Causes of Inflation | How to Control Inflation

What are the Causes of Inflation?

Inflation in an economy can be caused by excess demand or by reduction in the supply of goods and services or by monetary and fiscal factors.

The following figure gives a list of factors leading to inflation in India:

Causes of Inflation
Causes of Inflation

The following factors can be stated for the causes for inflation:

1. The mounting public expenditure is a basic reason for the excess demand in an economy. With the increase in public expenditure new projects will be implemented increasing the employment opportunities. This in turn increases the purchasing power of the people which constitutes the excess demand situation.

2. When the goods produced in the country are exported, the supply of goods for domestic consumption will go down. This in turn will create scarcity condition contributing to the rise in prices.

3. The increasing private expenditure is other reason. Usually when there is business prosperity, the investors expand the output, leading to increased demand for factors of production and increasing factor remuneration. This will increase the purchasing power of the people and it thereby causes excess demand.

4. The reduction in taxation will also add to the demand for goods as people will be left with more purchasing power.

5. The refund of public debt by the government certainly adds to the purchasing power thereby increasing the demand for goods.

6. The ever increasing population adds to the total demand for commodities causing scarcity and price rise.

7. A shortage in the supply of commodities can also lead to inflationary situation. This may be due to shortage in the factors of production. This will affect production of goods and services thereby creating shortage.

8. Sometimes, the traders also resort to large-scale hoarding for exploiting the public and making high profits. The consumers also indulge in hoarding thereby creating shortage which is artificial but adds to the price spiral.

Economists have explained the causes of inflation in many ways. Inflation may result due to variety of causes acting singly or in combination. Some terms are used to show some specific causes.

They are, Currency inflation, budgetary inflation, cost-push inflation, demand-pull inflation, profit-push inflation, excess demand inflation, speculation inflation, imported inflation, over-investment inflation, petroleum inflation, etc.

Let us discuss a few important types of inflation from the above list in detail.

1. Cost-push Inflation

Inflation may be the result of rising cost of production. Industries faced with rising production costs push prices up. Increased prices will further increase production costs. Normally this cost-push is associated with wage-cost as the trade unionists claim for excessive increase in wages.

Increased cost of living will urge the trade unions to demand more wages and the wage-cost would become the production cost. Thus, the inflationary spiral develops. One example is, the enormous increase in the cost of production due to the enormous increase in the prices of petroleum fuel. It is the result of wage-cost, fuel-cost and other material costs. The economy will be caught in a mesh of inflation due to increased cost of production.

2. Demand-pull Inflation

This is the other side of cost-push theory. Inflation sets in due to persistent increase in general demand. This is only complimentary to cost-push inflation. This can be the result of cheap money policy or deficit financing or excessive foreign investment. Industries wanting to produce more goods to meet the demand will bid up the prices of their inputs. This will spread inflation to other sectors. Any excessive general demand beyond full employment will become inflationary.

3. Import Inflation

Some economies may not generate trade cycles by themselves. But they may have ups and downs through external trade or through the international trade multiplier. Higher import prices or, higher export prices or both may generate inflation in the economy.

Measures to Check or Control Inflation

Inflation has to be controlled. Otherwise, the extent of damage done to the economy will be substantial and the economy would take a long time to recover from the effects of inflation. Measures to check inflation would include steps to control the growth of demand and increase in agricultural and industrial supply so that balance between demand and supply is maintained. Government has made efforts to overcome inflationary situation and bring about price stability.

Inflation is a complex phenomenon. It should be attacked from various angles. The methods of controlling inflation and mitigating its severity can be classified into the following broad categories of instruments, commonly used in order to control inflation, in a modern economy:

  1. Monetary measures/Restricted Availability of Credit.
  2. Fiscal measures/Reduced Budget Deficit.
  3. Physical and Direct method.

Let us see these measures in detail.

Monetary Measures to control inflation

Since too much money will be the fundamental problem in the economy, the central banking authorities use various weapons available in its armory to combat inflation through reduction of money supply and credit. The various methods available are:

  1. Changing the bank-rate,
  2. Open-market operations,
  3. Increasing the reserve ratio of commercial banks, and
  4. Placing effective curbs on advances made by the commercial banks.

By these methods, the available money in the economy will be reduced. A tight money condition will be created. But if inflation is due to expansion of currency to finance war or development, monetary measures will not be successful.

Fiscal Measures to control

By adopting suitable measures in taxation, public expenditure and borrowing, the government can effectively curb inflation. In order to reduce the disposable income with the people, the tax rates could be enhanced on a selective basis or new taxes could be introduced by which a sizeable portion of the purchasing power of the community could be reduced. The government would adopt various measures to mop up the savings of the people and thereby try to reduce current demand for goods. Reduction of public expenditure and surplus budgeting would go a long way to reduce inflationary pressures in the economy.

Physical and Direct Method

The two methods stated above are only indirect methods. Under direct method, the government will resort to actual control of supply of money and credit in the country. Wage-freeze and income-freeze will be imposed. Wages, salaries and profit margins could be controlled. Price control and rationing of essential commodities would be resorted to reduce evils of black-marketing, hoarding and profiteering and also to ensure equitable distribution. Thus, the government may adopt various measures to control inflation.

Honest implementation of these policies will reduce inflationary pressures in the country. However, with stringent penal measures the government can make effective policies in controlling inflation of a country.

Infographic on Causes of Inflation and How to Control Inflation