Causes & Consequences of Inflation (Cambridge (CIE) O Level Economics)
Revision Note
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
Firms | Consumers | Government | Workers |
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Examiner Tip
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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