The Demand-Pull Inflation!
This represents a situation where the basic factor at work is the increase in aggregate demand for output either from the government or the entrepreneurs or the households. The result is that the pressure of demand is such that it cannot be met by the currently available supply of output.
If, for example, in a situation of full employment, the government expenditure or private investment goes up, this is bound to generate inflationary pressures in the economy. Keynes explained that inflation arises when there occurs an inflationary gap in the economy which comes to exist when aggregate demand exceeds aggregate supply at full employment level of output.
Basically, inflation is caused by a situation whereby the pressure of aggregate demand for goods and services exceeds the available supply of output (both being counted at the prices ruling at the beginning of a period). In such a situation, the rise in price level is the natural consequence.
Now, this imbalance between aggregate demand and supply may be the result of more than one force at work. As we know aggregate demand is the sum of consumers’ spending on consumer goods and services, government spending on consumer goods and services and net investment being contemplated by the entrepreneurs?
The ordinary functioning of an economy should result in distributing and spending income in such a manner that aggregate demand for output is equivalent to the cost of producing total output including profits and taxes. At times, however, the government, the entrepreneurs or the households may attempt to secure a larger part of output than would thus accrue to them.
If other sectors are not prepared to acquiesce in this increase in the share of output used by any one sector, all of the sectors together will be trying to get more of the national output than production has provided. This is the basic cause for inflation to start. When aggregate demand for all purposes— consumption, investment and government, expenditure—exceeds the supply of goods at current prices, there is a rise in prices.
To illustrate the above point, let us assume that the government adopts expansionary fiscal policy under which it increases its expenditure on education, health, defence and finances this extra expenditure by borrowing from Reserve Bank of India which prints new notes for this purpose.
This will lead to the increase in aggregate demand (C +1 + G). If aggregate supply of output does not increase or increases by a relatively less amount in the short run, this will cause demand-pull inflation in the economy, that is, general rise in price level from one period to another.
To illustrate the above point, let us assume that the government wants to use more of national output than the ordinary functioning of the system provides through taxes and loans from the public. If the government is insistent on securing additional resources, it will get them in one way or another—by issuing currency or by borrowing from the central bank or from commercial banks.
If other sectors, particularly the active sectors—entrepreneurs and wage earners—are unwilling to contract their investment or consumption by the amount of these additional resources used by the government, an inflationary process will be initiated.
Similarly, an inflationary process will be initiated if entrepreneurs wish to use more of national output than the ordinary functioning of the economy provides (through savings out of profits and savings lent to them or invested by the public) while other sectors do not willingly reduce their demands for resources to the extent that entrepreneurs want to use them more.
It is important to note that Keynes in his booklet How to pay for the War published during the Second World War explained inflation in terms of excess demand for goods relative to the aggregate supply of their output. His notion of the inflationary gap which he put forward in his booklet represented excess of aggregate demand over full-employment output.
This inflationary gap, according to him, leads to the rise in prices. Thus Keynes explained inflation in terms of demand-pull forces. Therefore, the theory of demand-pull inflation is associated with the name of Keynes. Since beyond full-employment level of aggregate supply, output cannot increase in response to increase in demand these results in rise in prices under the pressure of excess demand.
Demand-pull inflation can be illustrated with aggregate demand and supply curves. Consider Fig. 23.1 in which aggregate demand and aggregate supply are measured along the X-axis and general price level along the Y-axis. Curve AS represents the aggregate supply which rises upward in the beginning but when full-employment level of aggregate supply OYF is reached, aggregate supply curve AS takes a vertical shape.
This is because after the level of full employment, supply of output cannot be increased. When aggregate demand curve is AD1 the equilibrium is at less than full- employment level where price level OP1 is determined. Now, if the aggregate demand increases to AD2, price level rises to OP2 due to the emergence excess of demand at price level OP1.
It will be noticed that here the rise in price level has also brought about increase in aggregate output supplied from OY1 to OY2. If the aggregate demand further increases to AD3, the price level rises to OP3 under the pressure of more demand.
But since he aggregate supply curves is yet sloping upward, increase in aggregate demand from AD2, to AD3 has -used the increase in output from OY2 to OYF. If aggregate demand further increases, say to AD4 only price level raises to OP4 with output remaining constant at YF. OYF is the full-employment level or output and aggregate supply curve is perfectly inelastic at YF.
Demand-Pull Inflation and Wage Price Spiral:
If the total claims on output exceed the available supply of output, prices will rise. The rise in prices provides the necessary mechanism whereby the real resources being currently used by inactive sectors are reduced so that they should be used by the more active sectors.
If, for example, the initiative for the inflationary pressure comes from the government demand for more resources, the only way that the government can have more resources is by the consumers and private entrepreneurs having less of them (assuming that all the resources are fully employed already).
If they are not willing to reduce their claims on resources voluntarily, the prices will rise and the result will be that the value of spending by these sectors will be reduced and to that extent resources will be made available for use by the government.
But that will not be the end of the story. A rise in prices reduces the real consumption of the wage earners. They will, therefore, press for higher money wages to compensate them for the higher cost of living. Now, an increase in wages, if granted, will raise the prime cost of production and, therefore, entrepreneurs will be tempted to raise the prices.
This adds fuel to the inflationary fire. A further rise in prices raises the cost of living still further and the workers ask for still higher wages. In this way, wages and prices chase each other and the process of inflationary rise in prices gathers momentum. If unchecked, this may lead to hyper-inflation which signifies a state of affairs where wages and prices chase each other at a very quick speed.
Monetarist Theory of Inflation:
It is important to note that both the original quantity theorists and the modern monetarists, prominent among who is Milton Friedman, also explain inflation in terms of excess demand for goods and services. But there is an important difference between the monetarist view of demand-pull inflation and the Keynesian view of it. Keynes explained inflation as arising out of real sector forces.
In his model of inflation excess demand comes into being as a result of autonomous increase in expenditure on investment or consumption, that is, the increase in aggregate expenditure or demand occurs independent of any increase in the supply of money. On the other hand, monetarists explain the emergence of excess demand and the resultant rise in prices on account of the increase in money supply in the economy. To quote Friedman, “Inflation is always and everywhere a monetary phenomenon……. and can be produced only by a more rapid increase in the quantity of money than in output.
Friedman holds that when money supply is increased in the economy, then there emerges an excess supply of real money balances with the public over the demand for money. This disturbs the equilibrium. In order to restore the equilibrium, the public will reduce the money balances by increasing expenditure on goods and services.
Thus, according to Friedman and other modern quantity theorists, the excess supply of real monetary balances results in the increase in aggregate demand for goods and services. If there is no proportionate increase in output, then extra money supply leads to excess demand for goods and services. This causes inflation or rise in prices.
The whole argument can be presented in the following scheme:
Ms > kPY → AD↑→ P ↑…(1)
M stands for quantity of money and P for the price level. Therefore, M/P represents real cash balances.
Y stands for national income and k for the ratio of income which people want to keep in cash balances. Hence represents demand for cash balances (i.e., demand for money)
AD represents aggregate demand for or aggregate expenditure on goods and services which is composed of consumption demand (C) and investment demand (I).
In the above scheme it will be seen that when the supply of money (Ms) is increased, it creates excess supply of real cash balances. This is expressed by Ms > kPY. This excess supply of real money balances leads to (→) the rise (↑) in aggregate demand (AD). Then increase (↑) in aggregate demand (AD) leads to (→) the rise (↑) in prices (P).
Friedman’s monetarist theory of inflation can be better explained with quantity equation (P = MV = M/Y.1/k) written in percentage from which is written as below taking V or k as constant
∆P/P = ∆Ms/ Ms – ∆Y/Y …(2)
∆P/P is the rate of growth of money supply and ∆Ms/ Ms is the rate of money supply and ∆Y/Y is the rate of growth of output. Thus, according to equation (2), rate of inflation (∆P/P) is determined by growth of money supply (∆Ms/ M) and rate of growth of output (∆Y/Y), with velocity of circulation (V) or k remaining constant. Friedman and other monetarists claim that inflation is predominantly a monetary phenomenon which implies that changes in velocity and output are small.It thus follows that when money supply increases, it causes disturbance in the equilibrium, that is, Ms > kPY. According to Friedman and other monetarists, the reaction of the people would be to spend the excess money supply on goods and services so as to bring money supply in equilibrium with the demand for money. This leads to the increase in aggregate demand or expenditure on goods and services which, k remaining constant, will lead to the increase in nominal national income (PY).
They further argue that the real national income or aggregate output (i.e., Y in the demand for money function stated above) remains stable at full employment level in the long run due to the flexibility of wages.
Therefore, according to Friedman and his followers (modern monetarists), in the long run, the increase in nominal national income (PY) brought about by the expansion in money supply and resultant increase in aggregate demand will cause a proportional increase in the price level.
However, in the short run, like Keynesians, they believe that the economy may be working at less than full employment, that is, in the short run there may prevail excess capacity and unemployment of labour so that expansion in money supply and consequent increase in nominal income partly induces expansion in real income (F) and partly results in rise in the price level as shown in Fig. 23.2.
To what extent price level increases depends upon the elasticity of supply or aggregate output. It will be seen from Fig. 23.2 that effect of increase in money supply fromM0 to M1 and resultant increase in aggregate demand curve for goods and services from AD0 to AD1 is split up into the rise in price level (from P0 to P2) and the increase in real income or aggregate output (from (Y0 to Y1).
It should be noted that Friedman and other modern quantity theorists believe that in the short run full-employment of labour and other resources, may not prevail due to recessionary conditions, therefore, they admit the possibilities of increase in output. But they emphasise that when the growth in money supply is greater than the growth in output, the result is excess demand for goods and services which causes rise in prices or demand-pull inflation.
It follows from above that both Friedman and Keynesians explain inflation in terms of excess demand for goods and services. Whereas Keynesians explain the emergence of excess demand due to the increase in autonomous expenditure, independent of any increase in money supply. Friedman explains that inflation is caused by proportionately greater increase in money supply than the increase in aggregate output. In both views inflation is of demand-pull variety.