Question

QUESTION 3 (25)
3.1 With the aid of fully labelled diagrams, describe the fundamental differences between cost-push and
demand-pull inflation and highlight the type of inflation that’s more prominent in your country. (10)
3.2 With the aid of relevant examples from your country, outline the distribution, economic and social
consequences of inflation in any economy. (15)

Answer 1

3.1

It shall be noted that cost-push inflation occurs when we experience rising prices due to higher costs of production and higher costs of raw materials. Cost-push inflation is determined by supply-side factors, such as higher wages and higher oil prices.

Cost-push inflation is different from demand-pull inflation which occurs when aggregate demand grows faster than aggregate supply. Cost-push inflation can lead to lower economic growth and often causes a fall in living standards, though it often proves to be temporary. The main causes of cost-push inflation are supply-side factors such as higher prices of the commodities, the rising cost of imported raw materials, rising wages, higher VAT and excise duties, the increased monopoly power of the firm, and higher food prices.

Demand-pull inflation is the increase in aggregate demand, categorized by the four sections of the macroeconomy: households, businesses, governments, and foreign buyers.

Demand-pull inflation will typically occur when the economy is growing faster than the long-run trend rate of growth. If demand exceeds supply, firms will respond by pushing up prices.

It shall be noted that in India, demand-push inflation is more prominent. This is because India is a consumption-driven economy. Due to the rapid increase in population, the demand for various goods & services increases more than proportionately vis-a-vis supply. Hence, inflation becomes demand-push.

3.2

Effect of inflation on the distribution of wealth:

Usually, during inflation, most people experience a rise in their income levels. Some people might gain at the cost of others. As the sellers will be able to sell the goods at a higher rate to its customers due to inflation. A certain set of people gain because their money income rises faster than the prices. A different set of people lose because prices rise faster than their incomes during inflation.

The social and economic effects of inflation are as follows:

1) If inflation is higher than previous years' inflation then unemployment must be lesser than that of previous years. So this is good for society and people are happy as they are getting employed. Thus, inflation reduces unemployment and increases growth.

2) If the prices are higher, means that firms can sell their products at higher prices. So they start producing more to generate more profit.

3) When there is inflation the real wage given by W/P falls as Price rises. This means for employed workers mainly the salaried class has to bear the brunt of a lower real wage rate. This is detrimental to society and burdensome.

4) Creditors and debtors: A debtor is returning less sum of money in real terms so it's beneficial for him. While the lender receives a lesser sum of money than what he lent out, so he would be unhappy.

5) If one is facing hyperinflation, that is more than 30–40% inflation every month, then people lose faith in the currency, they lose faith in the government, and it causes an economic and political crisis. This has happened in lots of countries like Venezuela and Zimbabwe.

6) Inflation erodes the purchasing power of the money holdings

7) High inflation is usually associated with a slumping exchange rate, though this is generally a case of the weaker currency leading to inflation, not the other way around. Economies that import significant amounts of goods and services – which, for now, is just about every economy – must pay more for these imports in local-currency terms when their currencies fall against those of their trading partners.