The Causes of Inflation
- An increase in the general price level in an economy can be caused by demand pull inflation or cost push inflation
1. Demand Pull Inflation
- Demand pull inflation is caused by excess demand in the economy
- Total (aggregate) demand is the sum of all expenditure in the economy
- rGDP = Consumption (C) + Investment (I) + Government spending (G) + Net Exports (X-M)
- If any of the four components of rGDP increase, there will be an increase in the total demand in the economy leading to an increase in the general price level
- Demand pull inflation has occurred
An Example of Demand Pull Inflation
- If the Central Bank lowers the base rate, there is likely to be increased borrowing by firms & consumers
- This will result in an increase in consumption & investment which will increase the rGDP
- It is likely to lead to a form of demand-pull inflation
2. Cost Push Inflation
- Cost push inflation is caused by increases in the costs of production in an economy
- If any of the costs of production increase (labour, raw materials etc.), or if there is a fall in productivity, the total supply will decrease
- With less supply, prices rise leading to an increase in the general price level
- Cost push inflation has occurred
An Example of Cost Push Inflation
- Trade Unions negotiate higher wages for workers
- The wage increases represent an increased cost of production for firms
- With the inputs, firms now produce less & supply reduces leading to higher general price levels
- Cost push inflation has occurred