Inflation

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ECONOMICS PROJECT

ON

INFLATION

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INTRODUCTION

Inflation can be defined as, a rise in the general


price level and therefore a fall in the value of
money. Inflation occurs when the quantity of buying
is higher than the output of goods and services.
Inflation also occurs when the value of money
exceeds the value of goods and services available.
The fall in the value of money will affect the
functions of money depends on the degree of the
fall. Basically, it refers to an increase in the supply of
currency or credit, relative to the availability of
goods and services, resulting in higher prices.
Therefore, inflation can be measured in terms of
percentage. The percentage increase in the price
index, as a rate percent per unit of time, which is
usually in years. The two basic price indexes are
used when measuring inflation, the producer price
index (PPI) and the consumer price index (CPI)
which is also known as the cost of
living index number.

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HOW INFLATION IS MEASURED?

Inflation is normally given as a percentage and generally


in years or in some instances quarterly and is derived
from the Consumer Price Index (CPI). However, there are
two main indices used to measure inflation. The first is
the Consumer Price Index, or the CPI. The CPI is a
measure of the price of a set group of goods and
services. The "bundle," as the group is known, contains
items such as food, clothing, gasoline, and even
computers. The amount of inflation is measured by the
change in the cost of the bundle: if it costs 5% more to
purchase the bundle than it did one year before, there
has been a 5% annual rate of inflation over that period
based onthe CPI. You will also often hear about the "Core
Rate" or the "Core CPI." There are certain items in the
bundle used to measure the CPI that are extremely
volatile, such as gasoline prices.

By limitation of the items that can significantly affect the


cost of the bundle (in either direction) on a month-to-
3
month basis, the Corerate is thought to be a better
indicator of real inflation, the slow, but steady increase in
the price of goods and services.

The second measure of inflation is the Producer Price


Index, or the PPI. While the CPI indicates the change in
the purchasing power of a consumer, the PPI measures
the change in the purchasing power of the producers of
those goods. The PPI measures how much producers of
products are getting on the wholesale level, i.e. the
price at which a good is sold to other businesses before
the good is sold to a consumer. The PPI actually
combines a series of smaller indices that cross many
industries and measure the prices for three types of
goods: crude, intermediate and finished.

Generally, the markets are most concerned with the


finished goods because these are a strong indicator of
what will happen with future CPI reports. The CPI is a
more popular measure of inflation than the PPI, but
investors watch both closely.

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TYPES OF INFLATION

Subsequently, when
either the prices of
goods or services or the
supply of money rises;
this is considered as inflation. Depending on the
characteristics and the intensity of inflation, there are
several types, namely.

- Creeping inflation
- Trotting inflation
- Galloping inflation
- Hyper inflation

When there is a general rise in prices at very low rates,


which is usually between 2-4 percent annually, this is
known as creeping inflation.

Whereas, trotting inflation occurs when the percentage


has risen from 5 to almost percent. At this level it is a
warning signal formost governments to take measures to
avoid exceeding double-digit figures.

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Another type of inflation is the galloping inflation, where
the rate of inflation is increasing at a noticeable speed
and at a remarkablerate, usually from 10-20 percent.

However, when the inflation rate rises to over 20% it is


generally considered as hyper inflation and at this stage
it is almost uncontrollable because it increases more
rapidly in such a little time frame.

The main difference between the galloping and hyper


inflation, is that hyperinflation occurs when prices rise at
any moment and there is no level to which the prices
might rise. During World War II certain countries
experienced a hyperinflation, where the price index rose
from 1 to over 1,000,000,000 in Germany during January
1922 to November1923.

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CAUSES OF INFLATION
Inflation comes in different forms and those at are
familiar withthe economic matters would observe that
there are trends in theway that prices are moving
gradual and irregular in relation toaggregate sections of
the economy. This suggest that there ismore than one
factor that causes inflation and as differentsections of
the economy develop it gives rise to different types
inflationary periods. The main causes of inflation are:
- Demand-pull Inflation
- Cost push Inflation
- Monetary inflation
- Structural inflation
- Imported inflation

DEMAND-PULL INFLATION

Demand-pull inflation occurs


when the consumers,
businesses or the
governments’ demand for
goods and services exceed
the supply; therefore the
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cost of the item rises, unless supply is perfectly elastic.
Because we do not live in a perfect market supply is
somewhat inelastic and the supply of goods and services
can only be increased if the factors of production are
increased.
The increase in demand is created from increase in other
areas, such as the supply of money, the increase of
wages which would then give rise in disposable income,
and once the consumers have more disposal income this
would lead to aggregate spending. As result of the
aggregate spending there would also be an increase
in demand for exports and possible hoarding and
profiteering from producers. The excessive demand, the
prices of final goods and services would be forced to
increase and this increase gives rise to inflation.

COST-PUSH INFLATION

Cost-push inflation is caused by an increase in production


costs. Itis generally caused by an increase in wages or an
increase in the profit margins of the entrepreneurs.
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When wages are increased, it causes the business owner
to inturn increase the price of final goods and services
which would be passed onto the consumers and the
same consumers are also the employees. As a result of
the increase in prices for final goods and services the
employees realize that their income is insufficient to
meet their standard of living because the basic cost of
living has increased. The trade unions then act as the
mediator for the employees and negotiate better wages
and conditions of employment. If the negotiations are
successful and the employees are given the requested
wage increase this would further affect the prices of
goods and services and invariably affected.

On the other hand, when firms attempt to increase their


profit margins by making the prices more responsive to
supply of a good or service instead of the demand for
that said good or service.

This is usually done regardless to the state of the


economy. This can be seen in monopolistic economies
where the firm is the only supplier or by entrepreneurs
that are seeking a larger profit fortheir own self interests.

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MONETARY INFLATION

Monetary inflation occurs when there is an excessive


supply of money. It is understood that the government
increases the money supply faster than the quantity of
goods increases, which results in inflation. Interestingly
as the supply of goods increase the money supply has to
increase or else prices actually go own. When a dollar is
worth less because the supply of dollars has increased,
all businesses are forced to raise prices just to get the
same value for their
products.

STRUCTURAL INFLATION

Planned inflation that is


caused by a government's monetary policy is called
structural inflation. This type of inflation is not caused by
the excess of demand or supply but is built into an
economy due to the government’s monetary policy.In
developed countries they are characterized by a lack of
adequate resources like capital, foreign exchange, land
and infrastructure. Furthermore, over-population with
the majority depending on agriculture for their livelihood
means that there is a
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fragmentation of the land holdings. There are other
institutional factors like land-ownership, technological
backwardness and low rate of investment in agriculture.

These features are typical of the developing economies.


For example, in developing country where the majority
of the population live in the rural areas and depend
on agriculture and the government implements a new
industry, some people get employment outside the
agricultural
sector and
settle down in
urban areas.
Because there
might be an
unequal
distribution of
land ownership
and tenancy, technological backwardness and low rates
of investments in agriculture inclusive of inadequate
growth of the domestic supply of food
which corresponds with an increase in demand arising
from increasing urbanization and population prices
increase. Food being the key wage-good, an increase in
its price tends to raise other prices as well. Therefore,
some economists consider food prices to be the major
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factor, which leads to inflation in the developing
economies.

IMPORTED INFLATION

Another type of inflation is imported inflation. This


occurs when the inflation of goods and services from
foreign countries that are experiencing inflation are
imported and the increase in prices for that imported
good or service will directly affect the cost of living.
Another way imported inflation can add to our inflation
rate is when overseas firms increase their prices and we
pay more for our goods increasing our own inflation.

EFFECT OF INFLATION

Inflation can have positive and negative effects on an


economy. Negative effects of inflation include loss in
stability in the real value of money and other monetary
items over time; uncertainty about future inflation may
discourage investment and saving, and high inflation may
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lead to shortage of goods if consumers begin hoarding
out of concern that prices will increase in the future.
Positive effects include a mitigation of economic
recessions, and debt relief by reducing the real level of
debt. Most effects of inflation are negative, and can hurt
individuals and companies alike, below are a list of
negative and “positive” effects of inflation:

“NEGATIVE” EFFECTS OF INFLATION ARE:

 Hoarding (people will try to get rid of cash before it


is devalued, by hoarding food and other

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commodities creatingshortages of the hoarded
objects).
 Distortion of relative prices (usually the prices of
goods gohigher, especially the prices of
commodities).
 Increased risk - Higher uncertainties (uncertainties in
business always exist, but with inflation risks are
very high, because of the instability of prices).

 Income diffusion effect (which is basically an


operation of income redistribution).
 Existing creditors will be hurt (because the value of
the money they will receive from their borrowers
later will be lower than the money they gave
before).
 Fixed income recipients will be hurt (because while
inflation increases, their income doesn’t increase,
and therefore their income will have less value over
time).
 Increased consumption ratio at the early stages of
inflation (people will be consuming more because
money is more abundant and its value is not lowered
yet).
 Lowers national saving (when there is a high
inflation, saving money would mean watching your

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cash decrease in value day after day, so people tend
to spend the cash on something else).
 Illusions of making profits (companies will think they
weremaking profits while in reality they’re losing
money if they don’t take into consideration the
inflation rate when calculating profits).
 Causes an increase in tax bracket (people will be
taxed a higher percentage if their income increases
following an inflation increase).

 Causes mal-investment (in inflation times, the data


given about an investment is often deceptive and
unreliable, therefore causing losses in investments).
 Causes business cycles (many companies will have to
go outof business because of the losses they
incurred from inflationand its effects).
 Currency debasement (which lowers the value of a
currency,and sometimes cause a new currency to be
born).
 Rising prices of imports (if the currency is debased,
then it’s purchasing power in the international
market is lower).

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"POSITIVE" EFFECTS OF INFLATION ARE:

 It can benefit the inflators (those responsible for the


inflation)

 It be benefit early and first recipients of the inflated


money (because the negative effects of inflation are
not there yet).
 It can benefit the cartels (it benefits big cartels,
destroys small sellers, and can cause price control
set by the cartels for their own benefits).
-It might relatively benefit borrowers who will have
to pay thesame amount of money they borrowed (+
fixed interests), but the inflation could be higher
than the interests, therefore they will be paying less
money back. (example, you borrowed $1000 in 2005
with a 5% fixed interest rate and you paid it back in
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full in 2007, let’s suppose the inflation rate for 2005,
2006 and 2007 has been 15%, you were charged 5%
of interests, but in reality, you were earning 10% of
interests, because 15% (inflation rate) – 5%
(interests) = 10% profit, which means you have paid
only 70% of the real value in the 3 years.

Note: Banks are aware of this problem, and when


inflation rises, their interest rates might rise as well. So
don't take out loans based on this information.

Many economists favor a low steady rate of inflation, low


(as opposed to zero or negative) inflation may reduce the
severity of economic recessions by enabling the labor
market to adjust more quickly in a downturn, and
reducing the risk that a liquidity trap prevents monetary
policy from stabilizing the economy. The task of keeping
the rate of inflation low and stable is usually given to
monetary authorities. Generally, these monetary
authorities are the central banks that control the size of
the money supply through the setting of interest rates,
through open market operations, and through the setting
of banking reserve requirements.

Tobin effect argues that: a moderate level of inflation can


increase investment in an economy leading to faster
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growth or at least higher steady state level of income.
This is due to the fact that inflation lowers the return on
monetary assets relative to real assets, such as physical
capital. To avoid inflation, investors would switch from
holding their assets as money (or a similar, susceptible to
inflation, form) to investing in real capital projects.

The first three effects are only positive to a few elite, and
therefore might not be considered positive by the
general public.

METHODS TO CONTROL INFLATION

A high inflation rate is undesirable because it has


negative consequences. However, the remedy for such
inflation depends on the cause. Therefore, government
must diagnose its causes before implementing policies.

MONETARY POLICY

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Inflation is primarily a monetary phenomenon. Hence,
the most logical solution to check inflation is to check the
flow of money supply by devising appropriate monetary
policy and carefully implementing such measures. To
control inflation, it is necessary to control total
expenditures because under conditions of full
employment, increase in total expenditures will be
reflected in ageneral rise in prices, that is, inflation.
Monetary policy is used to control inflation and is based
on the assumption that a rise in prices is due to excess of
monetary demand for goods and services by the
consumers/households because easy bank credit
is available to them. Monetary policy, thus, pertains to
banking and credit availability of loans to firms and
households, interest rates, public debt and its
management, and the monetary standard. Monetary
management is aimed at the commercial banking
systems, and through this action, its effects are primarily
felt in the economy as a whole. By directly affecting the
volume of cash reserves of the banks, can regulate the
supply of money and credit in the economy, thereby
influencing the structure of interest rates and the
availability of credit. Both these, factors affect the
components of aggregate demand and the flow of
expenditure in the economy.

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The central bank’s monetary management methods, the
devicesfor decreasing or increasing the supply of money
and credit for monetary stability is called monetary
policy. Central banks generally use the three quantitative
measures to control the volume of credit in an economy,
namely:
1. Raising bank rates
2. Open market operations and
3. Variable reserve ratio

However, there are various limitations on the effective


working of the quantitative measures of credit control
adopted by the central banks and, to that extent,
monetary measures to control inflationare weakened. In
fact, in controlling inflation moderate monetary
measures, by themselves, are relatively ineffective. On
the other hand, drastic monetary measures are not good
for the economic system because they may easily send
the economy into a decline.

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In a developing economy there is always an increasing
need for credit. Growth requires credit expansion but to
check inflationthere is need to contract credit. In such an
encounter, the best course is to resort to credit control,
restricting the flow of credit into the unproductive,
inflation-infected sectors and speculative activities, and
diversifying the flow of credit towards the most
desirable needs of productive and growth-inducing
sector.

It should be noted that the impression that the rate of


spending can be controlled rigorously by the contraction
of credit or money supply is wrong in the context of
modern economic societies. In modern community,
tangible, wealth is typically represented by claims in the
form of securities, bonds, etc., or near moneys, as they
are called. Such near money are highly liquid assets, and
they are very close to being money. They increase the
general liquidity of the economy. In these circumstances,
it is not sosimple to control the rate of spending or total
outlays merely by controlling the quantity of money.
Thus, there is no immediate and direct relationship
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between money supply and the price level,as is normally
conceived by the traditional quantity theories.
When there is inflation in an economy, monetary
restraints can, in conjunction with other measures, play a
useful role in controlling inflation.

FISCAL MEASURES

Fiscal policy is another type of budgetary policy in


relation to taxation, public borrowing, and public
expenditure. To curve the effects of inflation and changes
in the total expenditure, fiscal measures would have to
be implemented which involves an increase in taxation
and decrease in government spending. During
inflationary periods the government is supposed to
counteract an increase in private spending. It can be
cleared noted that during aperiod of full employment
inflation, the aggregate demand in relation to the limited
supply of goods and services is reduced to the extent
that government expenditures are shortened. Along with
public expenditure, governments must simultaneously
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increase taxes that would
effectively reduce private
expenditure,in an effect to
minimize inflationary pressures.
It is known that when more
taxes are imposed, the size of
the disposable income
diminishes, also the magnitude of the inflationary gap in
regardsto the availability of the supply of goods and
services.
In some instances, tax policy has been directed towards
restricting demand without restricting level of
production. For example, excise duties or sales tax on
various commodities may take away the buying power
from the consumer goods market without discouraging
the level of production. However, some economists point
out that this is not a correct way of combating inflation
because it may lead to a regressive status within the
economy.

As a result, this may lead to a further rise in prices of


goods and services, and inflation can spread from one
sector of the economy to another and from one type of
goods and services to another.Therefore, a reduction in
public expenditure, and an increase intaxes produces a

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cash surplus in the budget. Keynes, however, suggested a
programme of compulsory savings, such as deferred
pay as an anti-inflationary measure. Deferred pay
indicates that the consumer defers a part of his or her
wages by buying savings, bonds (which, of course, is a
sort of public borrowing), which are redeemable after a
particular period of time, this is some times called forced
savings. Additionally, private savings have a strong
disinflationary effect onthe economy and an increase in
these is an important measure for controlling inflation.
Government policy should therefore, include devices for
increasing savings. A strong savings drive reduces the
spendable income of the consumers, without any
harmful effects of any kind that are associated with
higher taxation. Furthermore, the effects of a large
deficit budget, which is mainly responsible for inflation,
can be partially offset by covering the deficit through
public borrowings. It should be noted that it is only
government borrowing from non-bank lenders that has a
disinflationary effect. In addition, public debt may be
managed in such a way that the supply of money in the
country may be controlled. The government should avoid
paying back and of its past loans during inflationary
periods, in order to prevent an increase in the circulation
of money. Anti-inflationary debt management also
includes cancellation of public debt held by the
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central bank out of a budgetary surplus.

Fiscal policy by itself may not be very effective in


combating inflation; therefore a combination of fiscal
and monetary tools can work together in achieving the
desired outcome.

DIRECT MEASURES OF CONTROL

Direct controls refer to the regulatory measure


undertaken to convert an open inflation into a repressed
one. Such regulatory measures involve the use of direct
control on prices and rationing of scarce goods. The
function of price controlis a fix a legal ceiling, beyond
which prices of particular goods may not increase. When
ceiling prices are fixed and enforced, it means prices are
not allowed to rise further and so, inflation is
suppressed. Under price control, producers cannot raise
the price beyond as specified level, even though there
may be a pressure of excessive demand forcing it up. For
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example, during wartimes, price controlwas used to
suppress inflation.

In times of the severe scarcity of certain goods,


particularly, food grains, government may have to
enforce rationing, along with price control. The main
function of rationing is to divert consumption from those
commodities whose supply needs to be restricted for
some special reasons; such as, to make the commodity
more available to a larger number of households.

Therefore, rationing becomes essential when necessities,


such as food grains, are relatively scarce. Rationing has
the effect of limiting the variety of quantity of goods
available for the good cause of price stability and
distributive impartiality. However, according to Keynes,

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“rationing involves a great deal of waste, both of
resources and of employment.”

Another control measure that was suggested is the


control of wages as it often becomes necessary in order
to stop a wage-price spiral. During galloping inflation, it
may be necessary to apply awage-profit freeze. Ceilings
on wages and profits keep down disposable income and,
therefore the total effective demand for goods and
services. On the other hand, restrictions on imports may
also help to increase supplies of essential commodities
and ease the inflationary pressure. However, this is
possible only to a limited extent, depending upon the
balance of payments situation. Similarly, exports may
also be reduced in an effort to increase the availability of
the domestic supply of essential commodities so
that inflation is eased. But a country with a deficit
balance of payments cannot dare to cut exports and
increase imports, because the remedy will be worse than
the disease itself.

In overpopulated countries like India, it is also essential


to check the growth of the population through an
effective family planning programme, because this will
help in reducing the increasing pressure on the general
demand for goods and services. Again, the supply of real
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goods should be increased by producing more.Without
increasing production, inflation just cannot be controlled.
Some economists have even suggested indexing in order
to minimize certain ill-effects of inflation. Indexing refers
to monetary corrections through periodic adjustments in
money incomes of the people and in the values of
financial assets such as savings deposits, which are held
by them in relation to the degrees of price rise. Basically,
if the annual price were to rise to 20%, the money
incomes and values of financial assets are enhanced by
20%, under the system of indexing.

Indexing also saves the government from public wrath


due to severe inflation persisting over a long period.
Critics, however, do not favor indexing, as it does not
cure inflation but rather itencourages living with
inflation. Therefore, it is a highlydiscretionary method.

In general, monetary and fiscal controls may be used to


repressexcess demand but direct controls can be more
useful when they are applied to specific scarcity areas. As
a result, anti-inflationary policies should involve varied
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programmes and cannot exclusively depend on a
particular type of measure only.

OTHER MONETARY PHENOMENA

In Keynes’ view, rising prices in all situations cannot be


termed as inflation. In a condition of under-employment,
when an increase in money supply and rising prices are
accompanied by the expansion of output and
employment, but when 1 here are bottlenecks in the
economy, an increase in money supply may cause cost
and pricesto rise more than the expansion of output and
employment. This may be termed as “semi-inflation” or
“reflation” till the ceiling of full employment is reached.
Once full employment level is reached, the entire
increase in money supply is reflected simply
by the rising prices - the real inflation.
Incidentally, Keynes mentions the following four related
terms while discussing the concept of inflation:
- Deflation
- Disinflation
- Reflation
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- Stagflation

DEFLATION
It is a condition of falling prices accompanied by a
decreasing level of employment, output and income.
Deflation is just the opposite of inflation. Deflation occurs
when the total expenditure of the community is not
equal to the existing prices. Consequently, the supply of
money decreases and as a result prices fall. Deflation can
also be brought about by direct contractions in spending,
either in the form of a reduction in
government spending, personal spending or investment
spending. Deflation has often had the side effect of
increasing unemployment in an economy, since the
process often leads to a lower level of demand in the
economy. However, each and every fall in price cannot
be called deflation. The process of reversing
inflation without either creating unemployment or
reducing outputis called disinflation and not deflation.
Therefore, some perceive deflation as under
employment phenomenon.

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DISINFLATION

When prices are falling due to anti-inflationary measures


adopted by the authorities, with no corresponding
decline in the existing level of employment, output and
income, the result of this is disinflation. When acute
inflation burdens an economy, disinflation is
implemented as a cure. Disinflation is said to take place
when deliberate attempts are made to curtail
expenditure of all sorts to lower prices and money
incomes for the benefit of the community.

REFLATION
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Reflation is a situation of rising prices, which is
deliberately undertaken to relieve a depression. Reflation
is a means of motivating the economy to produce. This is
achieved by increasing the supply of money or in some
instances reducing taxes, which is the opposite of
disinflation. Governments can use economic policies such
as reducing taxes, changing the supply of money or
adjusting the interest rates; which in turn motivates the
country to increase their output. The situation is
described assemi-inflation or reflation.

STAGFLATION

Stagflation is a stagnant economy that is combined with


inflation. Basically, when prices are increasing the
economy is decreasing. Some economists believe that
there are two main reasons for stagflation. Firstly,
stagflation can occur when an economy is slowed by an

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unfavorable supply, such as an increase in the price of oil
in an oil importing country, which tends to raise prices
at the same time that it slows the economy by making
production less profitable. In the 1970's inflation and
recession occurred indifferent economies at the same
time. Basically, what happened was that there was plenty
of liquidity in the system and people were spending
money as quickly as they got it because prices
were going up quickly. This gave rise to the second
reason for stagflation.

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