INFLATION

Inflation means a sustained increase in the general price level. Inflation has consequences for
people and firms throughout the economy, in their roles as lenders and borrowers, wage-earners,
taxpayers, and consumers. However, this increase in the cost of living can be caused by different
factors.

A. Demand-Pull Inflation
B. Cost-push Inflation

A. Demand-Pull Inflation _ is the type of inflation brought about by the excess demand pulling
prices up. When there is excess demand in the economy, producers are able to raise prices and
achieve bigger profit margins because they know that demand is running ahead of supply.

Possible causes of Demand-pull inflation:

1. Government fiscal/or monetary expansion, such as an increase in government spending, a

reduction in taxation, a money supply increase;
2. An increase in the demand for exports, in turn caused by higher inflation

B. Cost-Push Inflation_ is the type of inflation where increases in the costs of production push
prices up.

Possible causes of Cost-push inflation:

Component costs: e.g. an increase in the prices of raw materials and components. This might be
because of a rise in global commodity prices such as oil, gas copper and agricultural products
used in food processing – a good recent example is the surge in the world price of wheat.

Higher indirect taxes imposed by the government – for example a rise in the duty on alcohol,
cigarettes and petrol/diesel. Depending on the price elasticity of demand and supply, suppliers
may pass on the burden of the tax onto consumers.

A fall in the exchange rate – this can cause cost push inflation because it normally leads to an
increase in the prices of imported products.
Effects of Inflation:

1. Unequal Distribution of Income: Inflation will result in some groups to gain at the
expense of others. Fixed income earners (e.g. employees) will lose while variable income
earners (e.g. businessman) will gain.
2. Lower Standard of Living: If income of the individuals remains unchanged, any
increase in prices will result in an increase in the cost of living and hence a lower
standard of living.
3. Value of Currency Fall: With persistent price increase, the internal value of the
currency will fall and this will lead to a fall in the external value as we require more of
our currency in exchange for foreign currency. This also may cause balance of payments
deficit.

Measures for Controlling Inflation:

1. Contractionary Monetary Policy:

One of the important monetary measures is monetary policy. The central bank of the country
adopts a number of methods to control the quantity and quality of credit. For this purpose, it
raises the bank rates, sells securities in the open market, raises the reserve ratio, and adopts a
number of selective credit control measures, such as raising margin requirements and
regulating consumer credit. Monetary policy may not be effective in controlling inflation, if
inflation is due to cost-push factors. Monetary policy can only be helpful in controlling
inflation due to demand-pull factors.

2. Contractionary Fiscal Policy:

Fiscal measures are highly effective for controlling government expenditure, personal
consumption expenditure, and private and public investment.

(a) Reduction in Unnecessary Expenditure:

The government should reduce unnecessary expenditure on non-development activities in
order to curb inflation. This will also put a check on private expenditure which is
dependent upon government demand for goods and services.
(b) Increase in Taxes:
To cut personal consumption expenditure, the rates of personal, corporate and commodity
taxes should be raised and even new taxes should be levied, but the rates of taxes should
not be so high as to discourage saving, investment and production.