The document discusses various causes and effects of inflation, including demand-pull inflation which occurs when there is excess demand for goods and services, and cost-push inflation which is caused by external supply shocks that shift the short-run aggregate supply curve inward. It also examines the costs of inflation such as a loss of purchasing power and potential for a wage-price spiral, as well as the consequences like disruption to business planning and potential unemployment. The relationship between inflation, economic growth, and inflation expectations is explored.

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1
Causes &
Effects ofEffects of
Inflation
A2 Economics, November 2010
Causes of inflation
• Inflation is a sustained increase in the general level
of prices
• There are many possible causes of price inflation in
an economy – for example
1. Demand and supply-side causes
2. Inflation from internal and external sources
3. Inflationary effects of government / regulatory intervention
in the economy
• Average rates of inflation vary widely across the
world across countries at different stages of
development

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The consumer price index (CPI)Annual % change in the Consumer Price Index
UK Consumer Price Inflation
5.0
6.0
5.0
6.0
1.0
2.0
3.0
4.0
Percent
1.0
2.0
3.0
4.0
CPI Inflation target = 2%
Source: UK Statistics Commission
97 98 99 00 01 02 03 04 05 06 07 08 09 10 11
-1.0
0.0
-1.0
0.0
Mapping the main causes of
inflation in the UK
Import
Prices
Basic
Pay
Bonuses +
overtime
Exchange rate
/ Profit margins
Earnings
Productivity
Unit labour
costs
Commodity
Prices
Taxes
Rate of
inflation
Global
Economic
Cycle
+ =
+
+
Taxes
Profit Margins
Secular
Influences
(e.g. ICT
impact, quality
of education)
Economic
Cycle
Economic Cycle
Fiscal Policy
+

3. 01/11/2010
3
Demand-pull inflation
• Demand – pull inflation
– When there is excess demand for goods and– When there is excess demand for goods and
services
– Positive output gap (where actual GDP >
Potential GDP)
– Businesses respond by raising prices to increase
profit margins
D d ll i fl ti i t d ith b– Demand-pull inflation associated with boom
phase of the cycle (SRAS becomes inelastic)
– Root causes of demand pull inflation are usually
monetary in origin (excessive lending / growth of
the money supply – monetarist causes)
Main causes of demand pull
inflation
• A large depreciation of the exchange rate
• A reduction in direct or indirect taxationA reduction in direct or indirect taxation
• Rapid growth of the money supply as a
consequence of increased bank and building
society borrowing
• Rising consumer confidence and an increase in the
rate of growth of house prices
• Faster economic growth in other countries• Faster economic growth in other countries –
providing a boost to UK exports overseas

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4
Illustrating demand-pull inflation
General
Price
Level
SRAS1
LRAS
P1
P2
National
Income
AD1
Y1 Yfc Y2
AD2
SRAS responds to excess
aggregate demand
General
Price
Level
SRAS1
LRAS SRAS2
P3
P1
P2
P3
National
Income
AD1
Y1 Yfc Y2
AD2

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5
Demand-pull inflation using a non-
linear AS curve
General
Price
Level
LRAS
P1
P2
P3
Real National Income
AD1
SRAS
Y1 Yfc
AD2
Y2
AD3
Inflation and output gap for the UKOutput Gap = Actual GDP - Potential GDP. CPI inflation - annual % change in prices
The Output Gap and Consumer Price Inflation
6.0
8.0
10.0
6.0
8.0
10.0
-4.0
-2.0
0.0
2.0
4.0
Percent
-4.0
-2.0
0.0
2.0
4.0
CPI Inflation
Output gap
Source: UK Statistics Commission and OECD World Economic Outlook
90 92 94 96 98 00 02 04 06 08 10
-8.0
-6.0
-8.0
-6.0

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6
Cost Push Inflation
• Causes:
– External shocks (i.e. commodity price fluctuations)( y )
– A depreciation in the exchange rate (higher import costs)
– Acceleration in wages / unit labour costs in the labour
market
• Leads to an inward shift in SRAS curve
• Firms raise prices to protect their profit margins –
better able to do this when demand is price inelastic
• “Wages often follow prices” - a second-round
effects of an increase in the cost of living
• Rise in actual inflation can lead to an increase in
inflationary expectations
Illustrating cost-push inflation
SRAS1
LRAS
SRAS2
General
Price
Level
P1
P2
National
Income
AD1
Y1 YfcY2

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7
Illustrating cost-push inflation – with
a non-linear SRAS
General
Price
Level
LRAS
P1
P2
Real National Income
AD1
SRAS1
Y1 Yfc
SRAS2
Y2
AD2
Y3
Oil prices and CPI inflationAnnual % change in the Consumer Price Index and monthly average for Brent Crude
UK Inflation and Crude Oil Prices
100
150
SD/Barrel
100
150
Crude Oil Price
3.0
4.0
5.0
6.0
Percent
3.0
4.0
5.0
6.0
Consumer Price Inflation
0
50
US
0
50
Source: UK Statistics Commission and IPE
06 07 08 09 10
0.0
1.0
2.0
P
0.0
1.0
2.0

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Average Earnings and Consumer
Prices in the UKAnnual % change in earnings and consumer prices
Wage Growth and Consumer Prices - A Link?
5
6
5
6
Average Earnings
2
3
4
Percent
2
3
4
Consumer price inflation
Source: Reuters EcoWin
00 01 02 03 04 05 06 07 08 09 10
0
1
0
1
Import prices can have a direct
effect on the rate of inflation
Index 2003=100, source: Monthly Digest of Economic Statistics
Index of UK Import Prices
150
175
200
150
175
200
75
100
125
150
Index
50
75
100
125
150
Total Import Price Index
Import Prices for Fuels
Finished Manufactured Goods
Imports of Goods exc oil
Imports of Fuels
Imports of finished manufactures
Source: Reuters EcoWin
01 02 03 04 05 06 07 08 09 10
25
50
25
50

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How does the exchange rate affect
inflationary pressures?
Exchange rate index (top pane) and inflation (lower pane)
Inflation and the Exchange Rate for the UK
90
100
110
Index
90
100
110 Sterling Exchange Rate Index
3.0
4.0
5.0
6.0
Percent
3.0
4.0
5.0
6.0
Consumer Price Inflation
70
80
I
70
80
Source: Reuters EcoWin
95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10
0.0
1.0
2.0
P
0.0
1.0
2.0
ConsequencesConsequences
of inflation

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10
The costs of inflation
• ‘Taken together, the verdict of economics, history
and common sense is that inflation and deflation are
costly. It is clear that high inflation – in extreme
cases hyperinflation – can lead to a breakdown of
the economy. There is now a considerable body of
empirical evidence that inflation and output growth
are negatively correlated in high-inflation countries.
For inflation rates in single figures, the impact of
i fl ti th i l l ’inflation on growth is less clear.’
• Mervyn King adapted from a speech entitled “The
Inflation Target – Ten Years On” given in 2002
Costs and Consequences of
Inflation (1)
• Money loses its value or real purchasing power
and people lose confidence in money as the valuey
of savings is reduced
• Inflation can get out of control - price increases
lead to higher wage demands as people try to
maintain their living standards. This is known as a
wage-price spiral.
• Employees in poor bargaining positions lose outp y p g g p
and suffer a reduction in their real living standards
and relative income level (i.e. to other groups)

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Costs and Consequences of
Inflation (2)
• Inflation can favour borrowers at the expense of
savers – because inflation erodes the real value of
existing debts- if real interest rates are negative
• Inflation can disrupt business planning and lead
to lower capital investment
• Exporters may suffer – if prices in the UK rise higher
than those abroad – causing a deterioration in
global competitiveness and a worsening of theg p g
balance of payments position
• A possible cause of higher unemployment
• Rising inflation is associated with higher policy
interest rates - this reduces trend growth
UK Economic Growth and InflationUK Real GDP Growth and Consumer Price Inflation. annual % change
Economic Growth and Inflation
7.5
10.0
7.5
10.0
-2.5
0.0
2.5
5.0
Percent
-2.5
0.0
2.5
5.0
Consumer price inflation
Real GDP growth
Source: UK Statistics Agency
90 92 94 96 98 00 02 04 06 08 10
-7.5
-5.0
-7.5
-5.0

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12
Anticipated inflation
• When people are able to make accurate
predictions of inflation they can takepredictions of inflation, they can take
steps to protect themselves from its
effects
• For example, trade unions may exercise
their collective bargaining power to
negotiate with employers for increases innegotiate with employers for increases in
money wages so as to protect the real
wages of union members
Unanticipated inflation
• Unanticipated inflation occurs when
economic agents (people businesseseconomic agents (people, businesses
and governments) make errors in their
inflation forecasts
• Actual inflation may end up well below, or
significantly above expectations causing
losses in real incomes and alosses in real incomes and a
redistribution of income and wealth from
one group in society to another

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Inflation expectationsBank of England/NOP, how do you expect prices to change over the next 12 months?
Inflation Expectations
5.0
6.0
5.0
6.0
1.0
2.0
3.0
4.0
Percent
1.0
2.0
3.0
4.0
How do you expect prices to change over the next 12 months?
How has prices changed over the past 12 months?
Source: Bank of England
04 05 06 07 08 09 10
0.00.0
Some Inflation Web Resources

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