The Causes of Inflation [ Biz/ed Virtual Developing Country ]

The Virtual Developing Country is a case study of Zambia. There are a series of field trips available looking at different issues connected with economic development. This trip is the Copper Tour and this page looks at the causes of inflation including demand pull and cost push inflation.

Theories

The Causes of Inflation

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This area of economics has probably given rise to one of the most significant macroeconomic debates in recent history. There are essentially two causes of inflation.

  • Inflation bought about by an increase in demand (called Demand Pull Inflation)
  • Inflation bought about by an increase in the costs of the factors of production (called Cost Push Inflation)

The debate has been over which particular one of the above predominates. In addition there is also argument over how demand pull inflation is actually caused. These arguments exist because each protagonist in the debate has different ideas about the policy measures that can be used to tackle inflation. In the last two decades the prevailing view in most countries has tended to be predominantly the neo-classical view of inflation. The multilateral donor organisations such as the IMF and World Banks have supported this view and this has had an impact on the economy of Zambia through the macroeconomic stabilisation (including anti- inflation policies) that have been made conditions of loans and foreign aid.

Let us consider the debate.

Demand Pull Inflation
Increases in aggregate demand brought about by an increase in any of its component parts will cause the aggregate demand curve to shift to the right.

Demand pull inflation

The increase in aggregate demand causes excess demand and prices are raised from r0 to r1.

The cause of demand pull inflation
The debate exists about what actually brings about these changes. The two schools of thought are the:

  • Monetarists ( the neo-classical)
  • Non-monetarists (the neo-Keynesians)

The Monetarists essentially believe that the increase in aggregate demand is influenced almost entirely by the amount of money in the economy, namely the money supply. They argue that inflation is caused by the amount of money in the economy and hence the spending power of the population exceeding the capacity of the country to produce goods and services.

The monetarists argue that policies that result in increases in the money supply such as attempts to stimulate the national income of a country will only have short-term effect on real output but generate inflation. Increased money supply will lead to increases in spending through transmission mechanisms and this will invariably create a situation where aggregate demand for goods and services exceeds the aggregate supply resulting in demand pull inflation. This is shown by the shift of the short-run aggregate demand curve in the diagram below.

Demand pull inflation - increased aggregate demand

The role of the budget deficit
The Monetarists identify the budget deficit as one of the main culprits in inflation. If government spending exceeds government revenue printing more money or borrowing are inevitable. Both result in increases in the amount of money supplied. In Zambia the IMF argued that the high levels of government spending on supporting a large and bureaucratic civil service contributed to the inflationary pressures in the economy.

Instead they argue that policies should address the supply side. By complementing strict control of the money supply with supply side policies aimed at providing incentive for firms and workers to become more efficient situations of excess aggregate demand are unlikely to happen. The higher level of aggregate supply that results from the supply side policies can support a higher level of demand without inflation. This is shown in the diagram below.

Supply side policies

Finally they also stress the need for a market determined exchange rate. Fixed exchange rate systems take the control of the money out of the hands of the government.

The Non Monetarist or Keynesian Argument
These economists dispute the link between increases in the money supply and inflation. They do so on a number of counts. They argue that keeping a tight control over money supply so as to control spending is highly questionable. Spending they say is not only dependant on the amount of money in the system but also how rapidly it is used. This velocity of circulation will vary. So controlling money supply will not necessarily control spending as the velocity of circulation can adjust.

They argue that increases in money supply will lead to increases in spending and providing there are unemployed resources firms will increase output in response.

They also worry about the line of causality of the Monetarists assertion that increases in money supply lead to prices increase. Perhaps the amount of money in the economy responds to changes in the price level?

Finally they argue that basing economic problems on controlling money supply is fraught with practical problems. How do you define the money supply? What is included in the measure of money? Cash? Cheque Accounts? Savings Accounts? How do you actually go about controlling the amount of money. In a world where there many ways in which people can borrow money, can monetary policy successfully control the amount available for spending?

The Non- Monetarist View of Inflation
The non-monetarists put forward two possible explanations of inflation. Firstly they recognise that increases in aggregate demand may lead to demand pull inflation. Increases in spending in excess of the full employment level of output will create shortages (overheating) and firms will raise their prices. This can be shown by a shift of the aggregate demand curve to the right. Real GDP will increase but with higher prices. Given the diagram below with the distinctive aggregate supply curve the price level will increase once the economy has passed the full employment level of output.

Demand pull inflation - Keynesian

Cost Push Inflation
Increases in costs of production cause the aggregate supply curve to shift to the left. This may occur if there are increases in the costs of the factor inputs or if there is a supply shock such as a drought.

The non- monetarists also suggest that one of the main causal factors of inflation is an increase in the costs of the factors of production. When firms' costs increase they will raise their prices in order to maintain the real value of their profits. This will result in the real incomes of the owners of the factors of production e.g. wages, falling. In an attempt to maintain their real income labour will demand higher money wages and this will in turn raise costs. This is often referred to as cost push inflation and may be caused by:

  • Increases in factor prices e.g. oil price increase.
  • An increase in wage settlements in excess of any increase in productivity.
  • A devaluation or depreciation of currency leading to an increase in import prices.
  • Interest rate increases will increase the cost of borrowing.
  • Indirect taxation or the removal of subsidies.

Cosh push inflation can be shown using the aggregate demand and aggregate supply curves. In this case it is not the aggregate demand that increases, it is the aggregate supply curve that shifts to the left, as in the diagram below.

Cost push inflation

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Related Glossary Items:
Aggregate Demand
Aggregate Supply
Cost Push Inflation
Demand Pull Inflation
Devaluation
Monetarists
Supply Side Policies
Inflation

Related Issues:
The Impact of Inflation on Zambia

Related Theories:
Supply Side approaches
Producer subsidies
The Problems Associated with Inflation