Theories of Inflation

Prepared & Presented by:-

Md. Ahtezaz Parways (26)

Pratyush Kr. Mishra (45)

What does Inflation mean?

Inflation is defined as a continuous increase in the general level of prices for

goods and services.

Inflation increases

Purchasing power of money decreases

What are the types of Inflation?

• Demand Pull/Wage Inflation: Demand is more, supply is less. Thus price increases. Eg.: War

• Pricing Power Inflation: Raised price by business (to increase profits). Eg.: Indian Railways.

• Sectorial Inflation: Increase in price of one product affects other related product/ services. Eg.: Oil price increase Increase in transportation cost

• Cost Push Inflation: Increase of price in regard of the product/maintenance (production cost) of a product, resultant effect is expected increase in price. Eg.: Increase in price of a vital part of a car, thus decrease in labour cost to counter the new price.

Causes of Cost-Push Inflation

Wage - Push inflation→ trade union pressure on wage rate

Profit - Push inflation→ business monopoly power

Material - Push inflation → Increasing raw materials prices

What are different theories of Inflation?

The Theories can be broadly grouped under three approaches:

• the Monetarist approach (quantity theory of money)

• the Keynesian approach

• the Structural theory

Quantity theory of money

• This refers to the relationship between national income estimated at market prices and the velocity of circulation of the money supply. There is a positive relationship between price levels and the money supply. This relationship is presented using the equation: MV = PY

Where: M is the stock of money in circulationV is the velocity of circulationP is the general price levelY is the total income.

• Accordingly there will be a proportionate positive relationship between the money supply and the price levels of a given economy. That is, when the money supply increases by a certain percentage the price levels will also increase by an equal percentage.

• According to this theory it is believed that inflation is caused by an expansion in the money supply of a given economy. It is under the view that inflationary situations caused due to an increase in money supply which is not followed by or supported by an increase in output levels of an economy.

Keynesian theory

• According to Keynes, an increase in general price levels or inflation due to increase in the aggregate demand which is over the increase in aggregate supply. If a given economy is at its full employment output level, an increase in government expenditure (G), an increase in private consumption (C) and an increase in private investment (I) will create an increase in aggregate demand; leading towards an increase in general price levels.

• Such an inflationary situation is created due to the fact that at optimum or full employment of output (maximum utilization of scarce resources) a given economy is unable to increase its output or aggregate supply in response to an increase in aggregate demand.

C+I+G+∆G

C+I+G

AS

Inflationary gap

Yf INCOME, OUTPUT (Y)

AGGRERATE DEMAND

45

A

B

O

GRAPH: INFLATIONARY GAP

• Initial aggregate demand: C+I+G• Upward shift of the aggregate demand curve:

C+I+G+∆G, an excess demand equal to the amount AB, which is actually the excess demand at the full employment output.

• AB: Inflationary Gap is the amount by which the aggregate demand exceeds the aggregate output at the full employment level.

• Yf: Equilibrium Output/Full Employment Output• Since the output level cannot be increased beyond

the full employment level, the prices will increase leading to demand pull inflation.

• Aggregate demand must shift downwards such that it intersects the 45 degree line at point B. This can be achieved through appropriate policy like increasing taxes or reducing government expenditure.

Structural Theory

This theory states that the main reason for inflation is the in-elasticity in the structures of the economy. This theory is mainly used to explain the nature and basis of inflation in developing countries which are affected by the in-elasticity of the following reasons:

• Production level and capacity

• Capital formulation

• Institutional framework

• High in-elasticity in the agricultural sector

• In-elasticity of the labour force and employment structures.