Inflation Causes & Remedies

Recently updated on April 13th, 2023 at 06:02 pm

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. Hence the difficulty of defining ‘inflation’.

In economics, inflation (or less frequently, price inflation) is a general rise in the price level in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation reflects a reduction in the purchasing power per unit of money a loss of real value in the medium of exchange and unit of account within the economy. The opposite of inflation is deflation, a sustained decrease in the general price level of goods and services. The common measure of inflation is the inflation rate, the annualized percentage change in a general price index, usually the consumer price index, over time.

Economists believe that very high rates of inflation and hyperinflation are harmful, and are caused by an excessive growth of the money supply. Views on which factors determine low to moderate rates of inflation are more varied. Low or moderate inflation may be attributed to fluctuations in real demand for goods and services, or changes in available supplies such as during scarcities. However, the consensus view is that a long-sustained period of inflation is caused by money supply growing faster than the rate of economic growth.

Inflation affects economies in various positive and negative ways. The negative effects of inflation include an increase in the opportunity cost of holding money, uncertainty over future inflation which may discourage investment and savings, and if inflation were rapid enough, shortages of goods as consumers begin hoarding out of concern that prices will increase in the future. Positive effects include reducing unemployment due to nominal wage rigidity, allowing the central bank more leeway in carrying out monetary policy, encouraging loans and investment instead of money hoarding, and avoiding the inefficiencies associated with deflation.

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:

  1. 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.”

Keynesians hold a different argu­ment. They argue that there can be an autonomous increase in aggregate de­mand or spending, such as a rise in con­sumption demand or investment or government spending or a tax cut or a net increase in exports (i.e., C + I + G + X – M) with no increase in money sup­ply. This would prompt upward adjust­ment in price. Thus, DPI is caused by monetary factors (classical adjustment) and non-monetary factors (Keynesian argument).

(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.

  1. 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

Rising prices are the root of inflation, though this can be attributed to different factors. In the context of causes, inflation is classified into three types: Demand-Pull inflation, Cost-Push inflation, and Built-In inflation.

(i) Demand-Pull Effect

Demand-pull inflation occurs when the overall demand for goods and services in an economy increases more rapidly than the economy’s production capacity. It creates a demand-supply gap with higher demand and lower supply, which results in higher prices. For instance, when the oil producing nations decide to cut down on oil production, the supply diminishes. It leads to higher demand, which results in price rises and contributes to inflation.

Additionally, an increase in money supply in an economy also leads to inflation. With more money available to individuals, positive consumer sentiment leads to higher spending. This increases demand and leads to price rises. Money supply can be increased by the monetary authorities either by printing and giving away more money to the individuals, or by devaluing (reducing the value of) the currency. In all such cases of demand increase, the money loses its purchasing power.

(ii) Cost-Push Effect

Cost-push inflation is a result of the increase in the prices of production process inputs. Examples include an increase in labor costs to manufacture a good or offer a service or increase in the cost of raw material. These developments lead to higher cost for the finished product or service and contribute to inflation.

(iii) Built-In Inflation

Built-in inflation is the third cause that links to adaptive expectations. As the price of goods and services rises, labor expects and demands more costs/wages to maintain their cost of living. Their increased wages result in higher cost of goods and services, and the spiral continues as one factor induces the other and vice-versa.

Theoretically, monetarism establishes the relation between inflation and money supply of an economy. For example, following the Spanish conquest of the Aztec and Inca empires, massive amounts of gold and especially silver flowed into the Spanish and other European economies. Since the money supply had rapidly increased, prices spiked and the value of money fell, contributing to economic collapse.

Types of Inflation Indexes

Depending upon the selected set of goods and services used, multiple types of inflation values are calculated and tracked as inflation indexes. Most commonly used inflation indexes are the Consumer Price Index (CPI) and the Wholesale Price Index (WPI).

(a) The Consumer Price Index

The CPI is a measure that examines the weighted average of prices of a basket of goods and services which are of primary consumer needs. They include transportation, food and medical care. CPI is calculated by taking price changes for each item in the predetermined basket of goods and averaging them based on their relative weight in the whole basket. The prices in consideration are the retail prices of each item, as available for purchase by the individual citizens. Changes in the CPI are used to assess price changes associated with the cost of living, making it one of the most frequently used statistics for identifying periods of inflation or deflation.

(b) The Wholesale Price Index

The WPI is another popular measure of inflation, which measures and tracks the changes in the price of goods in the stages before the retail level. While WPI items vary from one country to other, they mostly include items at the producer or wholesale level. For example, it includes cotton prices for raw cotton, cotton yarn, cotton gray goods, and cotton clothing. Although many countries and organizations use WPI, many other countries, including the U.S., use a similar variant called the producer price index (PPI).

(c) The Producer Price Index

The producer price index is a family of indexes that measures the average change in selling prices received by domestic producers of goods and services over time. The PPI measures price changes from the perspective of the seller and differs from the CPI which measures price changes from the perspective of the buyer.

In all such variants, it is possible that the rise in the price of one component (say oil) cancels out the price decline in another (say wheat) to a certain extent. Overall, each index represents the average weighted cost of inflation for the given constituents which may apply at the overall economy, sector or commodity level.

Remedies of Inflation

Inflation is generally controlled by the Central Bank and/or the government. The main policy used is monetary policy (changing interest rates). However, in theory, there are a variety of tools to control inflation including:

  1. Monetary policy

Higher interest rates reduce demand in the economy, leading to lower economic growth and lower inflation.

In a period of rapid economic growth, demand in the economy could be growing faster than its capacity to meet it. This leads to inflationary pressures as firms respond to shortages by putting up the price. We can term this demand-pull inflation. Therefore, reducing the growth of aggregate demand (AD) should reduce inflationary pressures.

The Central bank could increase interest rates. Higher rates make borrowing more expensive and saving more attractive. This should lead to lower growth in consumer spending and investment. See more on higher interest rates.

A higher interest rate should also lead to a higher exchange rate, which helps to reduce inflationary pressure by:

  • Making imports cheaper. (lower price of imported goods)
  • Reducing demand for exports.
  • Increasing incentive for exporters to cut costs.
  1. Fiscal Policy

A higher rate of income tax could reduce spending, demand and inflationary pressures.

The government can increase taxes (such as income tax and VAT) and cut spending. This improves the government’s budget situation and helps to reduce demand in the economy.

Both these policies reduce inflation by reducing the growth of aggregate demand. If economic growth is rapid, reducing the growth of AD can reduce inflationary pressures without causing a recession.

If a country had high inflation and negative growth, then reducing aggregate demand would be more unpalatable as reducing inflation would lead to lower output and higher unemployment. They could still reduce inflation, but, it would be much more damaging to the economy.

  1. Control of money supply

Monetarists argue there is a close link between the money supply and inflation, therefore controlling money supply can control inflation.

The main way central banks control money supply is buying and selling government debt in the form of short term government bonds. Economists call this ‘open market operations’, because the central bank is selling bonds on the open market. Central banks usually own a big portion of their county’s debt. When they want to shrink the money supply, they can sell some that debt to banks or investors. People hand over money to buy the debt, and money is taken out of the economy, as money that used to be floating from person to person disappears into the central bank. When the central bank wants to add more money to the economy it can buy debt, taking government debt out of the economy and replacing it with new money.

All this bond buying and selling affects the interest rate too.  By shifting the supply and demand for debt, central banks can move the interest rate to affect how many people take new loans. Changing the interest rate allows central banks to also impact the money supply indirectly, because each loan a bank makes actually creates money.

Central banks have other tools to indirectly control the money supply, like requiring banks to keep more money on hand (called reserve requirements), or changing the interest rate at which they lend money to private banks. In recent years central banks have also experimented with a new policy called quantitative easing basically a turbocharged version of buying bonds.

  1. Supply-side policies

Supply-side policies are government attempts to increase productivity and increase efficiency in the economy. If successful, they will shift aggregate supply (AS) to the right and enable higher economic growth in the long-run.

There are two main types of supply-side policies.

  • Free-market supply: Side policies involve policies to increase competitiveness and free-market efficiency. For example, privatisation, deregulation, lower income tax rates, and reduced power of trade unions.
  • Interventionist supply: Side policies involve government intervention to overcome market failure. For example, higher government spending on transport, education and communication.

Benefits of Supply-Side Policies

In theory, supply-side policies should increase productivity and shift long-run aggregate supply (LRAS) to the right.

(a) Lower Inflation

Shifting AS to the right will cause a lower price level. By making the economy more efficient, supply-side policies will help reduce cost-push inflation. For example, if privatisation leads to more efficiency it can lead to lower prices.

(b) Lower Unemployment

Supply-side policies can contribute to reducing structural, frictional and real wage unemployment and therefore help reduce the natural rate of unemployment. See: Supply-side policies for reducing unemployment.

(c) Improved economic growth

Supply-side policies will increase the sustainable rate of economic growth by increasing LRAS; this enables a higher rate of economic growth without causing inflation.

(d) Improved trade and Balance of Payments

By making firms more productive and competitive, they will be able to export more. This is important in light of the increased competition from an increasingly globalised marketplace. See also: Economic Importance of Supply-Side Policies.

Limitations of supply-side policies

  • Productivity growth depends largely on private enterprise and trends in technological innovation. There is a limit to which the government can accelerate the growth of technological change and improvements in working practices.
  • Supply-side policies can be counter-productive. For example, flexible labour markets may reduce costs for business but if they cause job-insecurity, workers may become demotivated and labour productivity stagnates. Since 2009, the UK has seen a fall in structural unemployment due to more flexible labour markets – but productivity growth is almost stagnant.
  • In a recession, supply-side policies cannot tackle the fundamental problem which is lack of aggregate demand.
  • All supply-side policies take a long time to have an effect. Some policies, such as education spending may not influence the economy for 20-30 years.

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