It is not possible to specify any particular cause or causes of inflation. For this reason, there has never been a general agreement on the causes of inflation. The fact is that a market economy is subject to an unending process of adjustment, and any particular price adjustment may start an inflationary process.
In spite of the difficulties faced in identifying the causes of inflation, it is necessary to do so because we cannot be indifferent to its presence and must find ways of controlling it. And remedies of inflation cannot be found unless we are able to identify its causes.
1. Inflation can take place and persist only when there is a free market mechanism but in which supply flows fail to quickly adjust to shifts in demand flows. In other words, market imperfections can generate inflationary forces. These imperfections of the market manifest themselves in the form of inflexibility of demand and supply adjustment. Let us note some examples.
i. The market may be characterized by monopolistic or oligopolistic tendencies. If the goods happen to be essential (particularly if they are necessities of life), these restrictive practices can easily generate inflationary pressures. Even public sector undertakings having a monopoly of essential supplies can raise their sale prices and push up the cost of production and/or cost of living throughout the economy. In this connection, we can mention the rates charged by electricity boards, railways and others.
ii. The workers may have strong trade unions and resist any downward revision in wage rates. This may prevent a reduction in production costs and prevent an increase in supply. Similarly, there can be a collusion between suppliers of other inputs, which may cause inflation.
iii. Inappropriate demand elasticity can also contribute to the inflationary pressures. It is seen that a number of essential items like food, clothing, conveyance, fuel and power, etc. have very low elasticity of demand. This fact enables the producers to raise prices and trigger inflation.
iv. Even a competitive economy is not able to adjust its supplies without time lags. For example, agricultural output is largely subject to the vagaries of nature. We cannot raise crops faster than permitted by nature. There are similar limitations with regard to manufacturing industries having long gestation periods.
2. There can be situations in which supply may suddenly fall such as due to some natural calamity or a war etc. The shortage of supply of essential consumption goods and inputs can trigger an inflationary process.
3. It is generally agreed that an increase in the supply of money and credit is an important force, which feeds inflationary process. An excess supply of money may not initiate inflation. But its supply certainly strengthens it. It is through increasing supply of money and credit that a situation of persistent excess demand is maintained.
4. Budgetary policy of the government is considered an important cause of inflation. A deficit budget can be both the initial cause of excess demand and inflation and a cause, which sustains.
The impact of a budgetary deficit on inflation depends upon the manner in which it is financed and the nature of government expenditure.
(i) If the government finances its budgetary deficit by printing more currency, or by borrowing from the central bank (in which case again there is an increase in currency supply with the public), an excess demand is created without a corresponding addition to supply flows.
(ii) If the government finances its deficit by borrowing from the banks, they are able to create additional credit on the strength of their holdings of government securities. This also feeds inflation.
(iii) If the government borrows from the general public, there will be a reduction in the currency supply with the public and the result will be a deflationary impact on the economy.
(iii) If the government borrows from abroad, the economy can buy imports with the borrowed funds. This results in an addition to supply and a possible fall in prices.
However, the greater disturbing fact is not the initial budgetary deficit but the fact that an inflationary process forces the government to go in for ever-increasing deficits. It has to do so because its own expenditure keeps increasing with rising prices. To meet these expenses it has to resort to budgetary deficits. This, in turn, increases money supply and pushes up prices. It becomes a phenomenon of increasing money supply pushing up prices and rising prices necessitating increasing money supply.