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Many economists argue that achieving a low and stable rate of inflation is the single most important macroeconomic objective for governments. Explain how a high rate of inflation can be caused. [10]

High inflation as a problem is essentially is a persistent, sustained, and inordinate increase in the general price level (GPL) of an economy. Alternatively, however, inflation can be thought of as a percentage increase year-on-year in the GPL, commonly measured using the Consumer Price Index (CPI), which measures the changes in the price level of a weighted basket of goods and services consumed by an average household. This paper argues that a high rate of inflation can be caused by demand-pull and cost-push inflation. Demand-pull inflation occurs where aggregate demand (AD) rises when the economy is near or at full employment, while cost-push inflation occurs when production costs rise, independently of aggregate demand. 

First, let us address demand-pull inflation. Figure 1 shows demand-pull inflation where persistent, sustained, and inordinate increases in AD, near or at the full employment level, causes prices to rise persistently from P1 to P4. When AD increases, as depicted by a rightward shift of the AD curve, both output and prices increase when there is idle resources, or unemployment. Nearer and at the full employment level, there is no increase in real output as AD increases from AD3 to AD4 as existing resources are fully employed.

THINK: how do you represent demand pull inflation on an AD-AS diagram? 

Demand factors that could possibly contribute to this form of inflation include both non-monetary and monetary factors. Non-monetary factors include an increase in either components of AD, namely consumption (C), investment, (I), government expenditure (G), or net exports (X-M), because AD = C + I + G + (X-M), or a combination of both whereas monetary factors include a rise in the money supply, leading to a fall in interest rates.

First, expectations about the economic outlook, such as optimism about the health of the economy or a rising stock market, could also affect households and firms’ consumption and investment, with C and I increasing if the overall economic outlook is positive. 

Second, and more importantly, in the case of a rise in money supply, this would lead to lower interest rates and exchange rates to promote economic growth and employment. A lower interest rate would cause the cost of borrowing to decrease, and households would find it cheaper to borrow to consume, and firms would find it cheaper to borrow to invest, thus both C and I would rise, at the expense of savings. Since AD = C + I + G + (X-M), the increase in both C and I would cause AD to increase and shift to the right, hence promoting actual growth. Lower interest rate would also cause depreciation in the country’s currency and an increase in net exports (X-M), also promoting economic growth.

Third, rising AD could also arise due to an excessively expansionary monetary or fiscal policy as countries pursue macroeconomic goals such as high and sustained economic growth or low unemployment. In terms of expansionary monetary policy, governments could get too ambitious in adopting such policies and end up creating inflation by having drastic decreases in interest rates, or rapid depreciation of exchange rates for instance. In terms of expansionary fiscal policy, excessive increases in government spending could also increase G, and thus AD increases and shifts to the right.

On the other hand, cost-push inflation; a persistent rise in costs causing a sustained increase in the general price level is shown below:

THINK: how do you represent cost push inflation on an AD-AS diagram? 

A persistent, sustained, and inordinate increase in production costs causes aggregate supply (AS) to shift upwards, from AS to AS1. Producers respond partly by raising prices, partly by passing the costs on to consumers, and partly by cutting back on production. Real output falls while prices rise to P1. Possibly due to supply shocks such as increases in import prices, AS could fall further and prices would rise to P2, while real output falls further to Y2.

Factors that cause cost-push inflation could include, first, the phenomenon when wages rise faster than productivity, called wage-push inflation. When very strong trade unions demand an increase in wages that exceeds current productivity, unit costs of production and hence general prices of goods and services increase. The cost of living thus increases and trade unions in turn ask for higher wages to maintain their real income. In doing so, the cost of production rises further and the higher cost is passed on to consumers simultaneously, thus leading to a development of a wage price spiral.

Secondly, another major supply factor is imported inflation. For countries that heavily import raw materials and necessities, such as Singapore, a small and open economy which is heavily dependent upon imports, an increase in the world price of these goods is a significant source of inflation. Higher world prices can be caused by a decrease in supply due to poor crops, for example, or even from the actions of producers who restrict supply. Oil prices for example rose due to OPEC’s restriction of oil supply to the world market.  These higher prices are passed onto the consumers of countries importing these inflated raw materials and necessities, hence resulting in imported cost-push inflation.

Finally, cost-push inflation also results when the government raises indirect taxes such as GST for example. A firm’s cost of production would increase hence pushing up the general price level, and causing inflation.

In reality however, these causes of inflation may not be discrete and inflation could be multi-causal. In conclusion, there are many causes of inflation but they can be classified mainly in terms of demand-pull and cost-push inflation. 

JC Economics Essays: This economics essay is a contribution to an H2 A Level Economics essay question on explaining the causes of inflation with economics tutors' comments. Inflation is an important economics topic, especially because often times the A level examination can test students to explain the causes of a macroeconomic problem. The causes of a macroeconomic problem help governments find solutions to these economic issues.

What do you think were the strengths of this economics essay, and did the economics student explain the economic concepts of demand pull and cost push inflation effectively, accurately, and with real world examples to illustrate his point? Do you know what economics diagrams you could have drawn to ensure that the points and arguments are well illustrated? What do you think of this economics paper? How would you improve further on it? Overall, this is a well-crafted economics paper that explains inflation very carefully and accurately, using solid economic analysis.

Thank you for reading, and cheers. 

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