Definition
Inflation is a sustained rise in the general price level over a period of time.
It is measured using a price index, such as the Consumer Prices Index (CPI), which tracks the prices of a basket of goods and services.
Do not confuse it with:
- Deflation — a sustained fall in the general price level.
- Disinflation — a fall in the rate of inflation (prices are still rising, but more slowly).
The two main causes
Demand-pull inflation
Caused by an increase in aggregate demand (AD) that outpaces the economy's ability to produce.
An increase in consumer spending shifts AD to the right. Because firms cannot increase output quickly, they respond by raising prices. The result is demand-pull inflation.
Common triggers:
- lower interest rates
- higher government spending
- increased exports
- rising consumer confidence
Cost-push inflation
Caused by an increase in the costs of production, which shifts short-run aggregate supply (SRAS) to the left.
An increase in oil prices raises firms' costs of production, so SRAS shifts to the left. Firms pass part of the cost increase on to consumers as higher prices, which raises the general price level.
Common triggers:
- higher wages
- higher raw material prices
- higher energy costs
- a depreciation of the exchange rate raising import prices
The diagram
For demand-pull:
- Draw AD shifting right.
- SRAS stays in place in the short run.
- Price level rises and real output rises.
For cost-push:
- Draw SRAS shifting left.
- AD stays in place.
- Price level rises and real output falls.
That second case is important: falling output plus rising prices is stagflation.
Consequences
| Effect | Explanation |
|---|---|
| Loss of purchasing power | Money buys less, especially harmful to fixed-income groups |
| Uncertainty | Firms delay investment because future costs are unclear |
| Wage demands | Workers ask for higher wages, which can cause a wage-price spiral |
| Export competitiveness | Domestic goods become relatively more expensive abroad |
| Menu costs | Firms face costs from changing prices frequently |
Inflation also affects borrowers and savers differently. Borrowers benefit if inflation is higher than the interest rate on their debt; savers lose real value.
A chain that earns marks
An increase in government spending raises aggregate demand, so AD shifts to the right. Because the economy is near full capacity, firms cannot increase output enough to meet the higher demand. They therefore raise prices, which increases the general price level and causes demand-pull inflation. If workers then demand higher wages to protect their real income, firms' costs rise and SRAS shifts left, which can worsen the inflation.
Common lost marks
- Saying "prices rise" without "sustained". One price rise is not inflation.
- Confusing inflation with deflation. They are opposites.
- No diagram reference. State which curve shifts and why.
- Listing consequences without explaining them. Explain the mechanism.
- Ignoring the cause. Demand-pull and cost-push have different effects on output.
Evaluation angles
- Is the inflation demand-pull or cost-push?
- How close is the economy to full capacity?
- Are inflation expectations becoming entrenched?
- How independent is the central bank?
- Is the inflation imported, and therefore outside domestic control?
Quick check
- Define inflation.
- Explain demand-pull inflation with a chain.
- Explain cost-push inflation with a chain.
- Explain one reason inflation harms firms.