Unit – 6 Inflation & Business Cycles

Demand Pull Inflation

When aggregate demand of goods and services are greater than the
aggregate supply of goods and services, the price level gradually rises
and it is called demand pull inflation. According to Keynes, when the
economy is at operating below full employment, with increase in
aggregate demand, supply also increases and rise in price level is at
very low rate and it is called semi-inflation. Once the economy reaches
at full employment, with increase in aggregate demand, there is not
increase in supply and level of price rises significantly. It is known as
demand pull inflation. It can be illustrated with the help of below
graph:

In the above graph, AD and

AS represent aggregate demand and aggregate supply curve. AS is
horizontal straight line up to point A, then it is upward sloped from A to
B and then it is vertical straight line. When aggregate demand is
represented by AD1, the output of the economy is OY and price is OP.
When aggregate demand increases to AD2, level of output (aggregate
supply) increase to OY1 and price remains unchanged up to point A of
the supply curve. When aggregate demand increase to AD3, price level
slightly increases to OP1. Similarly, when aggregate demand further
increases to AD4, the price level rises further to OP2. From the point A
to B, there is increase price as well as in aggregate supply in the
economy, thus the rise in price is not much. But when aggregate
demand increase to AD5, there is no change in supply and rise in price is
significant. Beyond the point B, the economy is in full employment and
thus, there is no rise in output/ aggregate supply. Thus with increase in
aggregate demand, inflation occurs and it is called demand pull
inflation.
Causes of Demand Pull Inflation:
1. Increase in money supply and bank credit – When monetary
authority (central bank) practices expansionary monetary policy,
supply of money and credit creation increases. It results rise in
demand of all kinds of goods and services. If supply does not
increase accordingly, the price level may rise. And it results
demand pull inflation.
2. Increase in government expenditure – When government
practices expansionary fiscal policy, government spending
increases as wages and salaries of government employees or in
the form of government investment. It also results rise in overall
demand of goods and services compared to supply resulting rise
in price level. Is also causes demand pull inflation.
3. Increase in Exports – Normally, when government has to
encourage exports, local currency is devaluated. It results higher
level of export resulting higher demand of goods in the local
market. As a result, price level rises resulting demand pull
inflation.
4. Reduction in Tax – When government reduces tax, the disposable
income of the individual may rise or purchasing power of the
 consumer may increase. As result demand significantly rises
compared to supply. It also results rise in price level resulting
demand pull inflation.
5. Repayment of past debts – When government repays the past
debts, the disposable income of the consumers’ increase. It also
increases demand of goods and services resulting rise in price
level and consequently the demand pull inflation occurs.
6. Increase in private expenditure – Private expenditure plays very
important role in the development of economy. If such
expenditure increases, it also increases demand of all kinds of
goods and services. It also results demand pull inflation.
7. Shortage of goods and services – Shortage of goods may take
place due to various reasons such as war, calamity, pandemic, or
some deliberate attempts of producer and suppliers. It also
results rise in price level and leads to demand pull inflation.
Cost Push Inflation
When factor cost increases (that may be wage or rent or interest or
profit or all of them), the rise in cost is recovered by the
producer/supplier by increasing price. On the other hand, supply falls
due to rise in cost off product. It results rise in price level in the
economy and it is called cost push inflation. It also may result due to
increases in cost of raw materials. Cost Push inflation is also called
supply side inflation.
Cost push inflation are of following three types:
a) Wage Push Inflation – Normally, when wage rate is increased by
labour union, the firms may supply/produce lesser output. On the
other hand, the firms are compelled to raise the price to recover
the increased cost. As a result, rise in price of goods and services
take place. It is called wage push inflation.
 b) Profit Push Inflation – When oligopolistic and monopolistic firms
increase price to raise their profit margins, it also results inflation
and it is called profit push inflation.
c) Supply Shock Inflation – Due to any reason, if supply of goods and
services falls and demand remains the same, the price of goods
and services may rise and it is called supply shock inflation. The
reasons may be strike of labour union, hoarding, lack of security,
breakdown of supply chain, etc.
It can be explained with the help of graph presented below:

In the above graph, AD

represents aggregate
demand curve and AS
represents aggregate
supply curve. OYF is the
level of full employment in
the economy. E1
represents initial
equilibrium of the
economy. Where AD
intersects AS1. Therefore, the level of output is OY1 and price level is
OP1. When cost of production increases in most or all the sectors of
economy, the aggregate supply falls and AS curve shifts upward as
represented by AS2, which intersects existing AD curve at point E2. Thus
the new equilibrium level of out falls to OY2 and level of price increases
to OP2. This is called cost push inflation.
Since this inflation occurs, before the economy reaches to full
employment equilibrium, Keynes states that it is not true inflation.
Causes of Cost Push Inflation
a) Increase in wages – union – wage will be more than their
productivity.
b) Increase in profit margins –
c) International reasons –
d) War –
e) Natural calamities –
f) Hoarding –
g) Scarcity of factors of production

Measurement of Inflation
Consumer Price Index (CPI) is used to calculate rate of inflation and the
formula is as below:
a) Aggregate Expenditure Method or Weighted Aggregate Method
∑ 𝑝1 𝑞0
CPI = ∑ × 100
𝑝0 𝑞0
b) Family Budget Method
𝑝
∑( 1 ×100)𝑝0 𝑞0 ∑ 𝑝𝑤
𝑝 0
CPI = ∑ 𝑝0𝑞0
= ∑𝑤

𝑝1
Where, P = ( × 100)
𝑝0
w = p0q0,
p0 & q0 are price and quantity of base year and p1 & q1 are price
and quantity of current year (year in which inflation or CPI is to be
measured).
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐶𝑃𝐼
Rate of inflation = × 100
𝐶𝑃𝐼 𝑜𝑓 𝐵𝑎𝑠𝑒 𝑌𝑒𝑎𝑟
𝐶𝑃𝐼 𝑡ℎ𝑖𝑠 𝑦𝑒𝑎𝑟−𝐶𝑃𝐼 𝑜𝑓 𝐵𝑎𝑠𝑒 𝑦𝑒𝑎𝑟
= × 100
𝐶𝑃𝐼 𝑜𝑓 𝐵𝑎𝑠𝑒 𝑌𝑒𝑎𝑟
 H.W. Example 6.1 & 6.2 , Ex – problems to be done

Core Inflation
Rate of inflation calculated by excluding prices of food and energy
is called core inflation. These two items are excluded while
calculating core inflation as prices of these items are highly
fluctuating during the period of year.

Effects of Inflation
There are various types of effects of inflation and they are broadly
classified as economic effects and non-economic effects.

Economic effects are also divided into 4 categories as detailed

below:
1. Effects on production activities
a) Decline in value of money – Due to inflation value of money
falls. It results increase in expenditure and decrease in saving.
Consequently, the source of investment falls.
b) Discourage to foreign capital – When there is high rate of
inflation, not only the domestic investment is discouraging, it
also discourages the foreign investment. It is simply because,
the value of money invested in the economy decreases due to
inflation.
c) Changes in structure of production – Due to rise in price more
in luxury goods during the inflation, business people think that
they can earn more in these goods rather than producing
necessary goods. Thus production process gradually shifts from
necessary goods to luxury goods.
d) Decline in quality of product – Due to inflation, households
tends to spend the money immediately as they earn it. It
 results higher demand of goods in the market. When demand
is high, producers will compromise in quality of product.
e) Encourages hoarding of the products – When price rises
frequently, the producers start to hoard more goods with
them, to sell them at further higher price in future.
f) Speculative activities – Due to uncertainty in price, speculative
activities and middle man in the business increases.
g) Loss of faith in domestic currency – Due to excessive rate of
inflation i.e. hyperinflation, trust on monetary system
decreases or may fail completely. As a result, the earlier system
of barter exchange where goods are exchanged with other
goods may re-establish, which is not that easy n modern time.

2. Effects on output & employment

When inflation is very low i.e. creeping inflation, it increases
output of economy as well as the level of employment. Thus
creeping inflation is considered to be good. But when there is full
employment in the economy, the inflation may rise significantly
and it does not increase output as well as level of employment in
the economy. Thus higher rate of inflation is harmful for the
economy.

3. Effects on economic growth

If the rate of inflation is very low, in such situation, with increase
in inflation, level of output, employment and income increases.
Thus there will be higher economic growth. Bu when there is full
employment in the economy, with inflation, employment many
not rise, sometimes even employment level may fall. Thus the
possibility of economy growth is low during hyperinflation.
4. Effects on distribution
Inflation affects the income distribution among the different
classes of people. Normally fixed income group who earns
interest, rent, pension, wages & salaries, etc will lose during
inflation. On the other hand, entrepreneurs, traders, investors,
farmers, etc earns more during the inflation. The effect of
inflation on different classes of people in the economy has been
explained below:
a) Fixed income group – People who live on past saving, pension,
interest, rent, etc will severely affected by inflation as their
income cannot be revised, even though there is inflation.
b) Debtors & Creditors (Payer & Payment Receiver)– Debtors pay
the price of goods and services or money in the pre agreed
price using the currency, whose value has decreased due to
inflation. Thus they gain due to inflation. But, creditors receive
the payment in pre-agreed price and in terms of the currency,
value of which have been decreased due to inflation. Thus,
creditors lose during the inflation.
c) Wages & Salaries earners - Since wages and salary earners
cannot revise their wages and salaries as soon as inflation
occurs in the economy. There is significant time lag between
inflation and salary revision in most of the economies and it
hurts the labour class severely. Even though the labour union
raises the salary time to time, they cannot make the time lag
nil. Further, the labours without union cannot revise their
wages and salaries on time.
d) Entrepreneurs & Traders – They earn more during inflation as
they will be able to sell their products at higher price with more
profit margins. So they earn more during the inflation.
e) Investors – Investors are of two types; one category of
investors invest in bonds & securities with fixed rate of return.
Such investors lose during inflation as the rate of return cannot
be revised even after inflation occurs. But other investors who
invest in businesses, and shares will be earning more during
the inflation as the rate of dividend will be high due to rise in
price.
f) Farmers – In general, farmers will be also able to sell their
products at higher price as inflation occurs. But their cost of
production will not be increased. So, they earn more during the
inflation. But the farmers, who do not own land are again the
labours in agriculture and they earn only wages and are
severely hurt due to inflation.
Non-Economic Effects
a) Social Effects – Inflation affects the re-distribution of income in
the society. It makes some richer segment of people richer and
poorer segment of people poorer. Thus inequality increases
inequality in the society.
b) Moral effects – Producers and suppliers do not maintain
quality in their products as demand is relatively higher than
supply of the goods in inflationary economy. Also as the price is
rising day by day during the inflation, hoarding increases
among the traders and producers to sell them in further higher
price by creating artificial shortage/scarcity.
c) Political effects – When there is hyperinflation/ high rate of
inflation, it disrupts political system. Corruption may increase
and ultimately the political system fails. As result, political
instability is created.
Anti-Inflationary Measures / Measures to Control Inflation
Since inflation has severe effect in the economy, it should be
controlled. Normally, inflation arises due to excessive supply of
money, higher expenditure of public and private sectors and due
to relatively higher demand than supply. So, anti-inflationary
measures include the control measures to supply of money,
control measures of expenditure and maintaining balance
between demand and supply. So, anti-inflationary measures are
divided into following four categories:
A. Monetary Measures
Monetary measures are introduced through monetary policy
by central bank of the economy. Following are the major tools
used in controlling money supply:
a) Increase in Bank Rate – Bank rate refer to the interest rate
charged by the central bank while lending to the all the
banks and financial institutions(BFIs) in the market. Banks
borrow more from central bank, when the bank rate is low
and more when the bank rate is low. Thus, by controlling the
bank rate, supply of money with BFIs in the market can be
controlled by central bank.
b) Open Market Operation – When central bank sells securities
and development bonds in the market, individuals and BFIs
purchases these securities and bonds, which reduces the
deposits of BFIs. It helps to control money supply. If the
money supply is to be increased in the economy, the central
bank purchases these securities and bonds from the market.
c) Increase in Cash Reserve – Cash reserve refers to the
minimum amount of money deposited by banks from the
deposit accepted by them. If the cash reserve ratio is
increased by central bank, more cash is to be deposited at
 central bank and it reduces the supply of money from banks.
If the ration is decreased, then the amount of money to be
deposited at central bank by banks decrease. It increases the
supply of money in the market. At present CRR to be
maintained by be commercial banks in Nepal is 3.5%.
d) Consumer Credit Control - Normally, consumers borrow for
buying durables in installments. Consumer credit increase
the purchasing power of consumers. When there is inflation
in economy, central bank issues directives to the banks to
control such loans. For example, NRB has directed to provide
one home loan only for a family, an individual can take
personal loan only up to Rs 5.0 million only, etc. These
controls the consumer credit.
e) Higher margin requirements – Margin requirement is the
difference between the market value of an asset and
maximum loan that can be provided against that asset. If
the margin is increased, the borrower has to spend more
and borrow less to buy an asset. In such a situation, credit
will be controlled. For Eg: NRB has set the margin
requirements of 50% for Auto Loan and 50% for real estate
loan at present.

B. Fiscal Measures - Fiscal measures are introduced in the form

of fiscal policy or budget of the economy. The major fiscal tools
are as described below:
a) Reduction in public expenditure – Non-development
expenditures or unproductive expenditures should be
reduced.
b) Increase in taxation – direct tax & indirect taxes such as
sales tax, custom duty and VAT etc…..
 c) Public borrowing – voluntary / forceful borrowing from the
people by government …….
d) Control of deficit financing – Revenue collection is less that
he planned expenditure of government then it is called
deficit budget. New notes can be issued for deficit financing,
which significantly increases the rate of inflation. ………
e) Debt Management -

C. Direct Control of Price

a) Direct control on price
b) Rationing – Quota

D. Other Measure (Time taking measures)

a) Expansion of output – Excess demand over supply creates
inflation, so by increasing level of output, demand can be
met, thus chances of inflation can be avoided. Specially,
focusing in increasing the output such as food, clothes, and
other basic needs may help more in controlling inflation.
b) Proper Wage policy – Proper wage policy can help to control
cost push inflation that may result from wage rate. Proper
wage policy refers to the rate of wage which is just equal to
the value of marginal productivity of the labour. If the labour
are paid above the value of marginal productivity, it
increases the purchasing power above the total goods and
services produced in the economy resulting inflation. Thus
wage rate should not be above the value of productivity of
the labour.
c) Encouragement of saving - If the individuals save more, the
portion of disposable expenditure decreases resulting fall in
 demand of goods and services. As a result, inflationary
pressure in the economy decreases.
d) Overvaluation – In order to control inflation, government
can also appreciate the value of domestic currency. It can
help in controlling inflation in following ways:
i) It has discouraging effects on exports and thus the
availability of goods and services in domestic market
increases.
ii) It has encouraging effects in imports and thus add to the
domestic stock of goods and services.
iii) It has controlling effects of upward cost-price spiral by
reducing the prices of foreign raw materials needed in
domestic production.
Inflation & Unemployment – The Philips Curve
The graphical expression of relationship between percentage change in
price level (inflation) and percentage change in level of unemployment
in the economy is called Philips curve. This concept was developed by
A.W. Philips in 1958. According to him there is negative and non-linear
relationship between rate of inflation and unemployment rate. That
means, with rise in inflation, unemployment rate falls and vice versa as
illustrated in the graph below:
In the above graph, when rate
of inflation is i3, rate of
unemployment is u1. When the
rate of inflation falls to i2 and
then to i1, the rate of
unemployment increases to u2 and u3 respectively. Thus it shows that
there is negative and non-linear relationship between rate of inflation
and unemployment.

Concept of Stagflation
Normally, when the rate of inflation increases, unemployment falls.
But, some times when there is supply shock in factors of production,
rises in inflation and rise in unemployment exists at the same time and
it is called stagflation. Such situations were observed in USA and some
other developed countries like Britain, Germany and France during
1973-75 AD. It was due to supply shock of petroleum oil and rise in
price by four fold. Which was also repeated due to similar reason in
1979 as well. During stagflation, inflation occurs but real GDP falls.
Causes:
a) Restriction in labour supply –Normally when labour union
increases the wage rate significantly higher or government set the
minimum wage rate at higher side, producers produce less and
employs less labour. Due to less production price may rise. Thus
stagflation occurs.
b) Indirect taxes – When government increase indirect taxes
significantly, cost of doing businesses increase, which discourages
the producers to produce more. Thus the producers cut job and
shortage of goods takes place. As a result, stagflation occurs.
c) External Factors – When production is based on raw materials
imported for other economies, the inflation outside the economy
will be brought to the economy. It also results rise in price in
domestic market and may discourage production. Thus,
stagflation occurs.
Deflation – It is opposite in nature to the inflation. During deflation,
price level significantly falls and value of money rises. According to
Growther, “Deflation is that state of the economy where the value of
money is rising or the prices are falling.” It may be the result of
overproduction, unemployment, and fall in economic activity.
Causes of Deflation
a) Reduction in money supply and bank credit –
b) Sudden increase in output –
c) Increase in taxes –
d) Reduction in government expenditure –
e) Public borrowing –
f) Less investment expenditure –
g) Decrease in MEC
Scarcity of labour and capital increase the respective cost
resulting fall in MEC.
Output when expands abundantly, due to competition in selling
theses goods, price falls as a results, MEC also falls.
h) Increase in interest rate –

Nature of Inflation in Nepal

Nepal is one of the developing country. The factors that affects the
inflation in developed country and developing country differs.
Sometimes the cause and remedies also differs. Nepal’s economy is
characterized by fragmented markets, market imperfection, immobility
of factors of production, wage rigidities, disguised unemployment,
underemployment, sectorial imbalances with surplus in some sectors
and scarcity in some other sectors.
If we go through the rate of inflation in the history of Nepalese
economy, highest rate of inflation (double digit inflation) were
recorded during FY 1993/94 and 2008/09 respectively 12.8% and 12.
6%. Whereas the rate was lowest during the FY 2017/18 and it was
4.2%.
Thus nature of inflation in Nepal can be summarized as below:
 Inflation in Nepal is cost push as well as demand pull inflation.
 Inflation in Nepal heavily depends in inflation in India, as 65% of
our import is comes from India. Further NC and IC are pegged and
exchange rate is not adjusted immediately.
 One of the major factor of increasing demand in Nepal is
remittance inflow due to foreign employment. Other factors are
increasing government expenditure, deficit financing,
expansionary monetary policy, occasional shortage of vegetables
time to time.
 Major means of transportation and manufacturing are based on
petroleum products and the price of petroleum products are
gradually increasing. As a result, there is chances of cost push
inflation in Nepal every year.
 Since highest rate of inflation is 12.8% and lowest is 4.2%, the
type of inflation in Nepal is walking inflation and running
inflation. Nepal has not ever experienced creeping inflation and
hyperinflation.
Causes of Inflation in Nepal
1. Increase in government expenditure –
2. Exchange Rate –
3. Cheap monetary policy –
4. Deficit financing –
5. Black money –
 6. Expansion of private sectors –
7. Increase in wages –
8. Shortage of factors of production –
9. Increase in profit margin –
10. Natural calamities –
11. Influence of Indian inflation –
12. International factors –

Effects of Inflation in Nepal

Numerical –
2. GNP Deflator = Nominal GNP/Real GNP x 100

GDP Deflator = 120

GDP Deflator of previous Year - 100
Rate of inflation = Change in GDP Deflator/ GNP Deflator of Previous
Year x 100%
= (120 -100)/100 x 100= 20%

2. b) Difference between GDP of any two years give the change in

price index, which can be used to calculation of inflation rate.
Therefore, the change in GDP deflator from 2017 to 2021 is 8.9. it
means in average the price level (inflation) has been changed by
8.9(Rate of inflation = 8.9/102.65 x 100% = 8.67%)
c)
Rate of inflation = 8.9/102.65 x 100% = 8.67%
Therefore, over the period from 2017 to 2021, the total inflation is
8.67%.

3.
Index Number = Nominal /Real
Real GNP = Nominal GNP/ Index Number x 100
Year Nominal Wholesale Real GNP GNP Rate of
GNP (BIO) PIN Deflator Inflation
2018-19 54,195 228.1 23,579.31
2019-20 61,583 251 24,535.05

5.
Items Weights Price in Price in P = P1/P0 x pw
(w) 20202 (P0) 2021 (P1) 100

Food 50 150 180 120 6000

Rent 15 50 70 140 2100
Clothing 5 100 150 150 750
Fuel 10 20 40 200 2000
Misc. 20 60 120 200 4000
w = 100 pw =
14,850

CPI in 2021 = pw/w = 14850 / 100 = 148.50

Change in consumer price index number = 148.50 – 100 = 48.50
26. Central bank controls inflationary pressure during the economic
prosperity by controlling the supply of money. Supply of money can be
controlled by increasing CRR, by increasing margin in lending, by
controlling credit directly in specific sectors, by open market operation.