Causes Of Inflation

Long term inflation occurs when the money supply (currency and check writing deposits) grows at a faster rate than the output of goods and services. When there is more money available than is needed to accommodate normal growth in output, consumers and businesses want to purchase more goods and services than can be produced with current resources (labor, materials, and manufacturing facilities) causing upward pressure on prices. This is often described as "too much money chasing too few goods." Over a shorter term, inflation can result from various shocks to the economy. Food and energy price shocks are common examples of this in the U.S. The price of a critical commodity such as fuel may rise suddenly and sharply relative to other prices. Since the market does not have time to adjust other prices downward in response, a short-term increase in overall prices occurs. The rate of inflation is sometimes reported with food and energy omitted so the long-term, underlying (or "core") inflation rate is revealed. Governments need to control high levels of unpredictable inflation since it can severely disrupt the economy, cause uncertainty in financial decisions, and redistribute wealth unevenly. The tools they have available include: monetary policy (increase or decrease the money supply), fiscal policy (change the amount of taxes and governmental spending), and various controls on prices, tariffs, and monopolies. Many nations (including the U.S.) choose monetary policy as their primary tool since it has proven to be very effective, it is less disruptive to market operations, and it is easier and quicker to implement since adjusting the money supply does not require legislative approval as would, for instance, changing the tax structure. Monetary policy is almost always carried out by a government-controlled central bank that is usually somewhat insulated from political pressure. It is given the responsibility of maintaining an orderly market and juggling the sometimes conflicting goals of steady growth, low unemployment, and low inflation. The governments of some nations require the central bank to maintain a low, positive rate of inflation (usually well under 3%) as the over-riding goal of their monetary policy.2, 4 They must keep the money supply at a level that accommodates steady growth in goods and services, but is not so high as to cause excessive inflation or so low that deflation (an overall decrease in prices) results. The Federal Reserve System ("Fed"), the central bank of the U.S., does not publicly target a goal for the inflation rate. Instead, they announce goals for the Federal Funds Rate, the interest rate at which banks lend their excess reserves to one another. When the Fed wants to increase the money supply and thereby stimulate the economy, they publicly announce that they intend to lower the Fed Fund Rate. They then buy Treasury securites on the open market which, through a complicated combination of market transactions and federal banking regulations, will increase the amount of loans that private banks can make to consumers and businesses. As banks compete for customers for these new loans, short term interest rates will tend to fall toward the Fed Fund goal. With credit readily available at low interest, comsumers will tend to take out more loans for high-end goods such as homes and cars, and businesses will invest more in facilities and employ more workers to meet the demand. The increase in money supply is essentially borrowed into existance through the private banking system.

though even that would also mean fall in the purchasing power of money. large deficit spending in an expansion phase. expenditure financed by printing money and large expansion of money supply in the face of production capacity shortages and market imperfections like monopoly/ oligo[oly/ strikes/ lockouts can cause an inflationary price spiral up. on rehabilitation and relief work in an economy which was already in expansion phase. they have kept prices reasonably stable since about 1996 as shown in Figure 1. raise rates. People become poorer to that extent. The rise in food prices causes the cost of labor to industries go up. Let us consider an increase in demand caused by say sudden increase in govt. This means excess demand situation in food markets resulting in food prices.If the demand becomes greater then the current workforce and manufacturing facilities can produce at their natural growth limits. the producers may raise prices of industry made goods. inflation will generally occur. price increases feeding in to cost increases. expenditure through deficit financing to fund a disasterous widespread natural calamity resulting in loss of standing crops and damage to grain storages. If inflation means rising prices on an average ( prices of some items mat decline but most prices are rising). these increases the costs of production of other goods and their prices goes up to lead to cost and price rise in other goods. Rising prices also means the value or purchasing power of past savings also falls. Thus. This causes a hardships to those whose incomes do not rise at the eams rate of rise in prices. and thereby ward off inflation. There are two broad ways that a process of rising prices can work through its way. The above example is too extreme in terms of all types of factors working out. An one-shot rise in prices of goods and services in not inflation. In reality in most cases inflation can take place from sudden and sustained demand supply imbalances (shortage of supply) and/ or market imperfections. the purchasing power of money falls.price relationship can rwesult in an inflation. demand-supply imbalances. With example: Inflation is the phenomenon of a generally rising prices over a period of time. Prices must be showing continuous rise over successive weeks to be called as inflation. etc. sudden price shocks from oligopolistic markets and cost. Although the Fed does not publicly state an inflation goal as part of their policy. Higher prices mean you get to purchase lower quantity of goods and services within the same income or same expenditure budget. Now if the demand for goods produced by industries also goes up following strong demand from fresh labor employed by Govt. As prices of some goods rise. This may lead to all round rise in prices. Too strong growth in govt. . The Fed can reduce economic activity by announcing a higher goal for the Fed Fund Rate and then selling Treasury securities to shrink the money supply. This causes cost of production and transportation to go up further and a process of price spiral strengthens. its measured by the rise in the average prices of goods and services or the rise in the general price indexes like the Consumer Price Index or the Producers Price Indix or the Fuel Price Index or the Food Price Index and so on. In the meantime oil exporting countries also raise their orices taking advantage of their oligopolistic market situation.

Investments will create jobs. outputs will grow faster than prices. that claim cannot be true. income and outputs. the inflation rate). If. Start with the famous equation of exchange. the lower the prices of goods. Real GDP will increase. . then. Assume. This connection between the level of production and the level of prices also holds for the rate of change of production (that is. if the growth rates of M and V are held constant. that is. inflation must be 3 percent. however. economic growth rises to 4 percent. ³Tightening monetary policy slows spending growth. Some simple arithmetic will help clarify. Why. the claim that an increase in economic growth leads to an increase in inflation and that decreased growth reduces inflation has been a mantra. inflation falls to 2 percent.´ which puts downward pressure on the inflation rate. (Actually. Here¶s why. that the money supply grows at 6 percent a year and velocity is constant. It follows that the more goods that are produced. the speed at which money circulates. An increase in the rate of economic growth means more goods for money to ³chase. If µpotential GDP¶ is growing rapidly. if annual economic growth is 3 percent. if the growth rate of q increases. which is approximately 3 percent). it falls to 1. Then. does a man as brilliant as Federal Reserve chairman Alan Greenspan not get it? Actually. that is. inflation must be 2. and allows the slack to reduce inflation. and q is the real output of the economy. taken literally. Does Growth Cause Inflation? For the last few years. MV = Pq.´ Yet.9 percent. inflation is lower. then. he does.´ Translation: if growth is higher. In 1995 Chairman Greenspan testified before the Senate Committee on Finance: ³One factor in judging the inflationary risks in the economy is the potential for expansion of our productive capacity.How Can Inflation Lead To Rise In GDP? If prices go up. V is the velocity of money. If the growth rate of the economy increases. The seat-of-the-pants explanation of inflation is that it is caused by too much money ³chasing´ too few goods. the inflation rate must fall. If productivity is higher than wage rate. for illustrative purposes. Since the growth rate of the price level is just another term for the inflation rate. where M is the money supply. All other things being equal. opens up some slack temporarily in labor and product markets. the growth rate of the price level must fall. an increase in economic growth must cause inflation to drop. actual output can also continue to grow rapidly without intensifying pressures on resources. the rate of economic growth) and the rate of change of prices (that is. P is the price level.9 percent. (Actually.) That higher economic growth must reduce inflation is straightforward. He just never says things simply and straightforwardly when he can be complicated and obtuse instead. they will induce new investments.

5 to 2 percent a year.Can Productivity Grow? Of course.) There is strong reason to believe that productivity can grow by 1. This higher productivity growth is one of the reasons that real gross domestic product has grown by an average of 3.5 percent. exciting advances in biotechnology and artificial intelligence will likely lead to further productivity improvements over the next 10 to 20 years. and software will be able to increase productivity further. for example.S. and crucial.25 percent a year. The first statement is necessarily true: an economy¶s growth rate does equal the growth of employment plus the growth rate of output per worker (productivity). measured productivity² output per man-hour²in the United States increased by an annual average of 1.5 percent that was anticipated by the growth skeptics. Analysts who have studied the information technology (IT) industries can point to many ways in which the Internet. The second statement is probably true. But that past says little about the future. much higher than the 2 to 2. computers. would increase the U.46 percent.4 percent. Even in the recent past. assumption that limits on immigration to the United States are not progressively relaxed: allowing the number of workers admitted into the United States to increase by a million a year. labor force by about 0. Moreover.S. Various macro economists. may tell us that the upper limit on an economy¶s long-term growth rate is 2 or 2. then we can expect an explosion of growth as the IT industries are further integrated into the economy. productivity growth averaged 1. People who believe that productivity growth will be limited point to the past: between 1973 and 1993.23 percent. Stock prices have risen greatly over the last 5 years because the market has increasingly come to anticipate large productivity increases. the best they can do is to tell you that the economy¶s growth rate equals the sum of employment growth and productivity growth. (The other.8 percent. some of which will be captured by the firms that create them. If they¶re right. Some have compared the role of the IT industries in the current U. between 1993 and 1998. above what the ³growth skeptics´ thought was the upper limit. and that productivity can¶t be expected to grow by much more than about 1. for example.56 percent a year between 1993 and 1998. but it depends on the unstated. The third statement is the most controversial. that employment growth can¶t be much more than 1 percent in the long run. more important reason for higher growth is that employment grew by 2. economy to the economic role of electricity toward the end of the 19th century before electricity had been completely integrated into the economy. especially those trained in the Keynesian tradition. But if you push them for their reasons. it¶s hard to know at any given time what the potential growth rate of an economy is. .

overheating in India can be an agricultural phenomenon or an economy-wide pathology. Further. there is cause for worry because the implication is that the economy's current growth rate of 7-8 per cent is above its potential or trend growth rate. we are forced to turn to the third standard. and more worrying. and unless capacity can be significantly increased. it seems easy to identify the causes of overheating because a scissors effect seems to be at work. The weather Gods failed us last year. In this view. price smoothing by the government through greater imports and faster depletion of domestic stocks has been woefully inadequate. And fuel price increases should be of a one-off nature rather than an ongoing source of inflation. so the agricultural shock factor will not have the same bite going forward. In some ways. In either case. Korea and Indonesia. In agriculture. where inflation is closer to 3 per cent? Consider a few standard explanations.call it the supply shock factor . Minimum support prices for agriculture have also been increasing. The monsoon is looking better this year. In this case. India's agricultural output suffered a sharp drop as a result. Moreover.Why is inflation in India so stubbornly high and so much higher than other emerging markets. even those that are supposedly overheating.relates to agriculture. which is contributing to overall price inflation. courtesy the NREGS (which is increasingly looking like a pure cash-transfer programme). High inflation. Prices of fuel have recently been increased. especially consumer price inflation. such as China. the more plausible these explanations are. namely that inflation also reflects overheating: the supply capacity of the economy is simply unable to match the demands on that capacity. The first . rising prices are not restricted to agricultural goods and have now spilled over into other commodities: double-digit price increases are no longer confined to agricultural commodities. The most telling pieces of evidence against the view that inflation is supply shock and policydriven are twofold. in the face of agricultural supply shocks. On the other hand. The second explanation is what we might call policy shock. especially in pulses. Now. predated the monsoon shock of last year. is anaemic and possibly weakening further. On the one hand. the less worrying the prospects for the Indian economy. purchasing power and hence demand are accelerating. explanation. productivity growth. supply declined and prices rose. attaining China-type double-digit growth rates will remain elusive. .

the distortion. it will not be immediately achievable. There may. Such surges will lead to sudden increases in the price of land and related inputs. slow total factor productivity growth or some combination of all the three. raising the cost of production in the economy as a whole. Structural reforms of the land market will thus be good for inflation and good for growth. A whole range of services. however. education and finance which account for progressively larger shares of the economy use significant amounts of land as an input. entertainment.We do not know for sure what the bottlenecks are in the rest of the economy. Here's a possible hypothesis. which is believed to be the "Lakshman Rekha [ Images ]" that politicians dare cross only at their own peril. a fact that gets overlooked in inflation discussions. . Regardless. They could be inadequate investment in infrastructure. has tended to be above wholesale price inflation). In other words. will have increased the price level but cannot cause price inflation.as indeed those in agriculture . what is the cure? Clearly. which tend to focus on agriculture and manufacturing (this may also explain why inflation in consumer prices. this distortion cannot cause inflation because presumably the distortion leads to a one-off increase in the price of land as an input.are not addressed very quickly. So. aggressive monetary policy action will be warranted to bring inflation below 5 per cent. making inflation less likely. Serious micro-economic distortions afflict the land market. unless it is continually worsening. even if faster growth is possible. these constraints . And a corollary is that. inadequate supplies of skilled labour (always a possibility in India because its growth model is so skills-reliant). given the capacity situation. such as retail. converting a price-level effect into an inflation effect. But suppose that these micro-distortions interact with macroeconomic factors such as surging capital inflows into real estate and housing. the first best solution is to eliminate the distortions in the land market of which there are many. which reflect services to a greater extent than wholesale prices. In itself. be another explanation of high and persistent inflation that is more cheering in suggesting that inflation is less due to overheating than due to a different type of cost-push inflation. Generalised cost-push inflation could then be a natural consequence with the push resulting from the interaction between a pre-existing microeconomic distortion and a macroeconomic factor that serves to aggravate this distortion. If this is the diagnosis. construction. The resulting boost to productivity would increase the overall supply capacity of the economy. including urban land ceiling and tenancy laws.

the diagnosis of and cures for inflation may need some rethinking. this may require dampening foreign capital flows. In some cases. Inflation may have a lot more to do with services and land as an input. but does it also apply to the nature of its inflation? . policy-makers may have little choice but to address the macroeconomic factors that aggravate the underlying distortion. or they may involve other prudential measures such as higher provisioning requirements for real-estate lending. And curing it may require addressing the macroeconomic aggravators of microeconomic distortions in addition to traditional monetary policies. Exceptionalism characterises India's development pattern.But if land market reforms are infeasible. especially those going to real estate and housing. and inflation continues to be above acceptable levels. Thus.

Sign up to vote on this title
UsefulNot useful