Thursday, August 27, 2009

Inflation and its Types

According to professor Crother “Inflation is a state in which the value of money falls and price level persistently rises.” Professor Ackly Garden defines inflation as “Inflation is a persistent and appreciable rise in general level of average prices.” According to Professor Pigou “Inflation takes place when price level expands more in proportion to output.” Thus we conclude that Inflation is a phenomenon where by general price level rises persistently.

1. COST PUSH INFLATION:

If in an economy, price rises due to increase in costs of production, it is given the name of cost Push Inflation. The important feature of this type of inflation is that on one side the price level rises, while on the other side the level of output and employment decreases. In other words the inflation and unemployment go side by side in such type of inflation. It s said that whenever the inflation is accompanied by unemployment, it is accorded as stagflation. In other words the combination of rising price level and rising unemployment is given name of stagflation or slumplation. Cost Push Inflation occurs for reasons discussed as under.

(a) Trade union and Cost Push Inflation (Wage Push Inflation): Nowadays the trade unions are very strong. They are well informed about rise in price level, wages agreement, and change in fiscal and monetary policies. As a result they will never let their real wages to fall. More often, they force to increase their monetary wages more than increase in price level of country. The greater increase in price level of country. The greater increase in monetary wages put a burden on the cost of production of the firms. Consequent the role of competitive forces in the economy are washed out. Hence on the one side cost of production increase which leads to increased price level. While on the other side due to the decrease in aggregate supply the level of output and employment decrease. This results in unemployment in the economy. It may also happen that labour class is preferring leisure over work as a result, the labour market is tightened. Hence the wages start rising. This situation would generate inflation.

(b) Cost Push Inflation due to Supply Shock and Monopolistic Practices: Nowadays in real life we are unable to find perfect competition. Like imperfections in labour market, we also find market imperfections in goods market. It is being observed that big corporations or businesses that have monopoly over certain strategic raw material, technology and goods reduce the supply of goods in order to raise their profits. As it happened during 1973 when OPEC not only increased the price of crude oil but the production of oil was also cut during period of October 1973 to March 1974. When this oil carted increased the price the demand for oil in US and Europe greatly decreased. More over those automobiles and machinery which used oil excessively, their demand fell. Accordingly the demand for labour decreased as the wages and prices are rigid downward, the reduction in demand for labour did not decrease the monetary wages of labour. Thus because rise in costs of production price level rises, while because of decrease in demand for goods (and then demand for labour) and because of rise in costs of production, the aggregate supply is reduced. Hence unemployment along with increase in price level is result of this inflation.

2. DEMAND PULL INFLATION:

This represents a situation where the basic factor at work is the increase in demand for resources wither from the government or the entrepreneurs or the households. The result is that the pressure of demand is such that it can not be met by currently available supply of output. If for example in a situation of full employment, the government expenditure or private investment goes up this is bound to generate an inflationary pressure in the economy.

Demand pull inflation can be of two types.

(a) Perishable goods:

QS Is supply of goods which is perfectly inelastic curve. This is because the supply of goods is fixed in market period. It is the demand factor which plays an important role in determining the price level. Initially “dd” is the demand curve and equilibrium is at point “a” and the price is at “OP”. As the demand increase from “dd” to “d1d1” and further to “d2d2” the equilibrium is at point b and c. This brings an increase in price “OP” to OP1 and OP2.

This is due to the demand forces pulling the prices upward.

(b) Non-Perishable goods:

The SS curve is supply curve which is initially price elastic till the stocks are more and later it becomes perfectly inelastic due to non-availability of more stocks. Initially the “dd” is demand curve and the equilibrium is at point “a” which determines the price OP and quantity “OQ”. As the demand increases from “dd” to “d1d1” the equilibrium is achieved at point “b” which gives OP1 price and OQ1 quantity. Further increase in demand to d2d2 the price will increase to OP2 but the quantity supplied will be OQ1 only. The increase in price is due to demand pull.

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