CDS (I) 2023 General Knowledge · Question 20 of 120

Correct — A, Rapid growth of aggregate demand outweighing supply. Inflation is a sustained rise in the general price level, and the simplest way to produce one is for buyers collectively to want more than the economy can supply at current prices. When aggregate demand grows faster than aggregate supply, the excess demand bids prices up across the board — the standard demand-pull account, and the one this option describes. Each of the other three works the other way: sluggish demand, a smaller money supply and higher unemployment all slacken the pressure on prices rather than raise it.

• (b)Sluggish growth of aggregate demand — The opposite condition. If demand grows slowly, sellers compete for buyers and price rises are hard to sustain; persistently weak demand is associated with disinflation or, in the extreme, with falling prices.
• (c)Reduction in the money supply — This is the classic anti-inflation measure, not a cause of inflation. Contracting the money supply raises interest rates and cools spending, which is exactly what a central bank does when prices are rising too fast.
• (d)Higher levels of unemployment — Higher unemployment normally goes with weaker wage pressure and weaker demand, so it is associated with lower inflation — the relationship the Phillips curve describes. Rising prices alongside rising unemployment is possible, but that is stagflation and comes from a supply shock rather than from unemployment itself.

Economists separate inflation by where the pressure originates. Demand-pull inflation comes from the buying side — households, firms, government and foreign buyers together wanting more output than the economy can produce, so that too much money chases too few goods. Cost-push inflation comes from the supply side, when the price of an essential input such as crude oil rises and producers pass the cost on. The two need different remedies, which is why the distinction matters: demand-pull inflation responds to tighter money and a tighter budget, while cost-push inflation is not cured by squeezing demand.

The item is close to a definition and the options are arranged so that three of them are the standard cures rather than causes. A quick way through any question of this shape is to ask which option would put more spending into the economy; only one does. It is worth carrying the exception with the rule. India's inflation episodes of the 2020s were not mainly demand-pull — the wholesale price surge of 2021 and 2022 came from crude oil, freight rates and supply-chain disruption, which is cost-push. The paper is asking which situation can lead to inflation, and excess demand certainly can, but a student should not conclude that all inflation is demand-side.

• Inflation is a sustained rise in the general price level, not a one-off increase in a single price.
• Demand-pull inflation arises when aggregate demand grows faster than aggregate supply.
• Cost-push inflation arises from a rise in input costs such as crude oil, wages or freight.
• Reducing the money supply is a standard central-bank response to inflation, not a cause of it.
• Stagflation is the awkward combination of slow growth with high inflation, and typically follows a supply shock.

• Reading a cure for inflation as a cause of it, which is what options (c) and (d) invite.
• Assuming all inflation is demand-driven and missing the supply-shock cases.
• Confusing inflation with a one-off rise in the price of a single commodity.

As a which-situation-causes-it item, as a definition item on demand-pull versus cost-push, or as an anti-inflation-measure item.

• practice — not a real PYQ

  A sharp rise in international crude oil prices feeding through into domestic prices is an example of

  • (a)demand-pull inflation
  • (b)cost-push inflation
  • (c)deflation
  • (d)disinflation

  Answer(b) cost-push inflation — the pressure comes from the cost of an input rather than from an excess of spending.

• practice — not a real PYQ

  Which one of the following is a measure that a central bank would normally take to curb inflation?

  • (a)Lowering the repo rate
  • (b)Raising the repo rate
  • (c)Reducing the cash reserve ratio
  • (d)Buying government securities in the open market

  Answer(b) Raising the repo rate — dearer credit slows borrowing and spending, easing the pressure on prices; the other three loosen conditions instead.