The Causes of Inflation.

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Edexcel AS Economics        Unit 3 Inflation

The Causes of Inflation

There are three major causes of inflation:

  1. Demand – pull inflation
  2. Cost – push inflation
  3. Monetarist Theory

1.         Demand – Pull Inflation

This type of inflation is caused by excess aggregate demand, exceeding aggregate supply. Quite simply ‘too much demand is chasing too few goods’. This can occur when the growth in aggregate demand is so strong, that aggregate supply cannot respond quickly enough – resulting in prices getting bidded-up. Thus surges in aggregate demand can ( not necessarily always ) lead to greater inflationary pressures as bottle necks in supply are caused ie supply simply cannot respond quickly enough !!

Demand – pull inflation is also more likely to occur when the economy is approaching full employment, and unemployed resources are becoming more scarce ie where aggregate demand is quite strong and there is only a small negative output gap ( AD is on the inelastic section of AS ). However, this contrasts to the circumstances where AD increases and there is a lot of spare capacity. In this case it is relatively easy for businesses to find spare resources without having to bid – up prices to attract them. In this case real output can expand easily as AD is on the elastic part of the AS curve.

Task: Draw two AD and AS diagrams illustrating the above. One diagram should show how a positive AD shock should lead to inflation ( with little or no change to real output ), and the other should show that there is much less inflationary pressure. In each case comment on the change to real output and unemployment.

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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:

  1. How strong is the growth in ...

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