INFLATION
Definition
–
Inflation is a sustained rise in the cost of living and average price level.
2 types of inflation and their main causes (Important for Section A and
Section B):
1. Demand-pull inflation
–
this occurs when the economy grows quickly and starts
to
‘
overheat
’ –
Aggregate demand (AD) will be increasing faster than aggregate
supply (LRAS).
2. 2. Cost push inflation
–
this occurs when there is a rise in the price of raw
materials, higher taxes, etc.
What are the main causes of Demand-Pull Inflation?
1. A
depreciation of the exchange rate
increases the price of imports and reduces
the foreign price of a country's exports. If consumers buy fewer imports, while exports
grow, AD will rise
–
and there may be a multiplier effect on the level of demand and
output.
2.
Higher demand from a fiscal stimulus
e.g. lower direct or indirect taxes or higher
government spending. If direct taxes are reduced, consumers have more disposable
income causing demand to rise. Higher government spending and increased borrowing
creates extra demand in the circular flow.
What are the main causes of Cost-push Inflation?
3.
Higher indirect taxes
–
for example a rise in the duty on alcohol, fuels and
cigarettes, or a rise in Value Added Tax. Depending on the price elasticity of demand
and supply for their products, suppliers may choose to pass on the burden of the tax
onto consumers.
4.
Increase in the prices of raw materials and components:
An increase in the
prices of raw materials and other components might be a result of an increase in
commodity prices, such as oil and copper. A recent example is the price of wheat.
Costs of Inflation (with evaluation under some costs) (6 marks without
evaluation, 10 marks with evaluation)
1. Reduced international competitiveness
If a country has a relatively higher inflation rate than its trading partners, then its exports will
become less competitive, leading to a fall in demand and deterioration in the UK current account.
