Inflation and main causes of inflation / How can it be controlled
Inflation basically means a regular and persistent rise in the price level of the country. The definitions of inflation given by prominent economists are given below:
According to Pigou, “Inflation exists when money income is expanding more than in proportion to increase in earning activity.” According to Coulborn, inflation is a situation of “too much money chasing” too few goods.” According to Kemmerer, “Inflation is… too much currency in relation to physical volume of business.” Crowther defined inflation as, “a state in which the value of money is falling, that is, prices are rising.”
Causes of Inflation
Main causes of inflation are discussed below:
1. Demand-pull Inflation :
(1) Demand pull inflation occurs when aggregate demand is growing at an unsustainable rate.
(ii) When there is excess dem producers raise their prices
(i) Demand-pull inflation becomes a threat when an economy has experienced a boom with GDP rising faster than the long-run trend growth of potential GDP.
(v) Demand-pull inflation is likely when there is full employment of resources and Short-Run Aggregate Supply is inelastic.
Causes of Demand-Pull Inflation:
Main causes of Demand-Pull Inflation are given below:
(i) A depreciation of the exchange rate : Depreciation in exchange rate increases the price of imports and reduces the foreign price of a country’s exports. If consumers buy fewer imports, while exports grow, AD will rise and there may be a multiplier effect on the level of demand and output.
(ii) Higher demand from a fiscal Stimulate: If direct taxes are reduced, consumers have more disposable income causing demand to rise. Higher government spending and increased borrowing creates extra demand in the circular flow.
(iii) Monetary stimulate to the economy: A fall in interest rates may stimulate too much demand – for example to raise demand for loans to buy to houses the banks may reduce interest rates on home loans. However, increase in demand will increase the prices of the goods/services also.
(iv) Fast growth in other countries: A high rate of economic growth in other countries might also lead to demand-pull inflation. This is so because high rate of economic growth in other countries lead to increase in exports to that country. Increase in exports leads to increase in demand for domestic goods and services, thereby leading to demand pull inflation.
2. Cost-push Inflation : Cost-push inflation occurs when firms respond to rising costs by increasing prices in order to protect their profit margins.
Causes of Cost-push Inflation: There are many reasons why costs might rise:
(i) Rising component costs: An increase in the price of raw materials and other components leads to an increased in the production cost. Also, with rise in commodity prices such as oil, copper and agricultural products used in food processing production cost has gone up. A recent example has been a surge in the world price of wheat.
(ii) Rising labour costs: Increase in labour cost caused by: wage increases, which are greater than improvements in productivity leads to cost push inflation. Wage costs often rise when unemployment is low because skilled workers become scarce and this leads to higher wages. Wages might also increase when people expect higher inflation so they ask for more pay in order to protect their real incomes.
(iii) Expectations of inflation: When people see prices are rising for everyday items they get concerned about the effects of inflation on their real standard of living. This triggers a burst of higher pay claims as workers want to protect their way of life. This is also known as a “wage price effect”.
(iv) Higher indirect taxes: A rise in the duty on alcohol, fuels and cigarettes, or a rise in Value Added Tax also. Depending on the price elasticity of demand and supply for their products, suppliers may choose to pass on the burden of the tax onto consumers, leading to increase in prices.
(v) A fall in the exchange rate: This can also cause cost push inflation because it leads to an increase in the prices of imported products such as essential raw materials, components and finished products.
(vi) Monopoly employers/profit-push inflation: When dominants firms in a market use their market power to increase prices well above costs, then this results in cost push inflation
Measures to Control Inflation
The measures to control inflation are discussed ahead:
1. Fiscal Policy: Reducing Fiscal Deficit: The budget deals with how a Government raises its revenue and spends it. If the total revenue raised by the Government through taxation, fees, surpluses from public undertakings is less than the expenditure it incurs on buying goods and services to meet its requirements of defence, civil administration and various welfare and developmental activities, there emerges a fiscal deficit in its budget.
Thus, to finance its fiscal deficit, the Government borrows from Reserve Bank of India against its own securities. This helps to increase money supply as government returns this loan by printing new money.
This newly created money leads to the rise in incomes of the people. This causes the aggregate demand of the community to rise and results in inflations. Therefore to control inflation the government should try to decrease it’s fiscal deficit.
To reduce fiscal deficits and keep deficit financing within a safe limit, the Government can mobilise more resources through raising:
(1) Taxes, both direct and indirect,
(i) Market borrowings, and
(iii) Raising small savings such as receipts from Provident Funds and National Saving Schemes (NSC and NSS) by offering suitable incentives.
It can also reduce fiscal deficit by curtailing its wasteful and inessential expenditure.
2. Monetary Policy: Tightening Credit: Monetary policy refers to the adoption of suitable policy regarding interest rate and the availability of credit. Monetary policy is another important measure for reducing aggregate demand to control inflation. As an instrument of demand management, monetary policy can work in two ways.
First, it can affect the cost of credit and second, it can influence the credit availability for private business firms. Let us first consider the cost of credit. The higher the rate of interest, the greater the cost of borrowing from the banks by the business firms. As anti-inflationary measure, the rate of interest has to be kept high to discourage businessmen to borrow more and also to provide incentives for saving more. Besides, higher rates of interest will discourage more investment in inventories and consumer durables and will help in reducing aggregate demand. Also, to control inflation, the availability of credit should also be checked. There are several methods by which credit availability can be reduced. Firstly, it is through open market operations that the central bank of a country can reduce the availability of credit in the economy. Under open market operations, the Reserve Bank buys Government securities. This will tend to reduce the supply of credit or loanable funds which in turn would tend to reduce investment demand by the business firms.
The Cash Reserve Ratio (CRR) can also be raised to curb inflation. By law, banks have to keep a certain proportion of cash money as reserves against their deposits. This is called cash reserve ratio. To contract credit availability Reserve Bank can raise this ratio.
Another instrument for affecting credit availability is the Statutory Liquidity Ratio (SLR). According to statutory liquidity ratio, banks have to keep a certain minimum proportion of their deposits in the form of specified liquid assets. The Reserve Bank has often raised statutory liquidity ratio to check inflation.
3. Selective Credit Controls: By far the most important anti inflationary measure in India is the use of selective credit control. The methods of credit control described above are known as quantitative or general methods as they are meant to control the availability of credit in general.
Thus, bank rate policy, open market operations and variation in cash reserves ratio expand or contract the availability of credit for all purposes. On the other hand, selective credit controls are meant to regulate the flow of credit for particular or specific purposes.
These selective credit controls are also known as Qualitative Credit Controls. The measures of selective credit control are:
(1) Increase in the minimum margin money for lending by banks against specific securities.
(ii) The fixation of maximum limit or ceiling on advances to individual borrowers.
(iii) The fixation of minimum discriminatory rates of interest chargeable on credit for particular purposes.
4. Supply Management through Imports: To correct excess demand relative to aggregate supply, the latter can also be raised by importing goods in short supply. In India, to check the rise in prices of food-grains, edible oils, sugar etc., the Government has often taken steps to increase imports of goods in short supply to enlarge their available supplies. To increase imports of goods in short supply the Government reduces customs duties on them so that their imports become cheaper and help in containing inflation.
5. Income Policy: Freezing Wages: Another anti-inflationary measure which has often been suggested is the avoidance of wage increases which are unrelated to improvements in productivity. This requires exercising control over wage income…
Therefore, the proposal has been to freeze wages in the short run and wages should be linked with the changes in the level of productivity over a long period of time. According to this, wage increases should be allowed to the extent of rise in labour productivity only. This will check the net growth in aggregate demand relative to aggregate supply of output.
