Main Causes of Inflation 

In an open economy such as the UK, there are many potential sources of inflationary pressure. Some come direct from the domestic economy, for example the decisions of the major utility companies on their prices for the year ahead, or the pricing strategies of the leading food retailers based on the strength of demand and competitive pressure in their markets.

Inflation can also come from external sources, for example a sudden rise in the cost of crude oil or other imported commodities, foodstuffs and beverages. Fluctuations in the exchange rate can also have a powerful effect on inflation in the short and medium term. For now, we focus on the two main causes of cost and price inflation in an economy.

Cost Push Inflation

Cost-push inflation occurs when firms respond to rising costs, by increasing prices to protect profit margins. There are many reasons why costs might rise:

„     Rising imported raw materials costs perhaps caused by inflation in other countries or by a fall in the value of the pound in the foreign exchange markets.

„     Rising labour costs - caused by wage increases, which are greater than improvements in productivity.  This cause is important in industries, which are labour-intensive. If wages account for 25% of a firm’s total costs then a 10% increase in the total wage bill will cause the firm’s total costs to rise by 2.5%. Firms may decide not to pass on this to their customers (they may be able to achieve some cost savings in other areas of the business) but in the long run - wage inflation does tend to move closely in line with general price inflation in the economy.

„     Higher indirect taxes imposed by the government – for example a rise in the specific duty on alcohol and cigarettes, an increase in fuel duties or a rise in the standard rate of Value Added Tax. These taxes are levied on producers who, depending on the price elasticity of demand and supply for their products can opt to pass on the burden of the tax onto consumers.

Cost-push inflation can be illustrated by an inward shift of the short run aggregate supply curve. The fall in SRAS causes a contraction of real national output together with a rise in the general level of prices.

Cost inflation is more likely when unemployment has fallen to low levels.  In these circumstances there will be shortages of skilled labour. This means that businesses may have to offer higher pay to attract and retain their best workers when they are looking to expand their output.

Data on input prices for the UK over the last three years is provided in the table below. What is clear is that during 2001-02, there was input price deflation in the UK – an important factor in helping to keep inflation under control at a time when consumer demand was particularly strong. The main reason for the 11.5% increase in input prices in 2000 was the sharp rise in global crude oil prices (oil prices have a 10% weighting in total inputs). But higher oil prices did not filter through to increased retail prices for consumers on the high street.

During 2002, prices of the vast majority of inputs into the production process were falling. Import prices were held down by the continuing strength of the sterling exchange rate against other currencies together with weak commodity prices in world markets. Fuel and crude oil was also falling in price.

When input prices are falling – the effect is to cause an outward shift in the SRAS curve. This helps to keep the general price level under control at a time when aggregate demand is growing. There is no guarantee that input prices will fall each year. A significant fall in the exchange rate and / or a burst of price inflation in commodity markets could reverse the favourable input price position for the UK in the years to come.

Lower input prices reduces inflationary pressure

Demand Pull Inflation

Demand-pull inflation is likely when there is full employment of resources and aggregate demand is increasing at a time when SRAC is inelastic. AD might rise for a number of reasons:

„ A depreciation of the exchange rate increases the price of imports and reduces the foreign price of UK exports.  If consumers buy fewer imports, while exports grow, AD in will rise

„     A reduction in direct or indirect taxation.  If direct taxes are reduced, consumers will have more disposable income causing demand to rise.  A reduction in indirect taxes will mean that a given amount of income will now buy a greater real volume of goods and services. 

„     Rapid growth of the money supply as a consequence of increased bank and building society borrowing if interest rates are low and consumer confidence is high.

„     Rising consumer confidence and an increase in the rate of growth of house prices – both of which would lead to an increase in total household demand for goods and services

„ Faster economic growth in other countries – providing a boost to UK exports overseas. Remember that export sales provide an extra flow of income and spending into the UK circular flow. Exports are counted as an injection of AD

The effects of an increase in AD can be shown in the next diagram. Higher prices following an increase in demand lead to higher output and profits for those businesses where demand is growing but when short run aggregate supply becomes inelastic and the economy approaches a full-capacity level of national income, so further increases in AD fuel an increase in prices rather than higher levels of output.

In the diagram above we see a large outward shift in aggregate demand. This takes the equilibrium level of national output beyond full-capacity national income (Yfc) creating a positive output gap (i.e. excess aggregate demand relative to the economy’s capacity). This would be likely to put upward pressure on wage and raw material costs – leading the SRAS curve to shift inward (shown in the diagram below) and causing real output and incomes to contract back towards Yfc (long run equilibrium for the economy).

Wages and Prices – The Wage Price Spiral

Demand-pull inflation can lead to cost-push inflation if wages follow prices higher. For example a booming economy might see a rise in inflation from 3% to 5% due to an excess of AD. Workers will seek to negotiate higher wages to protect their real incomes – there is a danger that this will trigger a wage-price spiral that then requires deflationary economic policies such as higher interest rates or an increase in direct taxation.

Anticipated and Unanticipated Inflation

When inflation is volatile, it becomes difficult for individuals and businesses to correctly predict the rate of price inflation that will happen in the near future. When people are able to make accurate predictions of inflation, they can anticipate what is likely to happen and take steps to protect themselves. For example, people can bid for increases in money wages so as to maintain their real wages. Savings can be shifted into accounts offering a higher rate of interest or into assets where capital gains might outstrip general price inflation. Companies can adjust their prices; lenders can adjust interest rates.

Unanticipated inflation occurs when economic agents (people, businesses and governments) make errors in their inflation forecasts. Actual inflation may end up well below, or significantly above expectations.