Inflation is a constant and generalized rise in the price level over some time. Once the prices increase, it will continue growing. The continuous increase in prices will lead to a decline in purchasing power. Furthermore, labours would continuously ask for an increase in wage rate due to the rise in prices. This increase in wage rate results in the cost of production to increase and profit to decline. Therefore, producers increase the prices of products and services to maintain their profits, which will, in turn, decrease the real income of labours and their purchasing power will be managed by their demand for an increase in wage rates. This will lead to the second round of growth in the cost of production and price rates. This persistency in the prices is called ‘wage-price spiral’. The constant rise in the prices is due to the changes in the wages of the labour market. Hence, if the salaries increase proportionately to the increase in the price level, the labours are just compensated for inflation leading to the gradual decline in inflationary pressure. Pointing to the second round of increase in prices to be lesser as compared to the first round and the leading increases would be lesser and lesser.
The generalized increase is the consideration of the prices of all products and services selected to calculate inflation and inflation is the average increase in the price level of services and goods. Hence, the rise of a few or one product or services is not counted as inflation. However, it may have an essential role in the current inflation rate, for example, increase in petrol rate can drastically affect the inflation rate.
Supply of Money in an Economy
This is a significant cause of inflation, as an increase in the supply of money with specific quantities of services and goods will generate a condition where too much money is used for a few products and services. Due to which the price rates will increase, and the increased amount of money will be used to buy the same quantity of services and goods. Hence, the pricing power of money will decline. According to Monetarists, sustained inflation would only take place if there was a boost in the supply of money. The ‘Quantity Theory of Money’ can help explain the Monetarists’ statement.
M x V ≡ P x y
M (Money Supply) x V (Velocity of circulation) = P (Price level) x y (Real Output)
M (Money Supply) is the amount of money in the economy, V (Velocity of circulation) is how fast this money circulates around the economy. Hence, M times V is equal to the ‘money spent’ in an economy. On the other hand, P (Price Level) times y (Real Output) is the value of everything on which money is spent.
Money spent = What the money is spent on which is why there are three horizontal lines instead of the equals sign. Meaning, this is an identity, rather than being an equation.
According to Monetarists the increase in M meant that businesses and consumers found that they have excess money balances which would be invested by firms or spent by consumers, leading to a rise in inflation and aggregate demand.
On the other hand, Keynesians believed that the increase in price leads to improvements in the money supply. The increases in the money supply had nothing to do with the rise in prices.