Causes of inflation
Inflation can be caused by a number of factors. Economists divide them into two main
groups, demand-pull and cost-push inflation.
Demand – pull inflation
Demand Pull inflation occurs when total demand for goods and services exceeds
total supply. This type of inflation happens when there has been excessive growth in
aggregate demand (particularly when the economy is at or approaching full
employment level).
Demand pull inflation can be illustrated graphically using aggregate demand and
aggregate supply analysis.
Demand –Pull Inflation
Caused by persistent shifts of
AD curve to the right.
Aggregate demand can increase
by a rise in one of the
components
of
demand;
consumption, ____________,
government spending or net
exports
At low levels of output when there is plenty of spare productive capacity, firms can easily
expand output to meet increases in demand, resulting in a relatively ____________
LRAS curve.
When aggregate demand (AD) increases from AD1 to AD2 the economy is still operating
at relatively low levels of capacity. Output can expand relatively easily with minimal
increases in average costs so firms will only implement small increases in prices from P1
to P2.
As the economy approaches full employment (or full capacity), labour and raw material
shortages mean that it becomes more difficult for firms to expand production to meet
rising demand. As a result, the LRAS curve becomes more ______________.
When aggregate demand increases from AD2 to AD3 the economy is moving towards the
_______ employment of factors of production. Shortages of factor inputs mean that the
firms' costs of production start to rise and many firms choose to increase price (P2 to P3)
to widen profit margins.
All economists (Keynesian and Classical) agree that once the country’s resources are
fully employed, an increase in aggregate demand must (and only) lead to an upward
movement of prices.
Main causes of increased aggregate demand:







A depreciation of the exchange rate increases the price of imports and reduces
the foreign price exports. If consumers buy fewer imports, while foreigners buy
more exports, then ______________ increases and AD in the economy will rise.
If the economy is already at full employment, it is hard to increase output and
prices are pulled upwards.
A reduction in direct or indirect taxation: If taxes are reduced consumers will
have more disposable income causing ______________ and therefore AD to rise.
A reduction in indirect taxes (taxes on goods and services such as VAT) will
mean that a given amount of income will now buy a greater real volume of goods
and services.
Rising consumer confidence and an increase in the rate of growth of house
prices (increases household ________) - both of which would lead to an increase
in total household demand for goods and services
Faster economic growth in other countries - providing a boost to exports
overseas. Remember that export sales provide an extra flow of income and
spending into the circular flow. Exports are counted as an ________________
into the circular flow.
Demand-pull inflation is often monetary in origin - because the authorities allow the
money supply to grow faster than the ability of the economy to supply goods and
services. The phrase that is often used is that there is "too much money chasing too few
goods"
Therefore the rapid growth of the money supply as a consequence of increased bank
borrowing if interest rates are _________ and consumer confidence is _________ ,is
often seen as a cause of inflation in its own right. Some economists believe that AD
increases solely, or mostly, because of an increase in the money supply. Such economists
are known as monetarists.
Cost-Push Inflation
In an open economy such as China, there are many potential sources of inflationary
pressure. Some come direct from the domestic economy, for example the decisions of
the major utility companies on their prices for the year ahead e.g. electricity suppliers, or
the pricing strategies of the leading food manufacturers based on cost changes and
competitive pressure in their markets.
But inflation can also come from external sources, for example a sudden rise in the cost
of crude oil or other imported commodities, foodstuffs and beverages. Fluctuations in the
exchange rate can also have a powerful effect on inflation in the short and medium term.
For now, we focus on the two main causes of cost and price inflation in an economy.
Cost push inflation occurs when firms increase prices to maintain or protect profit
margins after experiencing a rise in their costs of production. This can be shown by
an inward shift of the short run aggregate supply curve which leads to a contraction in
aggregate demand and a fall in ___________, but an increase in the general price level.
Price
Level
(GDP
Price
Deflator)
Cost –push inflation
A rise in factor prices shifts the SRAS curve to
the left from SRAS1 to SRAS2, thereby raising
the price level (P1 to P2) and reducing real
output (Y1 to Y2). For cost-push inflation to
continue aggregate supply must continue to
fall. So a supply side shock will simply lead to
an increase in the price level but this will not
be sustained- therefore- no inflation
Output (Real GDP)
The main causes of cost push inflation are:

Rising imported raw materials costs perhaps caused by inflation in other
countries or by a fall in the value of the local currency in the foreign exchange
markets

Rising labour costs - rising labour costs are caused by wage increases, which are
greater than productivity increases this, is especially important in industries,
which are labour-intensive.

Higher indirect taxes imposed by the government - for example a rise in the
specific duty on alcohol and cigarettes, an increase in fuel duties or a rise in the
standard rate of Value Added Tax. These taxes are levied on producers who,
depending on the price elasticity of demand and supply for their products can opt
to pass on the _____________ of the tax onto consumers.
Use the above diagram to answer the following questions:
1. What is happening output prices between 1990 and 1992?
2. What is happening input prices between 1996 and 1998?
3. Does the diagram support the theory that rising consumer prices are caused by
rising business costs?
Cost inflation is more likely when unemployment is falling to low levels. In these
circumstances there will be shortages of ________________ labour. This means that
businesses may have to offer higher pay to attract and retain their best workers when they
are looking to expand their output
Rising expectations of inflation can often be self-fulfilling. If people expect prices to
continue rising, they are unlikely to accept pay rises less than their expected inflation rate
because they want to protect the _________________________________ of their
incomes. For example a booming economy might see a rise in inflation from 3% to 5%
due to an excess of AD. Workers will seek to negotiate higher wages and there is then a
danger that this will trigger a ‘wage-price spiral’ as higher wages may cause consumption
levels to rise - further shifting out AD. (see below)
THE WAGE PRICE SPIRAL
LRAS
200
AD3
Price
Level 150
(GDP
Price
Deflator
)
SRAS2
SRAS1
100
50
AD2
AD1
0
100 200 300 400 500 600 700 800 900
Real GNY (billions of 1999 US$)
The initial rise in AD1 to AD2 causes a
temporary rise in real output but also a rise in
the________ ________. As a result, workers
will bargain for a wage increase and firms
experience rising costs. Therefore SRAS shifts
in from SRAS1 to SRAS2. Higher wages may
cause an increase in consumption levels as
households feel relatively well off- this causes
AD to shift out further to AD3- and the process
continues.