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Macro Economics 8584992992 8584992992 B. Com. [ III year ] University of Calcutta www.eblackboard.co.in Macro Economics 8584992992 B. Com. [ III year ] University of Calcutta www.eblackboard.co.in Macro Economics 8584992992 8584992992 B. Com. [ III year ] University of Calcutta 3 www.eblackboard.co.in Visit to our website to access maximum benefits Click now < www.eblackboard.co.in > Macro Economics 8584992992 B. Com. [ III year ] University of Calcutta 4 www.eblackboard.co.in Inflation : Inflation refers to a process of consistent and persistent rise in general price level for a fairly long time. That means a trend of continuous rising in general price level is referred as inflation in a macro level economy. It is generally measured by GDP deflator. In India, consumer price index and wholesale price index are applied to do so. There are two views to the emergence of inflation. One is classical that believes it is a monetary phenomenon while Keynes argues it is non-monetary. *** Macro Economics B. Com. [ III year ] University of Calcutta 8584992992 5 www.eblackboard.co.in Demand Pull Inflation : When inflationary situation occurs due to demand forces, it is termed as demand pull inflation. In other words, demand pull inflation emerges in an economy when aggregate demand for goods and services exceeds the aggregate supply available at existing prices. Demand pull inflation can be shown with the following diagram : P Where AS E4 P4 P3 Price level ADi = aggregate demand curves E3 AS = aggregate supply curve Yf = full employment level P2 P1 E2 E1 Pi = price levels Ei = equilibria i = 1, 2, 3, 4 O Y1 Y2 Yf National Output Y Macro Economics 8584992992 B. Com. [ III year ] University of Calcutta 6 www.eblackboard.co.in In the diagram, the potential capacity of the economy is OYf, shown by the vertical portion of AS curve. When aggregate demand increases till full employment level, price level as well as output level, they both increase and this situation of the economy does not refer to a situation of inflation. Shifting of AD curves upward denotes an increase in aggregate demand. Now, if aggregate demand increases further at full employment level, price level increases proportionately, and this very situation is termed as demand pull inflation. Prof. Keynes calls such a rise in price level after the attainment of full employment output as pure inflation. *** Macro Economics 8584992992 B. Com. [ III year ] University of Calcutta 7 www.eblackboard.co.in Causes of demand pull inflation : Following are the main causes of demand pull inflation – (i) Increase in supply of money : ‘Too much money chasing too few goods’ is the famous saying of classical economists. They believe that additional increase in supply of money, economy has additional aggregate demand. Since full employment exists in the economy, there is no way to increase aggregate supply, general price level will go up and thus inflation occurs. This point of view suggests it is a purely monetary phenomenon. (ii) Increase in expenditure : The other famous saying is ‘too much spending chasing too few goods’. The Keynesian view is that it is increase in expenditure that consequence is the emergence of demand pull inflation in the economy. His four expenditures, viz. consumption, investment, government and import if increased at full employment level, excess aggregate demand creates inflationary situation. Thus from this point of view, it is a non-monetary phenomenon. Macro Economics 8584992992 B. Com. [ III year ] University of Calcutta 8 www.eblackboard.co.in (iii) Reduction in tax : A reduction in tax rate also increases the level of income, that further generates excess aggregate demand and ultimately inflation occurs if aggregate supply does not coincide. It is a tool of fiscal policy to curb inflation if it exists in the macro level economy. (iv) Increase in population : An increase in population, too, causes excess aggregate demand for goods and services over limited aggregate supply and thus a cause of demand pull inflation. (v) Black Money : A parallel economy of black money is one of the most important factors to increase aggregate demand in the present scenario. Black money, money without taxed, creates huge demands but supply lags behind, consequently price rises proportionately, demand pull inflation continues. *** Macro Economics B. Com. [ III year ] University of Calcutta 8584992992 9 www.eblackboard.co.in Cost Push Inflation : When inflationary situation occurs due to cost forces, it is termed as cost push inflation. In other words, it is cost of production that affects aggregate supply inversely and creates inflation in an economy. A rise in prices of cost of production like wagerate, cost of raw materials, increase in tax rate etc. will reduce aggregate supply that tends to price rise in an economy and termed as cost push inflation. A graphical presentation of cost push inflation is shown below : Where AS P AD = aggregate demand curve Price level ASi = aggregate supply curves Yf = full employment level Yi = different equilibrium output levels E3 P3 P2 P1 E2 E1 Pi = price levels Ei = equilibria i = 1, 2, 3, 4 O Y3 Y2 Y1 Yf National Output Y Macro Economics 8584992992 B. Com. [ III year ] University of Calcutta 10 www.eblackboard.co.in In the diagram, initially AD curve intersects AS1 curve at E1, therefore equilibrium price is P1 and equilibrium output is Y1. An increase in cost of production results in leftward shifting of aggregate supply curve to AS2, while AD curve remains unchanged, a new equilibrium level reduced to OY2 but price level rises to OP2. Likewise, shifting of AS2 to AS3,, the price level rises to OP3 and output level falls to OY3. A series of increase in cost of production results a series of leftward shifting of AS curves, indicating that the whole economy is under inflationary process. *** Macro Economics 8584992992 B. Com. [ III year ] University of Calcutta 11 www.eblackboard.co.in Causes of cost push inflation : Following are the main causes of cost push inflation – (i) Increase in cost of inputs : The cost of four basic factors of production when increased, cost of output also increased. Thus raised cost raises the prices of goods and services. Consequently, aggregate supply reduces but price level rises and the rising trend in price level is termed as inflation. (ii) Increase in taxes : Increase in tax rates like indirect tax, excise duty, custom duty etc., also have a positive relation with cost of production. Such increase will reduce aggregate supply, if the situation persists in an economy for a fairly long time, called it cost push inflation. (iii) Hoarding : Hoarding i.e., shortage of inventory deliberately is another cause of rising in prices of goods and services. An artificial scarcity in supply is created to raise the price. Macro Economics 8584992992 B. Com. [ III year ] University of Calcutta 12 www.eblackboard.co.in (iv) Increase in oil prices : In a present world economy, petroleum products are used directly or indirectly in all the sectors of an economy. Therefore, an increase in oil prices affect significantly the cost structure of an economy and thus creates inflation. (v) Corruption : Corruption is the another factor to raise in cost of production. Redtapism and license system create production process in stall. Prices keep on rising trend. *** Macro Economics 8584992992 B. Com. [ III year ] University of Calcutta 13 www.eblackboard.co.in Difference between demand pull inflation and cost push inflation : Inflation is a continuous rising trend in price level in an economy. Broadly there are two types are discussed to understand inflation. One is demand pull inflation and other is cost pull inflation. They both explain rising trend in price level but have some differences mentioned below : (i) Demand pull inflation occurs due to demand forces while cost push inflation due to cost forces. Rising in aggregate demand due to increase in money supply or expenditures, reduction in taxes etc. creates demand pull inflation. Rising in cost of production due to increase in wage rate, prices of raw materials, increase in tax reduces aggregate supply and inflationary situation occurs in the economy. (ii) Demand pull inflation is monetary and non-monetary phenomena while cost push inflation is only non-monetary phenomenon. (iii) Demand pull inflation occurs only when full employment is in the economy while cost push inflation may takes place before full employment level. Macro Economics 8584992992 B. Com. [ III year ] University of Calcutta 14 www.eblackboard.co.in (iv) During demand pull inflation, aggregate supply remains unchanged while during cost push inflation, aggregate supply reduces. (v) Demand pull inflation may be controlled by fiscal as well as monetary measures while these measures are not completely effective to check cost push inflation. *** Macro Economics 8584992992 B. Com. [ III year ] University of Calcutta 15 www.eblackboard.co.in Effects of inflation on different sections of society : Inflation affects different sections of society. If one section is inversely affected, on the contrary the section gets benefited. The impact of inflation on different sections of society can be discussed as under (i) Debtors and creditors : Debtors are gainer while creditors are loser during the period of inflation. Debtors get benefited because they borrow money when its purchasing power is higher during pre inflation period but when they return the sum to the creditors during inflation period, the purchasing power of money is lower due to price rise. Inflation reduces purchasing power of money though its face value remains unchanged. (ii) Wage-earner and salaried class : They both classes are affected inversely. Wage rate increases lag behind price increases. Obviously inflation results in a reduction in real purchasing power of fixed income earners. Macro Economics 8584992992 B. Com. [ III year ] University of Calcutta 16 www.eblackboard.co.in (iii) Investors : Inflation is beneficial for those investors who invest in equities because dividends increase as a result of increase in capital profits. On the other hands, the investors who invest their money in the form of bonds, debentures and deposits with commercial banks suffer loss because they earn only a fixed interest income from such investment. (iv) Profit earners : Inflation helps to earn more profits to entrepreneurs, traders because the value of their inventories is rising. Therefore, impact of inflation becomes positive for them (v) Exports and imports : Inflation has an adverse impact on balance of payment. Inflation makes export costlier and import cheaper, export reduces and import rises. Consequently, balance of payment becomes unfavourable. *** Macro Economics B. Com. [ III year ] University of Calcutta 8584992992 17 www.eblackboard.co.in Controls of inflation : There are two policies to control inflation. The one is monetary policy, regulated by the Central Bank of the nation and the other is fiscal policy which is governed by the government. a) Monetary policy : There are two techniques adopted by the Central Bank for the purpose of curbing inflation in the economy. One is quantitative measures and other is qualitative measures. (i) Quantitative measures – Bank rate, cash reserve ratio, open market operation are such measures which help to control inflation. Increase in bank rate and CRR decrease credit creation of commercial banks. Supply of money is reduced resulting a rise in interest rate. Demand for money falls and finally inflation comes under control. In addition, the apex bank performs open market operation means it sells government bonds, commercial banks and financial institutions purchase them. Supply of money in the economy is reduced and that has a positive impact for controlling inflation. Macro Economics 8584992992 B. Com. [ III year ] University of Calcutta 18 www.eblackboard.co.in Qualitative measures – The Central Bank issues directives to commercial banks so that their lending come under control so that credit policy should be under pressure. The apex bank also provides advice, appeal and persuade the commercial banks by moral suasion to achieve the same purpose. b) Fiscal policy : Fiscal policy is the policies of the government expenditure and its revenue. As Keynes believes that expenditure is the causing factor of inflation. When such expenditures are reduced, aggregate demand will be reduced and ultimately it helps to curb inflation in the economy. The other fiscal measure is increment in existing tax rates as well as imposing new taxes that will be helpful to control increased aggregate demand. An increment in direct tax is more effective because it reduces disposable income resulting purchasing capacity falls and then price level come down in the economy. Rationing and price control policy are also taken by a government to curb the same. It fixes the maximum price of commodities to control price level. Macro Economics 8584992992 B. Com. [ III year ] University of Calcutta For Download Links www.eblackboard.co.in www.facebook.com/eblackboard www.slideshare.net/eblackboard www.youtube.com/eblackboard 19 www.eblackboard.co.in Macro Economics 8584992992 B. Com. [ III year ] University of Calcutta 20 www.eblackboard.co.in Macro Economics 8584992992 B. Com. [ III year ] University of Calcutta 21 www.eblackboard.co.in