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 with labour shortages, workers can get higher wages which increases their spending power.
AD can increase due to an increase in any of its components C+I+G+X-M
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.
Example of demand pull inflation in the UK
In the 1980s, the UK experienced rapid economic growth. The government cut interest rates and also cut taxes. House prices rose by up to 30% fuelling a positive wealth effect and a rise in consumer confidence. This increased confidence led to higher spending, lower saving and an increase in borrowing. However, the rate of economic growth reached 5% a year – well above the UK’s long run trend rate of 2.5 %. The result was a rise in inflation as firms could not meet demand. It also led to a current account deficit. You can read more about this inflation at the Lawson Boom of the 1980s.
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.
What else could cause inflation?
1. 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.
2. 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 don’t increase lending but just keep more bank reserves.
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.