Be a part of our Instagram community. What is Inflation? Recommended read: An introduction to financial analysis The problem with printing money You might wonder what would happen if the Government printed loads of money in an attempt to solve the problem of money, but here is the thing: an increase in the supply of money is the root cause of inflation. Why Inflation Occurs There are many schools of thoughts regarding the cause of inflation.
The cause can generally be divided into two broad categories: 1 Demand-pull inflation 2 Cost-push inflation Demand-pull inflation It is caused due to aggregate demand increasing faster than aggregate supply. Causes of demand-pull inflation: Economic growth : This occurs when consumers feel confident then they can afford to spend more and take more debt; hence the increase in demand leads to an increase in price.
Asset inflation : This generally occurs when the currency of a particular economy suddenly depreciates, providing more money in the hands of the importers while the production of goods remains constant, hence sudden increase in demand Import demands resulting in an increase in price. Government spending : This occurs when the government spends capital on large scale projects creating an increase in demand overall because of trust, which leads to an increase in price and demand-pull inflation.
Inflation forecasts : When the government or media outlets forecast inflation, it will unintentionally cause demand-pull inflation.
In this situation, companies may increase their price to meet the expected inflation, and consumers may buy more thinking of future increase in price. Exorbitant supply of money : More money in the system increases the buying power of consumers, leading to an increase in price. Cost-Push Inflation Cost-push inflation occurs when there is a substantial increase in the cost of goods and no alternative is available. Higher Wages : High wages will lead to higher production cost because for any firm it is their main cost.
High wages can also generate demand-pull inflation. Many imported products prices are high due to higher excise duties. Profit-push inflation : When a company gains a monopoly in an industry, it can increase its price to make more profit which will lead to cost-push inflation.
Imported inflation : If a country devalues its currency, then the import price of goods will go up; hence it will increase the prices of imported goods. Key Takeaways Inflation is the rate at which the general prices of goods and services rises, while the purchasing power of the currency declines. In order to compensate, the increase in costs is passed on to consumers, causing a rise in the general price level: inflation.
For cost-push inflation to occur, demand for goods must be static or inelastic. That means demand must remain constant while the supply of goods and services decreases. One example of cost-push inflation is the oil crisis of the s.
The price of oil was increased by OPEC countries, while demand for the commodity remained the same. As the price continued to rise, the costs of finished goods also increased, resulting in inflation. Let's take a look at how cost-push inflation works using this simple price-quantity graph.
The graph below shows the level of output that can be achieved at each price level. As production costs increase, aggregate supply decreases from AS1 to AS2 given production is at full capacity , causing an increase in the price level from P1 to P2. The rationale behind this increase is, for companies to maintain or increase profit margins, they will need to raise the retail price paid by consumers, thereby causing inflation.
Demand-pull inflation occurs when there is an increase in aggregate demand, categorized by the four sections of the macroeconomy : households, businesses, governments, and foreign buyers.
When concurrent demand for output exceeds what the economy can produce, the four sectors compete to purchase a limited amount of goods and services. That means the buyers "bid prices up" again and cause inflation. This excessive demand, also referred to as "too much money chasing too few goods," usually occurs in an expanding economy. In Keynesian economics, an increase in aggregate demand is caused by a rise in employment, as companies need to hire more people to increase their output.
The increase in aggregate demand that causes demand-pull inflation can be the result of various economic dynamics. For example, an increase in government spending can increase aggregate demand, thus raising prices. As a result, the purchasing of imports decreases while the buying of exports by foreigners increases. This raises the overall level of aggregate demand, assuming aggregate supply cannot keep up with aggregate demand as a result of full employment in the economy.
Rapid overseas growth can also ignite an increase in demand as more exports are consumed by foreigners. Finally, if a government reduces taxes, households are left with more disposable income in their pockets. This, in turn, leads to an increase in consumer confidence that spurs consumer spending.
Looking again at the price-quantity graph, we can see the relationship between aggregate supply and demand. If aggregate demand increases from AD1 to AD2, in the short run , this will not change aggregate supply. Instead, it will cause a change in the quantity supplied, represented by a movement along the AS curve.
The rationale behind this lack of shift in aggregate supply is that aggregate demand tends to react faster to changes in economic conditions than aggregate supply. As companies respond to higher demand with an increase in production, the cost to produce each additional output increases, as represented by the change from P1 to P2. That's because companies would need to pay workers more money e. Just like cost-push inflation, demand-pull inflation can occur as companies pass on the higher cost of production to consumers to maintain their profit levels.
There are ways to counter both cost-push inflation and demand-pull inflation, which is through the implementation of different policies. To counter cost-push inflation, supply-side policies need to be enacted with the goal of increasing aggregate supply. To increase aggregate supply, taxes can be decreased and central banks can implement contractionary monetary policies , achieved by increasing interest rates. Countering demand-pull inflation would be achieved by the government and central bank implementing contractionary monetary and fiscal policies.
This would include increasing the interest rate; the same as countering cost-push inflation because it results in a decrease in demand, decreasing government spending, and increasing taxes, all measures that would reduce demand. International Monetary Fund. Google Books. What is the difference between cost-push and demand pull inflation?
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