Monday, May 2, 2011

Demand-pull Inflation

The classical theory states that inflation or constant price rise takes place when the quantity of money in circulation increases. The price rise is directly related to the percentage increase in the quantity of money.

Under a full-employment situation, when investment demand increases, there arises a total demand for goods, which outstrips the aggregate supply that is available. Prices then start going up. Consumer demand is dependent on disposable income. Sale of goods and services at higher prices creates more money income, and hence more demand. So the excess demand never gets checked.

Some price rise would occur even with a constant money supply. This price rise would increase the transaction demand for money, which will push up the interest rates. Higher interest rates would discourage extra investment demand. This would eliminate the inflationary effect.

We can explain demand-pull inflation with the help of inflationary gap. Inflationary gap may be defined as that part of government expenditure that is not covered by taxation or borrowing from the general public, and which is covered by borrowings from banks or other financial institutions, or by creation of money by the Government. Revenue spending of the Government then overruns revenue earning.

C+I+G shows the different expenditure levels at different levels of income. Equilibrium exists at point E, where the C+I+G cuts the income line. If, under a full-employment situation, the real income cannot reach Yo, but reaches only up to Yn, it gives rise to an inflationary gap, measured by XY.

If there is insufficient aggregate demand, there will be a fall in the C+I+G schedule. This is represented by the (C+I+G)' schedule. This will give rise to a deflationary gap, measured by YZ.

A boom in investment, technological advancements, opening up of new prospective territory etc. may give rise to some demand-pull inflation. However, increase in Government Expenditure, especially for the progress of backward areas, high defence expenditure etc. may also give rise to demand-pull inflation.

The inflationary gap may be eliminated in several ways.

1. Rate of interest can be increased by keeping the money supply constant. This will reduce investment, income and consumption. Prices will come down.

2. High prices will reduce the real value of wealth. This will reduce consumption expenditure and consequently prices. This is called the Pigou Effect.

3. If redistribution of income can be done in favour of the higher income group, consumption expenditure will come down. Higher income people will spend lesser portion of this redistributed income on consumption than the lower income group. The inflationary gap may come down in this way.

4. Extra tax collections will reduce the net disposable income. This will lower the consumption. Reduction in Government subsidies or welfare expenditure will also reduce disposable income and consumption.

5. Higher prices in the domestic market may discourage exports. This will increase supply in the domestic market. As a result, prices will come down. This may happen on its own.

Also read: Inflation and Deflation Cost-Push Inflation Effects of Inflation

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