Inflation
A-level Economics
causes of inflation
Defintion: A sustained rise in the general price level. In the UK, inflation is measured calculated most commonly using the Consumer Price Index (CPI).
Causes of Inflation:
There are two main causes of inflation that you need to be aware of. These are demand-pull and cost-push inflation.
1) Demand-Pull: occurs when there is an increase in the general price level due to demand-side factors. An increase in AD is responsible for this. It could occur when government spending increases for example, or any of the AD components.
If you notice from the diagram below, demand-pull inflation is occuring from the point A. It is most problematic when the economy is already operating on the LRAS curve. This is because the economy is already operating at maximum capacity, Yfc. If the economy is at full capacity, and demand continues to grow, then demand is likely to be growing faster than supply. If supply cannot keep up, then there will be shortages in the economy and prices will have to rise to reestablish long-run equilibrium. [It is useful to notice that point and mention in exams.]
2) Cost-Push: occurs when there is an increase in firms' cost of production. An increase in the costs of production will lead to them increasing the prices of their products. Ceteris paribus, the general price level will rise and the SRAS curve will shift to the left.
For example, an increase in the price of oil would lead to an increase in production costs for the majority of firms. These costs being passed onto the consumer is reflected in the SRAS curve shifting to the left, as can be seen in the diagram below.
Consequences of Inflation
Inflation in an economy can bring about many consequences, mostly negative. But you'd be surprised to know that inflation can be a good thing sometimes. See below for the costs and benefits of inflation.
Benefits of Inflation
1) Good for existing borrowers
Inflation decreases the purchasing power of money. Over time, money will essentially be worth less. If you have an existing loan, then the value of your loan is worth less and less over time too. In theory, it should get easier to pay back over time (as long as incomes have been increasing).
2) Stable inflation is a good sign to businesses
Low, sustained inflation is actually a healthy sign. It gives a business more certainty about future prices. It shows businesses that the economy is growing at a steady level and that prices are going up. Businesses are in business to make profit and prices going up is a good sign.
3) Reduces risk of deflation
Deflation is actually worse than inflation in many cases. An economy with a steady rate of inflation (for example, 2%) reduces its risk of being caught in the deflationary trap.
Costs of Inflation
1) An increase in the cost of living
Leads to a reduction in living standards for households, particularly if the economy has a severe inequality problem. The poorest in society will be most affected, which could mean an increase in relative poverty.
2) A decrease in real income
If income does not go up at the same rate as inflation, then real income will decrease over time. This means that the average person will be able to buy less than before. It could mean incomes have to be renegotiated with employers which could lead to...
3) Wage-price spiral
Employers are likely to receive increased demands for higher wages. Employers are likely to respond by meeting worker demands but at the same timealso increase their prices further to compensate. It could also lead to an increase in lay-offs by firms to cut costs.
4) Reduction in confidence levels
5) Menu Costs
An increasing rate of inflation means that business are more likely to need to increase the rate at which they increase their prices. This means changing prices more often, updating labels and menus etc. All this comes at a cost - businesses must pay workers to do this extra work.
6) Shoe leather costs
Inflation also brings about what is known as shoe leather costs. These are costs incurred by the shopper, going from shop to shop to get the best deal. Prices increasing at a faster rate means that consumers are likely to become more price sensitive and hunt for the best prices. This comes at a cost to the consumer in terms of time spent.
7) Decreased international competitveness
Prices increasing at faster rates, particularly compared to other countries, will mean that your country becomes less internationally competitive over time.
8) Decreased willingness to save
As inflation reduces the purchasing power of money, people are less likely to leave their savings in the bank. For example, if the bank pays 2% interest per annum, and inflation is 3% per annum, what does this mean? It means your savings are losing real value over time. So people will be more reluctant to save in banks.
9) Shortage of funds in banks
Less savers mean that banks are less willing and able to lend to people who want to borrow, particularly businesses looking to invest.
10) Risk of hyperinflation
This is a severe case and is generally unlikely if the economy is being managed well. It generally happens when the government (or central bank) is creating too much money. Inflation can be well over 100% in this case.
Firms and households are likely to experience a reduction in confidence, particularly if the inflation rate is high and unstable. Households are more likely to reduce their spending and 'save for a rainy day', while businesses are likely to hold back investment projects due to the uncertain economic environment.
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