CAUSES OF INFLATION

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CAUSES OF INFLATION

In the ucta ilcd analysis of inn,lIion given above, we have referred to the basic cause of in llanon, Ihat is when aggregate demand for output tends to be excessive  relation to Ole supply of output Thus.tho causes of inflation may be grouped under two headings.

These causes may operate singly or in combination with one another. Generally, the most important  cause of inflation is excessive public expenditure financed by deficit financing during war or on the implementation of plans for economic development. The  newly created money increases government demand for goods and services and also the purchasing power of the people through increase in disposable income.

(2) No corresponding increase in the output of goods and services which may be due to:
(a) deficiency of capital equipment;  (b) Scarcity of other complementary factors of production, e.g., skilled labour or technicians essential. raw materials or lack of dynamic entrepreneurs .

(c) increase in exports for earning the required foreign
exchange;
(d) decrease in imports owing to war or restrictions on on imports necessitated by an adverse balance. of payments and efforts to rectify it;
(e) speculative hoarding by the producers, traders and middlemen in anticipation of a further rise ill prices.
(j) drought, famine or  any other natural calamity adversely  affecting agricultural production.
(]:) prolong ed indu trial unrest resulting in reduction of industrial production.The demand-pull inflation is caused primarily by factors operating on the demand side resulting in excess of aggregate demand over the available supply  of goods and services. 11 e cost-push inflation, on the other hand, is caused by increase in salaries, wages, the rising cost of machinery and capital equipment and of essential raw materials. Actu Ir» all the above factors operate simultaneously to exert inflationary pressure and, if continued sufficiently long, to create hyperinflation.

FULL EMPLOYMENT AND INFLATION

Broadly speaking, we might distinguish many economy two phases in its development.  a zone below full employment; and  liil a full employment zone.In the ‘below full-employment zone  it is assumed that large amount of productive resources are lying idle  and arc waiting for employment. In these condition.If there is an increase in effective demand, it will  lead to fuller employment of the productive resources of the community and to a higher level of busine 5 activity and output, but it will not result in higher prices.

But as the process of expansion and development proceeds apace, the volume of idle resources will shrink, since most of them will now be gainfully employed. The margin of unemployment falls and the economy is heading towards the full employment zone. “As full employment is approached, the pressure for costs and prices increases progressively because the bargaining strength of labour is greatly enhanced and the remaining unemployed resources become less and less efficient as the bottom of the barrel is scraped. The number of the bottlenecks multiplies rapidly. Shortages are more and  difficult to overcome as substitutes are difficult to find, because the most satisfactory substitutes have already been fully employed, or nearly so. But  as long as there is unemployment,increase in effective demand will increase employment. When full employment is at last attained, further increases in effective demand no longer increase employment. They spend themselves entirely on  increase in prices. A rundiliun of true inflation sin as full employment is reached. We may, however, point out that it is not correct to assume that there is one precise point of full employment below which increase in effective demand is reflected by increase in output and employment, and above which the increase in effective demand  results in higher prices. The fact is that the changes inin effective demand can simultaneously affect the level of prices and the level of output in a country. Even where there is a considerable amount of unemployment, say, in a manufacturing industry, the general prices may show a tendency to rise with an increase  in effective demand owing to rise in prices of primary products, especially agricultural products. The rise in prices may lead to rise in wage rates, The rise in prices and wage rates push the economy to the verge of inflation.

Keynes showed why semi- develop with increasing  the point or 1’1111employment is reached and prices rise gradually as output and employment increase. This happened in India in 1974–75. There are five impor tant causes which contributeto this semi-inflation: (i) Effective demand (the flow of monetary expenditure) is shared among the rise of prices. the rise of costs and the rise of output and employment. (ii) Since the productive resources are not homogeneous, the use of less and less efficient ones will lead to a diminishing return. This means higher costs and the rising supply  price of output. (iii) Someresources have a perfectly inelastic supply and .ries of bottlenecks are bound to raise factor prices and, therefore, commodity prices in some sectors. (iv) Increase in wage rates cannot be avoided for long. Hence, costs, and, therefore, prices, must rise. (v) Some variable factors have different degrees of price elasticity of supply. Hence, the marginal costs curve will move  upwards via diminishing returns in cases where thesupply of factors is perfectly inelastic. In a structurally balanced economy, the point of full) employment and full capacity output will be reached simultaneously in all sectors, where as in the case of an unbalanced economy, there may be reached full employment condition in sume sectors with extensive unemployment in others. Once conditions of full capacity output and vcry low unemployment, are reached in some sectors of the economy, price rises become more marked and show increasingly strong tendencies to lead to other price rises. Thus, the inflationary price rises become cumulative in the full employment zone. Hence. there is a bias to secular inflation in modern industrial economy unless a very high level of employment is maintained: We may, therefore, conclude “that below a certain level of unemployment all changes in effective demand showed themselves
solely as price changes and abo ve a certainlevel of unemployment, the changes in effective demand showed themselves solely as changes in thc level of activity.” In terms of quantity theory, “So   as there  unemployment, employment chanuc in th(‘ same proportion as the quantity of I and when there is full employ mcnf prices will chanue in the same proportion a the quantity of money.’ Short-term here is no doubt that full employment economy is highly susceptible to inflation.  But the problem is a short-run problem, becauseit is only in short run that output cannot be expanded except by slow degrees. ‘That i Yo hy inflation is typically  a short-run phenomenon peculiar to a stationary,full-employment economy.” In the long run, for a dynamic and expanding economy. inflation is no problem. It is capable of incrcai ing output to match with the increasing demand. Thus. full employment can be maintained continuously without price inflation procontinues to grow at thc desired rate.

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CAUSES OF INFLATION