• Join over 1.2 million students every month
  • Accelerate your learning by 29%
  • Unlimited access from just £6.99 per month

Explain the possible causes of inflation

Extracts from this document...

Introduction

Inflation in an economy is defined as the sustained increase in the general price level, resulting in a decrease in purchasing power of consumers and a fall in the value of money. Some inflation is vital for the macro economy in order to maintain adequate levels of economic growth, and since 1997, the UK government has recognised this fact by allowing The Bank of England Monetary Policy Committee to target a rate of 2.0% over the past fifteen years or so. The measure currently used by EU countries, including Britain, is that of the CPI (Consumer Price Index). This takes a weighted, indexed mean of a basket of goods deemed to be most influential in current household spending across the country. Other measures include the RPI and RPIX (the RPI, excluding mortgage interest repayments, as these fluctuate too readily). The UK has preserved one of the lowest inflation rates among EU countries in recent years, due to a thorough understanding of the causes of inflation and the policies necessary to manage it. ...read more.

Middle

The former includes things like the depreciation of the exchange rate (whereby a fall in the value of the sterling reduces demand for imports and raises demand for exports, culminating in inflation) and the improving economic positions of other countries (naturally forcing them to buy overseas UK exports to fund their growth in the short-run due to capacity constraints). The latter includes things like fiscal stimulus (cutting taxes to give consumers more disposable income or government spending on projects, infrastructure and initiatives) and monetary policy (adjusting interest rates to reduce borrowing costs and mortgage repayments, or increasing the money supply). Careful consideration of the long-run effects must be taken into account, which emphasised by cost-push inflation - a drop in the base rate, for example, can affect spending by as much as two years in advance. Cost-push inflation is when firms respond directly to cost increases by raising their prices. This is done to protect profit margins, though in certain circumstances (such as the financial crisis of 2008), firms in oligopolies and monopolies with lots of market power may decide to absorb some or all of their profit losses. ...read more.

Conclusion

The quantity theory demonstrates how the excess supply of money in the financial system, in relation to the number of goods and services available, causes households to quickly spend this money and allow inflation to occur. The following equation illustrates this: Money Supply x Velocity of circulation = Price Level x Total Transactions There are several assumptions in this model, but it is effectively saying more money leads to more spending, which leads to higher prices in accordance with demand-pull inflation. Money supply is dangerous in that if not regulated properly, it can cause hyperinflation. However, most governments have this under control. In conclusion, inflation is caused by a combination of demand and supply side factors, and controlling it must take into account effective demand-side regulation in line with productive capacity in the short-run, along with a steady growth in the supply side using supply-side policies so that growth does not result in accelerating prices. Tight monetary policy, increases in technology and innovation, low global inflation from increased competition and a strong exchange rate, among other things, have all contributed to low UK inflation over the past 15 years. These are evidently both demand and supply related reasons. ...read more.

The above preview is unformatted text

This student written piece of work is one of many that can be found in our AS and A Level Macroeconomics section.

Found what you're looking for?

  • Start learning 29% faster today
  • 150,000+ documents available
  • Just £6.99 a month

Here's what a star student thought of this essay

4 star(s)

Response to the question

This essay responds to the question superbly, having a strong understanding of the different causes. I particularly liked the awareness that there are theories of inflation, rather than causes which are set in stone. This is a great skill to ...

Read full review

Response to the question

This essay responds to the question superbly, having a strong understanding of the different causes. I particularly liked the awareness that there are theories of inflation, rather than causes which are set in stone. This is a great skill to have in economics, as it shows an understanding of its relevance as a social science well beyond A-Level. Although the essay doesn’t explicitly ask for policies to reduce inflation, the essay poses a justified judgement to what can be done. I always like when essays go further to incorporate other ideas. This is a great way to revise, as it means you have all the ideas regardless of the question, and can then focus your essay for the exam.

Level of analysis

The analysis in this essay is strong, showing a strong understanding of concepts. I liked how the essay talks about “in the short run, aggregate supply is inelastic” thus causing demand-pull inflation. Being able to incorporate technical terms such as elasticity is a great way to gain marks! The discussion of cost-push inflation is particularly strong, with a reference to the Phillips curve being made. This is beyond the A-Level syllabus and will gain credit for analysis. I would’ve liked to have seen some diagrammatical analysis, as this is the easiest way to demonstrate an understanding of inflation. A simple shift of aggregate demand to show demand pull, and a shift in aggregate supply to show cost push. Whenever I talk about inflation, I always talk about the wage-price spiral, as this shows a strong understanding of mechanisms. This was well explained here!

Quality of writing

The structure here is strong, with the introduction placing in some background knowledge of how inflation is measured and why it is relevant. I like this, as it shows to the examiner immediately that you have a strong understanding. If this essay was a discussion, however, I would normally argue you should keep your introduction short and focussed. Technical terms are used throughout, and the style makes for a convincing argument. This is because each step follows on from the last, showing a clear progression in the argument. I just wanted to see more diagrams!


Did you find this review helpful? Join our team of reviewers and help other students learn

Reviewed by groat 13/03/2012

Read less
Not the one? Search for your essay title...
  • Join over 1.2 million students every month
  • Accelerate your learning by 29%
  • Unlimited access from just £6.99 per month

See related essaysSee related essays

Related AS and A Level Macroeconomics essays

  1. Peer reviewed

    How can inflation be reduced?

    5 star(s)

    A high government spending will add to aggregate demand meaning high inflation (assuming it exceeds aggregate supply). So in order to mitigate the problems of inflation, governments (on budget day) should look to decrease their spending. Governments can do this by spending less on public projects therefore less in spent

  2. Examine possible factors which might have led to changes in the value of the ...

    smaller effect on the value of the euro than the trading by Forex traders considering that billions of Euros/other currencies are traded on the Forex everyday, the trading takes precedence over the increase in imports. Given that the UK has always had a high propensity to import, therefore this effect has not changed significantly since the introduction of the Euro.

  1. What are the Government's main economic objectives?

    Formally the plan aimed to move people from welfare to jobs; it now aims to help people move from low skilled work to higher skilled work. This means the government is to now encourage employers to give employees time of work for skills training and development courses.

  2. What conditions are necessary for a devaluation to improve the BOP? Can a small ...

    If successful this may lead to further rounds of cost push inflation, known as a wage-price spiral. Another cause of inflation lies on the demand side. If the devaluation boosts exports it may create an upward multiplier effect. Those in the export industries will have extra income and this will lead to extra spending, shifting the aggregate demand (AD)

  1. What are the government objectives? Explain why each is important and how the government ...

    Secondly, raising interest rates will produce an inflow of money, increasing the demand for the pound, raising the price of the pound, and therefore encouraging purchase of the pound. Higher interest rates will also reduce aggregate demand. As these higher interest rates will reduce consumption, particularly of consumer durables such as cars, kitchens etc, and will reduce investment.

  2. What are the economic effects of inflation?

    It means that the real value of people's savings falls. It also means that people gain when they borrow money because the real value of the money they have to pay back will fall. When resources are transferred between the Government and households it is through tax and public sector salaries.

  1. ECONOMICS PAST PAPER QUESTIONS WITH ANSWERS - price elasticity and inflation.

    Price/ market mechanism which manipulates the allocation of resources or tries to resolve the three fundamental questions of what, how and for whom to produce. In other words, resources are allocated through changes in relative prices. Adam Smith referred to it as the ?invisible hands? of the market.

  2. Unemployment, inflation, economic growth and balance of payments have close relationships with aggregate demand

    However, increasing interest rate will lead to a decrease in aggregate demand and thus may has negative effects to other objectives and so will required to be considered. In the short-run, the objectives of macroeconomic are all vary with the course of the business cycle.

  • Over 160,000 pieces
    of student written work
  • Annotated by
    experienced teachers
  • Ideas and feedback to
    improve your own work