Increase in Money Supply: The most important reason of inflation is excessive growth of the money supply. A long sustained period of inflation is caused by money supply growing faster than the rate of economic growth. When there is more money in the system, too much money chases too few goods. That is why the RBI takes tight policy measures to reduce money in the system.
Increased Effective Demand: Another important reason for inflation is increased effective demand for goods and services. When there is an increased demand, the people tend to offer higher price for same good or commodity.
Decreased Effective Supply or Aggregate Output: Negative changes in available supplies such as during scarcities cause inflation. If there is a decrease in aggregate level of output, the money available in the economy will chase for goods / services which are now less available now. This may lead to inflation.
There are three major reasons of inflation, which is also known as Triangle Model given by Robert J. Gordon.
Demand Pull Inflation
Demand-pull inflation is caused by increases in aggregate demand due to increased private and government spending, etc.
Demand-pull inflation is constructive to a faster rate of economic growth since the excess demand and favorable market conditions will stimulate investment and expansion. Demand-pull theory states that the rate of inflation accelerates whenever aggregate demand is increased beyond the ability of the economy to produce (its potential output). Hence, any factor that increases aggregate demand can cause inflation. However, in the long run, aggregate demand can be held above productive capacity only by increasing the quantity of money in circulation faster than the real growth rate of the economy.
Cost Push Inflation
Cost-push inflation, also called “supply shock inflation,” is caused by a drop in aggregate supply (potential output). This may be due to natural disasters, or increased prices of inputs. For example, a sudden decrease in the supply of oil, leading to increased oil prices, can cause cost-push inflation.
Producers for whom oil is a part of their costs could then pass this on to consumers in the form of increased prices.
Built in Inflation
Built-in inflation is induced by adaptive expectations, and is often linked to the “price/wage spiral”. It involves workers trying to keep their wages up with prices (above the rate of inflation), and firms passing these higher labor costs on to their customers as higher prices, leading to a ‘vicious circle’. Built-in inflation reflects events in the past, and so might be seen as hangover inflation.
