inflation Flashcards
inflation definition
the rate of change in the average price level over time
how do you measure
the consumer price index
the retail prices index
what are the three primary causes of inflation
Demand-Pull
Cost-Push
Growth of the money supply
demand pull inflation explain
Demand-pull inflation is caused by excessive demand in the economy for goods and services
there is too much money chasing too few goods and services
The best way to think about this is using the AD formula: C + I + G + (X-M)
what are the causes of demand pull inflation
Reduced taxation
Increases disposable income
Lower interest rates
Makes borrowing more attractive and saving less rewarding
A general rise in consumer spending
Perhaps from higher incomes and consumer confidence
Improved availability of credit
Banks/Building Societies widen the availability of credit or make it more affordable
A weak exchange rate
Will boost export growth
Fast growth in other countries
May increase demand for UK exports
General rise in confidence / expectations of future growth
May feed through to higher consumer spending and investment
Certainty
Links to confidence and assists consumers and firms in their spending and investment decisions
demand pull inflation diagram
1) Begin with the equilibrium position.
2) If there is a cut in interest rates, this makes borrowing on credit more attractive, and saving less rewarding so consumption may rise.
3) This leads to a rise in AD to AD1.
4) In the short-run, factor resources remain unchanged and if demand for goods and services rises faster than firms are able to provide additional supply, then prices will be ‘pulled’ upwards to P1.
cost push inflation explanation
This occurs when firms respond to rising costs of production by increasing prices
Firms will typically do this to protect profit marginsThat said, firms may be able to absorb some increases in their costs of production,
but they will not be able to do this indefinitely, and so pass costs onto the consumer in the form of higher prices
what are the causes of cost push inflation
Wage increases
For many firms, wages is their largest single cost of production
It is likely that if prices are rising, workers will demand higher wages in order to maintain their ‘real’ incomes
If these higher wage costs are reflected in higher prices, then workers will continue to demand higher wages, leading to a wage-price spiral
Higher raw material costs
As primary raw materials become more scarce and in even greater demand, raw materials and associated components may rise in price
Higher taxes
The government may impose higher taxes on firms; for example, corporation tax, national insurance, or taxes on waste disposal
Higher import prices
A weaker exchange rate or rising prices abroad mean that imported components feed through to higher costs of production
Natural disasters
May temporarily or permanently reduce the supply of raw materials or disrupt the supply chain, adding to a firms costs
cost push inflation diagram
1) Begin with the equilibrium position
2) If there is an increase in wage rates, this will increase a firms costs of production.
3) This will reduce SRAS to SRAS1 because faced with higher costs of production, firms will reduce their supply, or may even leave the industry if they cannot maintain profit margins.
4) As a result, rising costs have “pushed” up prices to P1.
what is deflation
a decrease in the general price level
causes of deflation
Deflation tends to occur during periods of very low, or stagnant growth
Despite the fact that the value of money would be rising, deflation generally indicates that demand is very low or suppressed
problems of deflation
As prices are falling, consumers tend to delay purchasing decisions because they think prices will fall in future
As a result, consumption slows significantly
Which is likely to mean that firms will lose the confidence to invest, thus harming aggregate demand still further
disinflation
Disinflation occurs when the inflation rate is positive but falling
How changes in world commodity prices affect domestic inflation
Commodities such as oil and food make up a large proportion of UK imports
This means that they have a significant impact on the price level
Many of the commodities that are bought in the UK are price inelastic products
Therefore, a rise in the world price of commodities will feed through to UK inflation
How changes in other economies can affect inflation in the UK
The UK is impacted in a number of ways
Emerging markets are creating a growing demand for goods and services globally. This has led to demand pull inflation
These same markets are increasing productive capacity which has lead to lower cost products feeding through into lower prices e.g. China
The economic performance of our major trading partners such as the EU and the US will impact on demand for UK products
