Hi guys. Today we are focusing on a very important topic: inflation.
Here we go:
Explain the causes of inflation and why it could be considered by economists to be the most important macroeconomic objective.
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1) Inflation can be defined as a sustained rise in the general price level. It also happens to be one of the macroeconomic indicators and in the UK the inflation target is 2% CPI inflation +/- 1%.
There are two main causes of inflation. The first, is demand-pull inflation which involves a shifting to the right of the AD curve. It becomes a problem when the demand side of the economy is growing at a faster rate than supply. This is shown in the diagram below. It occurs mainly in the boom period of the economic cycle, because this is when consumer and business confidence is higher, causing a higher than normal amount of spending. When this spending surges, businesses raise their prices as we would expect causing the general price level in the economy to increase.
The other cause of inflation due to the cost of business rising. This is known as cost-push inflation. With this type of inflation, the increase in price is due to rising cost of production. This will shift the SRAS curve to the left and bring about an increase in the general price level. The reason this happens is because when costs rise, businesses want to achieve the same level of profit as before. This means they have to increase their prices to maintain the same profit. A business cost is the cost of any of the factors of production. For example, rent, raw materials, wages, oil prices etc. If any of these increase and businesses pass on the costs to the consumers, cost-push inflation occurs.
Inflation could be considered to be one of the most important macroeconomic objectives because price instability can act as a warning signal to businesses and consumers. If prices are fluctuating regularly, then this may put businesses off further investment projects as their investment is deemed more risky. Businesses prefer to have little risk and high return and any price movements will indicate a higher level of risk. Consumers are affected because price movements affect their cost of living. If the cost of living is continuously rising or changing then this could affect spending patterns. It also may affect their wage demands from their employers. If inflation is high, consumers will most likely demand higher wages from employers so their living standards remain the same.
These price movements can also affect a consumer's or business' expectations of inflation. They are unsure about the future, so they may again change their spending patterns and wage demands. So even if inflation is high this year and is low next year, consumers and businesses may still be put off because they expect inflation to be high next year.
[EXTRA INFO - you are a seller of peanuts and you buy your peanuts for £5 per kilo. You sell your peanuts to your customers at £10 per kilo. Next year, you can only buy peanuts for £6 per kilo. What must you do to maintain the same profit per unit? You must increase your price to £11 per kilo. This is how cost-push inflation occurs but on the macroeconomic level with many businesses/markets involved.]
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