The causes of inflation are multidimensional. However, the principal cause is the mismatch between the demand and supply which are influenced by multiple factors. Some of the well-known causes are increased disposable income among the people, supply chain bottlenecks, and an increase in the cost of production. In this article, we will see the causes of inflation which is important for the UPSC exam.

What is Inflation?

• Inflation is the rate at which the price of goods and services in a given economy rises.
• Inflation occurs when prices rise as manufacturing expenses, such as raw materials and wages, rise.
• Inflation can result from an increase in demand for products and services, as people are ready to pay more for them.
• Let us consider we can buy 1 liter of milk for Rs. 50 at the current time. Exactly 1 year before 1 liter of milk cost us Rs. 40.
• Here there is an increase of Rs. 10 per liter of milk or the purchasing power of Rs.40 has reduced from buying 1 liter of milk to 800ml of milk in 1 year.

• Therefore we can say that there is an inflation of 25% in milk prices compared to last year.

Types of Inflation

Inflation can be divided into two types, they are demand-pull inflation and cost-push inflation.

Demand-Pull Inflation:

• The major cause of demand-pull inflation is a rise in aggregate demand. The increase in aggregate demand is primarily due to an increase in government spending (Expansionary Fiscal Policy) or an increase in household and business spending.
• For instance, if the government is spending money in a system with limited resources, it can result in demand-pull inflation.
• Inflation that occurs due to expansionary monetary policy and fiscal stimulus are examples of demand-pull inflation.

Cost-Push Inflation:

• There is a condition in an economy where inflation is fueled by increases in the cost of producing goods and services, rather than by increases in aggregate demand.
• Demand remains generally consistent even as supply falls due to global policies, conflict, or natural disasters, gasoline prices rise. This results in cost-push inflation.
• Inflation that occurs due to rising oil prices and increased raw materials prices due to the breakdown of the supply chain during the COVID Pandemic is an example of cost-push inflation.

Causes of Inflation

Demand-Pull Inflation

Various variables might cause an increase in aggregate demand. Some of them are:

• Increase in Government Spending (Fiscal Stimulus): This will increase the money supply in the economy and will increase the aggregate demand and in turn cause inflation. The ways in which the government can increase its spending are:
  • Schemes like Universal Basic Income (UBI), etc
  • Increased financial assistance under PM-KISAN
  • Wages under the MGNREGA are increasing
• Population Pressure: Increase in population will increase the demand for goods and services. This would in turn create inflation.
• Increase in Net exports: If the essential items are exported from the country at an accelerated rate then the demand for these goods will increase in the economy given their poor availability. This will in turn result in inflation.
  • For instance, If Indian farmers export large quantities of foodgrains, onions, and other items, demand will not be met, resulting in demand-pull food inflation.
• Monetary Stimulus: When the central bank takes up monetary stimulus, the money supply in the economy is increased causing inflation. The other implications of the monetary stimulus also cause inflation by
  • The availability of surplus money increases Household consumption.
  • If the RBI has adopted a low-cost money policy, lower-cost credit will be available. As a result, people's willingness to spend rises resulting in inflation.
• Policy Decisions: Policy decisions that enable accessibility of funds to the public and increased money supply will result in increased aggregate demand.
  • The seventh pay commission put additional money in the hands of the public sector employees.
  • Private investment is on the rise which is due to liberalized FDI regulations that will, in turn, increase the money flow in the economy.
  • Increasing forex reserves increase the money supply in the economy due to the RBI buying dollars.

Cost-Push Inflation

The fundamental cause of cost-push inflation is rising production costs. The following reasons can cause production costs to rise.

• Employees salaries being raised: The increase in salaries of the employees will have a bearing on the final cost of the product. Therefore increased cost of production will result in cost-push inflation.
  • Wages have grown as a result of the 7th pay commission.
  • The management of a manufacturing firm is compelled by a labor union to raise worker wages.
• Raw material prices increasing: Raw material cost is a very important parameter in determining the cost of production of a product. Therefore any increase in raw material prices causes inflation.
  • A spike in crude oil prices (for a variety of causes) might increase input costs.
  • Floods, hunger, and other natural disasters reduce agricultural output.
• Firms profit margins: A firm's profit margin is added as a part of the cost of production. Any increase in the profit margin of the firm will increase the cost of the product and cause inflation.
  • When businesses opt to enhance their profit margin, the cost of goods and services rises. It usually occurs when a single company is the primary source of goods (monopoly)
• Import prices: If the raw and the production is dependent on imports then any import price rise results in cost-push inflation.
  • Increases in the price of imported inputs might lead to an increase in the overall price of goods.
  • Devaluation of currency increases the import costs.
• Increase in Indirect taxes: An increase in indirect taxes will cause inflation.
  • After the introduction of GST, many products and services earlier charged 12% of tax were brought into the 18% tax bracket increasing their prices.

Measures to control inflation

• In the case of demand-pull inflation all the control measures revolve around reducing the demand, this can be done by either reducing the money supply or increasing prices by taxation.
• In the case of cost-push inflation, the control measures revolve around increasing the supply to meet the demand in the market and reducing the prices by providing subsidies and technological expertise.
• In all cases, the inflation control measures can be divided into Monetary Measures, Fiscal Measures, and Administrative Measures.

*Click here to read more about Measures to control inflation.

Conclusion

Though the causes of inflation are many, they can be controlled by fiscal and monetary measures. The RBI has inflation targeting as its primary objective. Though slight inflation is desirable for the growth of the economy, uncontrolled inflation can do more harm to the country rather than good.