1) Inflation can be caused by demand-side factors like excess aggregate demand or cost-push factors like external supply shocks. 2) Demand-pull inflation occurs when aggregate demand exceeds potential output, leading businesses to raise prices to increase profits. Cost-push inflation is caused by increases in input costs like wages, commodities, or exchange rates, forcing businesses to raise prices. 3) The document discusses causes of inflation in the UK including the economic cycle, exchange rates, taxes, and money supply growth for demand-pull inflation and wage growth, import prices, and commodity prices for cost-push inflation.

1. 01/11/2010
Causes &
Effects 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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2. 01/11/2010
UK Consumer Price Inflation
The consumerchange in the Consumer Price Index
Annual % price index (CPI)
6.0 6.0
5.0 5.0
4.0 4.0
3.0 3.0
Percent
CPI Inflation target = 2%
2.0 2.0
1.0 1.0
0.0 0.0
-1.0 -1.0
97 98 99 00 01 02 03 04 05 06 07 08 09 10 11
Source: UK Statistics Commission
Mapping the main causes of
inflation in the UK
Exchange rate
Basic Bonuses + Import / Profit margins
Pay overtime Prices
+ Global
Economic
Commodity Cycle
Unit labour Prices
Earnings costs + = Rate of
+ inflation
Productivity
Taxes
+
Economic Secular Fiscal Policy
Cycle Influences Profit Margins
(e.g. ICT
impact, quality
of education)
Economic Cycle
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3. 01/11/2010
Demand-pull inflation
• Demand – pull inflation
– 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
–DDemand-pull i fl ti associated with b
d ll inflation i t d ith 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 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 –
providing a boost to UK exports overseas
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4. 01/11/2010
Illustrating demand-pull inflation
General
Price LRAS
Level
SRAS1
P2
P1
AD2
AD1
Y1 Yfc Y2 National
Income
SRAS responds to excess
aggregate demand
General
Price LRAS SRAS2
Level
SRAS1
P3
P2
P1
AD2
AD1
Y1 Yfc Y2 National
Income
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5. 01/11/2010
Demand-pull inflation using a non-
linear AS curve
General
Price LRAS
Level
P3
P2
P1
AD3
SRAS AD2
AD1
Y1 Y2 Yfc Real National Income
The Output Gap and Consumer Price Inflation
Inflation and output gapCPI inflation - annual % change in prices
Output Gap = Actual GDP - Potential GDP. for the UK
10.0 10.0
8.0 8.0
6.0 6.0
4.0 4.0
CPI Inflation
2.0 2.0
Per cent
0.0 0.0
Output gap
-2.0 -2.0
-4.0 -4.0
-6.0 -6.0
-8.0 -8.0
90 92 94 96 98 00 02 04 06 08 10
Source: UK Statistics Commission and OECD World Economic Outlook
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6. 01/11/2010
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
LRAS
SRAS2
General
Price SRAS1
Level
P2
P1
AD1
Y2 Y1 Yfc National
Income
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7. 01/11/2010
Illustrating cost-push inflation – with
a non-linear SRAS
LRAS
General
Price
Level
P2
P1
SRAS2
SRAS1
AD1
AD2
Y3 Y2 Y1 Yfc Real National Income
UK Inflation and Crude Oil Prices
Oil prices the Consumer Price Index and monthly average for Brent Crude
Annual % change in and CPI inflation
150 150
SD/Barrel
100 Crude Oil Price 100
US
50 50
0 0
6.0 6.0
5.0 5.0
4.0 4.0
Percent
Consumer Price Inflation
3.0 3.0
P
2.0 2.0
1.0 1.0
0.0 0.0
06 07 08 09 10
Source: UK Statistics Commission and IPE
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8. 01/11/2010
Average Earnings Consumer Prices - A Link?
Wage Growth and and Consumer
Annual % change in earnings and consumer prices
6
Prices in the UK 6
5 Average Earnings 5
4 4
Percent
3 3
2 Consumer price inflation 2
1 1
0 0
00 01 02 03 04 05 06 07 08 09 10
Source: Reuters EcoWin
Import prices can have a direct Statistics
Index of UK Import Prices
Index 2003=100, source: Monthly Digest of Economic
200 effect on the rate of inflation 200
175 175
150 150
125 125
Finished Manufactured Goods
Index
100 100
Total Import Price Index
75 75
Import Prices for Fuels
50 50
25 25
01 02 03 04 05 06 07 08 09 10
Imports of Goods exc oil Imports of finished manufactures
Imports of Fuels
Source: Reuters EcoWin
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9. 01/11/2010
How does the exchange rateRate for the UK
Inflation and the Exchange affect
Exchange rate index (top pane) and inflation (lower pane)
110
inflationary pressures? 110
Sterling Exchange Rate Index
100 100
Index
90 90
I
80 80
70 70
6.0 6.0
Consumer Price Inflation
5.0 5.0
4.0 4.0
Percent
3.0 3.0
P
2.0 2.0
1.0 1.0
0.0 0.0
95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10
Source: Reuters EcoWin
Consequences
of inflation
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10. 01/11/2010
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
inflation
i fl ti on growth i l
th is less clear.’
l ’
• 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 value
y
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 p
p y poor bargaining p
g g positions lose out
and suffer a reduction in their real living standards
and relative income level (i.e. to other groups)
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11. 01/11/2010
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
g
global competitiveness and a worsening of the
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
Economic Growth and Inflation
UKUK Real GDP Growth and Consumer Price Inflation. annual % change
Economic Growth and Inflation
10.0 10.0
7.5 7.5
5.0 Real GDP growth 5.0
2.5 2.5
Percent
0.0 Consumer price inflation 0.0
-2.5 -2.5
-5.0 -5.0
-7.5 -7.5
90 92 94 96 98 00 02 04 06 08 10
Source: UK Statistics Agency
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12. 01/11/2010
Anticipated inflation
• When people are able to make accurate
predictions of inflation they can take
inflation,
steps to protect themselves from its
effects
• For example, trade unions may exercise
their collective bargaining power to
negotiate 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, businesses
(people
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 a
redistribution of income and wealth from
one group in society to another
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13. 01/11/2010
Inflation Expectations
Inflation expectations
Bank of England/NOP, how do you expect prices to change over the next 12 months?
6.0 6.0
5.0 5.0
4.0 4.0
Percent
3.0 3.0
2.0 2.0
1.0 1.0
0.0 0.0
04 05 06 07 08 09 10
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
Some Inflation Web Resources
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