Rising inflation: A growing concern for policymakers

The rising inflation in 2023-24 has been shaped by a combination of domestic and global factors, with a recent report by the State Bank of India projecting India’s retail inflation to remain above 5 per cent in 2024.

Amid concerns over rising inflation, the Reserve Bank of India’s Monetary Policy Committee meeting has begun today to determine the policy rate in the country. But what are the major causes of inflation? What is demand-pull and cost-push inflation? What are the main factors behind the two? 

Causes of inflation  

Major causes of inflation can be categorised as demand-pull inflation and cost-push inflation.

Demand-pull inflation: A type of inflation that occurs when aggregate demand (AD) grows faster than the production of goods and services, resulting in higher prices. Aggregate demand is the sum of consumption demand, investment demand, government demand/spending, and net exports to the rest of the world: 

Aggregate Demand (AD) = C + I + G + (X – M)

When aggregate demand increases, it causes a rightward shift in the aggregate demand schedule. This shift signals a higher demand for goods and services than the economy can supply at current price levels. 

Firms respond to this shift partly by raising prices (causing inflation) and partly by increasing output. The extent to which prices rise depends on how close the economy is to its potential output – the maximum level of output an economy can sustain without causing excessive inflation.

In case the economy is operating close to its capacity, firms face an increase in production costs (such as rising cost of raw materials or higher wages) when they increase output.

In other words, the response of firms to increased demand depends on how much “slack” exists. Economic slack refers to the amount of resources in the economy that are not used such as labour (unemployment) or production capacity in factories. 

High slack means the economy is operating below its potential, while low slack means the economy is closer to full employment or full capacity. Thus, if there’s low “slack” in the economy, firms respond to rising demands by raising their prices to balance demand with their limited supply. 

Demand-pull inflation is generally associated with strong economic growth and reduced unemployment in a booming economy. However, when demand continues to rise beyond what the economy can supply efficiently, prices increase, leading to demand-pull inflation.

Figure 1: Demand-Pull inflation

— Cost-push inflation: Cost-push inflation is associated with a continuing rise in costs of production that leads to a decrease in the aggregate supply of goods and services. It is reflected in an upward (or leftward) shift of the aggregate supply curve. Such shifts occur when costs of production rise independently of aggregate demand.

There are several factors that drive cost-push inflation. For example, labour unions pushing up wages, firms with monopolistic control raising prices to increase their profits, increases in international commodity prices, natural disasters, or government policies and regulations. 

Firms respond to this increase in costs partly by increasing prices and passing the higher costs to consumers, and partly by cutting back on production, which can decrease supply further and exacerbate inflationary pressures. The extent to which firms can pass on rising costs to consumers depends on the elasticity of aggregate demand. 

If demand is less responsive to price changes (inelastic demand), firms can pass on a larger share of cost increases to consumers. In contrast, if consumers are sensitive to price changes (elastic demand), firms may struggle to raise prices without significantly losing sales.

It is important to distinguish between single shifts and continuous shifts in the aggregate supply curve. Single shifts (known as supply shocks) refer to a one time change in the supply curve due to temporary factors. Government raising excise duty on petrol or a short-term supply disruption due to a natural disaster are examples of single shifts. 

Inflation resulting from supply shocks is termed temporary inflation and stabilises once the shock is absorbed. For example, the government’s raising of the excise duty on petrol will cause an increase in industry’s fuel costs, which will be passed on through the economy. Once this has occurred, prices will stabilise at the new level and the rate of inflation will fall to zero again. 

If cost-push inflation is to continue over several years, the aggregate supply curve must continually shift to the left. If cost-push inflation is to rise, the leftward shifts must get larger.

Figure 2: Cost -push Inflation

Interplay between demand-pull and cost-push inflation

With the process of globalisation and increased international competition, cost push pressures have tended to decrease in recent years. An exception is in the case of oil shocks — when oil prices surge due to geopolitical or supply disruptions — that causes cost-push inflation by putting an upward pressure on costs and prices around the world.

Although demand-pull inflation stems from rising aggregate demand and cost-push inflation originates from rising production costs, the two can occur together. Wages and price rises can be caused both by increases in aggregate demand and by independent causes pushing up costs. Even when an inflationary process starts as either demand pull or cost push, it is often difficult to separate the two. An initial cost push inflation may encourage the government to expand aggregate demand to offset rises in unemployment. 

Alternatively, an initial demand-pull inflation may strengthen the power of certain groups, who then use this power to drive up costs. Either way, the aggregate demand curve (AD) shifts to the right and the aggregate supply curve (AS) to the left leading to continuous price increases.

Other types of inflation

— Expectations-generated inflation: There are other types of inflation not caused by excess of aggregate demand (AD), such as expectations-generated inflation. It occurs when people and firms anticipate future price increases and act accordingly.

 — Other types of unemployment: Similarly, there are other types of unemployment not caused by a lack of aggregate demand (AD), but rather by frictional and structural unemployment. Frictional unemployment occurs when workers are between jobs or searching for new opportunities. Structural unemployment, on the other hand, refers to a mismatch between the skills workers possess and the skills demanded by employers.

 — Stagflation: A rise in aggregate demand (AD) can sometimes lead to both stagnant employment and a rise in prices. This situation is called Stagflation. 

Figure 3: Stagflation

Some firms respond to the rise in demand by increasing output if they have unused resources or “slack”. Others may choose to increase prices without significantly increasing production. Some others respond by adopting a combination of the two: raising prices slightly while increasing output as much as possible.

Similarly, labour markets have different degrees of slack (the degree of unused labour capacity) and therefore the rise in demand will lead to various combinations of higher wages and lower unemployment.

Post Read Questions

What are the major causes of inflation? 

What is demand-pull and cost-push inflation? What are the primary drivers behind the two? 

India has experienced rising inflation in 2023-24. What were the major factors behind it? 

What role does the Reserve Bank of India play in controlling inflation?

Discuss measures by the government to manage rising prices and support economic stability?

(Meera Malhan and Aruna Rao are Professors in economics at Delhi University. In the second part of the article, the authors will analyse the causes of inflation.)

Share your thoughts and ideas on UPSC Special articles with ashiya.parveen@indianexpress.com.

Subscribe to our UPSC newsletter and stay updated with the news cues from the past week.