Understanding Inflation: Causes and Economic Impacts
The Economic Impacts of Inflation
- Shoe-leather Costs. This refers to the time wasted searching the marketplace for the lowest price. This is much harder when inflation is high.
- Menu Costs. This refers to the costs of inflation to businesses in terms of continually having to change their menus, price tags, and vending machines.
- Redistribution Effects. Periods of high inflation cause redistribution from savers to borrowers. Inflation erodes the real value of all money. Hence, if you are a net saver, the real value of your savings will fall, which is bad for the saver, but if you are a net debtor, the real value of what you owe will fall.
- Lack of Investment. Unanticipated inflation causes uncertainty. Firms dislike uncertainty. They want to be able to plan ahead, and unpredictable inflation makes this difficult. The amount of money that firms invest in new machinery is likely to be lower in times of high inflation because it is difficult for the firms to be confident that the investment will be worthwhile.
- Lack of Growth. This follows on from the last point. Lower investment will lead to lower growth in GDP. Also, at times of high inflation, the Monetary Policy Committee may be forced to act.
What Causes Inflation?
Demand-Pull Inflation
Remember that Keynesians assume that the long-run aggregate supply (LRAS) curve is horizontal, upward sloping, and then vertical. Assume that the current level of aggregate demand is AD1. The price level is P1 and the level of real output is Y1. There is a lot of spare capacity in the economy. The level of output is nowhere near the full employment level YFE. An increase in aggregate demand (AD from now on) to AD2 in this situation, due to a rise in government spending, for example, will cause an increase in real output (to Y2) with no penalty in terms of rising prices.
Further increases in government spending would start to be inflationary. A shift in the AD curve from AD2 to AD3 will increase real output (from Y2 to Y3) but the price level will also rise (from P1 to P2). The result is similar if AD rises to AD4. At this stage, the economy is approaching the full employment level of real output, so some industries still have some spare capacity but others will be at full capacity, resulting in price rises in some industries, and so a rise in the average price level when AD rises.
A further increase in AD when the economy is at full employment (AD level AD4) will simply result in a price rise with no increase in the level of real output.
The diagram shows that increases in the level of demand in an economy cause inflation. The rising level of demand is ‘pulling’ the price level up, hence the name ‘demand-pull’ inflation.
This effect can also be shown on the 45-degree diagram, where a level of demand above that which gives a full employment equilibrium results in an inflationary gap.
The best example of this happening in the UK economy was the consumer boom of the late 1980s. Excessive demand in the economy forced the inflation rate up to 10%.
Cost-Push Inflation
This cause of inflation is associated with rises in the costs of an industry, or the economy generally. The main reasons why costs might rise are:
- Increases in wages and salaries (the biggest cost of production economy-wide)
- Increases in the cost of raw materials
- Increases in the price of imported goods (either as finished goods, semi-finished manufactures, or raw materials) due to a fall in the value of the pound or price rises in the country of origin
- Increases in indirect taxes (or reductions in government subsidies)
Any of these factors will have the following effect:
Short-run aggregate supply (SRAS) curves have been used, but the analysis could be applied to LRAS curves. Quite simply, an increase in the costs of an economy will shift the SRAS curve to the left (from SRAS1 to SRAS2) causing the price level to rise to P2 and the level of real output to fall to Y2.
The oil price shocks of the mid-1970s and early 1980s are good examples of large increases in costs causing inflation. The militant trade unions made things worse by insisting on above-inflation pay rises to make up for the price rises plus any unpredictable future rises in the price level.
This brings us onto an important subsequent effect of cost-push inflation, namely, wage-price spirals. During the price rises of the mid-1970s, caused by the initial supply-side shock of the huge rise in the price of oil, trade unions would press for higher wages. They were powerful bodies in those days and usually got what they wanted. Firms were forced to raise their prices to maintain profit levels. The loss in international competitiveness may well cause the pound to fall in value, increasing the price of imported goods. These further increases in the price level caused more demands for higher wages from the trade unions. If successful, firms would raise their prices again, and so on. The price level would spiral out of control.
The unions may well have been aware that continual increases in their wages were self-defeating because the real value of these increases was quickly eroded by the subsequent rises in the price level, but which union was going to act sensibly first? Only if all unions stopped asking for more money would the spiral be broken.
The effect was made worse by the ‘leap-frogging’ that took place. If the car workers got 15%, the miners wanted 17% and the steel workers wanted 20%. The car workers would then go back to their employers and say, “The steel workers got 20%, so we want at least 20%”.