Whatever goes up will go up some more – Inflation | Trade Samaritan

Whatever goes up will go up some more – Inflation

In simple economic terms, inflation is a sustained increase in the average prices of goods and services.

Change is permanent and so is ‘Inflation’.

Inflation has existed and sustained not only since the invention of a medium of exchange ie coins and currency but there are traces of inflation right through the era of barter exchange. In the early years the concept of inflation was studied only in context to the universe and life science. Cosmic theories suggest that the universe is inflating since the Big Bang, in fact this rapid inflation is behind the Theory of Big Bang. Although there is an uncertainty to the quantum of inflation taking place in the cosmos, price inflation is certain and can be quantified.

If we were to plot the World inflation levels for a decade, the graph would look like the one below.

World Inflation

In this article we will explore the phenomenon of price inflation at an introductory or root level and we will understand the two basic theories of inflation. In our future articles we will delve further into specific economies and their inflationary trends. We will apply below or hybrid theories to specific economic events and introduce more concepts. We will also extend our horizon into the reverse phenomenon ie deflation, associated events and theories.

Economists have devised several theories to explain the impact of factors such as money supply, wages, interest rate, consumer demand and preferences that lead to price inflation in the economy. However these theories leave us pondering whether these factors cause inflation or is an ‘after-effect’ of inflation. What is at the very source of price inflation? This is more like the chicken and egg question. While theories state that factors such as money supply and interest rates are causing the inflation, it is also observed globally that these very factors are utilized as a measure to curb or manage the price inflation. For instance, hike in hourly wage in order to address the increase in rent or education or printing more currency to inject money supply or reducing the interest rate thereby facilitating consumer credit.

A. Monetarist theory of inflation (also known as Quantity theory of money)

Monetarist theory of inflation states that increase in the money supply leads to inflation. This theory is based on the equation of exchange.

Monetary Theory of inflation

M V = P Q

where M = money supply, V = velocity of money, P = price and Q = quantity.

Assumption

Velocity (V) is stable and the quantity of goods and services (Q) that can be produced in the short run is fixed.

As per the above assumption V and Q in the equation are not changing, therefore any change in the M will lead to a direct change in the P

Monetarism emphasizes the importance of controlling the money supply to control inflation.

The equation effect takes place from left to right i.e as the money supply (M) increases with a constant Velocity (V) and output (Q), one can expect a rise P ie the price. Let us understand this effect in its chronological order.

  • increase in money supply leaves the citizens of the economy with more disposable income
  • this raises the demand for goods and services
  • rise in demand for goods and services causes a shortage of goods and services,
  • in the short run firms cannot increase their output,
  • this gap in the demand and supply is known as an inflationary gap as the firms exercise their market power by increasing the price levels,
  • in the long run the output will return to its previous level of Real GDP
  • economy finally reaches its equilibrium of demand and supply but at a higher price level

The classical theory recommends that in order to curb the inflationary trend, government should reduce the money supply in the economy.

Classical theory is criticized mostly by the Keynesian school of thought which is of an opinion that reduction in money supply will increase the unemployment as the firms will operate below their optimum level. And that mild inflationary levels are conducive to the economic growth and reduce the unemployment.

B. The Keynesian theory

Keynesian theory is adopts a different route to explain the phenomenon of inflation. This theory was devised during the post world war recession phase to repair and rebuild the tumbled economies, Keynes did not refer to money supply at all. According to the Keynes theory, prices are somewhat rigid and any fluctuation in spending – investment, government or public expenditure and consumption cause output to fluctuate. Keynes theory has two sides; the demand side and the cost effect.

1. Demand – Pull – inflation

With an increase in Government spending the aggregate demand in the economy shifts upwards, in the short run this hike can be managed without any price hike whereas in the later stages the price level will start going up. At the same time the firm will move closer and closer to its optimum level of production. Once majority of the firms reach their optimal level the increase in demand will not result in any additional supply but only with a hike in the price. Keynes theory also applies to developing economies where the government expenditure is ever increasing.

Keynes Theory

Demand pull inflation was introduced by John M Keynes, the great British economist whose ideas have influenced and shaped macroeconomics to a very large extent. Lets use the above graph to elaborate this phenomenon.

  • X axis represents the Output level and Y axis represents the Price level
  • LRAS curve denotes the Long run average supply of goods and services
  • At demand level of AD1 and supply level Y1, the aggregate price is P1
  • With an increase in the government expenditure, the demand goes up from AD1 to AD2
  • This results to an increased level of output from Y1 to Y2  at the same price P1
  • There is a further rise in the aggregate demand;  AD2 to AD3 with a rise in both price P2 and output Y3
  • Government spending continues and demand goes up to AD4 with the output and price levels at YFE and P3 respectively
  • Please note that at YFE, the firms in the economy have reached their optimum plant/manufacturing size and they cannot manufacture more than YFE
  • Hence AD4 to AD5 does not result into any rise in the output as the firms have reached their optimal levels and rise in the demand is reciprocated with a mere rise in the price level
  • This will apply to any demand curve above AD4

It is very interesting to note that at some point firms will reach their optimum plant or production level and beyond that point every spike in the demand will lead to mere increase in the price. Demand is infinite and supply is finite.

Supply curve tends to be inelastic and vertical beyond point YFE.

The graph displays how the increases in the level of demand in an economy cause inflation. The ever increasing level of demand is ‘pulling’ the price level up, hence it is known as ‘demand-pull’ inflation.

 2. Cost – Push – inflation

This cause of inflation is associated with the rise in cost of production. The cost of producing goods and services can go up on account of numerous reasons, primary reasons being the rise in cost of factors of production which are land, labor, raw material and capital. Government can levy incremental indirect taxes or even the devaluation of currency could lead to an increase in the cost of production.

Keynes Theory

Let us demonstrate the cost push inflation with the above diagram. The cost push effect applies to both Short term and Long term aggregate supply curves.

An increase in the costs of an economy will shift the SRAS curve to the left (from SRAS1 to SRAS2) causing the price level to rise from P1 to P2 and the level of real output to fall from Y1 to Y2.

You will see that both the schools have stark differences and have faced popularity as well as criticism. It will not be inappropriate to say that there are more followers on the path of Keynesian school of thought. Unfortunately in today’s world both the schools cannot be applied in their purest form and entirety as the dynamics have changed. Greed is a part of human nature and desire to have more belongings pumps up the demand for goods and services. And our non-stop demand to posses more and more leads to a continuous rise in the prices of goods and services.

As rightly stated by David Attenborough, the renowned naturalist for over 60 years “Humans are a plague on the Earth. It’s coming home to roost over the next 50 years or so. It’s not just climate change; it’s sheer space, places to grow food for this enormous horde.”

 

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