According to Keynesian, inflation can be caused by increase in demand and/or increase in cost.
Demand-pull inflation is a situation where aggregate demand persistently exceeds aggregate supply when the economy is near or at full employment. Aggregate demand could rise because of several reasons. A cut in personal income tax would increase disposable income and contribute to a rise in consumer expenditure. A reduction in the interest rate might encourage an increase in investment as well as lead to greater consumer spending on consumer durables. A rise in foreigners’ income may lead to an increase in exports of a country. An expansion of government spending financed by borrowing from the banking system under conditions of full employment is another cause of inflation.
An increase in demand can be met initially by utilising unemployed resources if these are available. Supply rises and the increase in demand will have little or no effect on the general price level at this point. If the total demand for goods and services continue to escalate, a full employment situation will eventually be reached and no further increases in output are possible. This leads to inflationary pressures in the economy.
Demand-pull inflation is caused by excess demand, which can originate from high exports, strong investment, rise in money supply or government financing its spending by borrowing. If firms are doing well, theey will increase their demand for factors of production. If the factor market is already facing full employment, input prices will rise. Firms may have to bid up wages to tempt workers away from their existing jobs.
It is most likely that during full employment conditions, the rise in wages will exceed any increase in productivity leading to higher costs. Firms will pass the higher costs to consumers in the form of higher prices. Workers will demand for higher wages and this will add fuel to aggregate demand, which increases once again. The process continues as prices in the product market and factor market are being pulled upwards.
Keynesian theory of cost-push inflation attributes the basic cause of inflation to supply side factors. This means that according to Keynesian, rising production costs will lead to inflation.
Cost-push inflation is usually regarded as being primarily a wage inflation process because wages usually constitute the greaer part of total costs. Powerful and militant trade unions who negotiate wage increases in excess of productivity are more likey to succeed in their wage claims the closer the…