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
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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.
It must be remembered that in reality, aggregate demand and aggregate
supply are growing all the time. Therefore, ...
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... 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:
1. Explain how a rise in interest rates should help reduce
inflationary pressure
2. Examine the implications for interest setting if the government
lowered the inflation target to 1.5 %
3. Examine the implications for the wider economy of a reduced
inflation target.
4. Identify 10 pieces of data that the MPC might want to consider when
making its monthly interest rate decision.
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