Causes and effects of Causes and effects of inflationinflation

Topic objectivesTopic objectives

Define and explain the causes of Demand pull inflation

Define and explain the causes of Demand pull inflation

Demand Pull InflationDemand Pull Inflation

Demand –pull inflation –When there is excess AD for goods and services

–i.e. a positive output gap (where actual GDP > Potential GDP)

–Businesses respond by raising prices to increase their profit margins

–Demand-pull inflation associated with the boom phase of the cycle (when SRAS becomes inelastic)

–Root causes of demand pull inflation are usually monetary in origin

So, what causes it?So, what causes it? A depreciation of the exchange rate A reduction in direct or indirect taxation. If

direct taxes are reduced 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

Asset price inflation –e.g. in the housing sector Faster economic growth in other countries –

providing a boost to UK exports overseas

Illustration of Demand pull inflationIllustration of Demand pull inflation

Then SRAS….Then SRAS….

And using a non-linear SRASAnd using a non-linear SRAS

Cost push inflationCost push inflation

Causes:–External shocks (commodity price fluctuations)–A depreciation in the exchange rate –Acceleration in wages / unit labour costs

•Leads to inward shift in SRAS•Firms raise prices to protect their profit margins –better able to do this when demand is price inelastic•“Wages often follow prices” •Rise in actual inflation can lead to an increase in inflationary expectations

Illustrating cost-push inflation

Cost push with a non-linear SRASCost push with a non-linear SRAS

The costs of inflationThe costs of inflation

‘Taken together, the verdict of economics, history and common sense is that inflation and deflation are costly. It is clear that very high inflation –in extreme cases hyperinflation –can lead to a breakdown of the economy [or society]. There is now a considerable body of empirical evidence that inflation and output growth are negatively correlated in high-inflation countries. For inflation rates in single figures, the impact of inflation on growth is less clear.’

•Mervyn King adapted from a speech entitled “The Inflation Target –Ten Years On” given in 2002

Costs and consequencesCosts and consequences

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.

Employees in poor bargaining positions lose out

Costs and consequencesCosts and consequences

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 to lower investment

Deterioration in global competitiveness A possible cause of higher

unemployment Rising inflation is associated with higher

policy interest rates -this reduces trend growth

Anticipated Vs unanticipatedAnticipated Vs unanticipatedAnticipated inflation: –When people are able to make accurate predictions of inflation, they can take steps to protect themselves from its effects

–For example, trade unions may exercise their collective bargaining power to negotiate with employers for increases in money wages so as to protect the real wages of union members

Anticipated Vs unanticipatedAnticipated Vs unanticipated

Unanticipated inflation:–Unanticipated inflation occurs when

economic agents (people, businesses and governments) make errors in their inflation forecasts

–Actual inflation may end up well below, or significantly above expectations causing losses in real incomes and a redistribution of income and wealth from one group in society to another

Some web resourcesSome web resources

And, again, in diagramsAnd, again, in diagrams

continuedcontinued

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Advantages of PDAdvantages of PD

Some consumers are brought into the market who might not have been able to afford the product

E.g. lower income consumers / Cheaper anti-viral drugs for consumers in developing countries

Social benefits? Higher total output than under a single price monopoly Profits may finance research and development projects –

dynamic efficiency? Profits may help to cross-subsidise other activitiesE.g. postal service profits from business mail helps to

maintain the uniform national postal rates Doctors might charge lower income patients less –

supported by higher charges for wealthier patients Consider impact on allocative and productive efficiency

Is this a realistic model of Is this a realistic model of behaviour?behaviour?

Firms are assumed to know the shape and location of their cost and demand curves

Firms then chose price and/or quantity to maximise their desired objective

In the real world business environment firms will not be aware of the exact shape of their cost and revenue curves.

And they face uncertainty –e.g. about the likely reaction of other suppliers in the market

There are many different reasons for price differences for essentially the same product –not all of them are to do with price elasticity of demand!

Video presentationVideo presentation

Why popcorn costs so much at the Why popcorn costs so much at the moviesmovies

Another video explanationAnother video explanation

Further reading…Further reading…