Inflation means a general and a sustained rise in prices, and as money is the yardstick of measuring prices, a rise in the general price level automatically means a loss in the value of money. This is in confirmation with the fact that anything in excess is always less valuable. The value of money in turn, lies in the amount of goods and services it can buy, and when these become dearer, the same amount of money can buy a lesser amount of these goods and services. This is how the purchasing power of money declines.
There are two main causes of inflation: Demand Pull and Cost Push. Having described Demand Pull Inflation in the previous article on inflation, I will move on to Cost-Push Inflation.
This simply means that when the cost of producing something goes up, so does its price. The major inputs in the production process which contribute to rise in the production cost are:
- Raw materials, especially oil prices.
- Firms, who are not able to absorb the rise in prices of these inputs, pass on their burden to their customers. And the rise in the input prices can be because the production factors have become scarce or the demand for them has risen.
- Also, even if the rise in input costs is temporary, the same cannot be said of wages. Wages are considered to be ‘sticky’ downwards, which means they cannot be brought down easily. Labour, which has a collective bargaining capacity and whose supply is inflexible in the short-term, does not allow its price i.e. wages to come down.
- Rise in indirect taxes also add to price rise.
- Inflation can be imported, where the rise in prices of commodities in international markets can trickle down to domestic markets. This is especially true in the case of oil, where international fluctuations in oil prices dictate the cost of production here.
- When prices of commodities like oil rises, which is either an input in the production process or is essential for transporting goods from one place to the other, it has a spillover effect on the prices of other commodities and services, driving their prices upwards. Hence oil prices are very important to gauge the inflation trend.
- When inputs become scarce and costly, firms cut down on their output, and there is a reduction in the aggregate supply. So cost push inflation is associated with a reduction in aggregate supply as compared to demand.
When prices go up, wages do not remain far behind. Inflation reduces the buying power of the wage-earners, compelling them to demand for raises, to compensate them for the higher cost of living. If firms accede to this demand, their cost of production goes up which in turn tempts entrepreneurs to further raise prices of their products. Also, wage-earners, whose lost purchasing power is restored, expand their consumption, adding to more demand, thus adding fuel to the fire by pushing prices even further up. Hence prices and wages compete, and if unchecked, a vicious cycle is formed.