Causes and Consequences of Inflation
This domain tests whether you can distinguish demand-pull from cost-push inflation, explain expectations and imported inflation, and evaluate consequences for households, firms and macroeconomic performance. Answers should identify winners and losers rather than claim inflation harms everyone equally.
Core rules and concepts
- Demand-pull inflation occurs when aggregate demand grows faster than productive capacity. Causes include consumer booms, government spending, investment, export growth and rapid money supply growth.
- Cost-push inflation arises from rising costs: wages above productivity, energy and raw material prices, indirect taxes, and depreciation raising import prices.
- Imported inflation enters through higher import prices. Expectations can create a wage-price spiral as workers and firms build inflation into contracts.
- The quantity theory MV = PT links money supply growth to the price level, though the link depends on velocity and real output.
- Consequences include redistribution from savers and creditors to borrowers, menu costs, shoe-leather costs, uncertainty, reduced export competitiveness, fiscal drag and loss of confidence. Anticipated inflation is less damaging because contracts can be indexed.
- Policies include contractionary monetary policy, fiscal consolidation, supply-side measures, incomes policy and exchange-rate policy.
Worked example
A worker receives a 6% nominal wage rise while inflation is 4%. The real wage change is (1.06 ÷ 1.04 − 1) × 100 ≈ 1.92%, not 2%, because the wage is deflated by the price level. A saver earns 3% nominal interest; with 5% inflation the real interest rate is approximately 3 − 5 = −2%, so the real value of savings falls. A borrower with a fixed-rate loan gains because the real value of the debt is eroded. This explains why unanticipated inflation redistributes wealth even when nominal values rise.
Traps that cost marks
- Confusing inflation with a rise in the price level.
- Treating all inflation as harmful; anticipated and indexed inflation has lower costs.
- Drawing a demand-pull diagram when the cause is a rise in input costs.
- Ignoring that higher inflation than trading partners worsens competitiveness.
- Forgetting that fiscal drag raises the real tax burden when thresholds are not indexed.