How Does Economics Explain Inflation?

The pangs of inflation have been felt all around the world. In the US, the inflation rate was 7.7% in October 2022 and in India, it was 6.77%. The UK recorded its highest inflation rate at 11.1% in 41 years in 2022. After the Covid-19 pandemic, inflation has increased as a result of all the services re-opening but businesses not having the resources to provide the goods and services. But, let’s try to understand what is inflation.

What is inflation?

A price rise is considered inflation. It increases the cost of living in a country. By definition, inflation is the rise in prices during a given time period.

What are the factors behind inflation or price rises?

There are various reasons for price rises. Microeconomic theories like the law of demand, the law of supply, consumer preferences, cost of production, competition, and market condition are responsible for price rises. The book, Microeconomics Essentials You Always Wanted to Know deals with various microeconomic theories like demand, supply, consumer choice, the revenue of firms, cost of production, market, competition, etc. which are vital to understanding inflation in a country. The understanding of underlying reasons for inflation can help businesses and entrepreneurs take the right pricing decisions in an inflationary condition.

There are various reasons for price rises. Microeconomic theories like the law of demand, the law of supply, consumer preferences, cost of production, competition, and market condition are responsible for price rises. The book, Microeconomics Essentials You Always Wanted to Know deals with various microeconomic theories like demand, supply, consumer choice, the revenue of firms, cost of production, market, competition, etc. which are vital to understanding inflation in a country. The understanding of underlying reasons for inflation can help businesses and entrepreneurs take the right pricing decisions in an inflationary condition.

How do we explain these changes in price?

When we analyze the above situation, the price rise was due to the absence of workers in the production process. So, workers’ absence led to a short supply. In economics, we deal with the theory of supply and demand. If the demand increases, the price goes up. If the price goes up, demand falls. In case of an increase in supply, the price falls. Again, in case of an increase in price, suppliers are motivated to produce more and supply more. The price is dependent on the supply and demand of goods. There is a shift in consumer demand due to consumer preference and income level. It also shows how the production cost determines the supply of various materials. The production cost is determined by the prevailing wages, raw material cost, cost of electricity, and many other productions related factors”

When we analyze the above situation, the price rise was due to the absence of workers in the production process. So, workers’ absence led to a short supply. In economics, we deal with the theory of supply and demand. If the demand increases, the price goes up. If the price goes up, demand falls. In case of an increase in supply, the price falls. Again, in case of an increase in price, suppliers are motivated to produce more and supply more. The price is dependent on the supply and demand of goods. There is a shift in consumer demand due to consumer preference and income level. It also shows how the production cost determines the supply of various materials. The production cost is determined by the prevailing wages, raw material cost, cost of electricity, and many other productions related factors”

Steps taken to control inflation

Usually, the central bank in a country tries to taper the money flow in the economy to control inflation. When there is less money in the hands of the people, the demand for goods comes down, making the prices stable. However, this is not applicable when the inflation is due to supply-side constraints i.e. less production due to the unavailability of laborers or issues with the supply of raw materials. Sometimes, due to natural calamities, drought, etc. farm production may drop leading to price rises in food items.

Governments sometimes try to increase imports and curb exports to control inflation but economists do not find this sustainable.

About the Author 
Prof. Amlan Ray is currently Senior Director & Dean at SRISIIM, New Delhi, a management and research Institution recognized by the Ministry of Science & Technology and Ministry of Education, Government of India. He has 27 years of experience working in Corporates, Consulting, Training, and Academia.