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Theories of Inflation; A Brief Note
Today, all are aware of the economical events happening around them. Inflation is one of the most commonly discussing matters among all kind of people like politicians, policy makers, public lectures and even general public. Based on the notion of economics about inflation, there can be see different views or arguments among economists on inflation. This hub very briefly described the theory of inflation.
Reasons for inflation
Since the world or economy is an organized one in complexities, there are several reasons which lead to inflation. Among the numerous reasons, the most important two reasons for inflation are given.
i) Increase in Demand: It refers to the increasing in the demand of consumers. That is people hold more money. But unfortunately the supply of commodities is not in full employment condition. In short, the phenomenon of excess demand over the available supply of commodities will be resulted in inflation.
ii) Increase in cost of production: When the price or reward of factors of production increases, it pushes the cost of production. So, the producer compelled to increase the price of the commodity. It also leads to the problem of inflation.
Based on the above listed reasons there are two views on the theory of inflation. They are
I- Demand-pull Inflation and
II- Cost-pull Inflation
Now let us analyze each of the views.
I – Demand-pull Inflation
Demand pull inflation is a traditionally believed and most common type of inflation. According to demand pull inflation, the aggregate demand exceeds over the aggregate supply is lead to inflation. In other words huge amount of money hold by the public to purchase the limited supply. Demand pull inflation has two versions.
a) Monetarist version and
b) Keynesian version
a) Monetarist version on demand pull inflation
According to monetarist view, the oversupply of money is the main cause for inflation. The monetarist version is based on the Fisher’s equation of exchange (That is MV=PT, which says the price level in the economy varies directly with money supply). In short, when supply of money increases under the full employment condition, it may lead to increasing in aggregate demand. So, the availability of money is more and the price level also increases. It leads to inflation. Even though the aggregate demand increased, the economy cannot increase supply, because the available resources are fully utilized. The monetarist view on inflation can be represented graphically as shown in Figure I below.
In the figure quantity of demand and supply are represented on the ‘X’ axis and price represented on the ‘Y’ axis. Initially DD is the demand curve and SS is the supply curve. And equilibrium is determined at the point ‘E’, where price equal to ‘P’ and quantity equal to ‘Q’. Actually this is the full employment condition. Suppose, the supply of money increased, it will resulted in raising of price from ‘P’ to ‘P1’ and demand from ‘DD’ to ‘D1D1’. Since all resources are utilized, it is not possible to increase supply of commodity. In short the price level is increased over the available supply of goods and services. This resulted in inflation.
b) Keynesian version of demand pull inflation
Keynesian view on demand pull inflation agrees with monetarist's view in few concepts. According to Keynes there are many other reasons for inflation more than the increasing of aggregate demand as mentioned by monetarist. So, Keynesian view agrees with the monetarist in this concept. That is both of the views agreed that, excess aggregate demand is the cause for inflation. But, Keynes added his theory of ‘inflationary gap’ in the demand pull inflation. Inflationary gap is nothing, but an increase in total planned expenditure over the total output at full employment level of income. That is excess of aggregate expenditure means increasing in demand. In short excess of demand than the supply lead to inflation.
II – Cost Push Inflation
Cost-push inflation is another important reason for inflation. Cost-push inflation is mainly influenced by wage push and profit push. Actually this is a new phenomenon of inflation.
In this modern time, employees are organized and regulated by strong trade unions. These organizations of labors help them to enjoy the rights and avoid the exploitation. We know the living standards of human beings increasing steadily. That will indirectly increase the cost of living. So, the trade unions interfere to increase the wage. This is actually the wage push.
Once the firms are compelled to raise the wage of labors with the pressure of labor unions, the cost of production will also increase. In such a situation the producer required to increase price of his products to survive the production. So, along with the raising of prices, the producer imposes a margin of profit. This is the profit push.
Both the profit-push and cost-push resulted in the raising of price of goods and services. This lead to inflation