Causes & Consequences of Inflation (CIE IGCSE Economics)

• 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

The Impact Of Inflation On Different Stakeholders

Firms	Consumers	Government	Workers
Uncertainty: Rapid price changes create uncertainty & delay investment Menu change costs: Price changes force firms to change their menu prices too & this can be expensive Lenders: Financial firms that lend money are worse off as the money lent out is now worth less than before	Purchasing Power: Decrease in purchasing power worsens their quality of life Savings: There is a decrease in the real value of savings (as money will be worth less in real terms) Real Income: There is a fall in real income for those on fixed incomes/pension Borrowers: anyone who borrows money benefits as the repayments are worth less than when the money was originally borrowed	International Competitiveness: Inflation erodes international competitiveness of export industries as their products now look relatively more expensive to foreigners Trade-offs: There are  involved in tackling inflation e.g reducing inflation may increase unemployment and/or reduce economic growth Government Debt: inflation erodes the value of government debt as the repayments are worth less than when the money was originally borrowed	Higher Wages: Workers demand higher wages to compensate for reduced purchasing power Morale: If wage increases ≠ inflation, motivation & productivity may fall as workers do not receive the same real benefit for the work they are doing