The main types of inflation

Inflation can arise from different economic pressures, primarily categorised into two key types: cost-push inflation and demand-pull inflation.

Cost-push inflation

Cost-push inflation happens when higher production costs force firms to raise prices, leading to a reduction in aggregate supply (AS) and a contraction in aggregate demand (AD), which ultimately lowers real gross domestic product (GDP). It is shown on a diagram as a leftward shift of the AS curve.

Demand-pull inflation

Demand-pull inflation occurs when strong increases in AD outpace the economy's ability to supply goods and services, pulling prices upwards. It is illustrated on a diagram as a rightward shift of the AD curve.

Cost-push inflation and its causes

Cost-push inflation emerges when escalating costs of production compel businesses to increase prices. This results in a leftward shift of the AS curve, raising the general price level while reducing economic output.

Key causes of cost-push inflation

• Rising wage costs - When wages grow faster than labour productivity, unit labour costs increase, pushing up overall production expenses.
• Wage-price spiral - Initial wage increases lead to higher prices, prompting workers to demand further wage rises to preserve their purchasing power, creating a self-reinforcing cycle.
• Higher raw material prices - Increases in the cost of essential inputs, such as commodities, elevate production expenses for firms.
• Rising fuel costs - Escalating energy prices, often due to global supply issues, add to manufacturing and transportation expenses.
• Currency depreciation - A fall in the value of the domestic currency makes imported goods and materials more expensive, contributing to higher costs.
• Increased profit margins - Firms may widen their margins to boost profits, effectively passing higher costs onto consumers.
• Resource depletion or damage - Events like environmental degradation or exhaustion of natural resources (e.g., reduced soil fertility) limit supply and raise costs.

Demand-pull inflation and its causes

Demand-pull inflation arises when aggregate demand grows faster than the economy's productive capacity, pulling prices higher.

Characteristics of demand-pull inflation

• Impact on the price level - The inflationary pressure intensifies near full capacity.
• Long-term considerations - Certain demand increases, such as government investment in infrastructure or education, may not cause sustained inflation if they enhance the economy's overall productive potential over time.
• Components driving demand - Any rise in consumer spending, government expenditure, business investment, or net exports can trigger this type of inflation, represented by a rightward AD shift.

Key causes of demand-pull inflation

• Surges in consumer spending - Higher household expenditure, often fuelled by low interest rates or rising incomes, boosts demand for goods and services.
• Increases in government expenditure - Expanded public spending on projects or services can stimulate demand without a matching supply increase.
• Rising business investment - Greater confidence among firms leads to more spending on capital, amplifying overall demand.
• Growth in export markets - Stronger demand from overseas buyers increases net exports, pulling up domestic prices.

Monetarist and Keynesian views on inflation

Different economic schools offer contrasting explanations for inflation, focusing on the role of money supply and its relationship with prices and production costs.

The monetarist perspective

Monetarists argue that inflation primarily results from excessive growth in the money supply relative to the economy's output. This view emphasises a direct connection between money supply expansion and the general price level, often labelling it as "monetary inflation".

The Keynesian perspective

Keynesians contend that inflation drives increases in the money supply, rather than the reverse. Rising production costs prompt firms to borrow more from banks to cover expenses, thereby expanding the money supply as a response to inflationary pressures.

Interactions between types of inflation

Inflation types do not always occur in isolation; economic changes can trigger both cost-push and demand-pull effects simultaneously, potentially creating reinforcing cycles.

How inflation types can interact

• Dual effects from single events - For instance, currency depreciation raises the cost of imported raw materials (cost-push) while making exports cheaper and more competitive, boosting export revenues and demand (demand-pull).
• Inflationary spirals - Demand-pull factors, like increased government spending, can lead to higher prices, prompting wage demands that elevate production costs (cost-push). In turn, higher wages may boost consumer spending, further fuelling demand-pull inflation.