10.1 causes of inflation

8/3/2019 10.1 Causes of Inflation

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Inflation Measurement and Causes

AS Economics


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Areas to focus on


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Key Issues

The meaning of inflation

Measuring the general price level

Deflation and hyperinflation Causes of inflation (demand pull and cost push)

Controlling inflation demand and supply-side

policies

Recent trends in UK inflation

Why has inflation in the UK remained so low?


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Defining inflation

Inflation is a sustained increase in the average

price level of a country.

The rate of inflation is measured by the annualpercentage change in the level of prices as

measured by the consumer price index.

A sustained fall in the general price level is

called deflation in this situation, the rate ofinflation becomes negative.


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What are the main causes of inflation?

Watch this & make notes

on what have been the

causes of inflation


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Two types of causes of inflation

Demand pull inflation

Cost push inflation


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Demand pull inflation


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Demand-pull inflation

Occurs when there is excess AD i.e. when there is a

positive output gap (actual GDP > Potential GDP)

Businesses respond to high demand by raising prices to

increase their profit margins

Demand-pull inflation is associated with the boom

phase of the cycle (when SRAS becomes inelastic)

The main causes of demand pull inflation

Very fast growth of demand for credit / borrowing

High levels of consumer spending


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Draw a Classical AD/AS diagram


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Price Level

Real National

Output

Y1

LRAS

0

AD

What would happen if

there was an increase in

AD in the SHORT RUN?


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Price Level

Real National

Output

Y1

LRAS

Y2

AD1

0

AD

SRAS

How can an

economy

operate

beyond its

Fullemployment

level?


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PPF represents an economys capacity!

How can an

economy

operate

beyond its

Fullemployment

level?


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Price Level

Real National

Output

Y1

LRAS

Y2

AD1

0

AD

SRAS

In the SR

theeconomy

can work

overtime, at

a slightly

higher cost

(overtime)


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Price Level

Real National

Output

Y1

LRAS

Y2

AD1

0

AD

SRAS

In the LR,

workers are notwilling to

sacrifice Leisure

time for more

overtime. But

still have high

wage

expectations.demand pull

inflation

SRAS2


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To your notes..

Draw the AD/AS diagram (s) and

add your own explanation of whathappens


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Main causes of demand pull inflation

A depreciation .

A reduction in direct or indirect taxation

Rapid growth of the money supply

Rising consumer confidence

Faster rates ofeconomic growth in other countries

How can

each of

thesecause

inflation?


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Main causes of demand pull inflation

A depreciation of the exchange rate increases the price of

imports and reduces the foreign price of UK exports

A reduction in direct or indirect taxation - consumers will

have more disposable income causing demand to rise

Rapid growth of the money supply as a consequence of

increased bank and building society borrowing

Rising consumer confidence and an increase in the rate of

growth of house prices

Faster rates of economic growth in other countries

providing a boost to UKexports overseas (an injection of

AD)


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Cost push inflation


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Cost Push Inflation

Occurs when costs of production are increasing

Causes:

External shocks (commodity price fluctuations)

A depreciation in the exchange rate

Acceleration in wages

Leads to inward shift in SRAS curve

Firms raise prices to protect their profit margins better able todo this when market demand is price inelastic

Wages often follow prices

A rise in inflation can lead to rising inflationary expectations


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Draw an Classical AD/AS diagram

Price Level

Real National

Output

Y1

LRAS

0

AD

What would happen if

there was an inward shift

of the SRAS?

SRAS1

SRAS2

Y2


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Wage inflation in the UK economy

Annual percentage change in earnings and consumer prices

Earnings and prices

Average earnings Consumer Price Inflation [ar 12 months]Source: Reuters EcoWin

89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06

Percent

0

1

2

3

4

5

6

7

8

9

10

11

Consumer price inflation

Average Earnings


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Cost push inflation falling SRAS

Price Level

Real NationalOutput

LRAS

SRAS

Yfe

SRAS2


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Illustrating cost-push inflation

Price Level

Real NationalOutput

LRAS

SRAS

Yfe

AD1

Y1Y2

P2

Pe SRAS2


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Costs and Consequences of Inflation

Money loses its value and people lose confidence in

money as the value of savings is reduced

Inflation can get out of control - price increases lead to

higher wage demands as people try to maintain their

living standards. This is known as a wage-price spiral.

Consumers and businesses on fixed incomes lose out

because the their real incomes falls - employees in poor

bargaining positions lose out


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Consequences of growing inflation


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Costs and Consequences of Inflation

Inflation can favour borrowers at the expense of savers

because inflation erodes the real value of existing

debts

Inflation can disrupt business planning and lead tolower capital investment

Inflation is a possible cause of higher unemployment in

the long term because of a lack of competitiveness

Rising inflation is associated with higher interest rates -

this reduces economic growth and can lead to a

recession


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Explaining low inflation in the UK


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Explaining low inflation in the UK

Several factors explain the absence of inflation

Subdued growth of wages and earnings (below 5%)

Absence of major inflationary shocks such as a sharp jump in

international commodity prices

Success of the Bank of England in keeping aggregate demand

under control through interest rate changes

Much greater competitive pressure in many industries

Strong pound has helped to keep inflation under control

Expansion of technology has helped to reduce costs

Cuts in the prices charged by many of the privatized utilities

Expectations of inflation have fallen!


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The NICE-1990s!

In the 1990s, the UK experienced a non-

inflationary consistently expansionary - or "nice"

- decade; a decade in which growth was a little

above trend, unemployment fell steadily, andcheaper imports allowed consumers to enjoy

rising living standards without the need to ask

for inflationary pay claims

Mervyn King, Governor of the Bank of England


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Interest rates and inflation

Annual percentage change in the UK Consumer Price Index, the inflation target is 2%

Consumer Price Inflation and Interest Rates for the UK

UK Consumer Price Inflat ion [ar 12 months] Base Interest Rates for the UK

Source: Reuters EcoWin

97 98 99 00 01 02 03 04 05 06

Percent

0

1

2

3

4

5

6

7

8

CPI Inflation

Base Interest Rates


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A decline in global inflation

Annual percentage change in consumer prices, source IMF World Economic Outlook

World Inflation

Source: Reuters EcoWin

70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06

PercentperAnnum

0

5

10

15

20

25

30

35


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Reasons for continued low inflation

Success of Bank

ofEngland in

controlling AD

Strong exchange

rate has kept

import prices low

Effects of

globalisation

cheaper imports

Rising

productivity & new

technology

A fall in workers

expectations of

inflation

Increased

competition in

markets

Low Inflation in the UK Economy


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Homework

Read article about Economic Cycle

Highlight key issues use 2 different colours

highlight positives & negative issues

Make a summary of the key issues raised

Complete Q 1, 2 & 4 only.


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Further knowledge

http://www.bbc.co.uk/iplayer/episode/b00r92bp/Select_

Committees_Inflation_Report_Committee/

If you are really interested in what happens with the

BoE in managing inflation watch this select committee

meeting.

Listen to this reasons why inflation can be good for

the economy


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Some quick questions


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Inflation Qs

What is meant by Inflation? (2)

Explain how inflation is measured? (2)

Explain how a fall in the rate of unemployment might

effect the rate of inflation? (8 marks)

Using AD/AS analysis, assess the implications of a fall

in AD on the UK economy? (8 marks)

10.1 causes of inflation

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