As inflation is directly proportional with the aggregate demand in an economy and also the money supply, governments encourage a certain rate of inflation to prevail in an economy for gradual growth (Edwards, 1984).
Prior to setting up of a business or preparing the annual financial budget for the economy, inflation is always taken into account. Measures are taken to control inflation so as to leave room for investment, global competitiveness and local demand in the economy. Therefore, attaining price stability through controlled inflation has always been one of the major concerns for all economies (Hart, 2010).
Inflation is caused through various factors. It is however difficult to conclude as to what factor has precisely led to inflation and by how much. The forces of demand and supply and other factors concurrently result into inflation and the government has the tools of fiscal and monetary policy to control these factors simultaneously. The major causes of inflation can be because of a demand shocks, supply shocks, money supply and exchange rates, and future expectations (Mishkin, 1984):
Inflation is directly proportional to the aggregate demand in an economy. This is because, when the economy is at its growth stage, there are more employment opportunities. As more people are able to work, households’ incomes rise giving them more purchasing power. This causes a rise in the aggregate demand. As the aggregate demand curve moves to the left, the producers also have to increase their supply to exploit this rise in demand. As they increase their production/extend their supply, their costs of production increase which results into an increase in the price level. This Demand-pull inflation can be so intense that it can also cause a Stagflation where an economy reaches at a stagnant growth with high unemployment and high inflation rates. (Martin, 1985).
In contrast with Demand-Pull Inflation, Cost-Push Inflation is