inflation in the economy will occur when effective demand and production cost increase excessively. in other words, inflation will occur when there is an excessive increase in effective demand and production cost in the economy. that is, disequilibrium created in the economy when aggregate demand is excessively higher than the aggregate supply is known as inflation. the main cause for the increase in the aggregate demand is the increase in monetary income or increase in the quantity of money. therefore, there are mainly two causes for inflation. they are:
1. increase in money income
demand for goods and services increase as monetary income increases. but if production does not increase in proportion with the increase in demand, then disequilibrium will be creased. due to such disequilibrium, price of goods and services will increase. main cause for the increase in money income are as follows:
(a) monetary and credit policy of government
monetary expansion will occur when the government undertakes the policy of spending excessive quantity of money. failure of proper control in such a situation will create inflation. similarly, bank rate policy of the central bank and open market operations will influence the quantity of credit. low interest rate will increase the demand for credit resulting the increase in the credit expansion. similarly. if securities sold through the central bank in the open market are purchased by the people then quantity of money will increase in the society. so, due to monetary policy of the government and the central bank, the credit as well as the income of the people will increase. this will result disequilibrium in production and income creating inflation in the economy.
(b) deficit financing
the budget in which income is less than the expenditure indicated in the public budget is known as deficit budget. that is, if government expenditure is more than income then to meet or fulfill such expenditures the government will issue excessive quantity of money through the central bank. in such a situation, the government taken loan from the central bank. thus taken loan when spent in various sectors will increase the monetary expansion. this will increase the money income of the people and the situation of inflation will arise in the economy.
(c) credit policy of commercial bank
if demand for credit increase excessively, then only small part of the deposits deposited by the deposits will be kept in the cash-fund by the commercial banks. this will increase the credit expansion of the commercial banks excessively. due to excessive increase in credit expansion, more quantity of money will be in use in the society. increase in the use of money in the society will create the state of inflation.
(d)increase in the velocity of circulation of money
due to increase in the propensity to consume of the people, the personal expenditure will increase. as a result of this, the saving of the people will decrease and the velocity of the circulation of money will increase. due to increase in the velocity of circulation of money, the demand will increase and supply will decrease.as a result, there will be an excessive increase in the price of goods and services, and inflation will be encouraged.
(e)financial mismanagement
due to failure of proper financial management by the government, the tax won't be collected properly, while sometimes the government will reduce the tax for various reasons. as a result of this, the quantity of unaccounted money will increase with the people and demand for goods and services. the price of the goods and services will also increase resulting inflation in the economy.
(f) export promotion policy
every developing country's trade will be in as unbalanced state. to solve this problem the government will undertake export promotion policy and will discourage imports. for this , the government will evaluated the domestic currency. as a result of this domestic goods will be cheaper in the international market of foreign countries, the quantity of goods in the country will be less relative to the demand for the goods. as a result of the disequilibrium between demand and supply , the price will increase creating inflation in the economy.
(g) increase in unproductive expenditure
the excessive expenditure of the government in various wars and internal defence or construction of various infrastructures of development such as, health, education, transportation, communication sectors etc. will increase the money income of the public. but the production of consumption goods of the public will be less compared to the increase in income. this will also increase demand excessively and inflation will be resulted.
2. decrease in production
due to various reason the production in the country will decrease. as a result of decrease in production. disequilibrium will be created between demand, supply and inflation will be resulted. the causes for decrease in production are as follows:
(a) nature causes
nature calamities that occur at different times, such as , floods, landslides, earthquakes, drought,etc. decrease agricultural production. that is these natural calamities affect badly the countries based on agriculture. in other words the countries whose economy is dependent upon agriculture will be badly affected by the natural calamities. along with the decrease in the agriculture product this will also result in scarcity if raw materials required for the industries required for the industries based on agriculture will increase. in such a situation, despite the constant money income, due to natural causes the production will decrease and inflation will be resulted.
(b) law of diminishing returns
the returns of land are not always in proportion. sometimes the law if increasing returns is applicable and sometimes the law of diminishing returns is applicable. if the law of diminishing returns is applicable, then low production will be resulted through high production cost. as a result of high production cost the price of the goods will increase and inflation will occur. when production is less in proportion to productions cost, inflation will be created.
(c) lack of raw materials
lack of raw materials required for production will decrease the production. due to decrease in production, disequilibrium will emerge between demand and supply resulting in the increase price of goods. this will lead to inflation.
(d) techniques of production
the quantity of production is also affected by the techniques of production. if the production technique is very old, then production will decrease instead of increasing. if modern and scientific methods of production are not used, then production will decrease with the increase in price. this will lead to inflation.
(e) trade and taxation policy of the government
if excessive tax is levied on the production of goods by the government , then the price of the produced goods will also increase. due to increase in price the demand will decrease and this will result in the decrease in production. in addition to this, if the government undertakes the export promotion policy and encourages export, then the quantity of goods in the country will be less. that is , there will be a shortage of goods in the domestic market. due to this shortage the price of goods will increase. thus,trade and taxation policy of the government will also create the state of inflation.
(f) industrial disputation
due to various disputations in the industrial sector of a country, such as, strike by lab ours, conflict between trade union and industrialist, instability in the country,etc. will force the industries and factories to be closed down. closing down of factories and industries will decrease the production and increase the price. this increase in price will create the state of inflation.
(g) increase in population
if the population of a county increases more rapidly than the increase in production, then there will arise a state of disequilibrium between demand and supply. the demand will be more than the supply and as a result the price will increase which will be the cause of inflation.
(h) structure of production
if disequilibrium arises in the structure of production, then in such a situation also inflation will occur. due to production of other goods in greater quantity than the daily consumption goods of the public the price of the daily consumption goods will increase. so , decrease in the production of consumption goods will increase the price of such goods leading the way to inflation.
due to these various reasons when the state of disequilibrium arises between the quantity of money and credit and the quantity of available output, then the state of inflation will occur. but this does not mean that the state of inflation will always occur due to increase in the quantity of money or decrease in the quantity of production inflation is the result of the state of disequilibrium between these two . increase in the quantity of money or monetary will result the "cost push inflation".
1. increase in money income
demand for goods and services increase as monetary income increases. but if production does not increase in proportion with the increase in demand, then disequilibrium will be creased. due to such disequilibrium, price of goods and services will increase. main cause for the increase in money income are as follows:
(a) monetary and credit policy of government
monetary expansion will occur when the government undertakes the policy of spending excessive quantity of money. failure of proper control in such a situation will create inflation. similarly, bank rate policy of the central bank and open market operations will influence the quantity of credit. low interest rate will increase the demand for credit resulting the increase in the credit expansion. similarly. if securities sold through the central bank in the open market are purchased by the people then quantity of money will increase in the society. so, due to monetary policy of the government and the central bank, the credit as well as the income of the people will increase. this will result disequilibrium in production and income creating inflation in the economy.
(b) deficit financing
the budget in which income is less than the expenditure indicated in the public budget is known as deficit budget. that is, if government expenditure is more than income then to meet or fulfill such expenditures the government will issue excessive quantity of money through the central bank. in such a situation, the government taken loan from the central bank. thus taken loan when spent in various sectors will increase the monetary expansion. this will increase the money income of the people and the situation of inflation will arise in the economy.
(c) credit policy of commercial bank
if demand for credit increase excessively, then only small part of the deposits deposited by the deposits will be kept in the cash-fund by the commercial banks. this will increase the credit expansion of the commercial banks excessively. due to excessive increase in credit expansion, more quantity of money will be in use in the society. increase in the use of money in the society will create the state of inflation.
(d)increase in the velocity of circulation of money
due to increase in the propensity to consume of the people, the personal expenditure will increase. as a result of this, the saving of the people will decrease and the velocity of the circulation of money will increase. due to increase in the velocity of circulation of money, the demand will increase and supply will decrease.as a result, there will be an excessive increase in the price of goods and services, and inflation will be encouraged.
(e)financial mismanagement
due to failure of proper financial management by the government, the tax won't be collected properly, while sometimes the government will reduce the tax for various reasons. as a result of this, the quantity of unaccounted money will increase with the people and demand for goods and services. the price of the goods and services will also increase resulting inflation in the economy.
(f) export promotion policy
every developing country's trade will be in as unbalanced state. to solve this problem the government will undertake export promotion policy and will discourage imports. for this , the government will evaluated the domestic currency. as a result of this domestic goods will be cheaper in the international market of foreign countries, the quantity of goods in the country will be less relative to the demand for the goods. as a result of the disequilibrium between demand and supply , the price will increase creating inflation in the economy.
(g) increase in unproductive expenditure
the excessive expenditure of the government in various wars and internal defence or construction of various infrastructures of development such as, health, education, transportation, communication sectors etc. will increase the money income of the public. but the production of consumption goods of the public will be less compared to the increase in income. this will also increase demand excessively and inflation will be resulted.
2. decrease in production
due to various reason the production in the country will decrease. as a result of decrease in production. disequilibrium will be created between demand, supply and inflation will be resulted. the causes for decrease in production are as follows:
(a) nature causes
nature calamities that occur at different times, such as , floods, landslides, earthquakes, drought,etc. decrease agricultural production. that is these natural calamities affect badly the countries based on agriculture. in other words the countries whose economy is dependent upon agriculture will be badly affected by the natural calamities. along with the decrease in the agriculture product this will also result in scarcity if raw materials required for the industries required for the industries based on agriculture will increase. in such a situation, despite the constant money income, due to natural causes the production will decrease and inflation will be resulted.
(b) law of diminishing returns
the returns of land are not always in proportion. sometimes the law if increasing returns is applicable and sometimes the law of diminishing returns is applicable. if the law of diminishing returns is applicable, then low production will be resulted through high production cost. as a result of high production cost the price of the goods will increase and inflation will occur. when production is less in proportion to productions cost, inflation will be created.
(c) lack of raw materials
lack of raw materials required for production will decrease the production. due to decrease in production, disequilibrium will emerge between demand and supply resulting in the increase price of goods. this will lead to inflation.
(d) techniques of production
the quantity of production is also affected by the techniques of production. if the production technique is very old, then production will decrease instead of increasing. if modern and scientific methods of production are not used, then production will decrease with the increase in price. this will lead to inflation.
(e) trade and taxation policy of the government
if excessive tax is levied on the production of goods by the government , then the price of the produced goods will also increase. due to increase in price the demand will decrease and this will result in the decrease in production. in addition to this, if the government undertakes the export promotion policy and encourages export, then the quantity of goods in the country will be less. that is , there will be a shortage of goods in the domestic market. due to this shortage the price of goods will increase. thus,trade and taxation policy of the government will also create the state of inflation.
(f) industrial disputation
due to various disputations in the industrial sector of a country, such as, strike by lab ours, conflict between trade union and industrialist, instability in the country,etc. will force the industries and factories to be closed down. closing down of factories and industries will decrease the production and increase the price. this increase in price will create the state of inflation.
(g) increase in population
if the population of a county increases more rapidly than the increase in production, then there will arise a state of disequilibrium between demand and supply. the demand will be more than the supply and as a result the price will increase which will be the cause of inflation.
(h) structure of production
if disequilibrium arises in the structure of production, then in such a situation also inflation will occur. due to production of other goods in greater quantity than the daily consumption goods of the public the price of the daily consumption goods will increase. so , decrease in the production of consumption goods will increase the price of such goods leading the way to inflation.
due to these various reasons when the state of disequilibrium arises between the quantity of money and credit and the quantity of available output, then the state of inflation will occur. but this does not mean that the state of inflation will always occur due to increase in the quantity of money or decrease in the quantity of production inflation is the result of the state of disequilibrium between these two . increase in the quantity of money or monetary will result the "cost push inflation".
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