Classical theory of Inflation:-
This approach was one of the earliest approaches to explain inflation and is a quantity theory to explain inflation. This can explain long run inflation rate effectively.
Some important points of this theory are:
1) Level of prices and value of money:- As the prices of goods and services rise the value of money decreases i.e. the buying capacity of each unit of currency decreases. The prices have increased by many times during the last twenty years. But the general level of demand of any good has remained more or less the same. This means much more amount is spent now as compared to earlier days to obtain the same satisfaction. This indicates the decrease in value of money.
2)Effects of Monetary injection:- If money is injected into an economy by the central bank or the concerning monetary authority the value of money decreases. Some amount of money injected into an economy, means the money supply curve is shifted towards the right and results in decrease in value of money as shown.
3) Equilibrium is achieved:- After the inflation a new equilibrium is reached and the value of money stays at that equilibrium. After monetary injection into an economy, people tend to spend the excess money to buy goods and services. This creates a demand for the goods and services, which in turn raises the prices of goods. The prices rise to an extent where the demand of the goods and services becomes the same as the demand before inflation. The net effect is that both, the money possessed by an individual, and the prices of goods which he can buy increase proportionately such that the real value of goods which he can buy remains same.
Crux of the Argument:-
An insight into the causes of inflation shows that, the economy’s ability to produce goods and services has not changed. The real variables such as capital, labor, technology etc. remain same even after injection of money. Only the value of money changes. It is like a hypothetical agreement that every economic agent has agreed upon to follow which says: ‘from now on the value of the currency has decreased by 1.96% (say), so everyone pay 2%more for every thing and receive 2%more income’.
Other articles related to Inflation:
Inflation and its theories
Types of Inflation
Measures of Inflation
Role of Inflation
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