Inflation Inflation Do you remember how

Inflation

Inflation • Do you remember how much less you paid for things even two years ago? This increase in the general price level of goods and services in an economy is inflation, measured by the Consumer Price Index and the Producer Price Index. • But there are different types of inflation, depending on its cause. Here we examine cost -push inflation and demand-pull inflation.

Factors of Inflation • Inflation is defined as the rate (%) at which the general price level of goods and services is rising, causing purchasing power to fall. • This is different from a rise and fall in the price of a particular good or service. • So if the cost of one item, say a particular model car, increases because demand for it is high, this is not considered inflation.

Factors of Inflation • This is caused by four possible factors: 1. Increase in the money supply : An increase in the supply of money typically lowers domestic interest rates (rd) to foreign interest rates (rf). 2. Decrease in the demand for money. 3. Decrease in the aggregate supply of goods and services: The total supply of goods and services produced within an economy at a given overall price level in a given time period. 4. Increase in the aggregate demand for goods and services : The total amount of goods and services demanded in the economy at a given overall price level and in a given time period.

cost-push • Aggregate supply is the total volume of goods and services produced by an economy at a given price level. • When there is a decrease in the aggregate supply of goods and services due to an increase in the cost of production, we have cost-push inflation. • cost of production Aggregate supply cost-push inflation

cost-push • Cost-push inflation basically means that prices have been "pushed up" by increases in costs of any of the four factors of production (labor, capital, land or entrepreneurship) when companies are already running at full production capacity. • With higher production costs, companies cannot keep profit by producing the same amounts of goods and services. As a result, the increased costs are passed on to consumers, causing a rise in the general price level. (inflation)

cost-push (increase of Production cost) • increases wages of laborers • company has to allocate more resources to pay for the creation of its goods or services • the company makes retail prices higher. • Along with increasing sales, increasing prices is a way for companies to constantly increase their bottom lines and essentially grow. • Another factor that can cause increases in production costs is a rise in the price of raw materials.

cost-push (increase of Production cost) • The graph below shows the level of output that can be achieved at each price level. As production costs increase, aggregate supply decreases from AS 1 to AS 2 (given production is at full capacity), causing an increase in the price level from P 1 to P 2. • The rationale behind this increase is that, for companies to maintain (or increase) profit margins, they will need to raise the retail price paid by consumers, thereby causing inflation.

Demand-pull • Demand-pull inflation occurs when there is an increase in aggregate demand, categorized by the four sections of the macroeconomy: households, businesses, governments and foreign buyers. • Aggregate Demand (AD) = C + I + G + (X-M) • C = Consumers' expenditures on goods and services. • I = Investment spending by companies on capital goods. • G = Government expenditures on publicly provided goods and services. • X = Exports of goods and services. • M = Imports of goods and services.

Why Aggregate Demand increases? • an increase in government purchases can increase aggregate demand, thus pulling up prices. • depreciation of domestic exchange rates. • if government reduces taxes, households are left with more disposable income in their pockets. This in turn leads to increased consumer spending, thus increasing aggregate demand eventually causing demand-pull inflation.

Effect of increase in AD on demandpull inflation • When aggregate demand increases without a change in aggregate supply, the ‘quantity supplied' will increase (given production is not at full capacity). • If aggregate demand increases from AD 1 to AD 2, in the short run, this will not change (shift) aggregate supply, but cause a change in the quantity supplied as represented by a movement along the AS curve. • The rationale behind this lack of shift in aggregate supply is that aggregate demand tends to react faster to changes in economic conditions than aggregate supply.

Effect of increase in AD on demandpull inflation • As companies increase production due to increased demand, the cost to produce each additional output increases, as represented by the change from P 1 to P 2. • The rationale behind this change is that companies would need to pay workers more money (e. g. overtime) and/or invest in additional equipment to keep up with demand, thereby increasing the cost of production. • Just like cost-push inflation, demand-pull inflation can occur as companies, to maintain profit levels, pass on the higher cost of production to consumers' prices.