1. Inflation – Measurement and Causes
Causes of inflation
Inflation – Measurement and Causes
AS Economics

2. Areas to focus on
Causes of inflation

3. Key Issues The meaning of inflation Measuring the general price level
Causes of inflation
The meaning of inflation
Measuring the general price level
Deflation and hyperinflation
Causes of inflation (demand pull and cost push)
Controlling inflation – demand and supply-side policies
Recent trends in UK inflation
Why has inflation in the UK remained so low?

4. Defining inflation
Causes of inflation
Inflation is a sustained increase in the average price level of a country.
The rate of inflation is measured by the annual percentage change in the level of prices as measured by the consumer price index.
A sustained fall in the general price level is called deflation – in this situation, the rate of inflation becomes negative.
Inflation is defined as a sustained increase in the average price level. It is quite possible for example for prices to be falling quite steeply in for example audio-visual equipment and clothing and textiles, but other sectors such as leisure services and household services are seeing price increases over the same period

5. What are the main causes of inflation?
In an open economy such as the UK, there are many potential sources of inflationary pressure. Some come direct from the domestic economy, for example the decisions of the major utility companies on their prices for the year ahead, or the pricing strategies of the leading food retailers based on the strength of demand and competitive pressure in their markets.
Watch this & make notes on what have been the causes of inflation

6. Two types of causes of inflation
Demand pull inflation
Cost push inflation

7. Demand pull inflation…

8. Demand-pull inflation
Causes of inflation
Occurs when there is excess AD – i.e. when there is a positive output gap (actual GDP > Potential GDP)
Businesses respond to high demand by raising prices to increase their profit margins
Demand-pull inflation is associated with the boom phase of the cycle (when SRAS becomes inelastic)
The main causes of demand pull inflation
Very fast growth of demand for credit / borrowing
High levels of consumer spending
Demand-pull inflation is likely when there is full employment of resources and aggregate demand is increasing at a time when SRAC is inelastic

9. Draw a Classical AD/AS diagram

10. Draw a Classical AD/AS diagram
LRAS
Price Level
What would happen if there was an increase in AD in the SHORT RUN? AD Y1
Real National Output

11. Draw a Classical AD/AS diagram
LRAS
Price Level
How can an economy operate beyond its ‘Full employment level?
SRAS
AD1 AD Y1 Y2
Real National Output

12. PPF represents an economy’s capacity!
How can an economy operate beyond its ‘Full employment level?

13. Draw a Classical AD/AS diagram
LRAS
Price Level
SRAS
In the SR the economy can work overtime, at a slightly higher cost (overtime)
AD1 AD Y1 Y2
Real National Output

14. Draw a Classical AD/AS diagram
SRAS2
LRAS
Price Level
SRAS
In the LR, workers are not willing to sacrifice Leisure time for more overtime…. But still have high wage expectations….
demand pull inflation
AD1 AD Y1 Y2
Real National Output

15. To your notes…..
Draw the AD/AS diagram (s) and add your own explanation of what happens…

16. Main causes of demand pull inflation
Causes of inflation
A depreciation ….
A reduction in direct or indirect taxation …
Rapid growth of the money supply …
Rising consumer confidence …
Faster rates of economic growth in other countries –
How can each of these cause inflation?

17. Main causes of demand pull inflation
Causes of inflation
A depreciation of the exchange rate increases the price of imports and reduces the foreign price of UK exports
A reduction in direct or indirect taxation - consumers will have more disposable income causing demand to rise
Rapid growth of the money supply as a consequence of increased bank and building society borrowing
Rising consumer confidence and an increase in the rate of growth of house prices
Faster rates of economic growth in other countries – providing a boost to UK exports overseas (an injection of AD)

18. Cost push inflation

19. Cost Push Inflation Occurs when costs of production are increasing
Causes of inflation
Occurs when costs of production are increasing
Causes:
External shocks (commodity price fluctuations)
A depreciation in the exchange rate
Acceleration in wages
Leads to inward shift in SRAS curve
Firms raise prices to protect their profit margins – better able to do this when market demand is price inelastic
“Wages often follow prices”
A rise in inflation can lead to rising inflationary expectations
Cost push inflation is caused by increases in costs of production e.g. wage rises, increased import prices (imported inflation) or higher indirect taxation. Firms put up prices to maintain their profit margins.

20. Draw an Classical AD/AS diagram
LRAS
SRAS2
Price Level
SRAS1
What would happen if there was an inward shift of the SRAS? AD Y2 Y1
Real National Output

21. Wage inflation in the UK economy
Causes of inflation

22. Cost push inflation – falling SRAS
Causes of inflation
LRAS
Price Level
SRAS2
SRAS
Yfe
Real National Output

23. Illustrating cost-push inflation
Causes of inflation
LRAS
Price Level
Cost-push inflation is caused by an inward shift of the short run AS curve. The more inelastic is the demand curve, the higher is the effect on the general price level P2 Pe
SRAS2
SRAS
AD1 Y2 Y1
Yfe
Real National Output

24. Costs and Consequences of Inflation
Causes of inflation
Money loses its value and people lose confidence in money as the value of savings is reduced
Inflation can get out of control - price increases lead to higher wage demands as people try to maintain their living standards. This is known as a wage-price spiral.
Consumers and businesses on fixed incomes lose out because the their real incomes falls - employees in poor bargaining positions lose out
Inflation can be a problem because it creates a range of economic and social costs. In assessing the costs of inflation, we must distinguish between different degrees of inflation, since low stable inflation has less of a damaging effect on the economy than hyperinflation where prices are out of control.

25. Consequences of growing inflation

26. Costs and Consequences of Inflation
Causes of inflation
Inflation can favour borrowers at the expense of savers – because inflation erodes the real value of existing debts
Inflation can disrupt business planning and lead to lower capital investment
Inflation is a possible cause of higher unemployment in the long term – because of a lack of competitiveness
Rising inflation is associated with higher interest rates - this reduces economic growth and can lead to a recession
The overall effects of inflation on an economy depend on the rate, whether it is fluctuating or stable, whether the rate has been anticipated or not and its rate relative to that of other countries. High, unstable, accelerating and unanticipated inflation will involve more costs than low, stable, declining and anticipated inflation

27. Explaining low inflation in the UK

28. Explaining low inflation in the UK
Causes of inflation
Several factors explain the absence of inflation
Subdued growth of wages and earnings (below 5%)
Absence of major inflationary shocks such as a sharp jump in international commodity prices
Success of the Bank of England in keeping aggregate demand under control through interest rate changes
Much greater competitive pressure in many industries
Strong pound has helped to keep inflation under control
Expansion of technology has helped to reduce costs
Cuts in the prices charged by many of the privatized utilities
Expectations of inflation have fallen!

29. The “NICE-1990s”!
Causes of inflation
“In the 1990s, the UK experienced a non-inflationary consistently expansionary - or "nice" - decade; a decade in which growth was a little above trend, unemployment fell steadily, and cheaper imports allowed consumers to enjoy rising living standards without the need to ask for inflationary pay claims”
Mervyn King, Governor of the Bank of England

30. Interest rates and inflation
Causes of inflation
Inflation can be reduced by policies that (i) slow down the growth of AD or (ii) boost the rate of growth of aggregate supply (AS). The chart above shows how official UK interest rates have changed over recent years as the Bank of England has set monetary policy in order to maintain low inflation

31. A decline in global inflation
Causes of inflation

32. Reasons for continued low inflation
Causes of inflation
Increased competition in markets
Success of Bank of England in controlling AD
Strong exchange rate has kept import prices low
Low Inflation in the UK Economy
Effects of globalisation – cheaper imports
Rising productivity & new technology
A fall in worker’s expectations of inflation

33. Homework Read article about Economic Cycle
Highlight key issues – use 2 different colours – highlight positives & negative issues
Make a summary of the key issues raised
Complete Q 1, 2 & 4 only….

34. Further ‘knowledge’
If you are really interested in what happens with the BoE in managing inflation – watch this select committee meeting.
Listen to this – reasons why inflation can be good for the economy

35. Some quick questions

36. Inflation Q’s What is meant by Inflation? (2)
Explain how inflation is measured? (2)
Explain how a fall in the rate of unemployment might effect the rate of inflation? (8 marks)
Using AD/AS analysis, assess the implications of a fall in AD on the UK economy? (8 marks)