Inflation refers to a situation of continuous increase in the general price level over a long period of time. It is a quantitative measure of the rate at which the average price level of goods and services in the economy increase over a period of time. According to Crowther, “Inflation is a ‘state’ in which the value of money is falling, i.e., the prices are rising”. Gardner Ackley defines inflation as, “Inflation is a persistent and appreciable rise in the general level or average price. Keynes defined inflation is the result of the excess of aggregate demand over the available aggregate supply. According to him, true inflation starts only after full employment.
Inflation can be defined in four different ways:
1. Creeping Inflation
When the price rises by less than 3 per cent per annum, it is known as creeping inflation. It is the mildest form of inflation where the price is said to rise like a snail or creeper. Such type of inflation is often considered to provide a stimulus for economic development. However, if not controlled can be dangerous for the economy.
2. Walking Inflation
When the price rises approximately by 5 percent per annum, it is known as walking inflation. Price rise becomes more pronounced as compared to creeping inflation and can be harmful to the economy. Due to rising prices, consumers start stocking goods, to avoid future price rise, thereby causing excess demand and a further rise in prices in the economy.
3. Running Inflation
When the price rises rapidly at about 10 per cent per annum, it is known as running inflation. It increases at a faster rate compared to walking inflation and requires strong policy measures. Otherwise, it may lead to hyperinflation.
4. Galloping Inflation
In the words of Baumol and Blinder, “Galloping inflation refers to an inflation that proceeds at an exceptionally high.” Also known as jumping inflation, it refers to a type of inflation that occurs when the prices of goods and services increase at a two-digit or three-digit rate per annum. This type of inflation has an adverse effect on middle and low income groups in the society and requires strict measures to control such inflation.
Inflation is the result of disequilibrium between demand and supply. There are two situations that may give rise to such a situation. It may result in an increase in demand for goods and services and a decrease in the supply of goods and services.
Factors causing an increase in demand
- An increase in money supply (due to the printing of new currency or expansion of credit by the bank) increases money income and as a result demand for goods and services increase.
- An increase in government expenditure causes an increase in aggregate demand for goods and services.
- An increase in private investment increases the demand for factors of production resulting in an increase in the factor prices and factor income. This further raises the demand for goods and services.
- A decrease in taxes increases the disposable income of the people which raises the demand for goods and services.
- A rapid increase in population raises the level of demand in the economy which leads to excessive demand.
- When the government pays off its old debt to the public, the purchasing power of the people increases giving rise to increased aggregate demand.
- An increase in export sales provides an extra flow of income into the exporting country giving rise to increased demand.
Factors causing a decrease in supply
- Scarcity or shortage of factors of production (such as labour, raw materials etc.) reduces the production of goods and services.
- Traders and firms trade hard essential goods for earning profits in future. This may reduce supply in the current period further raising the prices.
- Trade union activities may raise prices either by succeeding in raising wages of the workers more than their productivity and pushing up the cost of production or by reducing production through strikes and stoppage of work.
- Natural calamities reduce the supply of products and raise their prices.
- An increase in exports creates a shortage of goods for domestic consumption.
- During the war period, resources are diverted from the production of normal goods and services to the production of war materials. This reduces the supply of normal goods and services, thus raising their prices.
- The effects of inflation in major industrial countries affect the other countries with which they have trade relations.
Inflation can be of, Demand-Pull Inflation and Cost-Push Inflation.
Demand-pull inflation, also known as excess demand inflation, occurs when aggregate demand for goods and services exceeds the aggregate supply of those goods at exiting prices. According to this theory, inflation is caused by an increase in the aggregate demand for goods and services in the economy, aggregate supply remaining unchanged. There are two views that explain the forces responsible for excess demand or demand-pull in the economy:-
- Monetarist view and
- Keynesian view
The Monetarist view
The monetarists viewed inflation as a monetary phenomenon. According to them, the supply of money is the principal cause of demand-pull inflation. They provide a similar explanation given by the quantity theory of money. Given the velocity of money and full employment, the expansion of the money supply creates more demand for goods. But since the supply of goods cannot be increased due to the full employment of resources, prices rise at the same rate at which the money supply rises. Thus increased demand pulls prices higher. The monetarist view of demand-pull inflation can be explained using figure.
In figure 3.1 horizontal axis represents output and the vertical axis represents price level. DD is the initial aggregate demand curve and SQ is the aggregate supply curve. The perfectly inelastic nature of the SQ curve indicates the full employment level of output. Initial equilibrium is attained at point ‘E’ where demand equals supply at price OP and quantity OQ. A change in the money supply can affect the aggregate demand curve. With an increase in money supply, the aggregate demand curve shifts rightward from DD to D1D1. Aggregate supply curve remaining the same, new equilibrium is attained at point ‘E1’. Equilibrium output remaining the same price rises from OP TO OP1. Further increase in money supply will shift the aggregate demand curve to D2D2 thus raising the price from OP1 to OP2.
The Keynesian view
The Keynesians viewed inflation as a non-monetary phenomenon. According to them, true inflation occurs when an excess increase in total expenditure (i.e. government expenditure and investment expenditure) leads to excess demand and price rise at full employment. The Keynesian view of demand-pull inflation can be explained using the figure.
In figure 3.2, the horizontal axis represents output and the vertical axis represents price level. PS is the aggregate supply curve. The aggregate supply curve is horizontal up to near full employment (PB segment) and after full employment is reached at point D, the curve becomes vertical.
Suppose the initial aggregate demand curve is DD which intersects the supply curve determining equilibrium output OQ and price OP at point ‘A’. Due to increased total expenditure when aggregate demand shifts to the right to D1 D1, the new equilibrium is attained at point ‘B’. The output increases to OQ1 without any increase in the price. Again, an increase in aggregate demand to D2D2 increases both price and output to OP1 and OQ2 respectively at point ‘C’. Further, an increase in aggregate demand to D3D3 places the economy at full employment level OQ3 and price rises to OP2 at point ‘D’. After the full employment is reached at OQ3 level of output, any increase in aggregate demand will not increase output. As shown in the diagram when the demand curve shifts to D4D4, output remaining fixed price rises to OP3.
Thus as long as the economy is in the flat or horizontal range (PB) of the aggregate supply curve, an increase in aggregate demand doesn’t affect the price. But beyond that range increase in aggregate demand will pull prices up and create demand-pull inflation. The increase in price level after the full employment (BS segment) is described as true inflation by the Keynesians.
According to cost-push inflation, the process of inflation is initiated by the increase in the cost of production. The increase in the cost of production is not absorbed by the producer and often leads to a decrease in the supply of these goods. Demand remains the same, the prices of commodities increase causing overall price rise. The increased cost of production thus pushes the price up and such a situation is termed as cost-push inflation. There are three causes of cost-push inflation-
- Wage-Push Inflation
- Profit –Push Inflation
- Material – Push Inflation
In modern times, the trade-unions are well organized and strong. They can succeed in getting higher money wages for their members than their productivity warrants. This increases the cost of production. To maximize their earnings, the producers pass off the burden of higher money wages on the customers by increasing the prices of goods that they produce. The rate of inflation (p), according to wage-push inflation is determined by the excess of the rate of wage increase (W) over the rate of increase in labour productivity (X). Although wages and prices both rise, but in the beginning it is the increase in wages that increases the cost of production. So it is known as the wage-push inflation.
Profit –Push Inflation
When the economy gets dominated by a few firms, they can fix higher prices for their respective commodities to earn abnormal profits. Such price fixing is said to be common practice with oligopolistic firms or firms with monopoly power. In the case of such firms, when profit-margins are pushed up by increasing the prices without any increase in the demand or cost of production, it is known as profit – push inflation. Once started, the inflationary process can spread to other areas since other firms also tend to mark –up their profit following the example of the leading firms.
Material – Push Inflation
When there is an increase in the prices of some key materials (like steel, basic chemicals, oil etc.) which are used, either directly or indirectly, in almost the entire economy, the cost of production increases and eventually the prices tend to rise. One classic example of material cost-push inflation is a hike in prices of crude oil (due to oil shock of the seventies) by the OPEC which resulted in a rise in prices of petroleum products.
The cost-push inflation can be illustrated with the help of aggregate demand and aggregate supply curves as depicted in figure.
Figure 3.3. Shows the cost-push inflation with the help of aggregate demand and aggregate supply function. DD and SS are the initial aggregate demand and supply curve respectively. Price is determined at point ‘E’ where the DD and SS curve intersect each other at price level OP and full employment output OQ. Now suppose, either due to wage rise or rise in the material price, the cost of production increases, shifting the aggregate supply curve from SS to S1S1. The new supply curve intersects the previous demand curve at point ‘E1’. The price level rises from OP to OP1 while output decreases from OQ to OQ1. If the government wants to raise the level of output up to full employment, it can do so by raising the aggregate demand at a higher price level (as shown by point E).
Unemployment implies when a person wanted to work, searching for employment but unable to find work. The natural rate of unemployment exists when the economy is in a steady state of full employment, and is the proportion of the workforce who are unemployed. It is the summation of frictional and structural unemployment that persists in an efficient, expanding economy when the labour and resource market is in equilibrium.
The natural rate of unemployment is based on the Friedman-Phelps model. It is the rate of unemployment to which the economy returns in the long run after the stabilization policies are correctly anticipated by the people. The natural rate of unemployment consists of two types of unemployment:
1. Frictional unemployment or the unemployment experienced by the people who are between steady jobs.
2. Unemployment due it rigidities, in the economic system and its interferences with labour mobility or wage rate changes. It may be due to union activity which restricts supply of labour, minimum wages laws, welfare system that reduces incentives to work etc.
Frictional Unemployment and Wait Unemployment:
Frictional unemployment is the unemployment which exists in an economy due to change in job from one to another. It is the time spent between jobs when a worker is searching a new job or transferring from one job to another. It arises a person may be looking for good job, better opportunities, services or wages due to dissatisfaction with the previous job. Trade union strikes may also create frictional unemployment. One kind of frictional unemployment is called wait unemployment.
Wait unemployment is one kind of frictional unemployment. It is the effects of the existence of some sectors where employed workers are paid more than the market clearing equilibrium wage. It arises from wage rigidity and job rationing. The people are unemployed not because they are searching for the jobs but because at the prevailing wage rate supply of labour is greater than the demand for labour. Wait unemployment not only restricts the amount of employment in the high wage sector, but it attracts workers from other sectors who wait to try to get jobs there. The main problem is that such workers will likely wait while having jobs, so that they are not counted as unemployed.
The relationship between inflation and unemployment was first made by A. W. Phillip in Britain. According to Phillip there exists an inverse, non-linear, stable relationship between inflation and unemployment. The reason for the inverse relationship between inflation and unemployment is due to difference in the bargaining strength of workers and producers, due to excess demand for labour for some labour market because of labour market imperfection and increasing cost of living of the workers. The tradeoff between inflation and unemployment (Phillips curve analysis) is only applicable in the short run.
The Phillips curve is depicted in the following diagram:
DIAGRAM TO BE UPLOADED
In the diagram, PC is the Phillips curve, which shows an inverse relationship between wage inflation and unemployment. When wage inflation is W, unemployment rate is U. when wage inflation increases to W2, unemployment rate decreases to U2 and when wage inflation falls to W1, unemployment rate increases to U1.
Sacrifice ratio is an economic ratio that measures the effect of rising and falling inflation on a country’s total production and output. In sacrifice ratio costs are associated with the slowing of economic output in response to a fall in inflation. When price falls, companies produce less goods as a result production falls. Sacrifice ratio measures the loss in output per each 1 percent change in inflation. It is calculated by taking the cost of lost production and diving by the percentage change in inflation.
Role of Adaptive and Rational Expectation:
Rational expectation implies the application of the rational behavior to the acquisition and application of information to the formation of expectations. It regards people are well informed, they are intelligent and they use all relevant information in making decisions and predictions about economic variables.
Rational expectations are the expectations made by the people regarding future values of the variables by applying a true model through which variables get changed. According to rational expectation hypothesis people are rational and therefore they cannot make a systematic error, they will correctly anticipate the effects of any policy change. The rational economist thinks that even in the short run people are rational, it is called policy ineffectiveness.
The implication of rational expectation:
There is no tradeoff between inflation and unemployment even in the short run because people are rational; if there is change in policy they will immediately anticipate the effects of changes in the policies. There is no any difference between actual and expected inflation.
Rational expectation says that government policies are ineffective; they cannot influence the macro economic variables and unemployment.