Causes & Consequences of Inflation (Cambridge (CIE) O Level Economics)

The Causes of Inflation

• 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

• Demand pull inflation is caused by excess demand in the economy

• Total (aggregate) demand is the sum of all expenditure in the economy

  • rGDP = Consumption (C) + Investment (I) + Government spending (G) + Net Exports (X-M)

• 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

• Demand pull inflation has occurred 

An Example of Demand Pull Inflation

• 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 investment 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

The Impact of Inflation on Different Stakeholders