Question 6. Inflation
(i) With reference to research that you have completed, discuss in
detail each of the THREE main causes of inflation
This research must be cited in the body of your slides and should
include two examples from economic history of times that Demand
Pull, Cost Push and Increases in Money Supply caused inflation.
(ii) Outline three problems caused by high inflation.
2. Causes of inflation
(Demand Pull, Cost Push, Increase in Money Supply)
3. Problems caused by inflation
Inflation is defined as a steady and persistent increase in the general level of
Its the rate at which your money loses its value to buy goods and services.
In Europe, the ECB aims to try to maintain inflation rate below, but close to,
2% over the medium term. The Central banks attempt to stop severe
inflation, along with severe deflation, in an attempt to keep excessive
growth of prices to a minimum.
Inflation is measured by CPI or by PPI. CPI (consumer price index) is a
measure of price changes in consumer goods and services such as gasoline,
food, clothing and automobiles (basket of goods).
PPI (producer price indexes) is a family of indexes that measure the average
change over time in selling prices by domestic producers of goods and
Current rates of inflation
Central Statistics Office (CSO) & Consumer Price Index (CPI)
Average rate of inflation 2013: 0.56%
Demand Pull Inflation
Occurs when aggregate demand is greater than aggregate
supply, therefore increasing prices.
Causes of demand pull inflation?
Continued rise in aggregated demand
Easy access to bank credit (celtic tiger)
Increase in government expenditure
Consumer purchasing power
Property Bubble in Ireland
From 1991 to 2001, Ireland’s real GDP growth averaged
above 7% and Ireland was reaching full employment. Per
capita income reached above average in the EU. This meant
that the population had more income to spend. Lending to
households from 2003-2007 was one of the highest in the
House prices increase by 17% between May 2000 and May
2001 alone. Since the population had more to spend, people
invested into housing. The amount of people wanting to buy a
house exceeded the amount of houses available for sale.
The direct aftermath of the 2008
global financial crisis caused an
inflation for one particular asset,
Investors worries grew over over the economic fallout
from both the eurozone and U.S debit crisis. This led to an
increase in demand pull inflation for gold.
The price of gold reached a record of $1,895 per ounce in
Cost Push Inflation
Cost Push inflation occurs when there is a shortage of
supply of labor, raw materials and capital. Demand for
products and services remains constant but the prices of
commodities increase causing a rise in the overall price
Cost push inflation occurs when firms increase prices to
maintain or protect margins after experiencing a rise in
their costs of production, wages, electricity bills. Firms
will cover these costs by partly passing it on the
customer (increase price) and by cutting back
Oil is an example of a cost push inflation. If oil prices increase, then they
may lead to sustained increase in the overall inflation rate. If rising oil
prices lead to higher inflation over the longer term, rising energy and
wage costs are more likely to be passed through in terms of rising
consumer prices. However if oil prices stabilise, the corresponding
inflationary pressure will disappear.
1970s Oil crisis
Series of energy caused by problems in
the Middle East. Price of crude oil rose
from 3 to 12 dollars by 1974. The price
of petrol rocketed,making transport
more expensive. Inflation rate hit more
Natural disaster or the environment can be catalysts for cost push inflation.
In 2011, a 9 magnitude earthquake and tsunami destroyed towns and cities in
Japan. This greatly affected Japan’s economy as well due the massive
damages to factories and production plants. Japan manufacturers 20% of the
world’s semiconductor products. Since production were halted, there was less
products manufactured and available which resulted in increase of prices.
In 2013, olive oil production was affected by series of natural disasters. Olive
trees in Italy are affected by a plant germ. This plant germ is killing centuries
old trees which are a great part of olive oil production. In Greece, bad
weather affected the olive trees which led to a shortage of crops. In Spain,
shortage of olive oil was due to the lack of water during the long hot summer
weather. The price of Spanish olive oil has risen by roughly 30 % while the
olive oil from Greece has risen in price by nearly 50%.
Increase in Money Supply
Inflation can occur due to the increase in money supply in the economy. As
more and more money is released into circulation, the more likely it can
Increase of money supply in circulation can occur due to
1. Monetization (more money being printed)
2. Banks lending loans
3. Banks giving out credit cards
4. Quantitative easing ( A monetary policy in which a central bank purchases
government securities from the market in order to lower interest rate and
increase the money supply)
Inflation caused by the increasing money supply circulation happened in
Zimbabwe, Hungary, Germany, Yugoslavia and Argentina (these countries
experienced hyperinflation due to the monetization).
Zimbabwe was the first in 21st century to experience hyperinflation due to
the large monetization by the government. Before becoming independent in
1980, the country was involved with guerrilla wars.Inflation occurred due to
the preceded economic decline over several years and the mounting public
Economy of Zimbabwe started to decline in 1999, when
external debt increased and commercial output
worsened. There was uncontrolled government
spending which greatly affected the economy as well.
Tax collection did not help to cover the large
government expenditure thus the government decided
to begin monetization. The government printed even
more money when they were unable to cover
expenditures thus increasing money supply in the
In summer 2008, inflation reached 231,000,000%.
In 2009, the Zimbabwean Government issued the highest
denomination which was one hundred trillion dollar
(100,000,000,000,000). Compared to this, in 1980, when
Zimbabwe gained independence, existed only Z$2, Z$5,
Z$10 and Z$20 denominations.
The high inflation rates throughout the years
eroded currency’s purchasing power. Usually when
the currency is almost worthless, the use of foreign
exchange or barter frequently occurs-People traded
gold for products and services, Zimbabwean dollar
By the end of 2009, the population started to use
US dollars which helped in stabilising the economy
Under Tito (Dictator), Yugoslavia (now Serbia and Montenegro) ran a budget deficit
that was financed by printing money. This led to a rate of inflation of 15 to 25
percent per year. New policies led to heavier reliance upon printing, creating money
to finance the operation of the government and the socialist economy. This created
The government tried to counter the inflation by imposing price controls. But when
inflation continued, the government price controls made the price producers were
getting so ridiculous low that they simply stopped producing. Later the government
tried to curb inflation by requiring stores to file paperwork every time they raised a
price. This meant that many store employees had to devote their time to fill out
these official forms. Instead of curbing inflation, this new policy actually increased
inflation because store owners tended to increase prices by a large increments so
they would not have to fill forms each time price changed.
In october of 1993, the Yugoslavian government created a new currency. One
that was worth one million of the ‘old’ dinars. The government simply removed
six zeros from the paper money. This did not stop the inflation. Between
October 1993 to January 1995, prices increased by 5 quadrillion percent. Many
Yugoslavian businesses refused to take the Yugoslavian currency and instead
used the German Deutsche Mark. The average daily rate of inflation was 100%.
In January 1994, the government introduced the ‘super’ dinar equal to 10
million of the ‘new’ dinars.
Balance of payments
Balance of payments record the flow of money between
residents of the country and the rest of the world. Inflation is
likely to worsen the balance of payments.
If a country suffers from relatively high inflation, its exports
will become less competitive in world markets (prices
increasing). Imports will become relatively cheaper than home
produced goods. Thus exports will fall and imports will rise. As
a result, the balance of payments will deteriorate and/or the
exchange rate will fall.
Shoe leather and Menu cost
Shoe leather refers to the costs (in time and energy) of efforts
intended to counteract the effect of inflation. The term comes
from the belief that people will cope with inflation by keeping
less cash on hand and making more trips to the bank. When
inflation is high, interest rates go up as well, which means
that keeping money in interest bearing accounts can be a
Menu cost occurs during high inflation. Minor costs of
changing catalogues, price labels or adjust slot machines due
the changing prices in the economy.
Inflation redistributes income away from those on fixed incomes and
those in a weak bargaining position, to those who can use their
economic power to gain large pay, rent or profit increases. Those
people on fixed incomes (social welfare) suffer when inflation is high
as their incomes remain at the fixed rate while prices continue to rise
thus reducing their standard of living.
High inflation redistributes wealth to those with assets that rise in
value particularly rapidly during periods of inflation, and away from
those with types of savings that pay rates of interest below the rate of
inflation and hence whose value is eroded by inflation. Unexpected
inflation can lead to borrowers paying a smaller real interest rate,
transferring wealth from creditors to borrowers.
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