Causes of Inflation
At present three main explanations are put forward: cost-push, demand-pull, and monetary.
Cost-push inflation occurs when he increasing costs of production push up the general level of prices. It is therefore inflation from the supply side of the economy. It occurs as a result of increase in:
a. Wage costs: Powerful trade unions will demand higher wages without corresponding increases in productivity. Since wages are usually one of the most important costs of production, this has an important effect upon the price. The employers generally accede to these demands and pass the increased wage cost on to the consumer in terms of higher prices.
b. Import prices: A country carrying out foreign trade with another is likely to import the inflation of that country in the form of intermediate goods.
c. Exchange rates: It is estimated that each time a country devalues it's currency by 4 per cent, this will lead to a rise of 1 per cent in domestic inflation.
d. Mark-up pricing: Many large firms fix their prices on unit cost plus profit basis. This makes prices more sensitive to supply than to demand influences and can mean that they tend to go up automatically with rising costs, whatever the state of economy.
e. Structural rigidity: The theory assumes that resources do not move quickly from one use to another and that wages and prices can increase but not decrease. Given these conditions, when patterns of demand and cost change, real adjustments occur only very slowly. Shortages appear in potentially expanding sectors and prices rise because slow movement of resources prevent the sector and prices rise because of slow sectors keep factors of production on part-time employment or even full time employment because mobility is low in the economy. Because their prices are rigid, there is no deflation in these potentially contracting sectors. Thus the process of expanding sectors leads to price rises, and prices in contracting sectors stay the same. On average, therefore, prices rise.
f. Expectational theory: This depends on a general set of expectations of price and wage increases. Such expectations may have been generated by a continuing demand inflation. Wage contracts may be made on a cost plus basis.