The Causes of Inflation

There are different factors that may cause demand, although three causes of inflation are demand-pull inflation, cost-push inflation and monetary inflation.

Inflation could result in an increase in national income (GDP) and/or an increase in wages/income.

Aggregate demand is the total demand in an economy and when aggregate demand increases it causes inflation to increase GDP. Aggregate demand includes consumption by consumers, investments by firms, government expenditures by the government as well as exports-imports (imports don’t count as they represent demand for foreign goods)

Demand-Pull Inflation 

Keynesians believe that inflation can be caused by too much demand in an economy, this is called demand-pull inflation

According to the law of demand, when there is an ↑ in Demand → ↑ in Price.

∴ when there is an ↑ in Aggregate Demand there is an ↑ in General Price Level which causes inflation.

Demand-pull inflation can be caused by:

• Rising consumer spending fueled by tax cuts or low interest rates
• An increase in government spending
• Rising demand for resources by firms
• Demand for exports

Cost-push inflation

Cost-push inflation is a Keynesian theory where costs in an businesses rises and causes inflation.

When businesses experience rising business costs they increase price in order to maintain their profit margins.

∴ due to the increase in price, inflation may occur.

For example;

A retailer buys goods from a supplier for £10 per unit. The retailer then adds 10 percent of the cost to get the selling price. This is £11 (£10 + 10% X £10). If the cost of this product from the supplier rises to £12, the new pice will be £13.20 (£12 + 10% X £12). The price of the product has been increased by the retailer from £11 to £13.20 because costs have risen. If the retailer did not increase the price when cost rose, profits would be reduced

Cost-push inflation can be caused by:

• Rising costs in commodities such as oil, steel, etc.
• Increase in wages
  • Employers may increase price in order to maintain their profit margin
• Higher indirect taxes from the government
  • Entrepreneurs can decided whether or not to pass on burden to the consumers in order to maintain their profit margin as raising prices can mean higher profit.
  • When a firm has monopoly power and decides to raise the prices in order to increase their profit

Monetary Inflation

Unlike Cost-push and demand-pull inflation, monetary inflation isn’t a Keynesian theory but instead is a theory followed by monetarists. When a country/economy experiences a sustained increase in money supply, it may result in inflation and that is called monetary inflation.

Monetary inflation is occurs when households, firms and governments borrow money to fund extra spending. As a result, the money supply increases as there are more bank deposits. This creates inflation because the extra money lent to the different parties causes demand to increase and prices to rise as well.

Introduction to Inflation

Inflation can be measured using CPI (consumer price index) or RPI (retail price index). CPI/RPI takes into account the size of an average family, their average income as well as what they buy (e.g. basic commodities) . They compare the prices of these basic commodities to previous years and determine the rate of inflation from there.

Inflation is when there is a general and sustained increase in the price of goods and services in an economy over a given period of time. Governments aim to keep inflation at a relatively stable rate and the target range for the rate of inflation is generally 0%-2%.

Deflation is the opposite of inflation where there is a general and sustained fall instead of increase.

Disinflation is when fall/slow down in inflation, prices may be increasing but at a slower rate.

The difference between deflation and disinflation is that disinflation is inflation is at a lower rate. Prices will still continue to rise but at a slower rate. While deflation means that prices aren’t increasing at all and are continuously decreasing.

Prices are generally increasing rather than decreasing thus meaning that inflation is more common than deflation. When average price levels increase, buying power decreases.

Inflation affects different people in different ways, for example;

• people with fixed incomes (e.g. those with pensions) are hurt as income stays the same while spending power decreases due to an increase in price.
• Inflation would help borrowers as with inflation, their wages and incomes will increase but their debt would remain the same. They will pay back money that will buy less than it did when they borrowed it.
• Lenders are hurt by inflation since they get payed back with lower valued money.
  • In order to avoid being payed back lower valued money, lenders estimate inflation rates during the time of the loan and set interest rates accordingly.
• Savers are hurt by inflation since their savings are worth less.

As mentioned before, deflation is the opposite of inflation so it would affect people in opposite ways. For example, people with fixed incomes would be helped by deflation as their income stays the same while the prices are decreasing so spending power increases.

Chapter 32: Key Words

Inflation – a general and sustained increase in the price of goods and services in an economy over a given period of time.

Deflation – a general and sustained decrease/fall in the price of goods and services in an economy over a given period of time after inflation drops below 0%.

Disinflation – when there is a fall/slow down in inflation, prices may be increasing but at a slower rate.

Hyperinflation – Very high inflation that often leads to money being useless/worthless

CPI – Consumer Price Index

RPI – Retail Price Index

Aggregate demand – Total demand in an economy

Aggregate Demand = C (consumer) + I (investments) + G (gov.) + (X-M) (exports – imports) 

Aggregate supply – Total supply in an economy

Demand-pull inflation – When inflation occurs due to excessive demand in an economy in relation to its supply

Cost-push inflation – When inflation is caused by increasing business costs

Monetary Inflation – When inflation occurs due to a sustained increase in the money supply

Monetarist – an advocate of the theory that fluctuations in the economy are linked to changes in the money supply

Inflationary Pressure –

Imported Inflation – When inflation occurs due to a rise in import costs following a fall in the value of the exchange rates of the importing country’s currency