1. Causes and effects of inflation

2. Topic objectives
Define and explain the causes of Demand pull inflation

3. Demand Pull Inflation
Demand –pull inflation –When there is excess AD for goods and services
–i.e. a positive output gap (where actual GDP > Potential GDP)
–Businesses respond by raising prices to increase their profit margins
–Demand-pull inflation associated with the boom phase of the cycle (when SRAS becomes inelastic)
–Root causes of demand pull inflation are usually monetary in origin

4. So, what causes it? A depreciation of the exchange rate
A reduction in direct or indirect taxation. If direct taxes are reduced 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
Asset price inflation –e.g. in the housing sector
Faster economic growth in other countries –providing a boost to UK exports overseas

5. Illustration of Demand pull inflation

6. Then SRAS….

7. And using a non-linear SRAS

8. Cost push inflation
Causes:–External shocks (commodity price fluctuations)
–A depreciation in the exchange rate
–Acceleration in wages / unit labour costs
•Leads to inward shift in SRAS
•Firms raise prices to protect their profit margins –better able to do this when demand is price inelastic
•“Wages often follow prices”
•Rise in actual inflation can lead to an increase in inflationary expectations

9. Illustrating cost-push inflation

10. Cost push with a non-linear SRAS

11. The costs of inflation
‘Taken together, the verdict of economics, history and common sense is that inflation and deflation are costly. It is clear that very high inflation –in extreme cases hyperinflation –can lead to a breakdown of the economy [or society]. There is now a considerable body of empirical evidence that inflation and output growth are negatively correlated in high-inflation countries. For inflation rates in single figures, the impact of inflation on growth is less clear.’
•Mervyn King adapted from a speech entitled “The Inflation Target –Ten Years On” given in 2002

12. Costs and consequences
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.
Employees in poor bargaining positions lose out

13. Costs and consequences
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 investment
Deterioration in global competitiveness
A possible cause of higher unemployment
Rising inflation is associated with higher policy interest rates -this reduces trend growth

14. Anticipated Vs unanticipated
Anticipated inflation:
–When people are able to make accurate predictions of inflation, they can take steps to protect themselves from its effects
–For example, trade unions may exercise their collective bargaining power to negotiate with employers for increases in money wages so as to protect the real wages of union members

15. Anticipated Vs unanticipated
Unanticipated inflation:
–Unanticipated inflation occurs when economic agents (people, businesses and governments) make errors in their inflation forecasts
–Actual inflation may end up well below, or significantly above expectations causing losses in real incomes and a redistribution of income and wealth from one group in society to another

16. Some web resources

17. And, again, in diagrams

18. continued

19. …

20. …

21. Advantages of PD
Some consumers are brought into the market who might not have been able to afford the product
E.g. lower income consumers / Cheaper anti-viral drugs for consumers in developing countries
Social benefits?
Higher total output than under a single price monopoly
Profits may finance research and development projects –dynamic efficiency?
Profits may help to cross-subsidise other activities
E.g. postal service profits from business mail helps to maintain the uniform national postal rates
Doctors might charge lower income patients less –supported by higher charges for wealthier patients
Consider impact on allocative and productive efficiency

22. Is this a realistic model of behaviour?
Firms are assumed to know the shape and location of their cost and demand curves
Firms then chose price and/or quantity to maximise their desired objective
In the real world business environment firms will not be aware of the exact shape of their cost and revenue curves.
And they face uncertainty –e.g. about the likely reaction of other suppliers in the market
There are many different reasons for price differences for essentially the same product –not all of them are to do with price elasticity of demand!

23. Video presentation

24. Why popcorn costs so much at the movies

25. Another video explanation

26. Further reading…