A-Level Economics (EDEXCELA) – Causes of inflation

5.3 - Causes of Inflation

2 min

Cost-push factors causing inflation

Cost-push inflation occurs when increases in the costs of production lead to higher prices for goods and services. These rising costs reduce the overall supply in the economy, shifting the aggregate supply (AS) curve to the left.

Key factors leading to cost-push inflation

Rise in wages above productivity growth - When wages increase faster than workers' output, firms face higher labour costs, which they pass on through price rises. If wages form a large part of total costs, this can significantly impact prices. This may trigger a wage-price spiral, where higher prices lead to further wage demands, creating ongoing inflation.
Increase in imported raw material costs - Higher global prices for inputs, such as commodities, force producers to raise their prices. A depreciation in the domestic currency also makes imports more expensive, adding to production costs and contributing to domestic inflation.
Rise in indirect taxes - Government increases in taxes like VAT add to business costs, which are then passed on to consumers via higher prices. If demand for the good is price inelastic, a larger share of the tax burden falls on buyers, intensifying the inflationary effect.

Graphical representation of cost-push inflation

In a diagram of aggregate demand and supply:

The aggregate demand (AD) curve slopes downwards.
The initial AS curve slopes upwards and intersects AD at price level P and a certain output level.
A leftward shift to a new AS curve (AS₁) intersects AD at a higher price level P₁, showing the inflationary pressure from reduced supply.

Demand-pull factors causing inflation

Demand-pull inflation arises when aggregate demand grows faster than the economy's ability to supply goods and services. This excess demand shifts the aggregate demand (AD) curve to the right, enabling sellers to increase prices as they respond to stronger buying pressure.

Key factors leading to demand-pull inflation

High consumer spending or export demand - Strong consumer confidence, often during low unemployment, boosts spending. Low interest rates make borrowing cheaper, encouraging more purchases. Rapid growth in other countries can increase demand for exports, pulling up domestic prices.
Money supply expanding faster than output - When the amount of money circulating exceeds the growth in goods and services, it creates a situation of 'too much money chasing too few goods', driving up prices. Monetarist economists argue this is a primary driver of inflation, especially with low interest rates fuelling spending.
Bottleneck shortages - Rapid demand growth when resources are already fully utilised leads to shortages of labour or materials. These shortages raise costs, such as wages for skilled workers, which can spread to other sectors and cause widespread inflation.

Graphical representation of demand-pull inflation

In a diagram of aggregate demand and supply:

The aggregate supply (AS) curve slopes upwards.
The initial AD curve slopes downwards and intersects AS at price level P and a certain output level.
A rightward shift to a new AD curve (AD₁) intersects AS at a higher price level P₁, illustrating how increased demand pushes prices upward.

Cost-push factors causing inflation

Key factors leading to cost-push inflation

Rise in wages above productivity growth - When wages increase faster than workers' output, firms face higher labour costs, which they pass on through price rises. If wages form a large part of total costs, this can significantly impact prices. This may trigger a wage-price spiral, where higher prices lead to further wage demands, creating ongoing inflation.

Increase in imported raw material costs - Higher global prices for inputs, such as commodities, force producers to raise their prices. A depreciation in the domestic currency also makes imports more expensive, adding to production costs and contributing to domestic inflation.

Rise in indirect taxes - Government increases in taxes like VAT add to business costs, which are then passed on to consumers via higher prices. If demand for the good is price inelastic, a larger share of the tax burden falls on buyers, intensifying the inflationary effect.

Graphical representation of cost-push inflation

In a diagram of aggregate demand and supply:

The aggregate demand (AD) curve slopes downwards.

The initial AS curve slopes upwards and intersects AD at price level P and a certain output level.

A leftward shift to a new AS curve (AS₁) intersects AD at a higher price level P₁, showing the inflationary pressure from reduced supply.

Demand-pull factors causing inflation

Key factors leading to demand-pull inflation

High consumer spending or export demand - Strong consumer confidence, often during low unemployment, boosts spending. Low interest rates make borrowing cheaper, encouraging more purchases. Rapid growth in other countries can increase demand for exports, pulling up domestic prices.

Money supply expanding faster than output - When the amount of money circulating exceeds the growth in goods and services, it creates a situation of 'too much money chasing too few goods', driving up prices. Monetarist economists argue this is a primary driver of inflation, especially with low interest rates fuelling spending.

Bottleneck shortages - Rapid demand growth when resources are already fully utilised leads to shortages of labour or materials. These shortages raise costs, such as wages for skilled workers, which can spread to other sectors and cause widespread inflation.

Graphical representation of demand-pull inflation

In a diagram of aggregate demand and supply:

The aggregate supply (AS) curve slopes upwards.

The initial AD curve slopes downwards and intersects AS at price level P and a certain output level.

A rightward shift to a new AD curve (AD₁) intersects AS at a higher price level P₁, illustrating how increased demand pushes prices upward.