Define inflation, explain its demand-pull and cost-push causes, and assess its consequences

What this dot point is asking

The syllabus wants you to define inflation, explain its two main causes (demand-pull and cost-push), and assess its consequences. The big idea is that inflation is a sustained rise in the general price level, which can come from too much demand or rising costs, and which harms households, firms and the wider economy, so keeping it low and stable is a key government aim.

The answer

What inflation is

Inflation is measured by tracking the price of a typical basket of goods and services that households buy, giving a consumer price index (CPI). The inflation rate is the percentage rise in this index over a year. Note that inflation means the average price level rising; some individual prices can still fall.

Demand-pull inflation

Demand-pull inflation is caused by the demand side. It occurs when aggregate demand rises faster than the economy can produce. With more spending than there are goods to buy, there is "too much money chasing too few goods", so prices are pulled up. This is most likely when the economy is near full capacity, so firms cannot easily produce more and respond by raising prices instead.

Cost-push inflation

Cost-push inflation is caused by the supply side. It occurs when the costs of production rise, so firms raise their prices to protect their profit margins. Causes include:

• Higher wages that are not matched by higher productivity.
• Dearer raw materials, such as a rise in the price of oil.
• A fall in the exchange rate, which makes imported inputs more expensive.

The consequences of inflation

High or unstable inflation causes several problems:

• Falling real incomes. If prices rise faster than incomes, people can buy less, so their real income falls.
• Eroded savings. Inflation reduces the real value of money saved, hurting savers.
• Uncertainty. When prices rise unpredictably, firms find it hard to plan and may delay investment, slowing growth.
• Loss of competitiveness. If a country's inflation is higher than its trading partners', its exports become relatively dearer, worsening its balance of trade.

Why low and stable inflation is the aim

Because of these problems, governments aim for low and stable inflation, not zero. A little stable inflation is healthy: it avoids the dangers of falling prices (deflation), which can lead people to delay spending. Stability matters as much as the level, because it lets households and firms plan with confidence.

Examples in context

Example 1. Imported inflation in Singapore. Because Singapore imports most of its food, energy and raw materials, a rise in world prices or a weaker exchange rate raises import costs and feeds cost-push inflation. This is why the Monetary Authority of Singapore manages the exchange rate partly to keep imported inflation in check.

Example 2. Demand-pull in a booming economy. When an economy booms and spending surges while it is already near full capacity, firms cannot produce enough to meet demand and raise prices instead, causing demand-pull inflation. This is why governments may cool spending when an economy overheats.

Try this

• Cue. Define inflation. A sustained rise in the general level of prices in an economy over time, which reduces the purchasing power of money.

• Cue. State the cause of cost-push inflation and give one example. Rising costs of production lead firms to raise prices; an example is a rise in the price of oil or other raw materials, or a fall in the exchange rate.

• Cue. Explain one reason high inflation harms savers. Inflation reduces the real value of money, so savings buy less in future; if prices rise faster than the interest earned, the saver is worse off in real terms.