is one when annual price rise varies between 2 p.c(%). and 3 p.c(%). If a rate of price rise is kept at this level, it is considered to be helpful for economic development. Others argue that if annual price rise goes slightly beyond 3 p.c. mark, still then it is considered to be of no danger.
(ii) Walking Inflation
If the rate of annual price increase lies between 3 p.c. and 4 p.c., then we have a situation of walking inflation. When mild inflation is allowed to fan out, walking inflation appears. These two types of inflation may be described as ‘moderate inflation’.
Often, one-digit inflation rate is called ‘moderate inflation’ which is not only predictable, but also keep people’s faith on the monetary system of the country. Peoples’ confidence get lost once moderately maintained rate of inflation goes out of control and the economy is then caught with the galloping inflation.
(iii) Galloping and Hyperinflation
Walking inflation may be converted into running inflation. Running inflation is dangerous. If it is not controlled, it may ultimately be converted to galloping or hyperinflation. It is an extreme form of inflation when an economy gets shattered. ”Inflation in the double or triple digit range of 20, 100 or 200 p.c. a year is labelled “galloping inflation”.
(iv) Government’s Reaction to Inflation
Inflationary situation may be open or suppressed. Because of anti-inflationary policies pursued by the government, inflation may not be an embarrassing one. For instance, increase in income leads to an increase in consumption spending which pulls the price level up.
If the consumption spending is countered by the government via price control and rationing device, the inflationary situation may be called a suppressed one. Once the government curbs are lifted, the suppressed inflation becomes open inflation. Open inflation may then result in hyperinflation.
Causes of Inflation
Inflation is mainly caused by excess demand/ or decline in aggregate supply or output. Former leads to a rightward shift of the aggregate demand curve while the latter causes aggregate supply curve to shift leftward. Former is called demand-pull inflation (DPI), and the latter is called cost-push inflation (CPI). Before describing the factors, that lead to a rise in aggregate demand and a decline in aggregate supply, we like to explain “demand-pull” and “cost-push” theories of inflation.
(i) Demand-Pull Inflation Theory
There are two theoretical approaches to the DPI—one is classical and other is the Keynesian.
According to classical economists or monetarists, inflation is caused by an increase in money supply which leads to a rightward shift in negative sloping aggregate demand curve. Given a situation of full employment, classicists maintained that a change in money supply brings about an equiproportionate change in price level.
That is why monetarists argue that inflation is always and everywhere a monetary phenomenon. Keynesians do not find any link between money supply and price level causing an upward shift in aggregate demand.
According to Keynesians, aggregate demand may rise due to a rise in consumer demand or investment demand or government expenditure or net exports or the combination of these four components of aggreate demand. Given full employment, such increase in aggregate demand leads to an upward pressure in prices. Such a situation is called DPI. This can be explained graphically.
Just like the price of a commodity, the level of prices is determined by the interaction of aggregate demand and aggregate supply. In Fig. aggregate demand curve is negative sloping while aggregate supply curve before the full employment stage is positive sloping and becomes vertical after the full employment stage is reached. AD1 is the initial aggregate demand curve that intersects the aggregate supply curve AS at point E1.
The price level, thus, determined is OP1. As aggregate demand curve shifts to AD2, price level rises to OP2. Thus, an increase in aggregate demand at the full employment stage leads to an increase in price level only, rather than the level of output. However, how much price level will rise following an increase in aggregate demand depends on the slope of the AS curve.
(ii) Causes of Demand-Pull Inflation
DPI originates in the monetary sector. Monetarists’ argument that “only money matters” is based on the assumption that at or near full employment excessive money supply will increase aggregate demand and will, thus, cause inflation.
An increase in nominal money supply shifts aggregate demand curve rightward. This enables people to hold excess cash balances. Spending of excess cash balances by them causes price level to rise. Price level will continue to rise until aggregate demand equals aggregate supply.
Keynesians argue that inflation originates in the non-monetary sector or the real sector. Aggregate demand may rise if there is an increase in consumption expenditure following a tax cut. There may be an autonomous increase in business investment or government expenditure. Government expenditure is inflationary if the needed money is procured by the government by printing additional money.
In brief, increase in aggregate demand i.e., increase in (C + I + G + X – M) causes price level to rise. However, aggregate demand may rise following an increase in money supply generated by the printing of additional money (classical argument) which drives prices upward. Thus, money plays a vital role. That is why Milton Friedman argues that inflation is always and everywhere a monetary phenomenon.
There are other reasons that may push aggregate demand and, hence, price level upwards. For instance, growth of population stimulates aggregate demand. Higher export earnings increase the purchasing power of the exporting countries. Additional purchasing power means additional aggregate demand. Purchasing power and, hence, aggregate demand may also go up if government repays public debt.
Again, there is a tendency on the part of the holders of black money to spend more on conspicuous consumption goods. Such tendency fuels inflationary fire. Thus, DPI is caused by a variety of factors.
(iii) Cost-Push Inflation Theory
In addition to aggregate demand, aggregate supply also generates inflationary process. As inflation is caused by a leftward shift of the aggregate supply, we call it CPI. CPI is usually associated with non-monetary factors. CPI arises due to the increase in cost of production. Cost of production may rise due to a rise in cost of raw materials or increase in wages.
However, wage increase may lead to an increase in productivity of workers. If this happens, then the AS curve will shift to the right- ward not leftward—direction. We assume here that productivity does not change in spite of an increase in wages.
Such increases in costs are passed on to consumers by firms by raising the prices of the products. Rising wages lead to rising costs. Rising costs lead to rising prices. And, rising prices again prompt trade unions to demand higher wages. Thus, an inflationary wage-price spiral starts. This causes aggregate supply curve to shift leftward.
This can be demonstrated graphically where AS1 is the initial aggregate supply curve. Below the full employment stage this AS curve is positive sloping and at full employment stage it becomes perfectly inelastic.
Intersection point (E1) of AD1 and AS1 curves determine the price level (OP1). Now there is a leftward shift of aggregate supply curve to AS2. With no change in aggregate demand, this causes price level to rise to OP2 and output to fall to OY2. With the reduction in output, employment in the economy declines or unemployment rises. Further shift in AS curve to AS3 results in a higher price level (OP3) and a lower volume of aggregate output (OY3). Thus, CPI may arise even below the full employment (YF) stage.
(iv) Causes of Cost-Push Inflation
It is the cost factors that pull the prices upward. One of the important causes of price rise is the rise in price of raw materials. For instance, by an administrative order the government may hike the price of petrol or diesel or freight rate. Firms buy these inputs now at a higher price. This leads to an upward pressure on cost of production.
Not only this, CPI is often imported from outside the economy. Increase in the price of petrol by OPEC compels the government to increase the price of petrol and diesel. These two important raw materials are needed by every sector, especially the transport sector. As a result, transport costs go up resulting in higher general price level.
Again, CPI may be induced by wage-push inflation or profit-push inflation. Trade unions demand higher money wages as a compensation against inflationary price rise. If increase in money wages exceed labour productivity, aggregate supply will shift upward and leftward. Firms often exercise power by pushing prices up independently of consumer demand to expand their profit margins.
Fiscal policy changes, such as increase in tax rates also leads to an upward pressure in cost of production. For instance, an overall increase in excise tax of mass consumption goods is definitely inflationary. That is why government is then accused of causing inflation.
Finally, production setbacks may result in decreases in output. Natural disaster, gradual exhaustion of natural resources, work stoppages, electric power cuts, etc., may cause aggregate output to decline. In the midst of this output reduction, artificial scarcity of any goods created by traders and hoarders just simply ignite the situation.
Inefficiency, corruption, mismanagement of the economy may also be the other reasons. Thus, inflation is caused by the interplay of various factors. A particular factor cannot be held responsible for any inflationary price rise.