A succinct and complete summary of the Inflation topic of AQA A-level Economics. Using only this material when revising for the Inflation section of Paper 1 I was able to achieve an A* in Economics.
Quick summary of inflation topic:
Inflation is a sustained rise in the general price level. It is generally measured in percentage terms; the Bank of
England’s Monetary Policy Committee aims for an inflation target of 2% using the Consumer Price Index, CPI. There
are two main causes of inflation: demand-pull, when aggregate demand shifts to the right, so rising expenditure
drives up the price level, or cost-push inflation, when aggregate supply shifts to the left, and rising production costs
are passed onto consumers in the form of higher prices. If the money supply continues to rise, then this leads to
sustained rises in prices and so inflation. Sustained falls in the price level are also possible and this is called deflation.
What is meant by inflation?
A sustained increase in the general price level in the economy.
Characteristics/Features of inflation
- Increasing demand/decreasing supply of money
- Fall in value of currency
- Erodes value of real disposable income and savings
- Reduces purchasing power
- Can worsens poverty and inequality (poorest in society are worst affected)
- Makes goods less internationally competitive
Types of inflation
Demand pull inflation Cost Push inflation
, Demand pull inflation
- Caused by an increase in the AD of an economy.
- When the economy is near to productive capacity an increase in AD will push the price up
(i.e. there may be a positive output gap). Usually associated with overheating in the
economy.
- Because aggregate supply can not rise enough to meet the increased aggregate demand.
- This growth in demand shifts the aggregate demand curve to the right (from AD1 to AD2),
which allows sellers to raise prices.
- The main triggers for demand pull inflation are:
- Fiscal stimulus in the form of lower taxes or more government spending. This means
consumers have more disposable income, so consumer spending increases
- Low unemployment or other reasons for high levels of consumer confidence which lead
to high consumer spending
- Lower interest rates makes saving less attractive and borrowing more attractive, so
consumer spending and investing increases
- The money supply growing faster than output - Monetarist economists believe that
excess money is the biggest cause of inflation
- High growth in the UK export market means UK exports increase and AD increases.
- A depreciation in the exchange rate, which causes imports to become more expensive,
whilst exports become cheaper. This causes AD to rise.
- Bottleneck - If demand grows quickly at a time when labour and resources are already being fully
used, then increasing output may lead to shortages (i.e. there may be a positive output gap). These
shortages will cause prices to rise and firms’ costs to increase.
- Price rises caused by shortages (e.g. a rise in wages for skilled labour) in one area of the market may
be copied by other markets (e.g. higher wages for low-skilled labour), leading to more general
inflation.
Cost push inflation
- Caused by an increase in the cost of production.
- Rising CoP, shifting SRAS to the left, forces producers to pass on higher costs to consumers in
the form of higher prices
- Causes include:
- Changes in world commodity prices can affect domestic inflation - If the world prices
of inputs rise then, in the short run, producers will pay the higher cost and set higher
prices
- A rise in wages above any increase in productivity. As labour is the largest
proportion of a firm's cost of all factors of production an increase in wages could
significantly increase price levels. This could be through trade unions or higher
NMW, for example.
- Wage price spiral - if consumers expect prices to rise, they may ask for higher wages
to make up for this, and this could trigger more inflation
- Indirect taxes could increase the cost of goods such as cigarettes or fuel, if producers
choose to pass on cost onto the consumer.
- Depreciation in the exchange rate, which causes imports to become more expensive
and pushes up the price of raw materials
- Monopolies, using their dominant market position to exploit consumers with high
prices.
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