Inflation means there
is a sustained increase in the price level. The main causes of inflation are
either excess aggregate demand (economic growth too fast) or cost push factors
(supply-side factors).
1. Demand-pull
inflation: If the economy is at
or close to full employment, then an increase in AD leads to an increase in the
price level. As firms reach full capacity, they respond by putting up prices
leading to inflation. Also, near full employment with labour shortages, workers
can get higher wages which increase their spending power.
AD can increase due to an increase in any of
its components C+I+G+X-M. We tend to get demand-pull inflation if economic
growth is above the long-run
trend rate of growth. The long run trend
rate of economic growth is the average sustainable rate of growth and is
determined by the growth in productivity.
Example of demand-pull
inflation in the UK
In the 1980s, the UK
experienced rapid economic growth. The government cut interest rates and also
cut taxes. House prices rose by up to 30% fuelling a positive wealth effect and
a rise in consumer confidence. This increased confidence led to higher
spending, lower saving and an increase in borrowing. However, the rate of
economic growth reached 5% a year – well above the UK’s long run trend rate of
2.5 %. The result was a rise in inflation as firms could not meet demand. It
also led to a current account deficit. You can read more about this inflation
at the Lawson
Boom of the 1980s.
2. Cost-push inflation
If there is an increase in the costs of firms,
then businesses will pass this on to consumers. There will be a shift to the
left in the AS.
Cost-push inflation
can be caused by many factors
1. Rising wages: If
trades unions can present a united front then they can bargain for higher
wages. Rising wages are a key cause of cost push inflation because wages are
the most significant cost for many firms. (higher wages may also contribute to
rising demand)
2. Import prices: One
third of all goods are imported in the UK. If there is devaluation, then import
prices will become more expensive leading to an increase in inflation. A
devaluation / depreciation means the Pound is worth less. Therefore we have to
pay more to buy the same imported goods.
In 2011/12, the UK
experienced a rise in cost-push inflation, partly due to the depreciation of
the Pound against the Euro. (also due to higher taxes)
3. Raw material
prices: The best example is the price of oil. If the oil price increase by 20%
then this will have a significant impact on most goods in the economy and this
will lead to cost-push inflation. E.g., in early 2008, there was a spike in the
price of oil to over $150 causing a temporary rise in
inflation.
4. Profit push
inflation: When firms push up prices to get higher rates of inflation, this is
more likely to occur during strong economic growth.
5. Declining
productivity: If firms become less productive and allow costs to rise, this
invariably leads to higher prices.
6. Higher taxes: If
the government put up taxes, such as VAT and Excise duty, this will lead to
higher prices, and therefore CPI will increase. However, these tax rises are
likely to be one-off increases. There is even a measure of inflation (CPI-CT)
which ignores the effect of temporary tax rises/decreases.
7. Rising house
prices: Rising house prices do not directly cause inflation, but they can cause
a positive wealth effect and encourage consumer-led economic growth. This can
indirectly cause demand-pull inflation.
8. Printing more
money: If the Central Bank prints more money, you would expect to see a rise in
inflation. This is because the money supply plays an important role in
determining prices. If there is more money chasing the same amount of goods,
then prices will rise. Hyperinflation is usually caused by an extreme increase
in the money supply.
However, in
exceptional circumstances – such as liquidity trap/recession, it is possible to
increase the money supply without causing inflation. This is because, in
recession, an increase in the money supply may just be saved, e.g. banks don’t
increase lending but just keep more bank reserves.
9. Inflation expectations: Once inflation sets in it is
difficult to reduce inflation. For example, higher prices will cause workers to
demand higher wages causing a wage-price spiral. Therefore, expectations of
inflation are important. If people expect high inflation, it tends to be
self-serving.
The attitude of the
monetary authorities is important; for example, if there was an increase in AD
and the monetary authorities accommodated this by increasing the money supply
then there would be a rise in the price level.
Editor: Md. Mahbub Hussain
Associated by: Sumi Akther
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