Inflation

Inflation can be caused by cost- push factors

Cost push inflation is inflation which is caused by the rising cost of inputs to production

Rising costs of inputs to production force producers to pass on the higher costs to consumers in the form of higher prices which causes the aggregate supply curve to shift to the left

Example of cost push factors

A rise in wages above any increase in productivity

• If wages make up a large proportion of a firms total costs then this could lead to a significant rise in prices

• Price rises could lead to further wage demands, which in turn could lead to price increases and so on

A rise in the cost of imported raw materials

• If the world prices then , in the short run, producers will pay the higher cost and set higher prices. this is how price increases in world commodity markets can lead to higher domestic inflation

• Also, if a country’s currency decreases in value then producers will have to pay more for the same imports

A rise in indirect taxes

• If the government raises indirect taxes this will increase costs and in turn prices

• If a good is price inelastic then more of the cost of the tax will be passed on to the consumer

Inflation can also be caused by demand pull factors

Demand pull inflation is inflation caused by excessive growth in aggregate demand compared to supply

This growth in demand shifts the aggregate demand curve to the right which allows sellers to raise prices

Examples of demand pull factors

High consumer spending or high demand for exports

• High consumer spending could be cause by high levels of confidence in consumers’ future employment prospects e.g. during a period of low unemployment. Low interest rates encourage cheap borrowing and greater spending

• High foreign demand for exports could be caused by rapid growth in other countries

The money supply growing faster than output

• If the amount of money in the economy is not matched by the output of goods and services, this can lead to a rise in prices. This might be the case, for example, when interest rates are low and consumers are spending more

• Monetarist economists believe that excess money is the biggest cause of inflation

Bottleneck shortages

• If demand grows quickly at a time when labour and resources are already being fully used, then increasing output may lead to shortages (i.e. there may be a positive output gap). These shortages will cause prices to rise and firms’ cost to increase

• Price rises caused by shortages e.g. a rise in wages for skilled labour, in one area of the market may be copied by other markets e.g. higher wages for low skilled labour, leading to more general inflation

Quantity theory of money

The quantity theory of money is based on Fisher’s equation of exchange

money supply x velocity of money = price level x aggregate transaction (MV = PT)

Monetarists argue that, in the short run, V and T are unlikely change, so any increases in P, price level, will be directly caused by an increase in the M, money supply

To avoid inflation, monetarists believe that the money supply needs to be strictly controlled