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PROJECT REPORT ON

INFLATION

Submitted to: Submitted by:

Dr. Prabhat Kr. Pankaj Ajeet Yadav (FT-09-


709) Adarsh Tyagi (FT-09-
707 )
Monmee Das (FT-09- 773)
Omshyam (FT-09-789)

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Sandeep Yadav (FT-09-835)

CONTENTS

PARTICULARS PAGE

NUMBER

• Inflation 3

• How inflation is measured? 4

• Causes of inflation 7

• Effect of inflation 11

• Methods to control 15

• Other monetary phenomena 22

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1. INFLATION

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
amount of buying power is higher than the output of goods and
services. Inflation also occurs when the amount of money exceeds
the amount of goods and services available. As to whether the fall
in the value of money will affect the functions of money depends
on the degree of the fall. Basically, 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 percentages. The
percentage increase in the price index, as a rate per cent 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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2. 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 on
the 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
eliminating the items that can significantly affect the cost of the
bundle (in either direction) on a month-to-month basis, the Core
rate is thought to be a better indicator of real inflation, the slow,
but steady increase in the price of goods and services.

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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.

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

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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 for
most governments to take measures to avoid exceeding double-
digit figures.
Another type of inflation is the galloping inflation, where the rate
of inflation is increasing at a noticeable speed and at a remarkable
rate, 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.

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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 November
1923.

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3. CAUSES OF INFLATION
Inflation comes in different forms and those at are familiar with
the economic matters would observe that there are trends in the
way that prices are moving gradual and irregular in relation to
aggregate sections of the economy. This suggest that there is
more than one factor that causes inflation and as different
sections 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 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 in 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 a

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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. It
is generally caused by an increase in wages or an increase in the
profit margins of the entrepreneurs.
When wages are increased, this causes the business owner to in
turn 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 realise 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

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supplier or by entrepreneurs that are seeking a larger profit for
their own self interests.

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 down.
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
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

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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 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.

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4. 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 lead to shortages 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:

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NEGATIVE EFFECTS ARE:
 Hoarding (people will try to get rid of cash before it is
devalued, by hoarding food and other commodities creating
shortages of the hoarded objects).
 Distortion of relative prices (usually the prices of goods go
higher, 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 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 were
making profits while in reality they’re losing money if they

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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 out


of business because of the losses they incurred from inflation
and 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).

"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).

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 It might relatively benefit borrowers who will have to pay the
same 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 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 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

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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.

5. METHODS TO CONTROL

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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
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 a
general 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 e 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

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affect the components of aggregate demand and the flow of
expenditure in the economy.

The central bank’s monetary management methods, the devices


for 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 adapted by the central
banks and, to that extent, monetary measures to control inflation
are 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.

In a developing economy there is always an increasing need for


credit. Growth requires credit expansion but to check inflation,
there 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.

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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 moneys 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 so
simple to control the rate of spending or total outlays merely by
controlling the quantity of money. Thus, there is no immediate
and direct relationship 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 a
period of full employment inflation, the aggregate demand in

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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
increase taxes that would effectively reduce private expenditure,
in an effect to minimise 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 regards
to 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 in
taxes produces a 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

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redeemable after a particular period of time, this is sometimes
called forced savings.
Additionally, private savings have a strong disinflationary effect on
the 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 any 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
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

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Direct controls refer to the regulatory measures 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 control
is 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 a
specified level, even though there may be a pressure of excessive
demand forcing it up. For example, during wartimes, price control
was 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, “rationing involves a great deal of waste,
both of resources and of employment.”

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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 a
wage-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 goods should be increased by producing more.
Without increasing production, inflation just cannot be controlled.

Some economists have even suggested indexing in order to


minimise certain ill-effects of inflation. Indexing refers to monetary

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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 favour indexing, as it does not cure inflation but rather it
encourages living with inflation. Therefore, it is a highly
discretionary method.

In general, monetary and fiscal controls may be used to repress


excess 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 programmes and cannot exclusively
depend on a particular type of measure only.

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6. 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 when1here are bottlenecks in the
economy, an increase in money supply may cause cost and prices
to 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
− 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

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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 output
is called disinflation and not deflation. Therefore, some perceive
deflation as an underemployment phenomenon.

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
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

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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 as
semi-inflation or reflation.

STAGFLATION
Stagflation is a stagnant economy that is combined with inflation.
Basically, when prices are increasing the economy is deceasing.
Some economists believe that there are two main reasons for
stagflation. Firstly, stagflation can occur when an economy is
slowed by an unfavourable 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 in
different 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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