Inflation means there is a sustained increase in the price level. The main causes of inflation are either excess aggregate demand (economic growth too fast) or cost push factors (Supply side factors). The main cause of inflation is the increase in the demand of goods and services and at the same time decrease in the supply of goods and services.

1. Demand pull inflation

If the economy is at or close to full employment then an increase in AD leads to an increase in the price level. As firms reach full capacity, they respond by putting up prices leading to inflation. AD can increase due to an increase in any of its components C+I+G+X-M

The link between output and inflation suggests that there will be a similar link between inflation and unemployment, The Phillips curve initially showed a link between money wages and unemployment, it was then argued an increase in wages would lead to inflation

Factors affecting demand are as under:

  1. Taste and preferences
  2. Seasonal demand
  3. Natural calamities
  4. Price of substitute goods
  5. Increase in money supply
  6. Increase in consumer spending
  7. Cheap monetary policy
  8. Black Money
  9. Increase in public expenditure

2. Cost Push Inflation

If there is an increase in the costs of firms, then firms will pass this on to consumers. There will be a shift to the left in the AS.

Cost-push inflation can be caused by many factors

1. The Labour Market

If trades unions can present a common front then they can bargain for higher wages, this will lead to wage inflation.

2. Import prices

One third of all goods are imported in the UK. If there is a devaluation then import prices will become more expensive leading to an increase in inflation

3. Raw Material Prices,

The best example is the price of oil, if the oil price increase by 20% then this will have a significant impact on most goods in the economy and this will lead to cost push inflation.

E.g. in early 2008, there was a spike in the price of oil to over $150 causing a rise in inflation.

4. Profit Push Inflation

When firms push up prices to get higher rates of inflation.

5. Declining productivity

If firms become less productive and allow costs to rise, this invariably leads to higher prices.

Effects of Inflation

1. Effects on Distribution of Income 

  1. Businessmen
  2. Debtors & Creditors
  3. Investors
  4. Fixed Income Group
  5. Agricultural community

2. Effects on Economic Activities

  1. Distortion of Price Mechanism
  2. Hindrance in capital formation
  3. Uncertainty and confusion
  4. Hoarding and Black Marketing
  5. Deterioration of quality of product
  6. Adverse effect on pattern of Investment
  7. Loss of flexibility in economic system

3. Social, Political &Moral effects