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

Revision Note

Written by: Steve Vorster

Reviewed by: Jenna Quinn

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
Uncertainty: Rapid price changes create uncertainty and delay investment Menu change costs: Price changes force firms to change their menu prices too and this can be expensive Lenders: Financial firms that lend money are worse off as the money lent out is now worth less than before	Purchasing Power: Decrease in purchasing power worsens their quality of life Savings: There is a decrease in the real value of savings (as money will be worth less in real terms) Real Income: There is a fall in real income for those on fixed incomes/pension Borrowers: anyone who borrows money benefits as the repayments are worth less than when the money was originally borrowed	International Competitiveness: Inflation erodes international competitiveness of export industries as their products now look relatively more expensive to foreigners Trade-offs: There are involved in tackling inflation e.g. reducing inflation may increase unemployment and/or reduce economic growth Government Debt: inflation erodes the value of government debt as the repayments are worth less than when the money was originally borrowed	Higher Wages: Workers demand higher wages to compensate for reduced purchasing power Morale: If wage increases ≠ inflation, motivation and productivity may fall as workers do not receive the same real benefit for the work they are doing

Examiner Tips and Tricks

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.

Last updated: 22 June 2024

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