Types of Inflation (Edexcel IGCSE Economics)
Demand Pull Inflation
Spec point —
2.1.1b
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An increase in the average prices in an economy can be caused by demand-pull inflation or cost-push inflation
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Demand-pull inflation is caused by excess demand in the economy
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This excess demand leads to higher prices as suppliers increase prices to balance the demand-supply gap
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Excess demand is often caused by higher incomes, resulting in more money flowing around the economy
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Factors that lead to higher incomes include:
- Salary increases
- Lower taxes raise disposable income
- More government spending
- Lower interest rates reduce interest payments, leading to an increase in disposable income
- Higher employment levels
- Increased exports generate more income in the country
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Examples of demand pull inflation
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If the Central Bank lowers the base rate, there is likely to be increased borrowing by firms and consumers
- This will result in an increase in consumption and investment
- It is likely to lead to a form of demand-pull inflation
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If the government increases public spending or lowers taxes, people may have more money to spend, which could result in demand-pull inflation
Cost Push Inflation
Spec point —
2.1.1b
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Cost push inflation is caused by increases in the costs of production in an economy
- This can be a result of an increase in cost of raw materials, labour, or interest rates
- It passes on the increased costs to consumers in the form of higher prices
- E.g If there's a rise in oil prices, it will increase the cost of production for goods that rely on oil, leading to cost-push inflation
Impacts of Inflation
Spec point —
2.1.1b
- The aim is to have a low and stable rate of inflation of approximately 2%, which means there is a steady rate of economic growth
- Higher levels of inflation have many negative impacts on firms, workers, consumers and the government
Impact of Inflation
| Factor Impacted by Inflation | Explanation |
|---|---|
| Purchasing power | - If inflation increases by more than 2% and income does not increase by the same rate, there is a loss of purchasing power |
| Wages | - Workers demand higher wages to compensate for reduced purchasing power - If wage increase ≠ inflation, motivation and productivity may fall |
| Exports | - Inflation erodes international competitiveness of export industries as the country's exports are now relatively more expensive - Economic growth may slow due to a fall in exports and a possible fall in consumption |
| Unemployment | - Generally, there is an inverse relationship between inflation and unemployment - When inflation increases unemployment decreases and vice versa |
| Menu costs | - Price changes force firms to change their menu prices too - Businesses have the additional cost of updating menus or price cards |
| Shoe leather costs | - Shoe leather costs refers to hidden costs or waste of resources during periods of high inflation - E.g People spend more time browsing Google for a better deal |
| Business and consumer confidence | - With falling output and rising unemployment, households and business lose confidence choosing to **save or delay investment ** - Consumption and investment fall, and real GDP reduces even more - Consumers delay purchasing goods and services as they believe prices will be cheaper in a few weeks or months |
| Investment | - Rapid price changes create** uncertainty** and firms delay investment - Low and stable inflation improves confidence in future purchasing power, encouraging long-term investment |
Exam Hint When analysing inflation, make certain that you consider the size of any inflation. Low Inflation is generally positive and a sign of a healthy economy, as it is indicative of economic growth
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