Inflation is the continuous increase in price of goods and products over a period of time. When the price of general articles or items goes up, it reduces the value of the domestic currency as the same currency is able to buy lesser quantity because of price increases. This is called the erosion in the purchasing power of the money and affects the purchasing power parity between two different countries.
While deflation is the decrease of the price of the goods and services and the boundary between them is price stability. Hyperinflation is when the situation is out of control where the prices increase soaring high and the money was losing its value. The main cause for hyperinflation is the imbalance in the demand and supply of money as there is a fast increase of money when compared to the demand of goods and services. The hyperinflation in Zimbabwe is an example.
Reason behind Inflation
Let us now find out the reasons behind inflation or price increase. We can explain the reason by using the demand-supply concept of economics. As per the demand supply concept price increase happens in two scenarios. One for higher demand than supply when supply is static and another for lower supply than demand when demand is static. In both these cases, demand is higher than supply which pushes the price as buyers have to pay more to buy the required goods or articles.
There are two major types of inflation which also justifies the demand-supply rationale behind the price increase.
Demand-pull inflation is caused by the increase in aggregate demand due to increased private, public and government spending. The main reason behind increased spending is the higher liquidity in the market which prompts people and private companies to spend more to buy necessary goods and articles.
The demand pull inflation is shown as constructive in an economy with fast growth rate as the excess demand helps to increase investment and expansion of industries to cater the increased demand.
Demand-pull inflation can be checked by restricting the liquidity in the market to reduce demand. Central banks use monetary policies to check the liquidity in the market to tame the demand-pull inflation.
Cost push inflation is caused by the increased input material prices which affect the profit margin and erases the economic advantage of producing more. In creased labor cost, high taxes imposed by the government are also the main reasons behind cost-push inflation. The only way to tame cost-push inflation is to decrease the raw material costs and taxes for the same.
Supply-shock inflation is caused by the drop in aggregate supply or potential production in the economy due to natural disasters or unfavorable environment. As this is caused by sudden drop in aggregate supply, it is also known as inflation. Like a sudden drop in supply of global crude oil leads to increased crude oil prices. Government passes on the increased crude oil price to the consumers by increasing the petrol/diesel prices, which causes cost-push inflation.