Q&A - Explain the causes of inflation

There are two main causes of inflation: • Demand-pull (when there is excess demand), and • Cost-push (when costs rise)

Demand-pull inflation

This occurs when there is excess aggregate demand in the economy (overall) or in a specific market or industry. Businesses respond to high demand by raising prices to increase their profit margins. Demand-pull inflation is associated with the boom phase of the business cycle

The main causes of demand pull inflation are
• A weaker exchange rate which increases the price of imports and reduces the foreign price of UK exports
• A reduction in direct or indirect taxation - consumers have more disposable income causing more demand
• Rapid growth of the money supply as a consequence of increased bank and building society borrowing
• Rising consumer confidence and an increase in the rate of growth of house prices
• Faster rates of economic growth in other countries – providing a boost to UK exports overseas

Cost-push inflation

This occurs when costs of production or operation are increasing. The key causes include:

• External shocks (e.g. commodity price fluctuations)
• A depreciation in the £ exchange rate (weaker pound = more expensive imports)
• Acceleration in wages

What happens when faced with cost-push inflation?

• Firms raise prices to protect their profit margins – better able to do this when market demand is price inelastic
• “Wages often follow prices”
• A rise in inflation can lead to rising inflationary expectations

Examples of cost-push inflation are shown in the chart below:

A great example to use of cost-push inflation which affects almost every industry is that of rising oil prices – also illustrated below: