It must be remembered that in reality, aggregate demand and aggregate supply are growing all the time. Therefore, demand – pull inflationary pressure occurs when the growth in aggregate demand significantly outstrips the growth in aggregate supply.
Demand – Pull Inflation – Points for Analysis
Examination questions often ask for evidence that there are risks of demand – pull inflationary pressures. Or they may ask the opposite, what indicators are there that demand - pull risks are relatively weak. It is important to try to establish two things:
- How strong is the growth in aggregate demand ( ie is it likely to be outstripping any possible growth in aggregate demand ? )
In the case of the strength of AD look for indicators that may be boosting any of the AD components eg C or I or G or X :
• Fall in the savings ratio
• Higher consumer spending
• Increased borrowing on credit cards
• Higher retail sales
• Increased investment spending from firms
• Strong overseas growth boosting exports
• Strong house price growth ( positive wealth effect )
• Expansionary fiscal policy ( ie possible tax cuts on income or government spending increases )
- How close is the economy to its full employment position ? How much of an negative output gap is there ?
The size of the negative output gap could be signaled by:
• Low levels of unemployment ( eg on the LFS measure )
• Shortages of suitably skilled workers to fill vacancies - this is often referred to as a tightening of the labour market.
• Possible pressures on wage rates due to skills shortages
• Difficulty in finding suitable office space / vacant buildings.
• Rising rents for office space due to shortages
2. Cost – Push Inflation
This type of inflation is caused by costs rising for firms – which are in turn passed on to consumers In the form of higher prices. Very importantly, this type of inflation can occur irrespective of the state of the economy. ie AD might be fairly weak, and there could even be relatively high unemployment, cost –push inflation is still possible. A good example of this would be due to oil prices rising.
Task: Using an AD and AS diagram show how an increase in oil prices can lead to inflationary pressure irrespective of the strength of AD.
Costs can rise for several reasons:
- Higher wage costs. This is where wages rise by more than any productivity gains inflating unit costs of production. Strong trade unions in the past have been blamed for forcing up wages that have not be warranted by productivity gains – in turn triggering cost – push inflationary pressure.
- Imported good prices could rise. A trigger for this is often the exchange rate. If sterling depreciates it causes the price of imported goods to rise, and this in turn can lead to higher imported good prices feeding in to UK retail prices. This is especially likely due to the UK’s deindustrialization, making the UK very heavily reliant on many imported goods ( in effect making the UK fairly price inelastic ).
- Taxation increases can be cost – push in nature if they are levied on firms or on goods. Increasing excise duties on petrol for instance is likely to result in prices rising, contributing to higher inflation.
The real danger of cost – push inflation is the wage – price spiral which leads to possibly one of two things:
• Either inflation rates becoming locked into the UK economy or /
• Ever higher rates of inflation spiralling upwards.
Wage price spirals occur when prices rise…workers demand compensating wage increases…this in turn forces up unit costs…in turn triggering firms to push prices further… with workers then asking for higher wages still… and so the process continues.
Task: Explain how the above mechanism can lead to inflation rates spiraling upwards ( not just prices )
3. The Monetarist Theory of Inflation
This theory states that increases in the money supply lead to inflationary pressure. Quite literally if there were more money in circulation, then part of this extra money balances will be spent on goods and services – boosting AD. This in turn will lead to inflation. Monetarists believe that the money supply can grow steadily – without creatung inflationary pressure. However, if increases become too large, then the prices will get bidded-up.
The Government’s Inflation Target
Remember the Government has given the Monetary Policy Committee at the Bank of England an inflation target of 2.5 % RPIX ( with an allowable + or – 1 % deviation ). The MPC are in control of interest rates, and manipulate these in order to reach the inflation target. Thus the MPC must often look at current data ( eg retail sales, unemployment figures, wage inflation, savings ratios, consumer borrowing etc ) to gauge future inflationary pressure. If inflationary pressures are building, interest rates will be increased. If there are reduced inflationary pressure – rates will fall.
Task:
- Explain how a rise in interest rates should help reduce inflationary pressure
- Examine the implications for interest setting if the government lowered the inflation target to 1.5 %
- Examine the implications for the wider economy of a reduced inflation target.
- Identify 10 pieces of data that the MPC might want to consider when making its monthly interest rate decision.