Previous Year Question

The question uses the expression “may be caused by.” It does not suggest that prices must rise under every circumstance. It means that, other things remaining unchanged, each of the three developments can create upward pressure on the general price level.

Statement 1 is correct. If money supply increases without a corresponding increase in the production of goods and services, the spending capacity of households and institutions may rise. More money may then compete for a relatively limited quantity of goods and services, increasing aggregate demand and prices.

However, every increase in money supply does not automatically produce immediate inflation. Its effect also depends on factors such as the velocity of money, demand for credit, productive capacity and the amount of spare capacity in the economy.

Statement 2 is correct. A decline in aggregate output reduces the availability of goods and services. If demand remains unchanged, the reduced supply relative to demand can raise prices.

Aggregate output may decline because of:

• Higher input or energy costs

• Crop failure

• Supply-chain disruptions

• Natural disasters

• Reduction in productive capacity or labour supply

Such conditions are generally associated with supply-side or cost-push inflationary pressures.

Statement 3 is correct. Effective demand refers to demand backed by actual purchasing power. When aggregate demand rises faster than the economy’s productive capacity because of higher consumption, investment, government expenditure or net exports, the general price level may increase. This is known as demand-pull inflation.

Thus, an increase in money supply, a decrease in aggregate output and an increase in effective demand can all cause a rise in the general price level.