Automatic Stabilizer and Discretionary Fiscal and Monetary Policy

In a stable economy relative prices and outputs must be free to vary with changes made in technology, tastes and preferences of consumers and suppliers of factors of production, namely land, labour and capital.

An automatic stabilizer is any feature of the economic system, which automatically tends to reduce the strength of recessions or inflations without any policy changes being made. Automatic adjustments in expenditures or revenues take place to bring about economic stability without deliberate government intervention.

This can be shown in the following diagram.

Taxes act in such a way that the economy is automatically stabilized. At full-employment National Income NP1, tax revenues are just adequate to cover government expenditure (E). Now if business activity falls and the economy swings down into a recession to NP2, tax collections fall as income falls, and the budget automatically moves towards a deficit. CD measures the amount of deficit at NP2. As tax collections fall, more disposable income is left in the hands of the public. Thus the downward trend is checked as demand increases, and the budget deficit is wiped off.

The tax system also acts as a restraint to upward swing. As National Income rises from NP1 to NP3, tax collections rise and this produces a budget surplus. As a result the disposable income in the hands of public is reduced. This reduces the demand and subsequently inflation. Thus the upward momentum is slowed down.

The degree of automatic stabilization depends on the tax rates. Higher the tax rates, higher will be the degree of stabilization.

Automatic stabilizers are there on the government expenditure side also. During recession unemployment, insurance, compensation and welfare expenditures automatically rise. This maintains the sufficient level of disposable income and checks recession and downward swing by increasing the aggregate demand. The opposite thing happens in case of inflation and budget surplus.

Discretionary Fiscal Policy

Automatic stabilizers can never fully stabilize the economy. So government action is necessary to make the economy stable.

The principal weapons of discretionary fiscal policy are

a) Varying public works and other expenditure programmes
b) Varying transfer expenditure programmes (welfare, subsidy, social security etc.)
c) Varying rates of tax cyclically

Discretionary variations in transfer expenditure programmes and tax rates may have greater short-run stabilizing effects.

Monetary Policy and Fiscal Policy

An important function of the modern government is the attempt to prevent chronic unemployment and stagnant growth and to wipe off the effects of demand inflation or deflation.

Monetary Policy: It is the policy of the Central Bank, which aims at changing the quantity of money or credit conditions. There are various ways like open market operations, change in discount rate etc. The main aim is to ensure that the monetary conditions are consistent with the achievement of the goods of high employment and stable prices.

Fiscal Policy: The government has the ability and responsibility to manage the aggregate demand to ensure a continued prosperity or sustained growth without unemployment and inflation. Fiscal policy is the tool by which the government can affect the aggregate demand. Fiscal policy means change in government expenditure or tax rates.

During depression the government initiates work on public investment projects for the unemployed. These investments are primarily aimed to create work for the people. But the effect of public works on the economy is felt after a certain time. There is a time lag between the launching of the project and generation of production and employment.

Therefore during a mild recession economists rely more on monetary policy than on public works programme (fiscal policy). However, fiscal measures are not to be dispensed with. They should be carried on for their own sake and over long periods of time.

Transfer expenditure programmes (welfare, subsidy, social security etc.) may also be undertaken to stabilize the economy. The government can stop giving some veteran's bonus in inflationary times to bring down the disposable income and aggregate demand and disburse them during periods of depression.

Variation of tax rates: If the economists think that the recession will be brief, a temporary tax cut may prevent income and demand from falling, or a tax rise may be used to eliminate extra demand and inflationary gap.

However there is a need for coordination between fiscal policy and monetary policy. It will not be proper on the part of a government to adopt a restrictive monetary policy when the demand is increasing as a result of an expansionary fiscal policy. An optimum mix of the two must be chosen by the government. In short, fiscal policies, along with stabilizing monetary policies, can provide a favourable and stable economic environment, giving the people a maximum opportunity for achievement.

Automatic Stabilizer Versus Discretionary Fiscal and Monetary Policy

While automatic stabilizers reduce the severity of economic fluctuations, they do not eliminate them. The objective of Discretionary Policy is to reduce the fluctuation even more. So a government should stress on two things.

1) The automatic stabilizers are the first line of defense, but are not sufficient to maintain full stability.

2) Reliance on them in preference to discretionary programme raises some philosophical and ethical questions.

In short, a built-in stabilizer acts to reduce part of any fluctuation in the economy, but does not wipe out 100 per cent of the disturbance. It leaves the rest of the disturbance as a task for fiscal and monetary discretion.

Also read: Role of Fiscal Policy and Monetary Policy

Theory of Consumption - Revealed Preference Analysis

Introduction: In 1960 Mr. Samuelson introduced the Revealed Preference Analysis to explain the behaviour of the consumer. The fundamental difference between the Utility Analysis, Indifference Curve Analysis and Revealed Preference Analysis is that when the first two are based on the psychology of the consumer, the revealed Preference is based on the actual behaviour of the consumer.

Assumptions: In order to explain the behaviour of the consumer with the help of Revealed preference Analysis, Mr. Samuelson made the following assumptions.

1. Utility cannot be measured.

2. The consumer always prefers more of a good to less, until his income is exhausted.

3. It is based on the Principle of Strong Ordering. This means that if the consumer is given many commodities, he can place them in order of his preference.

4. It is based on the Principle of Consistency, and the consumer acts consistently. 'Consistency in choice' means that if the consumer chooses the commodity combination P in preference to all other combinations, then he will never subsequently choose any combination from the rejected ones in a situation in which P is also available. This is the key to this approach.

5. The choice made by the consumer will reveal the preference of the consumer for the commodity. If he chooses P over Q, then this choice reveals his preference for P.

6. The consumer's preference pattern maintains transitivity. If the consumer prefers P over Q, and Q over R, Then he definitely prefers P over R.

The substitution effect is always non-positive. It can never result into a reduction in the purchase of the commodity whose price has fallen.

In order to find out the consumer's equilibrium position with the Revealed Preference Analysis, we make the following assumptions.

1. The consumer has a fixed amount of income.
2. There are only two commodities available in the market, namely A and B.

On the basis of these assumptions we can now draw the following diagram and find out the consumer's equilibrium position.

Let us assume that the price line or budget line is XY. It represents all combinations of commodities A and B available to the consumer. The consumer can choose any of the combinations of commodities A and B, lying within, or on border of the shaded triangle OXY.
We now assume that out of all the combinations available to him, the consumer chooses to consume Oa of commodity A and Ob of commodity B. This combination is represented by the point P. Thus the consumer has chosen the combination P in preference to all other combinations lying within the triangle OXY. So in future he will never choose any combination from triangle OXY in a situation where P is also available.

Now there is a fall in the price of commodity B. The price of commodity A and the income of the consumer remains constant. Given the same income, the consumer can still consume OX of commodity A by spending all his income on commodity A. Also as the price of commodity B has fallen, he can consume OZ of commodity B instead of Ob, by spending all his income on commodity B. Therefore, XZ is the new budget line.

A fall in the price of a commodity is equivalent to an increase in real income. This income effect needs to be eliminated. This is done by moving the new budget line XZ towards the origin O, keeping it parallel to its original position, until it passes through point P. So the new budget line is X'Z', where the consumer is able to purchase his original combinations of commodities A and B at P, but at the new set of prices. (new price for commodity B only; price of commodity A has not changed). The consumer can now choose any point on X'Z'.

Considering the segment X'P: All points on segment X'P were available to the consumer before the fall in the price of commodity B. All these points were within the triangle OXY and rejected by him originally in favour of the combination at point P. So, in the new situation, where P is still available, he will definitely choose P rather than a combination previously rejected. This is because the consumer moves according to the Principle of Consistency.

Considering the segment PZ': The segment PZ' represents combinations of commodities which were not previously available to the consumer. It would therefore be quite consistent for the consumer to choose some combination along the PZ' part of the new budget line. This could mean consuming more of commodity B, whose price has fallen.

This implies that the consumer either consumes same quantity of commodity B as before by remaining at point P, or more of the commodity B by choosing a point on the segment PZ'. The consumer selects the point Q. If we now restore the income effect and return to the changed budget line XZ, the consumer will move to R on the changed budget line XZ, as a result of both income effect and substitution effect, where bc (the price effect) = bs (the substitution effect) + sc (the income effect).

Conclusion: The substitution effect can never lead the consumer to buy less of a commodity whose price has fallen.

Unless the income effect is negative and of sufficient magnitude to neutralize the substitution effect, under the assumption of consistency in choice, the demand curve of a consumer for any product will slope downward to the right.

Criticism: Some economists have said that this analysis is based on the assumption of Strong Ordering. But according to the critics if the consumer is given many commodities it will not be possible for him to follow the Principle of Strong Ordering. In the case of many commodities there may be a stage where the consumer will be indifferent.

Though there are some defects in this analysis, the advocates of this analysis regard this as superior to the other two because it is based on the actual behaviour of the consumer. So according to them this is more scientific because it is based on the actual behaviour of the consumer.

General Equilibrium Theory - Overview

Micro-economics is the study of the behaviour of isolated economic entities as individual consumers, firms or industries. It deals with the division of the total output among individuals, industries, products, and firms and the allocation of resources among competing users. It looks at the whole thing with a singular point of view.

Contrarily, macro-economics is the study of the behaviour of the economy as a whole, as measured by the aggregate value of such variables like the aggregate volume of output of an economy (GNP), the extent to which its resources are employed, the size of the national income, the price level (i.e. whether there is inflation, deflation or price stability), and the level of employment. It is concerned with the overall dimension of economic life. It looks at the size, shape and functioning of the whole economic system.

General equilibrium theory actually forms a bridge between these two branches of economic theory and uses the tools of micro-economics to analyze the behaviour of the entire economy.
In common with macro-economics, general equilibrium theory is concerned with inter-relationships that exist among the markets for goods and services in the economy.
In common with micro-economics, the analysis in general equilibrium theory is carried out in terms of individual decision-makers and commodities, rather than in terms of aggregates.
The fundamental questions that general equilibrium theory attempts to answer are the same as those posed in macro-economic theory. Given different economic environments, what goods will the economy produce, how will these be produced, and who will obtain them? But, whereas macro-economics provides answers in terms of aggregates, general equilibrium theory provides answers in terms of the individual consumers, producers and commodities making up these aggregates.

Micro-economics may be regarded as a simple form of general equilibrium theory in which the decision makers in the economy are the consumers, the producers and the government. The consumer has to make decisions with respect to the allocation of his income between consumption and saving, the amount of labour he is to supply, and the form in which he will hold his wealth (money or security). The producer, in his turn, has to take decisions on the number of units of labour to hire to produce a particular commodity, which may be used either as a consumption or as a capital item. The producer has also to determine how much units to set aside for production in future. The resulting interaction among these consumption, wealth-holding, and production decisions determine such variables as the price of a commodity, the interest rate, the number of units of labour and capital employed, the number of units of output, their distribution cost etc. within a framework of government policies, namely fiscal and monetary.

Macro-economics provides simple and straightforward answer to such questions like which goods will be produced and how, and also who will acquire them. General equilibrium theory has a much more ambitious goal - that of analyzing the operations of the economy, explicitly taking into account of such things as the diversity of consumption and capital goods, and the varying tastes and preferences and wealth and income positions of consumers, as well as the differences in technological possibilities available to production firms. To quote J. K. Galbraith: "There is also the world of farmers, repairmen, retailer, small manufacturer, plumber, television repairmen, service station operator, medical practitioner, artist, actress, photographer..... In economics, as in anatomy, the whole is much more than the sum of the parts." The analytical framework of general equilibrium analysis is that of micro-economics.

The essential theme of general equilibrium analysis is that all markets are interrelated (commodity market, labour market, money market, capital market, stock market etc). It deals with interconnected markets and emphasizes the inter-relationship of prices and output of various goods and factors of production. Consumers spend their incomes on all commodities, and the demand for each commodity depends upon all prices. If the goods A and B are gross substitutes, an increase in the price of A will induce consumers as a whole to substitute B for A. The opposite would be the case if A and B were compliments. Likewise pairs of inputs may also be defined as substitutes and compliments. Furthermore, production and consumption are not independent. Consumers earn their incomes from the sale of labour, services, and other productive factors to producers. Similarly they spend their incomes on goods and services produced by the firms. Thus business firms earn their income from the expenditure made by consumers. As a consequence, equilibrium from all commodity markets and factor (land, labour and capital) markets must be determined simultaneously in order to secure a consistent set of prices.

The general equilibrium theory uses utility and production function of consumers and producers, prices of all factors of production and commodities, and quantities purchased by each consumer and producer. Consumers and producers behave in a manner to maximize their utility and profit correspondingly, and there exists a set of equilibrium prices, with which all the markets will be cleared. Existence of a competitive economy is assumed, and the general equilibrium analysis is done with a relative price concept in view. Absolute prices are nor relevant.

General equilibrium theory deals with the fundamentals of supply and demand within an economy where there are a group of markets. It considers all markets in totality. Its objective is to prove that all input and output prices are at equilibrium. It was initially done by Leon Walras, a French economist in the year 1870. The concept was revised by Gustav Cassel in 1932. It is popularly known as the Walras-Cassel Model.

Part IV- Shifts of IS and LM Curves

Synthesis of Monetary and Income Analysis - Part IV

Any fiscal policy change shifts the IS Curve, and any monetary policy change shifts the LM Curve.
a) Shift of the IS Curve due to changes in fiscal policy

The IS Curve shifts to the right to I'S' due to expansionary fiscal policy. Expansionary fiscal policy may be adopted through

i) Cut in taxes
ii) Increase in government expenditure
These are basically called real disturbances in the economy.

H becomes the new equilibrium position. When government spends more, there is an increase in income due to the operation of the multiplier. So the income increases to Yc from Ye. If national income increases, the demand for money also increases. This leads to an increase in the rate of interest, which now goes up to rc.

A cut or fall in taxes lead to an increase in the disposable income (Yd). Similarly this also leads to an increase in the rate of interest. Yd = Y - Tax.

The opposite thing will happen if the national income falls. The demand for money will fall. This would lead to a fall in the rate of interest.

b) Shift of the LM Curve due to changes in monetary policy

An increase in money supply or adoption of an expansionary monetary policy leads to a fall in the price of money, namely the rate of interest. This is basically called a monetary disturbance in the economy. Rate of Interest falls from re to rd. This shifts the LM Curve downward to L'M'. E' becomes the new equilibrium position. Due to a fall in the rate of interest, investment increases in the commodity market. Change in investment will increase the national income because ΔY = m(ΔI). National Income increases from Ye to Yd.

Thus, an increase in money supply leads to
a) Fall in the demand for money
b) Fall in the rate of interest
c) Rise in investment
d) Rise in the level of income

Similarly, a decrease in money supply leads to
a) Rise in the demand for money
b) Rise in the rate of interest
c) Fall in investment
d) Fall in the level of income

Any change in consumption function, investment function, government expenditure or taxes Shifts the IS Curve. Upward or downward shift depends upon whether the effect is expansionary or contractionary.

Any change in the demand for money, supply of money (or price level) Shifts the LM Curve. Again, upward or downward shift depends upon whether the effect is expansionary or contractionary.

c) There will be a number of possibilities if both the curves shift, due to simultaneous changes in monetary policy and fiscal policy.

If the IS Curve shifts to the right and the LM Curve to the left, the rate of interest increases from ro to r1, but income remains unchanged at Yo.
If both the curves shift to the right, the rate of interest remains unchanged at ro, but the level of income increases from Yo to Y1.
Various combinations of expansionary and contractionary monetary and fiscal policies may be adopted by the government to bring about the desired change in the economy.

Part IV of IV

Part III - Derivation of the LM-Curve and Equilibrium

Synthesis of Monetary and Income Analysis - Part III

Derivation of the LM-Curve and equilibrium

The derivation is based on the following three propositions.

1. An increase in the level of income leads to an increase in the demand for money.
2. An increase in the demand for money leads to an increase in the rate of interest.
3. Therefore, an increase in the level of income leads to an increase in the rate of interest.

The left part of the diagram shows the Demand for and Supply of money.
Ms is the supply curve for money.
Md is the demand curve for money.
E is the point of equilibrium in the money market.
Oro is the equilibrium rate of interest.
The right part of the diagram shows the relationship between level of income and the rate of interest in the money market, and the derivation of the LM_Curve.
OYo is the level of income.
Oro is the rate of interest.

Now income increases from Yo to Y1. So the demand for money will go up, and the demand curve for money, Md, will shift to the right. M'd becomes the new demand curve for money. F becomes the new equilibrium point, and the rate of interest goes up to Or1.

Now if we join the points E', F' etc. in diagram (b), we get the LM-Curve. 'L' stands for the demand for money (speculative) or liquidity preference and 'M' stands for the supply of money. The LM-Curve shows the alternative combinations of the rate of interest and the level of income for which money market is in equilibrium. In other words, at any point on the LM-Curve demand for money or liquidity preference is equal to the supply of Money.

General Equilibrium of the Commodity market and the Money market

We have shown two different equilibrium relationships between the rate of interest and the level of income, in the form of the IS-Curve and the LM-Curve. The commodity market and the money market are closely related to one another. Decisions regarding consumption and investment determine people's behaviour regarding wealth-holding between money and bond, and thus their demand for money. The rate of interest and the level of income in both the commodity market and the money market are the same.

Therefore the general (overall) equilibrium of the economy is ensured when the rate of interest and income are such that these are compatible with equilibrium in both the markets. The IS-Curve shows the equilibrium in the commodity market, and the LM-Curve shows the equilibrium in the money market. In other words, what it implies is that the values in question must lie on both the LM and the IS Curves for an overall equilibrium condition to be true. This can occur only when both the curves intersect.

Here both the IS and LM Curves are plotted on the same axes. The equilibrium level of income is given at Ye, where OYe is the equilibrium level of income, and that of interest at re, where Ore is the equilibrium rate of interest. Only at point G both the markets are at equilibrium. The diagram shows the general equilibrium of the commodity market and the money market. This is called the Synthesis of Monetary Analysis and Income Analysis, or the Synthesis of Fiscal Policy and Monetary Policy.

Part III of IV | Part IV: Shifts of IS and LM Curves

Part II - Derivation of the IS Curve

Synthesis of Monetary and Income Analysis - Part II

Derivation of the IS-Curve

The derivation is based on the following three propositions.

1. The rate of interest determines the level of investment (Autonomous). 2. The level of investment determines the level of income. 3. Therefore, the rate of interest determines the level of income.

Diagram (a) shows that lower the rate of interest, the higher the volume of investment.
Diagram (b) shows the relationship between income and investment.
We know that change in income = multiplier times change in autonomous investment
Or, ΔY = m(ΔI)
Or, m = ΔY/(ΔI)

If investment changes by a small amount, national income changes by a multiplied amount.

Corresponding to each level of investment there is a particular level of income. Here the rate of interest and the level of income move in opposite directions. Lower the rate of interest, higher is the level of investment and higher the level of national income.

The IS-Curve shows the alternative combinations of the rate of interest and the level of income, which bring about equilibrium in the commodity market. In other words, every point on the IS-Curve is a point of savings-investment equality.

Part II of IV | Part III: Derivation of the LM Curve and equilibrium

Synthesis of Monetary and Income Analysis - Part I

IS-LM Analysis - Commodity Market and Money Market Equilibrium

Macro Economics deals with the fundamental problems, which are concerned with determination of gross domestic output, income and employment, price level, and growth of national income. In the short-run determination of income, employment and price level are the primary concerns. Government policies, necessary to control these variables, are required to be ascertained, and put into use at the right time to accelerate or retard the economy.

Keynesian analysis is known as Income Analysis. The Monetary Analysis was done by classical economists. But this is actually a sysnthesis of Keynesian economics.

Economists Hicks and Hansen designed a model, which is popularly known as the Hicks-Hansen IS-LM Analysis. Assumptions of this analysis are as follows.

1. An economy consists of four types of markets, namely commodity market, money market, securities market and labour market.
2. There are enough resources available to produce the required quantity of goods and services, in accordance with the demand.
3. Any change in demand is reflected in a change in output.
4. Aggregate demand or expenditure consists of consumption expenditure, investment expenditure and government expenditure.
5. Aggregate supply consists of consumption goods and savings. To this we add tax collected (T), which is the income of the government.

I) Income Analysis - This is done in the commodity market. II) Monetary analysis - This is done in the money market.

Commodity market equilibrium condition
1. Consumption Function
'a' is the minimum level of consumption even at zero income. The income identity is Y = C + S (income = consumption + savings)
C = a + b*Y
Or, C = a + (ΔC / ΔY)*(Y)
Y = disposable income







2. Savings Function

s = ΔS / ΔY
3. Investment Function

Investment (I) = f(r), where 'r' is the rate of interest. Investment is inversely related to the rate of interest, as rate of interest is the cost of borrowing investment money.
This shows the equilibrium condition in the commodity market. The commodity market is said to be in equilibrium when the economy spends as much as it earns, or when income is equal to expenditure. That means when the supply side Y = the demand side E.
Y = E Or, C + S = C + I
C cancels out from both the sides of the equation, leaving S and I on either side, which are equal. That is, S = I (savings = investment)

Money Market Equilibrium condition

Demand function for money or Money-Demand function is Md = KPY + L(r)
where Md = demand for money
P = Price Level
Y = money income (gross national product)
PY = National Income or the money value of the goods and services produced. It is the real income.
K = proportion of money that is held for transactions purpose and precautionary purpose.
Transaction demand and precautionary demand depend upon the level of income. If the income increases, the demand for money also increases. Any increase or decrease in the rate of interest is unable to influence these two demands for money. Only speculative demand for money is influenced by the rate of interest.

"L" = Speculative demand for money or Liquidity Preference (that is, preference to keep liquid cash). 'L' is a function of the rate of interest. That is, L = f(r)
Suppose an individual is initially at point A. He is holding OMo amount of money, when the rate of interest is Oro. Money holding means the sacrifice of the current rate of interest. If the rate of interest goes up, an individual reduces his money holding, in order to earn the high rate of interest. Therefore, the rate of interest is called the opportunity cost of holding money, i.e. loss of the opportunity to earn interest at the current rate. Higher the rate of interest, higher is the opportunity cost of holding money, and consequently lower is the demand for money. People will then want to maintain their wealth in the form of bonds and securities.

Money Supply curve
Ms = C + D
C = currency in circulation in the form of notes and coins.
D = deposit or bank money
Money supply, Ms, remains fixed in the short-run, as it is controlled by the Central Bank, the central monetary authority. Equilibrium condition in the money market is established when Md = Ms (demand for money = supply of money).

Part I - of IV | Part II - Derivation of the IS Curve

Effects of Inflation

Effect on Production

During inflation producers try to minimize the risk. Hence a lot of production potential is sacrificed. Goods that are more durable are produced more; as compared to goods that are less durable. This alters the pattern of production.

Inflation gives rise to more speculation and hoarding, which is bad for the economy.

The basic knowledge about the market tends to lose its importance, and producers and consumers have to update themselves constantly.

Production and economic growth gets seriously retarded, as the products, at high prices, may fail to find a buyer.

Wrong anticipations and misallocation of resources lead to loss of profit and growth.

Effect on Distribution of Wealth

Inflation has its own effects on the aggregate demand, which in turn puts its effects on total production and income. Following are the several effects of inflation.

1. As demand for money increases, its price, namely the rate of interest, rises. That brings down the investment.

2. Inflation reduces the total output of the community.

3. As consumers feel insecure during periods of inflation, their desire to save increases. Thus, propensity to save rises.

4. As the value of money falls, and consequently the real value of wealth in the hands of consumers, spending made by the consumers fall.

5. As goods fetch higher prices in the domestic market, it discourages export, and to an extent encourages imports. More imports deplete the foreign exchange reserve of a country.

6. As profit expectation remains high due to high prices, it encourages investment in some way.

Redistribution of income and wealth take place during periods of inflation. Rate of growth of the economy in also reduced. During inflation people do not want to hold the money, whose value is falling. So there may be a conversion into other assets, in the form of bonds, securities or gold and silver. Wages and profits increase relatively more that rent and interest.

People belonging to the fixed income group are the major losers. Their earnings and accumulated savings diminish or get eroded. Debtors try to pay back their past debts in currencies which are of very little value.

Low-income groups suffer the most during inflation.

Effect on Employment

Inflation and unemployment are inter-related. A near full-employment situation with stability of prices is the aim. However measures to control inflation creates unemployment, whereas measures to reduce unemployment gives rise to inflation. It is like a trap. It is considered that a full-employment situation is a country's inflation threshold.

The Philips Curve merges the demand-pull and cost-push inflation and eliminates the distinction between them. It is proclaimed that the society itself chooses the best possible combination of price-level and employment. The least desired combination between the two could thus be eliminated by the society. Thus the Phillips Curve shows the trade-off between level of unemployment and wage-price increase. It is assumed that wage rise percentage is slightly more than price rise percentage. It shows that greater the unemployment, the lesser is the price rise, and vice versa. On the other hand, more the wage rise, less is the level of unemployment, and vice versa.

Social costs of involuntary unemployment are quite obvious. It cannot be ignored. Inflation can ultimately be considered as a severe form of taxation on the economy as a whole.'

Also read: Inflation and Deflation Demand-Pull Inflation Cost-Push Inflation

Cost-Push Inflation

Cost-push inflation is also known as Cost Inflation. It basically arises due to a rise in wage rates, which in modern economic conditions, are affected somewhat frequently due to pressure from labour unions. Interaction between demand for and supply of labour is no longer the only factor responsible for the determination of wage rates. That way we can say that wages rates these days are somewhat 'administered'.

Normally wage rate should increase only when there is excess demand for labour. Collective bargaining, through labour unions, is often responsible for a hike in wage rate, which has no relationship with the demand for labour exceeding supply. This way when the employers are forced to increase wages, their cost of production also increases. They cannot supply the finished goods at previous prices. Unable to curtail production, for which there may not be any apparent reason, producers and left only with the option of increasing the market price of the commodity.

It is very difficult to control this type of inflation through Fiscal and monetary policies. Through restrictive monetary and fiscal policies the aggregate demand can be brought down, which will bring down the price. But that affects economic growth, as production and investment gets curtailed and unemployment is created. Basically producers' profit is caught between restrictive monetary and fiscal policies on one side, and pressure for higher wages from labour unions on the other. Ultimately an understanding between employers and unions ascertain a stable wage rate that can drive out the inflationary price rise, where unions are faced with further unemployment, and producers are faced with reduced profits, both due to curtailed production.

Mixed Demand-Cost Inflation

Inflation may arise without an increase in general aggregate demand. Under a condition of full-employment, if there is an increase for a particular class of goods in the product or commodity market, it will push up the prices of that class of goods. This will induce producers to produce more of that particular class of goods. So more labourers or workers will be employed at a higher wage rate, as there is no idle labour force in the labour market. This may induce labourers in other industries to go for a wage hike as well, though there is no extra demand for labour in those industries. This way market prices of commodities will eventually go up due to increase in cost of production.

Also read: Inflation and Deflation Demand-Pull Inflation Effects of Inflation

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