Causes of inflation

A single jump in the price level, such as a one-time rise in an indirect tax, lifts prices once and then stops. Inflation is a continuing rise in the price level. The causes below are the things that start a rise, and the question of what keeps it going (money growing, wages chasing prices, expectations) comes at the end of this lesson and again in Lesson 7. Keep the two apart: an exam statement that says a one-off shock “causes inflation” is usually speaking loosely about the shock’s first effect.

Demand-pull inflation is “too much money chasing too few goods”: total spending rises faster than the economy can produce, so firms raise prices. Anything that raises aggregate demand can start it: higher government spending, lower taxes, easier credit, a rise in exports or in investment. The footprint is a rise in the price level together with a rise in output (and, as Lesson 5 shows, a fall in unemployment): the economy moves up its supply curve (CUET 2024).

Cost-push inflation starts on the supply side: firms’ costs rise and they pass them on. Inflation caused by supply shocks is called cost-push (Hyderabad 2014). The usual sources are wages that rise faster than productivity, dearer imported inputs such as oil, a rise in the international prices of food and fuel (CUET 2024), and higher indirect taxes or lower subsidies, which raise the price firms must charge (CUET 2024). The footprint is the opposite of demand-pull: the price level rises while output falls. That combination, rising prices with a stalling economy, is stagflation, the subject of Lesson 9.

Once wages respond to prices and prices respond to wages, a cost shock can feed on itself: this is the wage-price spiral. It needs accommodating money and credit to continue, which is why the next chapters matter.

An economy with aggregate demand and short-run supply. The dashed lines are where it begins. Press “A demand boom” and then “A cost shock”, and compare what happens to output, not only to prices: that is how the two kinds of inflation are told apart.

Pull and push treat the economy as one market. Structural inflation says the trouble is in the structure: some sectors cannot expand as fast as demand for their output grows, so their prices rise and, through costs and wages, pull the rest up. Our case is the JNU 2011 passage, from Geoffrey Maynard’s Economic Development and the Price Level:

• Agricultural prices respond to shifts in the balance of supply and demand faster than industrial prices do, so farm prices largely govern the behaviour of the general price level.
• If agricultural output lags behind industrial growth, excess demand appears in agriculture, and the needed improvement in agriculture’s terms of trade comes through a rise in farm prices rather than a fall in industrial prices.
• That rise lifts industrial raw-material costs and, through money wages, industrial costs generally, so industrial prices are prevented from falling and may rise: a rise in the general price level.

The papers also list the structural causes in a more general form: wage increases, import substitution that puts a strain on the foreign-exchange available for essential imports, and the nature of the tax system (UGC NET 2026). Export promotion is the one that is not on the list. Be careful with the label: one Hyderabad paper keys “both cost-push and demand-pull” for structural inflation (Hyderabad 2012). That is a loose reading, since structuralists treat bottlenecks as their own cause, but if “both” is offered and the alternatives are plainly worse, it is the answer the paper wants.

Demand pull can be traced to anything that raises spending. Behind a sustained rise sits money. The quantity equation says the money stock times its velocity (how often each rupee is spent) equals the price level times real output:

With velocity constant, inflation is money growth less output growth: money has to outgrow output. That is the reading behind the opening question of Lesson 1 (GATE 2021). The lab shows where it fails: when velocity rises, as it does when people rush to spend money that is losing value, prices can rise faster than money, and when people hoard money they can rise more slowly.

Hyperinflation is inflation so rapid (a common textbook definition is more than 50% a month) that money stops working as money. It usually occurs when a government is forced to print money to finance its spending (Hyderabad 2019): tax revenue has collapsed, borrowing is impossible, and creating money is all that is left. People run from the money, velocity soars and prices rise faster than the printing press. Lesson 4 shows why the government raises less and less by doing so.