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Inflation means there is a sustained increase in the price level. The main causes of inflation are
either excess aggregate demand (economic growth too fast) or cost push factors (supply side
factors)
1. Demand pull inflation
If the economy is at or close to full employment then an increase in AD leads to an increase in
the price level. As firms reach full capacity, they respond by putting up prices, leading to
inflation. Also, near full employment, workers can get higher wages which increases their
spending power.
We tend to get demand pull inflation, if economic growth is above the long run trend
rate of growth. The long run trend rate of economic growth is the average
sustainable rate of growth and is determined by the growth in productivity.
2. Cost Push Inflation
If there is an increase in the costs of firms, then firms will pass this on to consumers. There will
be a shift to the left in the AS.
In 2011/12, the UK experienced a rise in cost-push inflation, partly due to the depreciation in the
Pound against the Euro. (also due to higher taxes)
4.
When firms push up prices to get higher rates of inflation. This is more likely to occur during
strong economic growth.
5. Declining productivity
If firms become less productive and allow costs to rise, this invariably leads to higher prices.
6. Higher taxes
If the government put up taxes, such as VAT and Excise duty, this will lead to higher prices, and
therefore CPI will increase. However, these tax rises are likely to be one-off increases. There is
even a measure of inflation (CPI-CT) which ignores the effect of temporary tax rises/decreases.
CPI-CT is less volatile because it ignores the effect of taxes. In 2010, some of the UK
CPI inflation was due to rising taxes.
What else could cause inflation?
Once inflation sets in it is difficult to reduce it For example, higher prices will cause workers to
demand higher wages causing a wage price spiral. Therefore, expectations of inflation is
important. If people expect high inflation, it tends to be self-serving.
The attitude of the monetary authorities is important for example if there was an increase in AD
and the monetary authorities accommodated this by increasing the money supply then there
would be a rise in the price level