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Causes of Inflation .docx

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ECON 1010
Sarrah Vakili

Causes of Inflation Cost Push Inflation Cost-push inflation occurs when businesses respond to rising production costs, by raising prices in order to maintain their profit margins. There are many reasons why costs might rise: Rising imported raw materials costs perhaps caused by inflation in countries that are heavily dependent on exports of these commodities or alternatively by a fall in the value of the pound in the foreign exchange markets which increases the UK price of imported inputs. A good example of cost push inflation was the decision by British Gas and other energy suppliers to raise substantially the prices for gas and electricity that it charges to domestic and industrial consumers at various points during 2005 and 2006. Rising labour costs - caused by wage increases which exceed any improvement in productivity. This cause is important in those industries which are „labour-intensive‟. Firms may decide not to pass these higher costs onto their customers (they may be able to achieve some cost savings in other areas of the business) but in the long run, wage inflation tends to move closely with price inflation because there are limits to the extent to which any business can absorb higher wage expenses. Higher indirect taxes imposed by the government – for example a rise in the rate of excise duty on alcohol and cigarettes, an increase in fuel duties or perhaps a rise in the standard rate of Value Added Tax or an extension to the range of products to which VAT is applied. These taxes are levied on producers (suppliers) who, depending on the price elasticity of demand and supply for their products, can opt to pass on the burden of the tax onto consumers. For example, if the government was to choose to levy a new tax on aviation fuel, then this would contribute to a rise in cost-push inflation. Cost-push inflation can be illustrated by an inward shift of the short run aggregate supply curve. This is shown in the diagram below. Ceteris paribus, a fall in SRAS causes a contraction of real national output together with a rise in the general level of prices. Demand Pull Inflation Demand-pull inflation is likely when there is full employment of resources and when SRAS is inelastic. In these circumstances an increase in AD will lead to an increase in prices. AD might rise for a number of reasons – some of which occur together at the same moment of the economic cycle  A depreciation of the exchange rate, which has the effect of increasing the price of imports and reduces the foreign price of UK exports. If consumers buy fewer imports, while foreigners buy more exports, AD will rise. If the economy is already at full employment, prices are pulled upwards.  A reduction in direct or indirect taxation. If direct taxes are reduced consumers have more real disposable income causing demand to rise. A reduction in indirect taxes will mean that a given amount of income will now buy a greater real volume of goods and services. Both factors can take aggregate demand and real GDP higher and beyond potential GDP.  The rapid growth of the money supply – perhaps as a consequence of increased bank and building society borrowing if interest rates are low. Monetarist economists believe that the root causes of inflation are monetary – in particular when the monetary authorities permit an excessive growth of the supply of money in circulation beyond that needed to finance the volume of trans
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