Inflation is the rate at which the general price level for goods and/ or services rises, and subsequently, the purchasing power of the currency declines. It is one of the most quintessential topics as far as the Economics subject is concerned. For practical purposes too, one must have adequate know...
Inflation is an increase in the prices of goods and Causes of inflation
services. The most well-known indicator of inflation
is the Consumer Price Index (CPI), which measures The main causes of inflation can be grouped into
the percentage change in the price of a basket three broad categories:
of goods and services consumed by households 1. demand-pull,
(see Explainer: Inflation and its Measurement). 2. cost-push, and
The CPI is the measure of inflation used by the 3. inflation expectations.
Reserve Bank of Australia in its inflation target,
As their names suggest, ‘demand-pull inflation’ is
where it aims to keep annual consumer price
caused by developments on the demand side of
inflation between 2 and 3 per cent, on average,
the economy, while ‘cost-push inflation’ is caused
over time (see Explainer: Australia’s Inflation
by the effect of higher input costs on the supply
Target). Other measures of inflation are also
side of the economy. Inflation can also result from
analysed, but most measures of inflation move in
‘inflation expectations’ – that is, what households
similar ways over the longer term.
and businesses think will happen to prices in the
This Explainer describes the main causes of future can influence actual prices in the future.
changes in the inflation rate. These different causes of inflation are considered
by the Reserve Bank when it analyses and
forecasts inflation.1
Inflation
Demand-pull OI Inflation
L
expectations
Cost-push
1 See the Bulletin article on ‘Explaining Low Inflation Using Models’ for more information.
RESERVE BANK OF AUSTRALIA | Education Causes of Inflation 1
, Demand-pull inflation demand. With increased demand for labour, firms
may have to offer higher wages to attract new
Demand-pull inflation arises when the total staff and retain their existing employees. Firms may
demand for goods and services (i.e. ‘aggregate also increase the prices of their goods and services
demand’) increases to exceed the supply of goods to cover their higher labour costs.2 More jobs
and services (i.e. ‘aggregate supply’) that can be and higher wages increase household incomes
sustainably produced. The excess demand puts and lead to a rise in consumer spending, further
upward pressure on prices across a broad range increasing aggregate demand and the scope for
of goods and services and ultimately leads to an firms to increase the prices of their goods and
increase in inflation – that is, it ‘pulls’ inflation higher. services. When this happens across a large number
of businesses and sectors, this leads to an increase
in inflation.
Price
AS The opposite will happen when aggregate
level
demand decreases; firms facing lower demand
P2 will either pause hiring or make staff redundant
which means that fewer staff are required. This puts
P1 upward pressure on the unemployment rate.
More workers searching for jobs means that firms
AD2 can offer lower wages, putting downward pressure
on household incomes, consumer spending and
AD1 the prices of their goods and services. As a result,
inflation will decrease.
Y1 Y2 Real
output The supply of goods and services that can
be sustainably produced is also known as the
Aggregate demand might increase because there is economy’s potential output or full capacity. At this
an increase in spending by consumers, businesses level of output, factors of production, such as
or government, or an increase in net exports. As a labour and capital (which includes the machines
result, demand for goods and services will increase and equipment firms use to produce their goods
relative to their supply, providing scope for firms and services) are being used as intensively as
to increase prices (and their margins – which is possible without putting upward pressure on
their mark-up on costs). At the same time, firms will inflation. When aggregate demand exceeds the
seek to employ more workers to meet this extra economy’s potential output, this will put upward
Aggregate Firms’ demand Firms’
Wages
demand for workers prices
2 Labour accounts for a large share of most firms’ total costs of production. The effect of an increase in the cost of labour on inflation
depends on both the growth in wages and the productivity of labour. Labour productivity refers to how much output can be produced
per worker or per hour worked (see Explainer: Productivity). If wages rise more quickly than labour productivity, the cost to the firm of
producing each unit of output also increases – pushing up prices and inflation.
2 RESERVE BANK OF AUSTRALIA | Education Causes of Inflation
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