Inflation; Causes, Consequences and Cures

Text Book 2, Pages: 135-158

 Defined as a phenomenon of continued and substantial price increase as
measured by some appropriate index number
 Causes — broadly speaking due to excess demand in relation to supply or
factors operating on the supply side
(a) Demand pull
(i) MV=PY
(ii) Y =C+I+G+(X-M)-increase in any of the components without
matching increase in output.
(b) Cost Push
(i) Market power—Labor unions, business management
(ii) Cost increase due to factors exogenous to an industry— higher import
prices of inputs, higher interest cost etc.
(c) Expectational
For example, expectation of higher prices—reduced supply expecting higher
profit and increased demand to build up stocks.

 Causes may operate interdependently e.g. Cost push inflation—possible

unemployment—validating increase in money supply and aggregate demand—
leading to further expectations of higher prices.

 Some specific causes in developing countries

(i) Government deficit
(ii) Monetary expansion
 (iii) Foreign trade sector—both from export and import side.

Arguments in favor of inflation-

(i) Low level of private and government savings (limited capacity to raise
revenue) —Inflation as an instrument of forced savings.
(ii) Redistributes income in favor of government and producers—more
investment (substitute for revenue raising for government and higher
profitability for private investors).
(iii) Reduces real interest cost for investment
(iv) Better than deflation which causes unemployment
(v) Inescapable consequence of growth — need for deficit financing by
governments — growth leading to higher income—higher income
elasticity at low levels of income—food price increase—other price
increases either sympathetically or wage price pressures.
 Adverse Consequences
(i) Negative interest rate— reduce personal savings.
(ii) Pressure from shareholders for higher dividend distribution—less
corporate reinvestment
(iii) Reduced governmental savings if revenue collection is not elastic in
relation to money income.
(iv) Distorts allocation of resources —(a) uncertainty with regard to long-
term projects — (b) price controls and supply rigidities (c) investment
flows into luxury houses, other real estate, gold etc.
(v) Uncertainty and less pressure of competition discourage innovation—
permits inefficient enterprises to stay in business
(vi) Worsens trade balance, encourage flight of capital and discourage FDI
(eventual devaluation, restriction on repatriation)
 (vii) Financial disintermediation.
(viii) Hurts the poor more.

Comments—Rate differential—adjustment cost

Instruments of control

(a) Monetary policy—reducing availability or increasing cost of credit—

increase in reserve requirements, increase in policy rate, imposition of credit
ceilings etc.
 Limits—interest inelasticity of investment—various types of lag
(recognition, administrative, operational)
 Large non-monetized sector— un-integrated interest rate structures
(informal markets, NGOs) — excess cash reserve of commercial banks—
amenability of central banks to government deficit financing—high
exposure to external sector disturbances.
(b) Fiscal policy—tax, expenditure, methods of financing deficit, public
enterprise pricing, subsidies etc.
 Limits—inflexibilities on the expenditure side (Defense, social Safety net,
wages and pensions etc.) — lags noted above—Low ratio of government’s
revenues to GDP— over ambitious commitment of public expenditure.
 Others—increased production of wage goods— selective price controls—
use of foreign exchange revenue/external assistance to increase availability
of wage goods and alleviate supply bottlenecks.
 Bangladesh Scenario — generally prudent macro policies and relatively
low inflation—causes (Money supply, Exchange rate, petroleum price,
international prices of imported items).
 Suggested actions—Avoidance of excessive credit—limiting government
budget deficit—stable exchange rate (while ensuring no appreciation of real
exchange rate) — adjustment of taxes on imports (small country, domestic
market imperfections) — Domestic food production and subsidy for the
poor—Adjustment of administered prices.