The British 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 since 1968.

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.

DEMAND PULL INFLATION

Demand Pull 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.

Demand-pull 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"

An example 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.

A similar 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.

Demand pull inflation can be illustrated graphically using aggregate demand and aggregate supply analysis.

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.

As the 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.

When 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.

Furthermore, 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 in demand.

Main causes of increased aggregate demand:

·        Rapid growth of household consumption

·        Increases in government spending

·        Injections of demand from higher exports

COST PUSH INFLATION

This occurs when firms increase prices to maintain or protect profit margins after experiencing a rise in their costs of production.

The main causes are:

·        Growth in Unit Labour Costs

·        Rising input costs

·        Increases in indirect taxes

·        Higher import prices (Imported inflation)

An increase 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 to AS₂.

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.

Will an increase in a firm’s costs always feed through into inflation?

No, because 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.

Many firms 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.