CAUSES OF INFLATION

Before getting deeper into the causes of inflation, let us first understand what is meant by the term inflation which we keep hearing in our day to day lives. Inflation in general terms is a rise in the prices of goods and services (CPI) without the increase in the value or quality of those goods & services. For instance, in 1995, a pen’s price was Rs.5 and in 1996, the same pen costs around Rs.10. This increase in the price of a commodity from 5 to 10 is called inflation, generally. The price rise does not denominate inflation always. There might be number of good reasons for that.  For instance, the price of a watch in 1995 was Rs.100 and in 1996, the manufacturer added a steel strap to the watch to increase the durability of the same. This has led to the rise in price to Rs. 300. This price rise cannot be taken to inflation.

The calculation of the price rise does not intend only to one or two goods. The nationwide hike in prices shown by the increase in the Consumer Price Index reflects inflation. Is it the only price rise, we call it inflation? No. There are many parameters added. But all the parameters boil down to the resultant effect i.e.; rise in prices.

The excess money flow in the market leaves people with more and more money. Too much money chasing too few goods results in inflation. This is also termed as “demand pull inflation”. It usually arises when the demand for the goods increases with the adequate money with every individual (increase in the disposable income). When everyone in the economy is content with their jobs and wages means that the standard of living is convincing.  As the people are well acquainted, they are able to buy anything needed and also add luxury. Aggregate demand for a country’s products can increase due to higher consumption, higher investment, higher government expenditure or higher net exports. Such an increase in aggregate demand will not necessarily cause inflation, if aggregate supply can extend to match it. If there is a shortage of some resources, for example – skilled workers, then aggregate supply may not be able to rise in line with aggregate demand and in­flation occurs. For instance, if the price of the bitter gourd is, say Rs. 20 per kg but the demand for the bitter gourd rose due to the higher consumption levels of people leading to the increase in the price to Rs. 40 per kg. Even if the price increases here, the people are ready to buy as they have good amount in their hands.

Population increase tends to be another reason for the increase in demand thereby, increasing price. For suppose, if there are 100 laptops in an island of 100 people in an island, each gets a laptop. But if the population of the island increases to 150 people, the demand for the laptop increases as the supply to the all of 150 is not possible with the production of 100 laptops. This increases the price of the laptop. Thus, as the population increases, it happens to be one of the causes of inflation.

The increase in the cost of production remains to be another important cause for the amplification the prices. Why should the cost of production intensify all of a sudden? India is a country with huge imports. Although the country is stabilised internally, there are many external factors that might affect India which wobble the market. This results in the swelling of the prices of raw materials thereby increasing the cost of production. For instance, the oil crisis globally due to the endangered oil wealth led to the sharp increase in the prices of oil in India which automatically risen the prices of diesel, petrol and related goods. Not only the raw materials but the demand for the increase in wages also ends up with the high cost of production. Trade unions are considered very important when it comes to the increase in the cost of production as the labour contributes the most essential and largest part in the production. Thus increase in the wages even in smaller amounts would enable the rise in cost of production. This is also termed as “cost push inflation’.

High liquidity of money in the market also is the cause for the expansion of prices. How is that? For example, if the money supply is $100bn and, on average, each dollar changes hands four times, a total of $400bn will be spent. If an output of $200bn products is produced, the average price would be $2 (200bn x $2 = $400bn). If the money supply increases by 50% to $150bn and output and the velocity of circulation remain unchanged, the average price would rise to $3 ($150bn x 4/200bn). This expansion of money in the market may be due to the RBI monetary policy to control deflation or to upsurge the growth.

The evolving black money in the market is also something to be worried about. The black money passes the hands of many and in a course of time, this adds to the money supply resulting in the state of affairs similar as above. The corporate cartels if restrict the supply, tends to the extension of prices as there is no required supply to meet the demand for the goods. Moreover, the increase in demand for the domestic goods in the foreign arena ends up with heavy exports and also with a raise in the prices in the Indian economy.

The important thing to remember here is that the entire plot of inflation is based on liquidity of money and the prices. As we are in the age of fiat money, the government is responsible for everything happening around us as it is the sole authority to let the money flow in the market. There are many complications involved, though. It is not as easy to curb the inflation as it seems to be. Why? Why cannot the government just curb the money flow in the market by the monetary policy tools? This will be discussed in the upcoming blogs.