Tom King 6Y2

Explain the Causes of Inflation

Inflation is defined as a sustained general rise in prices. The opposite of inflation – Deflation – is a term which can have two meanings. Strictly speaking it is defined as a fall in the price level. However it can also be used to describe a slowdown in the rate of growth in the economy. Inflation is measured using either The Retail Price Index (RPI), the Retail Price Index excluding interest payments and indirect taxes (RPIY) or the Retail Price Index excluding mortgages (RPIX). The causes of inflation are down to four main reasons; demand-pull, cost-push, wage-price spirals and money supply inflation. Keynesians have traditionally argued that inflation occurs because of changes in real variables in the economy.

One important Keynesian theory is that inflation is caused by excess demand in the economy; known as demand-pull inflation. It occurs when total demand for goods and services exceeds total supply, or in other words when the money supply grows faster than the ability of the economy to supply goods and services. When demand exceeds supply, firms are liable to increase price (as all firms wish to maximise profit), this has no effect on the demand they actually sell as there are excess numbers of people who wish to buy the product. The inflation rate largely depends on the economies output and the closer the AD curve is to full employment/potential output, the larger the increase in the inflation rate.

According to Keynes, in the long run, an increase in demand (causing an increase in output) has no effect in the price level as it is perfectly elastic however in the short run aggregate supply curve is not perfectly elastic, an increase in the price levels

The main cause of demand-pull inflation (on a sudden increase in demand) can be low exchange rates (decreases price of exports), lower taxes (leads to more disposable income), low interest rates (more people borrow) and increase in consumer confidence.

The second cause of inflation is cost-push which is due to increases in costs of production causing firms to raise prices. This causes the SRAS curve to shift inwards raising prices but decreasing output when firms do experience an increase in the cost of production, it will naturally went to pass these costs onto the consumer so are forced to raise prices. There are four main reasons leading to an increase in the costs of production; they are an increase in wages and salaries, imported goods, profits and taxes. If workers demand higher wages in order to keep the real wage constant, and firms are forced to pay them, costs of production obviously increase and so profit decreases. An increase in the price of imports raises the costs of production for firms and so they are forced to raise prices as they wish to pass the costs onto the consumer. If firms have relatively inelastic demand, they may wish to increase their profits, demand may decrease but in total the firm will gain higher revenue. When taxes, are placed, the firms wish to pass them onto the consumer, prices go up and therefore inflation in the economy rises.

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The third cause of inflation is known as “wage price spirals”. This occurs when the workers suffer an increase in the cost of living. In order to maintain there original standard of living, they must demand a higher wage. Many firms have little or no choice and so accept. By paying higher wages, costs of production increase and companies are forced to raise the price level of their product. Higher goods prices means that workers will have to pay a larger percent of their wage on these goods. These extra costs force workers to yet aging demand an even ...

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