Question

Indicate whether you think the following statements are true, false or uncertain. Support your answer by giving all necessary reasoning and calculations:

b) According to the quantity theory of money, “inflation is always and everywhere a monetary phenomenon.”

Answer 1

According to the quantity theory of money, “inflation is always and everywhere a monetary phenomenon.”

• Milton Friedman was one of the leading economic voices of the latter half of the 20th century.
• Milton Friedman's economic theories became what is known as monetarism, which built on and overturned important parts of Keynesian economics.
• Friedman popularized many economic ideas that are still important today.

Friedman's work busted the classic Keynesian dichotomy on inflation, which asserted that prices rose from either "cost-push" or "demand-pull" sources. It also put monetary policy on the same level as fiscal policy.

Inflation refers to the rate at which the overall prices of goods and services rises resulting in the decrease in the purchasing power of the common man, which can be measured through Consumer Price Index. Modern analysis of inflation revealed that it is mainly caused either by demand side or supply side or both the factors. Demand side factors result in demand-pull inflation while supply side factors lead to cost-push inflation.

Definition of Demand-Pull Inflation

Demand Pull Inflation arises when the aggregate demand goes up rapidly than the aggregate supply in an economy. In simple terms, it is a type of inflation which occurs when aggregate demand for products and services outruns aggregate supply due to monetary factors and/or real factors.

• Demand-Pull Inflation due to monetary factors: One of the major cause of inflation is; increase in money supply than the increase in the level of output. The German inflation, in the year 1922-23 is the example of Demand-Pull Inflation caused by monetary expansion.
• Demand-Pull Inflation due to real factors: When the inflation is due to any one or more of the following reasons, it is said to be caused by real factors:
  • The increase in government spending without the change in tax revenue.
  • Fall in tax rates, with no change in government spending
  • Increase in investments
  • Decrease in savings
  • Increase in exports
  • Decrease in imports

Out of these six factors, the first four factors, will result in the rise in the level of disposable income. The increase in aggregate income result in the increase in aggregate demand for goods and services, causing demand-pull inflation.

Definition of Cost-Push Inflation

Cost push inflation means the increase in the general price level caused by the rise in prices of the factors of production, due to the shortage of inputs i.e. labour, raw material, capital, etc. It results in the decrease in the supply of outputs which mainly use these inputs. So, the rise in prices of the goods emerges from the supply side.

Moreover, cost-push inflation may also be caused by depletion of natural resources, monopoly and so on. There are three kinds of cost-push inflation:

• Wage-push inflation: When the monopolistic groups of the society like labour union exercise their monopoly power, to enhance their money wages above the competitive level, which cause an increase in the cost of production.
• Profit-push inflation: When the monopoly power is used by the firms operating in the monopolistic and oligopolistic market to increase their profit margin, leading to rise in the price of goods and services.
• Supply shock inflation: A type of inflation arising due to unexpected fall in the supply of necessary consumer goods or major industrial inputs.