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Explain carefully what causes inflation [10]

Explain carefully what causes inflation. [10]

Inflation is a persistent and sustained increase in the general price level, or also defined by a persistent and sustained rise in the consumer price index. Inflation is caused by demand side factors or supply side factors, and these are called demand-pull inflation and cost push inflation respectively. A concatenation of increasing aggregate demand and rising costs cause inflation, although it is possible to have entirely demand pull inflation or cost push inflation. This paper discusses all these.

The AD-AS diagram below demonstrates demand pull inflation.

Insert diagram, AD-AS diagram: showing only demand pull inflation

AD comprises C + I + G + (X-M), which are consumer spending, investment spending, government spending, and net exports. If consumers spend more because of low interest rates encouraging borrowing, or if firms feel positive about future economic outlook, or if governments spend more money on military forces, or there is an export boom for local products exported overseas, then AD will shift to the right. Therefore, AD moves to AD’ and then AD’’, causing an upward shift in the general price level and therefore inflation, ceteris paribus. Hence, it is clear that excessive C, I, G or high exports with low imports will lead to demand pull inflation.

On the other hand, there is cost push inflation as well, where AS moves upwards from AS to AS’ and to AS”. This is demonstrated in the diagram below:

Insert AD-AS diagram showing cost push inflation

This is due to rising costs, and since the aggregate supply of goods and services in the economy is made up of various inputs, increases in the various inputs lead to rising costs. The supply of goods and services result from labour, capital, land and entrepreneurship. There are internal cost push factors. Rising wages or the rising power of trade unions demanding higher salaries, rising capital costs, and increasing scarcity of land and various input resources make cost push inflation a pertinent possibility. There are also external cost push factors. Exchange rates and the foreign sector can also lead to inflation if much of the goods produced use foreign inputs; hence there might be imported price push and exchange rate depreciations causing cost push inflation as well.

Thus, inflation can be caused by demand pull factors, cost push factors, or most probably and most conceivably, a combination of both. It depends on the particular situation.


PS Tutor's Note: Some Keynesian economists argue that it is primarily excess demand for goods and services that lead to such demand pull inflation, and other economists, namely the monetarists, claim that demand pull inflation is caused by excess money supply.

Tutor's Comments: A very well written essay! Well developed and relevant materials. Note: This economics essay paper was also written under examination conditions. 

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