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Meaning and Causes of Inflation

Demand-Pull Inflation, Cost-push inflation, Supply-side inflation Open Inflation, Repressed Inflation, Hyper-Inflation, are the different types of inflation. Increase in public spending, hoarding, tax reductions, price rise in international markets are the causes of inflation. These factors lead to rising prices. Also, increasing demands causes higher prices which leads to Inflation. In this article, we will discuss the meaning of inflation and what causes it.

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What is Inflation?

According to many classical writers, inflation is a situation when too much money chases too few goods and services. Inflation is measured by the Consumer Price Index(CPI).

Therefore, there is an imbalance between the money supply and the Gross Domestic Product (GDP). There are many types of inflation like demand-pull inflation, cost-push inflation, supply-side inflation. But Inflation can be divided into two broad types:

  1. Open inflation – when the price level in an economy rises continuously and
  2. Repressed inflation – when the economy suffers from inflation without any apparent rise in prices.

According to Keynes, inflation is an imbalance between the aggregate demand and aggregate supply of goods and services. Therefore, if the aggregate demand exceeds the aggregate supply, then the prices keep rising.                                                                                        causes of inflation

Causes of Inflation

  • Primary Causes
  • Increase in Public Spending
  • Deficit Financing of Government Spending
  • Increased Velocity of Circulation
  • Population Growth
  • Hoarding
  • Genuine Shortage
  • Exports
  • Trade Unions
  • Tax Reduction
  • The imposition of Indirect Taxes
  • Price-rise in the International Markets

Having understood the inflation meaning, let’s take a quick look at the factors that cause inflation.

Primary Causes

In an economy, when the demand for a commodity exceeds its supply, then the excess demand pushes the price up. On the other hand, when the factor prices increase, the cost of production rises too. This leads to an increase in the price level as well.

Increase in Public Spending

In any modern economy, Government spending is an important element of the total spending. It is also an important determinant of aggregate demand.

Usually, in lesser developed economies, the Govt. spending increases which invariably creates inflationary pressure on the economy.

Deficit Financing of Government Spending

There are times when the spending of Government increases beyond what taxation can finance. Therefore, in order to incur the extra expenditure, the Government resorts to deficit financing.

For example, it prints more money and spends it. This, in turn, adds to inflationary pressure.

Increased Velocity of Circulation

In an economy, the total use of money = the money supply by the Government x the velocity of circulation of money.

When an economy is going through a booming phase, people tend to spend money at a faster rate increasing the velocity of circulation of money.

Population Growth

As the population grows, it increases the total demand in the market. Further, excessive demand creates inflation.

Hoarding

Hoarders are people or entities who stockpile commodities and do not release them to the market. Therefore, there is an artificially created demand excess in the economy. This also leads to inflation.

Genuine Shortage

It is possible that at certain times, the factors of production are short in supply. This affects production. Therefore, supply is less than the demand, leading to an increase in prices and inflation.

Exports

In an economy, the total production must fulfill the domestic as well as foreign demand. If it fails to meet these demands, then exports create inflation in the domestic economy.

Trade Unions

Trade union work in favor of the employees. As the prices increase, these unions demand an increase in wages for workers. This invariably increases the cost of production and leads to a further increase in prices.

Tax Reduction

While taxes are known to increase with time, sometimes, Governments reduce taxes to gain popularity among people. The people are happy because they have more money in their hands.

However, if the rate of production does not increase with a corresponding rate, then the excess cash in hand leads to inflation.

The imposition of Indirect Taxes

Taxes are the primary source of revenue for a Government. Sometimes, Governments impose indirect taxes like excise duty, VAT, etc. on businesses.

As these indirect taxes increase the total cost for the manufacturers and/or sellers, they increase the price of the product to have a minimal impact on their profits.

Price-rise in the International Markets

Some products require to import commodities or factors of production from the international markets like the United States. If these markets raise prices of these commodities or factors of production, then the overall production cost in India increases too. This leads to inflation in the domestic market.

Non-economic Reasons

There are several non-economic factors which can cause inflation in an economy. For example, if there is a flood, then crops are destroyed. This reduces the supply of agricultural products leading to an increase in the prices of the commodities.

Investment in Gold, Real estate, stocks, mutual funds, and other assets are some of the ways to deal with Inflation.

Solved Question on Meaning and Causes of Inflation

Q1. What is Inflation?

Answer: Inflation is a situation when too much money is chasing too few goods and services in an economy. Hence, an imbalance exists between the GDP and the total money supply.

As per Keynes, inflation is an imbalance between the aggregate demand and aggregate supply of goods and services. If the aggregate demand is more than the aggregate supply, prices rise, leading to inflation.

Q2. What are the causes of inflation?

Answer: If the demand for a commodity exceeds its supply, then the excess demand increases the price of the commodity. Also, if the price of the factors of production increases, the price of the commodity increases too. The common causes that led to inflation are:

  • Primary Causes
  • Increase in Public Spending
  • Deficit Financing
  • Increased Velocity of Circulation
  • Population Growth
  • Hoarding
  • Genuine Shortage
  • Exports
  • Tax Reduction
  • Imposition of Indirect Taxes
  • Price-rise in the International Markets
  • Non-economic Reasons
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