Causes of Inflation

Inflation is a general increase in the price levels of products and services with time. Inflation in Hindi means मुद्रास्फीति (decrease in value of mudra i.e. currency). This increase in prices affects us in many ways directly and indirectly. Effects of Inflation on people and economy are both positive and negative but are inevitable. It is also very interesting to find out actually how this process of price fluctuation works? Is inflation only dependent on government policies and large production firms or we, the people of country also contribute somehow?
what causes of inflation?

Main cause behind Inflation

Change in the mutual balance between demand and supply is the main cause behind not only Inflation but deflation (fall in price level) also. In this article, we are going to discuss two terms very oftenly, they are Aggregate Demand and Aggregate Supply :
  • Aggregate Demand : Aggregate demand is the total demand of all finished goods and services all over the. It is expressed by calculating the total amount of money exchanged for those goods and services country at a fixed point of time and specific price.
  • Aggregate Supply : Aggregate supply is the total supply of goods and services in entire economy in given period and price level. Aggregate supply can also be referred as the total output of the economy.
    Aggregate Demand and Aggregate Supply are main reason or we can say, the root causes of inflation.
You have to keep one thing in mind, if quantity of something is less than the number of people willing to buy it, than the people will even pay more to get it before others get them. Therefore, prices increase in such cases.
If quantity of some product available is more than number of people willing to buy it, than the producer or seller will decrease the price to increase the sales and prevent themselves from heavy losses. So, one thing becomes clear here, if there is a shortage of something, its prices increase (this is what inflation is).
There are two routes to create a shortage and cause Inflation:
  • If demand of certain product increases but supply (production) remains same or increase but not upto the level of increasing demand, then prices will go up because of relative shortage of the product. Such Inflation (increase in prices) caused by increase in the demand is known as Demand Pull Inflation.
  • In other case, if shortage comes due to decrease in supply and not due to increase in demand, then price increase in such condition is referred as Cost Push Inflation.
    Following table will explain everything regarding the relation between price change with respect to change in demand or supply.
S.No. Relation between AD, AS and Inflation
1. Demand increase AD > AS (Shortage) Demand pull inflation
2. Demand decrease AD < AS (Excess) Price decrease
3. Supply increase AD < AS (Excess) Prices decrease
4. Supply decrease AD > AS (Shortage) Demand pull inflation

NOTE : In case 2,3 i.e. cases of price decrease; fall in prices here does not talk about deflation in whole country. Items having excess supply due to some reason can see fall in prices. It is very rare to see that demand for all products decrease at same time to such a level that country start facing the problem of deflation (negative inflation). You may consider it a good scenario but it is not. Read here to find out Why deflation is Bad?

So, as of now, we have discussed two reasons behind inflation i.e. increase in demand or decrease in supply. Now we will discuss the factors that lead to fall in supply or increase in demand to cause inflation or increase the Consumer Price Index.

Factors Affecting Demand or causing Demand Pull Inflation

1. Money Supply:

When we talk about Inflation, it is generally associated with increased Money supply. If money supply increase, it means people have more money to spend. Therefore, increased Money Supply leads to rise in Aggregate Demand and thus leads to Inflation.
According to Quantity Theory of Money;
Here; M : Money Supply;
V : Velocity of Money Circulating through economy;
P : Current Price Level;
Y : Output of economy or we can say; current Nominal GDP.
Velocity of money is the number of times the same money is being used for purchasing either goods or services in fixed time. If it is used more number of times in given period of time, it means velocity of money has increased.
Above formula also proves that increased Money Supply leads to increase in price level. Moreover, increase in money circulation i.e. increase in velocity of money will also lead to inflation. This is because money is used more number of times to buy something which means demand had increased.

2. Deficit Financing:

When government spending turnout to be more than its income through tax collection, it resorts to deficit financing by borrowing or printing more money (by asking RBI).
After printing more money, Money Supply will also increase which leads to price Inflation. Such Inflation is also known as deficit induced inflation. In other case, if it takes loan, its expenditure increase and will have to pay interest also. In such cases, it may also increase tax like transportation tax, or increased excise duty etc.

3. Credit Expansion:

This is one of the biggest tools that RBI use to manipulate or control inflation. The tool is to control the rate of interest at which Bank gives loan to people and businesses. RBI can do so by controlling Repo and Reverse Repo Rates which are special part of its monetary policy. If interest rates decrease, people will get loan more easily and will have more money in hand to spend. This will increase demand and raise price levels.
Remember: People take loan to spend (either on home or car etc.), all these things add up to increase demand level.
Decrease in interest rates also lets Businesses to get loan easily and expand which increases employment and wages.

4. Black Money:

India faces a huge problem of Black Money. People earn Black Money through corruption, tax-evasion and then spend it extravagantly by using malicious tricks like Money Laundering to create unnecessary jump in prices.

5. Increase in Population:

It is very simple to understand; as the population increases, Aggregate Demand also increases and thus, prices may increase. This is not actually very strong factor to raise price level. First of all, increase in population is not going to happen suddenly. It grows gradually and production facilities of country accommodate itself in such a time. But if we talk about independent India before 2000, population was increasing at a very high pace (as population control campaigns were also not very active at that time). On the other hand, Indian production and agriculture was not much developed. So this factor also had an effect to cause inflation.

6. Changes in Taxes:

There are 2 types of taxes:
i) Direct Tax: Which people directly pay from their pocket; ex: Income Tax.
ii) Indirect Tax: When we buy something, for example biscuit, it comes to local market after going through many tax layers. Even when buy them, we pay VAT which we consider as the price of product. Such taxes are known as Indirect tax. Even if we don’t pay them directly, buy these taxes increase the price of products which decreases our purchasing power. So, what types of change in taxation system leads to Inflation?
a) Decrease in Direct Tax: If people have to pay less money to government from their pocket, it means they have more money to spend which raises Aggregate Demand leading to increase in price level and causing Inflation.
b) Increase in Indirect Tax: When government increases Indirect taxes like VAT, excise duty etc., the price of final product paid by the customer increases which we call as Inflation.

7. Increase in Real Wages:

By Increase in real wage, I mean increase in your disposable money (the money that you can really spend). Take a case where your income gets increased by Rs. 1000 per month but at the same time, government increases tax such that you have to pay 1000 Rupees more as tax. In this case, even if your income has increased, you can not really spend it.
If your income remains same, your real wage can increase if government decides to reduce the amount of income tax that you pay. So, if your real income rise, you will have more money to spend. Increase in wages is really a big cause of Inflation. If total real income of India increases, it increases the aggregate demand and this will lead to inflation. Such type of Inflation is called Wage Inflation.

8. Increased Consumer Spendings:

As we have discussed above factors, most of them were leading to increased spending of consumer. Then also, this extra point is formulated to tell you some extra cases that can increase consumer spending which are not really economic factors:
• If credit or EMI facilities for the customer increase, he or she tends to purchase more. These types of changes take place in relatively less period of time. Bajaj FinServ is a leading example which have increased Indian Consumerism to a huge extent. EMI options available on online shopping portals these days like Amazon, Flipkart have also resulted in a huge jump of sales.
• Conspicuous Consumption: Conspicuous Consumption means purchase of luxury goods and services in order to showcase one's wealth, social status or economic power. Housing, cars, clothing, iphones etc. all things that people buy to showcase can be examples of items related to conscious consumption. Problem of maintaining social and economic status is so influencial that people can even take loans to buy such items even though, they are fine without them. So, this can also be one of the factor to cause inflation.

9. Rise in Government Spendings:

Public facilities provided by the government like Public hospitals, toilets, Bus stations, roads etc. These are all done by government earnings. Suddenly, if government starts some large project and government spendings increase by huge amount, this increases demand above the normal level. This rise in demand causes Cost Push Inflation.

Factors affecting Supply, Cost Push Inflation

1. Shortage or Increase in prices of the factors of production:

This is one of the major causes of Cost push Inflation. If any of the factor that is responsible for production of a product become scarce or gets its value increased, then the total cost of production will rise. If cost of production increases, the manufacturer is not going to pay it from his pocket, he will increase the price of final of product to secure his profit. And as the prices increased, Inflation is induced through supply side.
Factors of production can be any, like labour force, machinery, oil and energy, raw material etc. If any of them go through a price change, cost of production rises. Some of the factors responsible for inflation written below are actually factors of production but I thought to write them separately to highlight them.

2. Increase in Exports:

Production in the country should always be at a level to fulfill the demand of consumers both inside and outside our country. If exports suddenly rise, this may create shortage in local markets and as the supply in local market decrease, prices definitely tend to increase.

3. Hoarding:

Hoarding, also known as Black-marketing means storing goods in warehouses or factories in large quantity with an aim to sell them later when local market is facing its scarcity and their price are increasing at higher rates.
Hoarding of onions is very good example in the context of India. You must be remembering the first half of decade 2010 – 20, prices of onion were increasing with a high pace and Black-marketers had large shops, warehouses filled with onions. Government had to deploy police in cities like Mumbai to check shops and warehouses.
NOTE: In India, government keeps a list of essential commodities and hoarding of these commodities is strictly prohibited by law. If somebody dares to perform it, strict punishments will be given.
Although, definition of its essential quantities is quite vague and the list items can be added or removed any time according to the situation. By situation, I mean when government feels like it is a time when demand and supply of some commodity are not at balanced-level and its hoarding will cause a bigger problem, than it can put that item in essential commodities list. It can be removed after some time.
Giving an example, in the wake of Corona, demand had increased suddenly and many people were trying to sell them at higher rates due to public fear. So, the government decided to prohibit the Black-marketing of Sanitizers and Masks for the time being.

4. Non-Economic Factors:

Natural Calamities like flood, drought, earthquake, some widespread animal or plant disease, sudden increase in crops damaging pests, etc. have huge power to damage the agricultural production or its supply by halting transportation system. Scarcity of raw material caused and then difficulties produced in connectivity result in decreased production and supply. This all makes the prices to rise and cause inflation.

5. Lop-sided Production:

Lop Sided Production means disproportionality in the production. If producers in the economy start focusing on the production of only on some particular type of commodities; or; they don't focus on production of some particular commodities (due to any reason) , there will shortage of those less produced entities. And due to this shortage, we will have to import them from foreign countries at higher cost.

6. Prices in International Prices:

Markets of different countries are interlinked to each other these days. Fluctuations in Indian Market will have an impact on the economies having trade relations with India. Same goes with foreign markets too. If oil producing nations increase the price of crude oil suddenly, it will lead to inflationary condition in India because the prices of petrol and thus, transportation will also increase. As the production cost increase in India and price of goods rise, we will export them at higher price to other nations and those countries will also see an increase in prices of those products and the products that are affected by them. Here the inflation of prices is not due to any increase in demand, it is due to the changes in supply from international markets. High Inflation in America during 1970s Stagflation is a good example of this. To learn about 1970s stagflation in USA, you may follow the following article.
1970s stagflation in USA

7. Other Factors:

Other factors like Industrial disputes between corporates and Labourers, law of diminishing returns are not very common at large scale but can also contribute to halt in production process or increase the price of production.

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