economy has experienced inflation throughout the last thirty years - but the
rate at which prices have been rising has not been stable. The chart below
tracks the annual rate of inflation for the British economy in each year
In an open
economy (i.e. a country that engages in international trade), price inflation
can be caused by a number of factors. Economists divide them into two main
groups, demand-pull and cost-push inflation.
inflation occurs when total demand for goods and services exceeds total
supply. This type of inflation happens when there has been excessive growth
in aggregate demand and there is an inflationary gap.
inflation is often monetary in origin - because the authorities allow the
money supply to grow faster than the ability of the economy to supply goods
and services. The phrase that is often used is that there is "too much
money chasing too few goods"
of this was during the late 1980s with the so-called "Lawson Boom".
There was a sharp rise in the demand for credit and an explosion in house
prices. The amount of money in circulation grew at alarming rates and caused
excess demand in the economy. By the autumn of 1990, retail price inflation
had climbed to 10.9%. A recession was needed to bring it back down again.
though smaller inflationary gap appeared in the UK economy in 1997/98 after
five years of sustained economic growth. This led the newly independent Bank
of England to raise interest rates from 6% to 7.5% between May 1997 and June
1998. Fortunately the British economy responded well to the "monetary
medicine" and experienced a slowdown through late 1998 and 1999.
Demand-pull inflationary pressures subsided leaving retail price inflation
comfortably within the Government's chosen target range.
inflation can be illustrated graphically using aggregate demand and aggregate
supply (AS) shows the total supply of goods and services that firms are able
to produce at each and every price level. At low levels of output when there
is plenty of spare productive capacity, firms can easily expand output to
meet increases in demand, resulting in a relatively elastic AS curve.
economy approaches full employment (or full capacity), labour and raw
material shortages mean that it becomes more difficult for firms to expand
production to meet rising demand. As a result, the AS curve becomes more
inelastic. When aggregate demand (AD) increases from AD1 to AD2
the economy is still operating at relatively low levels of capacity. Output
can expand relatively easily so firms will only implement small increases in
prices from P1 to P2.
aggregate demand increases from AD1 to AD2 the economy
is moving towards the full employment of factors of production. Many firms
choose to increase price to widen profit margins. Shortages of factor inputs
mean that the firms' costs of production start to rise.
it is likely that, as employment in the economy grows, demand for goods and
services will become more inelastic. This will allow firms to pass on large
price increases (P1 to P2) without any significant fall
causes of increased aggregate demand:
Rapid growth of household consumption
Increases in government spending
Injections of demand from higher exports
when firms increase prices to maintain or protect profit margins after
experiencing a rise in their costs of production.
Growth in Unit Labour Costs
Rising input costs
Increases in indirect taxes
Higher import prices (Imported inflation)
in input costs will mean that firms can produce less at each and every price
level and, as a result, the AS curve will shift to the left from AS1
At the new
equilibrium level of national output, the economy is producing a lower level
of output (Y1) at a higher price level (P1). Higher
cost push inflation therefore causes a contraction in real output as well a
higher average price level.
an increase in a firmís costs always feed through into inflation?
a business can absorb an increase in costs by reducing its profit margin. An
example of this occurred after the devaluation of Sterling in September 1992.
The fall in the value of the pound caused a rise in the cost of imported fuel
and raw materials. Although input costs rose in 1993, this increase did not
fully feed through into the prices of goods and services leaving the factory
gate, as measured by Producer Prices.
were forced to reduce profit margins and absorb the increase in costs or face
a loss in market share. This was due to the high level of spare capacity in
the economy. Effectively, firms were facing elastic demand curves and any
increases in price would have resulted in a fall in demand and total revenue.