Causes & Consequences of Inflation (Cambridge International IGCSE Economics)
The Causes of Inflation
Spec point — Causes of inflation: demand-pull and cost-push. The consequences of inflation for consumers, workers, savers, lenders, firms and the economy as a whole.
- An increase in the general price level in an economy can be caused by demand pull inflation or cost push inflation
1. Demand pull inflation
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Demand pull inflation is caused by excess demand in the economy
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Total (aggregate) demand is the sum of all expenditure in the economy
- rGDP = Consumption (C) + Investment (I) + Government spending (G) + Net Exports (X-M)
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If any of the four components of rGDP increase, there will be an increase in the total demand in the economy leading to an increase in the general price level
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Demand pull inflation has occurred
An Example of Demand Pull Inflation
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If the Central Bank lowers the base rate, there is likely to be increased borrowing by firms and consumers
- This will result in an increase in consumption and i nvestment which will increase the rGDP
- It is likely to lead to a form of demand-pull inflation
2. Cost push inflation
- Cost push inflation is caused by increases in the costs of production in an economy
- If any of the costs of production increase (labour, raw materials etc.), or if there is a fall in productivity, the total supply will decrease
- With less supply, prices rise leading to an increase in the general price level
- Cost push inflation has occurred
An Example of Cost Push Inflation
- Trade Unions negotiate higher wages for workers
- The wage increases represent an increased cost of production for firms
- With the inputs, firms now produce less and supply reduces leading to higher general price levels
- Cost push inflation has occurred
The Consequences of Inflation
Spec point — Causes of inflation: demand-pull and cost-push. The consequences of inflation for consumers, workers, savers, lenders, firms and the economy as a whole.
The Impact of Inflation on Different Stakeholders
| Firms | Consumers | Government | Workers |
|---|---|---|---|
| - Uncertainty: Rapid price changes create uncertainty and delay investment - Menu change costs: Price changes force firms to change their menu prices too and this can be expensive - Lenders: Financial firms that lend money are worse off as the money lent out is now worth less than before | - Purchasing Power: Decrease in purchasing power worsens their quality of life - Savings: There is a decrease in the real value of savings (as money will be worth less in real terms) - Real Income: There is a fall in real income for those on fixed incomes/pension - Borrowers: anyone who borrows money benefits as the repayments are worth less than when the money was originally borrowed | - International Competitiveness: Inflation erodes international competitiveness of export industries as their products now look relatively more expensive to foreigners - Trade-offs: There are involved in tackling inflation e.g. reducing inflation may increase unemployment and/or reduce economic growth - Government Debt: inflation erodes the value of government debt as the repayments are worth less than when the money was originally borrowed | - Higher Wages: Workers demand higher wages to compensate for reduced purchasing power - Morale: If wage increases ≠ inflation, motivation and productivity may fall as workers do not receive the same real benefit for the work they are doing |
Exam Hint Remember, governments want some inflation - usually 2-3% as this is a sign of economic growth. However, inflation in excess of that is harmful in many of the ways described above.
When evaluating inflation a considerable positive for many governments is the fact that it erodes the value of government debt. This may be difficult to grasp, but if a government has a lot of debt, it may actually be happy to let inflation run at a higher level for a period of time. The trade-off is that everyone in the economy who is not a 'borrower' is worse off and if inflation is high, it can lead to social unrest and economic instability.
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