Inflation is a numerical measure of how quickly the average price level of a basket of selected goods and services in an economy rises over time. It’s when the general level of prices rises to the point where a unit of currency buys less than it did previously. Inflation is a decrease in the purchasing power of a country’s currency, often expressed as a percentage. 

Causes of Inflation

Inflation is mainly caused either by demand Pull factors or Cost-Push factors. Apart from demand and supply factors, Inflation sometimes is also caused by structural bottlenecks and policies of the government and the central banks. Therefore, the major causes of Inflation are:

• Demand-Pull Factors (when Aggregate Demand exceeds Aggregate Supply at Full employment level).
• Cost-Push Factors (when Aggregate supply increases due to an increase in the cost of production while Aggregate demand remains the same).
• Structural Bottlenecks (Agriculture Prices fluctuations, Weak Infrastructure, etc.)
• Monetary Policy Intervention by the Central Banks.
• Expansionary Fiscal Policy by the Government.

Demand-Pull Inflation

The main cause of demand-pull inflation is an increase in aggregate demand. The increase in aggregate demand is primarily due to an increase in government spending (Expansionary Fiscal Policy) or an increase in household and business spending. Aggregate demand > aggregate supply is the root cause of demand-pull inflations. This simply means that the economy’s firms are unable to produce the goods and services that households require at the present time. Inflation is fueled by shortages of goods and services due to increased demand.

Consider what happened in India during the swine flu outbreak. Because of the swine flu outbreak in India, the government issued a warning that people should wear breathing masks to protect themselves from infection. As a result, demand for masks had risen to an all-time high, but supply was limited because mask manufacturers had not anticipated the swine flu epidemic. Mask prices had risen dramatically due to high demand and limited supply. The mechanism of demand-pull inflation is captured in the example above.

The above example only captures the mechanism of Demand led inflation and that too for a particular product. What happens at the Macro level? What fuels inflation in the entire economy? Before answering the question. Let’s understand some basic concepts related to the economy:

• Full Employment Level: Full employment is an economic situation in which all the available resources of the economy are fully utilized, and there exists no further scope of improvement in the economy. The Full employment level represents that economy is operating at its maximum potential. The level of unemployment is minimum, the prices in the economy are stable, resources are fully utilized, whatever firms are producing is getting sold, and there exist no shortages in the economy.

Inflationary Gap

The Inflationary gap is a situation that arises when Aggregate demand in an economy exceeds the Aggregate supply at the full employment level.

Inflation in a Demand-Pull scenario is basically caused by a situation whereby the Aggregate demand for goods and services in the economy rises and exceeds the available supply of the goods and services. In such a situation, the excessive pressure on demand will fuel inflation in the economy.

Deflationary Gap: Deflationary Gap is a situation that arises when Aggregate demand in the economy falls short of Aggregate Supply at the full employment level.

Cost Push Inflation

• There exists a situation in an economy where inflation is fuelled up, not because of an increase in Aggregate Demand but mainly due to an increase in the cost of producing goods and services.
• The cost can be increased mainly due to three factors:

Let’s understand Cost-Push Inflation with an Example

Assume that the Indian economy is performing to its full potential. Prices are stable, resources are fully utilized, and anyone willing to work gets hired (unemployment is at its minimum). People will form the expectation that the economy’s future is bright, and they will plan their savings and investment decisions accordingly.

However, the United States decides to attack Iran one day in order to dismantle its nuclear weapons. As a result of the attack, crude oil prices all over the world begin to rise. India, which imports 90% of its oil, has suddenly found itself in trouble. The rising cost of crude oil puts a brake on India’s booming economy, and the cost of basic goods begins to rise (crude oil is a key input for many industries and is a lifeline of the transport economy). Manufacturers decide to raise the price of their products as a result of rising production costs. As a result, the first round of cost-push inflation is fueled (Raw material).

After a period of time, the final consumer learns that the product’s prices have increased. Consumer expectations about future price movement will shift as he expects prices to rise even more in the future. To compensate for the impending price increase, he begins to demand higher wages from his or her employer. The second round of cost-push inflation will be fueled by this (wage push).

Cost-Push Inflation/Supply Shock

Stagflation: The most significant distinction between Demand-Pull and Cost-Push Inflation is that in Demand-Pull Inflation, the economy’s overall output does not fall. In Cost-Push Inflation, however, along with an increase in prices, the economy’s output level falls.

With a drop in output, the economy’s employment will drop, as will its growth. Cost-push inflation is more dangerous than demand-pull inflation because of falling growth and rising prices. Stagflation is defined as a situation in which prices rise while growth and employment decline.

Hyperinflation: Hyperinflation is a situation when inflation rises at an extremely faster rate. The rate of inflation can increase from 50 times to 300 times.

Hyperinflation can have disastrous consequences for the economy. The situation could result in the total collapse of the economy’s currency, as well as an economic crisis, rising external debt, and a decrease in the purchasing power of money.

The government issuing too much currency to finance its deficits; wars and political instabilities, and an unexpected increase in people’s anticipation of future inflation are the main causes of hyperinflation.

People begin to consume more goods and services when they anticipate future inflation will rise at a rapid rate, fearing that higher inflation will destroy the purchasing power of money. As a result, demand for goods and services rises, fueling even more inflation. The cycle continues, eventually leading to hyperinflation.

Structural Inflation

Another type of inflation is structuralist inflation, which is most common in developing and low-income countries. According to the structural school, inflation in developing countries is primarily caused by the weak structure of their economies. They go on to say that increasing the money supply and government spending can only partially explain the inflationary scenario.

The structuralist argues that developing countries’ economies, such as those in Latin America and India, are structurally underdeveloped and highly volatile as a result of weak institutions and market imperfections. As a result of these flaws, some sectors of the economy, such as agriculture, will face supply shortages, while others, such as consumer goods, will face excessive demand. Such economies face both supply shortages and resource underutilization, as well as excessive demand in some sectors.

Assume that a farmer in India produces fruits and vegetables at a cost of Rs.10,000 per quintal. However, at Rs.20,000 per quintal, the final consumer receives the same. Infrastructure and agriculture bottlenecks are to blame for the huge disparity between what farmers receive and what consumers pay. The bottleneck is caused by a lack of roads, highways, cold chains, and agricultural markets that are underdeveloped. All of these factors raise the cost of moving goods from farmers to consumers, resulting in inflation.

Deflation versus Disinflation

Deflation: Deflation is when the overall price level in the economy falls for a period of time.

Disinflation: Disinflation is a situation in which the rate of inflation falls over a period of time. Remember the difference; disinflation is when the inflation rate is falling from say 5% to 3%.

Deflation is when, for instance, the price of a basket of goods has fallen from Rs 100 to Rs 80. It’s the reduction in the overall prices of goods.

Reaganomics

Reaganomics is a popular term used to refer to the economic policies of Ronald Reagan, the 40th U.S. president (1981–1989), which called for widespread tax cuts, decreased social spending, increased military spending, and the deregulation of domestic markets. These economic policies were introduced in response to a prolonged period of economic stagflation that began under President Gerald Ford in 1976.

Headline versus Core Inflation

The headline inflation rate reflects the economy’s overall inflation. Core inflation measures, on the other hand, exclude highly volatile food and fuel prices from the inflation index.

Supply shocks dominate the Indian inflation process to a large extent. Supply shocks (e.g., rainfall, oil price shocks, etc.) are transient in nature, resulting in only transient price movements. When food and fuel prices rise, India’s headline CPI inflation rises as well. According to conventional wisdom, monetary policy’s response to such temporary shocks is least warranted because it is a tool for managing aggregate demand pressures.

Core inflation is the underlying trend inflation that excludes the highly volatile food and fuel components. The future path of overall inflation is determined by trend inflation. As a result, even if food and fuel inflation moderates over time, persistently high inflation in non-food, and non-fuel components raises the risk of future inflation, posing monetary policy challenges.