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ECON 1010
Sarrah Vakili

Inflation What is inflation? Inflation is best defined as a sustained increase in the general price level leading to a fall in the purchasing power or value of money The rate of inflation is measured by the annual percentage change in the level of consumer prices. Deflation Price deflation is when the rate of inflation becomes negative. I.e. the general price level is falling and the value of money is increasing. Some countries have experienced deflation in recent years – good examples include Japan and China. In Japan, the root cause of deflation was slow economic growth and a high level of spare capacity in many industries that was driving prices lower. In China, economic growth has been rapid – but the huge amount of capital investment and rising productivity has led to economies of scale being exploited and a fall in production costs. The main causes of inflation Inflation can come from several sources: Some come direct from the domestic economy, for example the decisions of the major utility companies providing electricity or gas or water on their prices for the year ahead, or the pricing strategies of the leading food retailers based on the strength of demand and competitive pressure in their markets. A rise in government VAT would also be a cause of increased domestic inflation because it increases a firm’s production costs. Inflation can also come from external sources, for example an unexpected rise in the price of crude oil or other imported commodities, foodstuffs and beverages. Fluctuations in the exchange rate can also affect inflation – for example a fall in the value of sterling might cause higher import prices – which feeds through directly into the consumer price index. We make a simple distinction between demand pull and cost push inflation. Demand-pull inflation Demand-pull inflation is likely when there is full employment of resources and aggregate demand is increasing at a time when SRAS is inelastic. This is shown in the next diagram: In the diagram above we see a large outward shift in AD. This takes the equilibrium level of national output beyond full-capacity national income (Yfc) creating a positive output gap. This would then put upward pressure on wage and raw material costs – leading the SRAS curve to shift inward and causing real output and incomes to contract back towards Yfc (the long run equilibrium for the economy) but now with a higher general price level (i.e. there has been some inflation). The main causes of demand-pull inflation Demand pull inflation is largely the result of the level of AD being allowed to grow too fast compared to what the supply-side capacity can meet. The result is excess demand for goods and services and pressure on businesses to raise prices in order to increase their profit margins. Possible causes of demand-pull inflation include: 1. A depreciation of the exchange rate which increases the price of imports and reduces the foreign price of UK exports. If consumers buy fewer imports, while exports grow, AD in will rise – and there may be a multiplier effect on the level of demand and output 2. Higher demand from a fiscal stimulus e.g. via a reduction in direct or indirect taxation or higher government spending. If direct taxes are reduced, consumers will have more disposable income causing demand to rise. Higher government spending and increased government borrowing feeds
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