Readers Question: How does an increase in imports cause inflation in the economy?
If the quantity of imports increases, this will reduce domestic demand pull inflation (AD = C+I+G+X-M). So a rise in import spending, ceteris paribus, reduces consumer spending on domestic goods and so reduces domestic inflationary pressure.
However, often a rise in imports occurs because there is a rise in general spending, and the rise in imports reflects the inflationary pressure in the economy.
The other effect is that a rise in imports will ceteris paribus, cause a depreciation in the exchange rate. This is because domestic firms supply more pounds to be able to buy foreign imports. This rise in the supply of sterling causes a depreciation in the pound.
A depreciation in the exchange rate tends to increase inflationary pressure because:
- Imports become more expensive
- Exports and AD increase causing demand pull inflation
- firms may have less incentive to cut costs
It is one of those issues where it is impossible to say with certainty exactly what will happen. It depends which effect is bigger – reduction in AD or depreciation in exchange rate. Overall, I would imagine the impact on inflation of higher imports to be negligible.
It’s a bit like saying how does higher interest rates effect current account deficit?
- Higher interest rates increase exchange rate worsening current account
- But, on other hand, higher interest rates reduce consumer spending, reduce imports and improve the current account.