1. Of Wages, rent, materials, energy

2. Causes of inflation Two principal causes of inflation: 1.Cost-push inflation When costs of production rise 2.Demand-pull inflation When aggregate demand increases without an increase in aggregate supply Also have to be aware of how growth in the money supply can influence inflation

3. Causes of inflation: cost-push Cost-push inflation happens when costs are rising. Principal causes are: Increase in wages and related costs. Labour costs are more than 50% of total costs for firms, so this is a key factor Increase in the cost of raw materials, such as commodities (eg oil). These prices are determined by global demand and supply Increase in taxes, particularly indirect taxes like VAT, or a reduction in subsidies Price Level Real Output SRAS 2 AD Y2Y2 P1P1 Y1Y1 P2P2 0 SRAS 1

4. Causes of inflation: demand-pull Demand-pull inflation happens when aggregate demand increases without an increase (shift) in aggregate supply When demand is growing faster than supply. Can think of when actual growth is faster than potential growth The diagram shows an increase in the price level from P1 to P2. This is sufficient to show demand-pull inflation Demand can grow rapidly whenever a component of AD rises significantly Real Output SRAS Price Level AD 1 Y1Y1 P1P1 AD 2 Y2Y2 P2P2 0

5. Causes of inflation: demand-pull When the economy is at full employment, ie on the LRAS, then an increase in demand will eventually all be passed on in higher prices At first firms pay workers overtime, but this is not sustainable so they seek to hire more workers. Demand for labour is greater than supply so wages rise (Also, workers will demand higher wages because prices are rising) Real Output Price Level Y1Y1 0 LRAS Y2Y2 P2P2 P1P1 AD 2 AD 1 SRAS 1 SRAS 2

6. Causes of inflation: money supply “Demand-pull inflation may also be caused by growth of the money supply” What this means is that the central bank (Bank of England in the UK) and commercial banks can influence how much consumers and firms borrow If firms and households borrow more, then the money supply increases. The borrowing will be to spend more, and so will be linked to an increase in aggregate demand For example, banks may become more willing to lend to smaller firms. This may lead to an increase in investment Pay day lenders, banks and credit card companies may be willing to lend more to consumers, and so this may lead to an increase in consumption Note inflation is then because the increase in money supply is linked to an increase in aggregate demand

7. Effects of inflation - costs Loss of competitiveness If inflation is higher in the UK, then the price of our goods and services rise relative to competitors, so are less competitive. Exports fall, unemployment increases But if pound falls in value, this may not be a problem Uncertainty reducing growth and jobs High inflation is associated with fluctuating inflation (ie it varies considerably) If inflation is unpredictable, this makes it harder for firms and consumers to plan – for example if a firm does not know what prices will be next month or next year, it may be less willing to invest, since the risk of investment appears higher Both households and firms may reduce spending, leading to lower growth, both actual as AD falls, and potential as investment falls But this argument is not about high inflation per se, but unpredictable, or unanticipated inflation. Steady inflation of 10% would not be a problem

8. Effects of inflation - costs Redistributional costs High inflation may benefit some groups at the expense of others Losers include anyone on a fixed income, ie an income which does not rise as prices rise. Examples include some pensioners with private pensions Some pension payments are indexed to inflation (ie rise with prices), but these are expensive, so not all pensioners have these Depending on what interest rates are, there may be a transfer from lenders to borrowers or vice versa. If real interest rates are negative (interest rates lower than inflation) which often happens when inflation is high, lenders/savers lose and borrowers gain For example, if prices rise by 20% with interest rates only 10%, then the real value of savings falls, so savers lose

9. Effects of inflation - costs Shoe leather and menu costs As prices are rising quickly and so the value of money is falling, individuals do not want to keep much cash with them. They leave it in the bank earning interest, and so visit the bank many times to withdraw cash, thus wearing out the leather on their shoes! This is one of the original favourites, but applies less now with increased use of debit and credit cards The other more likely shoe leather cost now is that consumers need to compare prices since prices are changing frequently – so wear out the leather on their shoes Menu costs arise because firms have to re-print menus more frequently (and change prices in vending machines etc)

10. Benefits of low and stable inflation A target of 2% inflation is felt to be about right At 2% inflation tends to be stable, reducing uncertainty and encouraging firms to invest And the greater the confidence that the central bank will achieve the target of 2%, the higher the confidence No loss in competitiveness (bigger effect from the currency) Neither savers or lenders will be impacted a great deal and there will be limited redistributional costs

11. Costs of deflation Deflation means falling prices Principal cost, or concern, about falling prices is that consumers delay purchases of goods This leads to a fall in AD, so real output and the price level fall, leading to an increase in unemployment and a multiplier effect Moreover, the further fall in prices may lead to a further delay in purchases, so a deflationary spiral leading to deep recession/depression This was a fear after the global financial crisis in 2008 The concern is about purchases of non-necessities, ie goods which consumers do not need – cars, phones, handbags, new kitchens, beds etc If the price of necessities fall, this does not mean a delay in spending. Some people find it hard enough delaying eating for a couple of hours! The recent fall in inflation (disinflation) has not been a concern, since it has largely been due to a fall in the price of oil, which is a cost to firms, and which in the form of petrol and energy is a necessity for consumers. In fact, consumers have more income to spend after paying for petrol and energy, so this is good news