PRICE INFLATION
Inflation is the general and sustained rise in the level of prices of goods and services in an
economy.
CAUSES OF INFLATION
Demand-pull inflation
Inflation caused by an increase in aggregate demand is called demand-pull inflation.
This is also defined as the increase in price due to aggregate demand exceeding aggregate
supply. Demand could rise due to higher incomes, lower taxes etc. The demand curve will shift
right, causing an extension in supply and a rise in price.
Cost-push inflation
Inflation caused by an increase in cost of production in the economy.
The cost of production could rise due to higher wage rate, higher indirect taxes, higher cost of
raw materials, higher interest on capital etc. The supply curve will shift left causing a contraction
in demand and a rise in price.
A lot of economics agree that a rise in money supply in contrast with output is the key reason for
inflation. If the GDP isn’t accelerating as much as the money supply, then there will be a higher
demand which could exceed supply leading to inflation.
CONSEQUENCES OF INFLATION
Lower purchasing power
When the price level rises, the lesser number of goods and services you can buy with the same
amount of money. This is called a fall in the purchasing power. Thus, inflation causes a fall in the
purchasing power of money.
Exports are less internationally competitive
If the price of exports are high, its competitiveness in international markets will fall as lower
priced foreign goods will rival it. This could lead to a current account deficit is exports lower,
especially if they are price elastic.
Inflation causing inflation
During inflation, the cost of living in the economy rises as you have to pay more for goods and
services. This might cause workers to demand higher wages increasing the cost of production.
If the price of raw materials also increase, the cost of production again increases, causing cost-
push inflation.
Fixed income groups and lenders lose
A person who has a fixed income will lose as he cannot press for higher wages during inflation.
Lenders who lent money before inflation and receive the money back during inflation will lose
valuable purchasing power. The same amount of money is now worth less (here, the people
who borrowed gain purchasing power).
Hyperinflation - runaway inflation during which prices rise at phenomenal rates and money
becomes almost worthless.
There are many millions of different goods and services exchanged in an economy, so most
countries track the prices of a selection of goods and services to construct a price index
Year 0 (base year)
Identify the basket of goods and services purchased by the ‘typical’ family
Monitor the ‘average’ price of each item in the basket at a sample of different retail outlets
Monitor how much the ‘typical’ family spends on each item in the basket
Weight the average price of each item by the proportion of household expenditure spent on it
Add up all the weighted average prices
Set the total weighted average price of the basket equal to 100
Year 1 onwards
Repeat the monitoring of household spending patterns and prices
Compare the total weighted average price of the basket to base year to calculate the change in
the price index