Q. A rise in general level of prices may be caused by

1. an increase in the money supply
2. a decrease in the aggregate level of output
3. an increase in the effective demand

Select the correct answer using the codes given below.

• 1 only
• 1 and 2 only
• 2 and 3 only
• 1, 2 and 3

Answer: (d) 1, 2 and 3

Notes:

• The increase in the general level of prices may be caused by many factors like an increase in the money supply, a decrease in the aggregate level of output, an increase in the effective demand, an increase in income, the rapid growth of population, etc.
• Increase in general price level or inflation has two influencing factors Demand-pull inflation and Cost-push inflation.
  • Demand-pull inflation occurs when aggregate demand for goods and services in an economy rises more rapidly than an economy’s productive capacity. One potential shock to aggregate demand might come from a central bank that rapidly increases the supply of money.
    • The  decrease in aggregate level of output and increase in the effective demand also lead to inflation.
    • The increase in the money supply will generate inflation and increase more customer spending. The rate of interest will become low.
    • Various variables might cause an increase in aggregate demand. Some of them are
      • Fiscal Stimulus
      • Population Pressure
      • Increase in Net Exports
      • Monetary Stimulus
      • Policy Decisions
  • Cost-push inflation, on the other hand, occurs when prices of production process inputs increase.
    • The following reasons can cause production costs to rise.
      • Employees’ salaries being raised
      • Raw material prices increasing
      • Firms profit margins
      • Import prices
      • Increase in indirect taxes

Impact of Inflation

• Positive Impacts:
  • Increased Profits for Producers
    • In most cases, inflation benefits the producers of goods. They make more money because they can sell their products at higher prices.
  • Increased Investment Returns
    • During periods of inflation, investors and entrepreneurs are given additional incentives to invest in productive activities. As a result, they benefit from higher returns.
  • Increase in production output
    • When producers receive the appropriate investment, they produce more goods and services. As a result, inflation causes an increase in product/service production.
• Negative Impacts:
  • Real-Income falls for groups with fixed income.
    • An individual’s true income is the purchasing power of his income money. To put it another way, Real Income=Money Income/Price Level.
    • This means that people on fixed incomes, such as salaried workers, pensioners, and the like, will see a drop in real income. To put it another way, their purchasing power will reduce.
  • Income Distribution Inequality Rises
    • Profits for business owners and entrepreneurs rise as a result of inflation.
    • As a result, income inequality becomes more pronounced during this time period.
    • People in fixed-income groups, on the other hand, see a decrease in their real income.
  • Disturbs the Planning Process
    • Inflation raises the prices of goods, raw materials, and factor services. As a result, the government must spend more money to complete any investment project initiated during the planning period.
    • If the government fails to raise more financial resources through savings or taxation, the entire planning process is thrown off.