Inflation occurs when there is a continuous increase in the general price level as measured by the CPI. There are various explanations for this.
1. Monetarists argue that inflation is caused when the Monetary authorities allow the money supply to increase at a faster rate than the growth in national income( this is termed an “unmerited rise in the Money Supply)
A version of the quantity equation states that MV=PY. According to Monetarists, V (the velocity of circulation) is fixed, at least in the short term and does not change. Also Y (National Income is an exogenous variable) in other words it is determined by supply side factors and is not influenced by changes in the money supply.
Therefore if there is a significant increase in the money supply then there must be an equivalent rise in the price level.
An increase in the money supply causes a rise in AD; in the short term this may cause a rise in actual output as workers receive higher wages and work more. However this causes an increase in inflation and therefore firms costs increase therefore the SRAS shifts to the left causing output to return to full employment (YF) and the price level increases.
Therefore this type of inflation is termed demand pull inflation because it is caused by too much money chasing too few goods.
There are various reasons which could cause an excessive increase in the money supply.
For example if the Bank of England cut interest rates this would reduce the cost of borrowing and reduce the incentive to save. Therefore there would be an increase in demand for money and hence cause AD to increase. Also, if the Bank of England bought back govt bonds then this would increase the money supply.
Monetarists also argue that inflation can be caused by govt borrowing. To finance the govt debts the B of E may sell short term gilts to the banking sector. However these short term gilts are seen by the banks as highly liquid therefore they are willing to increase their borrowings against these. Therefore there will be an increase in the money supply. Also, if the government decided to increase the money supply through a policy of quantitative easing (creating money to buy assets), this could also cause inflation.
Demand Pull Inflation.
This occurs when AD increases at a faster rate than AS. state that inflation can be caused by any factor which causes an increase in AD.
Therefore increased consumer confidence, rising house prices and rising wages would all cause higher C and therefore AD would increase. If the economy was close to full capacity and AD increases faster than AS this will cause inflation. Arguably this occurred in the UK economy in the late 1980s; consumer spending rose rapidly causing a very fast rate of growth, however this was unsustainable and inflation rose to 10.9%
Another cause of inflation is cost push inflation. This occurs when firms have an increase in costs and then pass these costs on to the consumer in the form of higher prices. This could occur due to various reasons such as
1. Wage push inflation. Wages are one of the biggest costs of firms therefore if wages increase this is likely to cause inflation. For example, in the 1970s, trades unions were powerful and they were able to bargain for significant wages. As well as increasing costs rising wages will also cause increased AD.
2. Increased price of raw materials. If input prices increase firms will either have to increase their prices or reduce their profit margins. When OPEC increased the price of oil in the 1970s, all transport costs were increased; this led to an increase in the general price level.
A devaluation in the exchange rate is also likely to cause inflation, Firstly, this will cause an increase in the price of imports which will be passed onto the consumers.
Secondly, there will be an increase in Exports and therefore higher AD. Also firms may have less incentives to cut costs because exports become cheaper without them trying.