Question

1. According to the classical economists how does inflation come about?

2. Explain three causes of inflation and why it may be is undesirable.

Answer 1

Question 1 answer:- Classical Theory of Inflation says that money is the asset which is utilized by people to purchase goods and services on a regular basis. Money is the mode of exchange in every economy at the present day. Inflation occurs in an economy when the overall price level increases and the demand of goods and services increases.
The classical theory of inflation attributes sustained price inflation to excessive growth
in the quantity of money in circulation. For this reason, the classical theory is sometimes
called the “quantity theory of money,” even though it is a theory of inflation, not a
theory of money.
More specifically, the classical theory of inflation explains how the aggregate price level
gets determined through the interaction between money supply and money demand.
As a matter of fact, because it traces the behavior of an important economy-wide
variable – inflation – back to the most basic forces of supply and demand, the classical
theory must qualify as one of the oldest “microfounded” models in all of
macroeconomics!

The classical theory of inflation owes its genesis to certain factors. Inflation is determined by the quantity theory of money. This theory which is contained in the classical theory of inflation is employed to explain the most important and long run determinants of inflation rate and price level. Inflation is a phenomenon which takes the whole economy into its grasp. It spreads across the whole of the economy. It is such a phenomenon which impacts the whole of the economy and is concerned about the value of the mode of exchange in an economy that is, it concerns itself with money. With the rise in the supply of money the price rate rises and the value of money falls that is devaluation of money takes place.

The supply of money is controlled by the FED through a policy of open market. Open market is a powerful tool of controlling the supply of money. The demand of money actually depends on a lot of factors. These factors include interest rates, average level of prices in the economy. Every economy endeavors to reach an equilibrium where the demand and supply of the money becomes equal.

Question 2 answer :-

Inflation is defined as a rise in the general price level. In other words, prices of many goods and services such as housing, apparel, food, transportation, and fuel must be increasing in order for inflation to occur in the overall economy. If prices of just a few types of goods or services are rising, there isn't necessarily inflation.

Main causes of inflation
Demand-pull inflation – aggregate demand growing faster than aggregate supply (growth too rapid)
Cost-push inflation – For example, higher oil prices feeding through into higher costs.
Devaluation – increasing cost of imported goods, and also the boost to domestic demand.

Demand-pull inflation
If the economy is at or close to full employment, then an increase in aggregate demand (AD) leads to an increase in the price level (PL). As firms reach full capacity, they respond by putting up prices leading to inflation. Also, near full employment with labour shortages, workers can get higher wages which increase their spending power.

Cost-push inflation
If there is an increase in the costs of firms, then businesses will pass this on to consumers.Cost-push inflation can be caused by many factors

1. Rising wages

If trades unions can present a united front then they can bargain for higher wages. Rising wages are a key cause of cost push inflation because wages are the most significant cost for many firms. (higher wages may also contribute to rising demand)

2. Import prices

One-third of all goods are imported in the UK. If there is a devaluation, then import prices will become more expensive leading to an increase in inflation. A devaluation / depreciation means the Pound is worth less. Therefore we have to pay more to buy the same imported goods.

Raw material prices

The best example is the price of oil. If the oil price increase by 20% then this will have a significant impact on most goods in the economy and this will lead to cost-push inflation. E.g., in 1974 there was a spike in the price of oil causing a period of high inflation around the world.

Profit push inflation

When firms push up prices to get higher rates of inflation. This is more likely to occur during strong economic growth.

5. Declining productivity

If firms become less productive and allow costs to rise, this invariably leads to higher prices.

6. Higher taxes

If the government put up taxes, such as VAT and Excise duty, this will lead to higher prices, and therefore CPI will increase. However, these tax rises are likely to be one-off increases. There is even a measure of inflation (CPI-CT) which ignores the effect of temporary tax rises/decreases.