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Causes of Inflation

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, workers can get higher wages which increases their
spending power.
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.
2. Cost Push Inflation

If there is an increase in the costs of firms, then firms 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 common 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 a 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 in 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.

CPI-CT is less volatile because it ignores the effect of taxes. In 2010, some of the UK
CPI inflation was due to rising taxes.
What else could cause inflation?

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
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 dont increase lending but just keep more bank
reserves.
Inflation expectations

Once inflation sets in it is difficult to reduce it For example, higher prices will cause workers to
demand higher wages causing a wage price spiral. Therefore, expectations of inflation is
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