Causes of Inflation
Economics: IB Diploma, topic 2.3.10
Cost-Push Inflation
Cost-push inflation is due to a rise in costs of production, causing the SRAS to shift up, and reducing profit margins of firms. This then prompts firms to push up the final price of goods and services to maintain profit.
Causes of cost-push inflation
- National minimum wage increases.
- Trade union wage increases.
- Increase in world commodity prices, e.g. oil price rises globally.
- External supply-side shocks, e.g. bad harvest abroad causing the price of wheat to rise.
- Rise in indirect taxes, e.g. VAT (if it is passed on to consumers).
- Rise in corporation tax (if it is passed on to consumers).
- Falling productivity (which causes unit costs to then increase, as each good costs more to produce).
Impact of currency depreciation
- Exchange rate depreciation causes the price of imports to rise in domestic currency terms.
- Note the exchange rate depreciation could happen because of events in another country that causes their exchange rate to appreciate, so causing the Pound to depreciate.
- The Pound depreciated immediately after the EU referendum in June 2016, causing the price of imports to rise and inflation to increase.
Money Supply
- A growth of the money supply can also cause inflation.
- This is because more money is pushed into the economy and therefore the purchasing power of the currency decreases. This leads to price rises.
Demand-Pull Inflation
Demand-pull inflation is caused by increases in aggregate demand outstripping aggregate supply. The economy is close to full employment, and increases in AD lead to the general price level rising because supply cannot keep up with increased demand.
Causes of demand-pull inflation
- Exchange rate depreciation – causes the price of exports to be cheaper in foreign currency terms and thus demand for exports rises. This causes the value of exports to increase, so X-M increases.
- Rising animal spirits (confidence) e.g. due to positive wealth effect from rising house prices.
- Excessive borrowing.
- Global economy experiencing faster growth in incomes and buying a lot of goods from the UK, causing UK exports and AD to rise quickly, causing demand-pull inflationary pressure.
Government causes of demand-pull inflation
- Excessively 'loose' fiscal policy: income taxes could be cut too much or government spending be increased too quickly.
- Excessively 'loose' monetary policy: interest rates could be cut too much or too quickly and Quantitative Easing could be too high.
Test yourself on Causes of Inflation
Which of the following could contribute to cost push inflation?
Which of these are characteristics of demand-pull inflation?