|
Explain Causes of Inflation OCR (10)
Inflation occurs when there is a continuous increase in the general price level as measured by the RPI. Inflation could be caused by excess AD in the economy. If AD increases at a faster rate than AS the Price Level will increase.
Diagram Demand Pull inflation
AD is composed of C+I+G+X-M. Therefore, an increase in any of these will lead to inflation. For example, if the govt cut interests rates then there would be a fall in the cost of borrowing encouraging people to spend more and save less.. Also, if consumer confidence was high or income taxes cut then this would also encourage spending.
If the economy is close to full capacity and the LRAS is inelastic then an increase in AD will cause a lot of inflation.
Demand-pull inflation occurred in the 1980s because monetary policy was loose and there was a rise in consumer confidence caused by a property boom and lower taxes
Inflation can also occur if the AS shifts to the left, this is known as cost-push inflation. This could occur due to various reasons:
Firstly if there was an increase in labour costs for firms, this is a significant cost so higher wages often cause inflation. (also AD will increase with higher wages)
Secondly, an increase in the price of raw materials will be very important, for example if the price of oil increases transport costs will increase and therefore inflation will increase. This occurred in the 1970s when OPEC tripled the price of oil.
If there was a decline in productivity, then AS would shift to the left; for example if workers became lazy.
Diagram Cost Push Inflation
It is often argued that a devaluation will cause inflation because imports become more expensive and there is less incentive for firms to cut costs (this is because the devaluation makes exports cheaper therefore firms can be more profitable with less effort)
I