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)

Main Cause of Inflation

 

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.

ad increase

AD can increase due to an increase in any of its components C+I+G+X-M

The link between output and inflation suggests that there will be a similar link between inflation and unemployment,

The Phillips curve initially showed a link between money wages and unemployment, it was then argued an increase in wages would lead to inflation

     
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.

costpush 

Cost push inflation can be caused by many factors

  1. The Labour Market

If trades unions can present a common front then they can bargain for higher wages, this will lead to wage inflation.

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

E.G. a German car costs DM 40,000. If the exchange rate is DM £1:3DM then it will be priced at £13,333.
If the E.R falls to £1 : 2DM then it will be priced at £20,000

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 rise in inflation.

           

4.    Profit Push Inflation

When firms push up prices to get higher rates of inflation.           

5.   Declining productivity

If firms become less productive and allow costs to rise, this invariably leads to higher prices.

Continuing Inflation

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.

The attitude of the monetary authorities is important for example if there was an increase in AD and the monetary authorities accomodated this by increasing the money supply then there would be a rise in the price level

See also: Monetarist Theory of Inflation