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Macro Economics

Notes Factors on Demand Side

On the demand side, the major inflationary factors are:
Money Supply: The first major source of inflation is an increase in money supply in the
economy. Increase in money supply results primarily from an increase in demand deposits
and expansion of loans and investments by the commercial banks. Expansion of bank
credit is at once a cause and an effect of inflationary pressures since it reflects an enlarged
income stream resulting from the use of bank credit and parting a growing business and
personal demand for funds due to higher prices and costs.

Disposable Income: This refers to the income payments to factors after personal taxes have
been paid. An increase in disposable income results in an increase in the absolute amount
of consumption expenditure in the economy. Such an increase is inflationary in character.
Increase in Business Outlays: Increase in business outlays or capital expansion takes on a
speculative character during an inflationary boom. New equipment and plants and excessive
inventories are often financed by speculative borrowing, not to mention an increase in
replacement demand. Most of business expenditure finds its way into the income stream
dividends, wages and other income payments. These are often inflationary in character.
Increased Foreign Demand: Another factor responsible for increased demand is foreign
expenditure for domestic goods and services. This factor is particularly significant if a
country maintains an export surplus on its balance of trade. Foreign demand exerts
considerable inflationary pressures on domestic areas of shortages which may be a focal
point of spreading inflation.
It is the cumulative effect of all or most of these factors that the aggregate demand function in an
economy shifts upwards, resulting in inflation in prices.

10.3.2 Cost Push Inflation

Modern information is far more complex than what can be explained by the simple demand pull
theory. Prices and wages start rising before the economy reaches full employment. They rise
even under conditions of a large idle capacity and a sizeable portion of the labour force being
unemployed. This is known as “cost push” or “supply-shock” inflation.

The supply or cost analysis of inflation also known as the “new-inflation theory” maintains that
inflation occurs due to an increase in the cost or supply price of goods caused by increases in the
prices of inputs. Rapidly rising money wages, with no corresponding rise in labour productivity
in certain key sectors of the economy, result in higher prices in these sectors, particularly when
the demand rises. This leads to further erosion of real wages forcing organised labour, including
trade unions not involved in the initial round of wage increases, to seek a further rise in money
wages. This is what is commonly referred to as wage price spiral.

!

Caution The notion of cost push inflation is not new. As Bronfen-bparting Benner and
Holzman have observed, “cost inflation” has been the layman’s instinctive explanation of
general price increases since the dawn of the monetary system. We know of no inflationary
movement that has not been blamed by some people on “profiteers”, “speculators”,
“hoarders”, or workers and peasants, “living” beyond their station.

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