Understanding Inflation: Causes and Measurement
Inflation is a sustained increase in the cost of living or the average/general price level, leading to a fall in the purchasing power of money. The opposite of inflation is deflation, which is a decrease in the cost of living or average price level.
How is the Rate of Inflation Measured?
- The rate of inflation is measured by the annual percentage change in consumer prices.
- The British government has set an inflation target of 2% using the Consumer Price Index (CPI).
- It is the job of the Bank of England to set interest rates so that aggregate demand is controlled, inflationary pressures are subdued, and the inflation target is reached.
- The Bank is independent of the government, with control of interest rates, and it is free from political intervention. The Bank is also concerned with avoiding price deflation – we return to this a little later.
Demand-Pull Inflation
Demand-pull inflation occurs when aggregate demand is growing at an unsustainable rate, leading to increased pressure on scarce resources and a positive output gap. When there is excess demand, producers are able to raise their prices and achieve bigger profit margins because demand is running ahead of supply.
Demand-pull inflation becomes a threat when an economy has experienced a boom, with GDP rising faster than the long-run trend growth of potential GDP. Demand-pull inflation is likely when there is full employment of resources and SRAS is inelastic.
Main Causes of Demand-Pull Inflation
- A depreciation of the exchange rate increases the price of imports and reduces the foreign price of a country’s exports. If consumers buy fewer imports, while exports grow, aggregate demand will rise – and there may be a multiplier effect on the level of demand and output.
- Higher demand from a fiscal stimulus, e.g., lower direct or indirect taxes or higher government spending. If direct taxes are reduced, consumers have more disposable income, causing demand to rise. Higher government spending and increased borrowing creates extra demand in the circular flow.
- Monetary stimulus to the economy: A fall in interest rates may stimulate too much demand – for example, in raising demand for loans or in leading to house price inflation. Monetarist economists believe that inflation is caused by “too much money chasing too few goods” and that governments can lose control of inflation if they allow the financial system to expand the money supply too quickly.
- Fast growth in other countries – providing a boost to UK exports overseas. Export sales provide an extra flow of income and spending into the UK circular flow – so what is happening to the economic cycles of other countries definitely affects the UK.
Cost-Push Inflation
Cost-push inflation occurs when firms respond to rising costs by increasing prices to protect their profit margins.
Reasons Why Costs Might Rise
- Component costs: For example, an increase in the prices of raw materials and other components. This might be because of a rise in commodity prices such as oil, copper, and agricultural products used in food processing. A recent example has been a surge in the world price of wheat.
- Rising labor costs – caused by wage increases which are greater than improvements in productivity. Wage costs often rise when unemployment is low because skilled workers become scarce, and this can drive pay levels higher. Wages might increase when people expect higher inflation, so they ask for more pay to protect their real incomes. Trade unions may use their bargaining power to bid for and achieve increasing wages; this could be a cause of cost-push inflation.
- Expectations of inflation are important in shaping what actually happens to inflation. When people see prices rising for everyday items, they get concerned about the effects of inflation on their real standard of living. One of the dangers of a pick-up in inflation is what the Bank of England calls “second-round effects” – i.e., an initial rise in prices triggers a burst of higher pay claims as workers look to protect their way of life. This is also known as a “wage-price effect.”
- Higher indirect taxes – for example, a rise in the duty on alcohol, fuels, and cigarettes, or a rise in Value Added Tax. Depending on the price elasticity of demand and supply for their products, suppliers may choose to pass on the burden of the tax onto consumers.
- A fall in the exchange rate – this can cause cost-push inflation because it leads to an increase in the prices of imported products such as essential raw materials, components, and finished products.
- Monopoly employers/profit-push inflation – where dominant firms in a market use their market power (at whatever level of demand) to increase prices well above costs.
