KMAT and Other Exam News

The word inflation is quite in the news these days. Before talking about why inflation is so much in the news, let us understand its meaning. The meaning of the term inflation means there is a sustained increase in the price level. When the general price level goes up, every unit of a currency will buy fewer goods and services. This consequently results in inflation which leads to a decrease in the purchasing power of money. There are many factors which cause inflation. Today we will get to know about the same.

Factors which cause Inflation: An Overview

To give you a brief overview of the factors determining inflation, we have attached a table below.

Factors which cause InflationMeaning
Demand-pull inflationAggregate demand growing faster than aggregate supply.
Cost-push inflationAn increase in the costs of firms is passed on to consumers.
Growing EconomyEmployment is generated, and people get money in their pockets that they are willing to spend. This higher demand allows suppliers to increase prices, which in turn leads to more jobs, which puts more money in circulation, and it goes round and round.
Printing more moneyIf there is more money buying the same amount of goods, then prices will rise.
Expectations of inflationHigh inflation expectations cause workers to demand wage increases and firms to push up prices.

Factors Determining Inflation

Now that we have got a brief idea of the factors which cause inflation, let us get into the details.

1. Demand-pull inflation

The factors leading to demand-pull inflation are

  • If the economy has full employment or is close to it, then there will be an increase in aggregate demand (AD). This leads to an increase in the price level (PL). According to the law of demand and supply, more the demand, more the price. 
  • When firms reach full capacity, they respond by putting up prices leading to inflation. 
  • Full employment means there will be more labour shortages. Firms cannot hire cheap and fast labour. So the existing workers can get higher wages which increase their spending power. 
Demand-pull inflation

In the picture above, the aggregate demand is increasing which leads to a right shift. To match this level, price is also increased. This is one of the factors which cause Inflation.

2. Cost-push inflation

If there is an increase in the costs of production by the firms, then the same will be passed on to consumers. This will lead to a shift to the left in the curve. 

Cost-push inflation

Cost-push inflation can be caused by many factors such as 

  • Rising wages-  A rise in the cost of wages and salary increases the cost of production. This can happen in various forms, if trade unions can present a united front then they can bargain for higher wages. Rising wages are a critical cause of cost-push inflation. This is because wages are the most significant cost for many firms. Higher wages may also contribute to rising demand. This theory is explained in detail in the Growing Economy factor. As mentioned above, when people get money in their pockets, they are willing to spend it. This higher demand allows suppliers to increase prices, which in turn leads to more jobs, which puts more money in circulation, and it goes on. 
  • Import prices- A rise in the prices of imported goods will also lead to inflation. For example, if one-third of all goods are imported into India and there is a devaluation, then import prices will become more expensive leading to an increase in inflation. A devaluation or depreciation means the Indian Rupee is worth less. Therefore one has to pay more to buy the same imported goods. In 2011/12, the UK experienced a rise in cost-push inflation, because of the depreciation of the Pound against the Euro.
  • Raw material prices- The raw materials used in making a product are also important and companies want to keep this cost low to reduce the cost of production. One example could be the price of oil. If the oil price increases by 20% then this will have a major impact on most goods in the economy and this will lead to cost-push inflation. For example, in 1974 there was a rise in the price of oil causing a period of high inflation around the world. Even today, the rise in oil prices is followed by inflation.

3. Higher inflation expectations

Once a country witnesses inflation, it is difficult to reduce it. For example, higher prices of goods will cause workers to demand higher wages causing a wage-price spiral. Therefore, expectations of inflation are critical. If people foresee high inflation, it tends to be self-fulfilling. However, when expectations are low, temporary rises in prices tend to be short-lived and fade away. Also, higher wages lead to an increase in the price of goods thus leading to inflation. We have read the same above.

4. Printing more money

If the Central Bank of a country prints more money, it is expected to witness a rise in inflation. This is because the money supply plays a major role in determining prices. If there is more money buying the same amount of goods, then prices will rise. Hyperinflation, as in the case of the Weimar Republic, is usually caused by an extreme increase in the money supply. This is also one of the factors which cause Inflation.

5. Growing Economy

In a growing or expanding economy, unemployment is low and wages usually rise. This leads to more people finding themselves with more money in their pocket, which they are willing to spend. This can be spent on luxuries as well as necessities. Anyway, this leads to higher demand which in turn allows suppliers to increase prices. This results in more jobs, which puts more money in circulation, and this cycle goes on until burst.

Factors which cause Inflation: Conclusion

In this context, inflation is sometimes considered a positive thing. Indeed, the Central Bank of a country wants there to be inflation because it is a sign of a humming economy. But such institutions want only a little inflation and aim for a 2% annual core inflation rate. Many economists also consider this a healthy increase as long as it does not drastically outpace the growth of the economy as measured by gross domestic product (GDP).

Factors which cause Inflation can be of different varieties. But a little inflation is a good thing as it is the proof of an expanding economy. Hopefully, now you know the factors which cause Inflation. Read more such articles to ace the section of current affairs for your upcoming exams!

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Factors which cause Inflation: FAQs

What are the factors which cause Inflation?

The factors which cause Inflation are Demand-pull inflation, Cost-push inflation, Growing Economy, Printing more money, and Expectations of inflation.

Why do economists consider a little inflation good for the economy?

Economists consider a little inflation healthy as long as it does not drastically outpace the growth of the economy as measured by gross domestic product (GDP). 

How do Demand-pull factors lead to more inflation?

When aggregate demand grows faster than aggregate supply it leads to inflation.

How do Cost-push factors lead to more inflation?

An increase in the costs of production of the company is passed on to consumers, which in turn increases the price and leads to inflation.

How Growing Economy witness more inflation? 

In a growing economy, employment is generated, and people get money in their pockets that they are willing to spend. This higher demand allows suppliers to increase prices, which in turn leads to more jobs, which puts more money in circulation, and it goes round and round.

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