2.1.2 - Inflation - Causes

Question 1

Name Three Causes of Inflation

Answer 1

. Cost -Push Inflation
. Demand Pull Inflation
. Growth of Money Supply

Question 2

Define Demand - Pull Inflation

Answer 2

. Inflation when aggregate demand rises with no increase in aggregate supply meaning excess demand

. When AD shifts to right, there is greater pressure on existing factors of production to produce more output.

Existing factors of production are being more scarcer and more pressure is put on scarce factors of production. This results in an increase in price.

.Furthermore, if AD increases there is a profit incentive so firms may increase their price

Question 3

Causes of Demand Pull Inflation

(Factors that causes a shift to the right in AD)

Answer 3

. Cut in interest Rates
. Government boost spending
. Government reduces corporation tax
. Exchange Rate Weakened

Question 4

Explain ‘ Cut in Interest Rates’

Cause of Demand Pull Inflation

Use ALL FOUR in test for full CoR

Answer 4

1.) A cut in interest rates will reduce the cost of borrowing. This makes it cheaper for consumers to borrow, reducing the opportunity cost of doing so.

. The disposable income of consumers increase, allowing them to spend money on goods and services, increasing consumption in the AD

. This shifts AD to the right from AD1 to AD2

2. ) Additionally, a cut in the rate of return of saving, reduces the incentive to save and instead spend or borrow. This results in more consumption take place in the AD equation, shifting AD to the right from AD1 to AD2
3. ) Cut in interest rates, reduces the monthly payments for those with variable rate mortgages. These homeowners will receive an increase in their disposable income, increasing their marginal propensity to consume thus boosting consumption in the economy

. This shifts AD to the right from AD1 to AD2, since consumption is part of aggregate demand

4.) Cut in interest rate will reduce the cost of borrowing for firms, enabling them to reach their hurdle more easily (the required rate of return for investment projects to go ahead). This increases the marginal propensity to invest, increasing investment in AD, shifting AD to the right from AD1 to AD2

Question 5

Explain ‘ Government reduce level of corporation tax’

Cause of Demand Pull Inflation

Answer 5

. Corporation tax is the tax on business profits

. If the government reduces the level of corporation tax, this will increase retained profits for businesses making it easier for them to finance investment thus increasing the marginal propensity to investment.

. An increase in investment shifts AD from AD1 to AD2, since investment is a component of AD

Question 6

Explain ‘Government can boosting spending’

Cause of Demand Pull Inflation

Answer 6

The government can increase their spending on education, healthcare and wages.

. Government spending is a component of AD, which will shift AD from AD1 to AD2

. This will also create a large multiplier effect in the economy, where an initial increase in spending will increase incomes in the economy, resulting in further rounds of spending and income generation

. This could further increase in AD

Question 7

Explain ‘Exchange Rate being Weakened’

Cause of Demand Pull Inflation

Answer 7

. A weak exchange rate could happen if interest rates are reduced (hot money outflows) or increasing the money supply

. A weak exchange rate makes exports cheaper and imports dearer

. Demand and expenditure for imports decrease, whereas demand and revenue for exports increase

. This leads to an improvement in the trade balance of the current account and reduces current account deficit or move it to a surplus

. Since (X-M) is a component of AD, AD shifts from AD1 to AD2

Question 8

Define Cost Pull Inflation

(Factors that shift aggregate supply to the left)

Answer 8

Inflation caused by an increase in the cost of production in the economy

Firms pass on increases in their costs to consumers leading to cost push inflation

Question 9

Explain ‘Raw material / commodity price increase’

Cause of Cost Pull Inflation

Answer 9

1.) Raw material or commodity prices can increase.

For example oil prices

. This increase the cost of production for firms, which shifts short run aggregate supply to the left

. Firms will pass on these higher costs via higher prices increasing cost push inflation

Question 10

Causes of Cost Pull Inflation

(Factors that affect cost of production meaning aggregate supply shifts to the left)

Answer 10

. Raw material / Commodity price increasing

. Business Tax increase

. Wages increasing

Question 11

Explain ‘Business Tax increase’

Cause of Cost Pull Inflation

Answer 11

If business taxes like VAT increases (indirect tax), this will increase the cost of production for firms in the economy

. This reduces SRAS, shifting it inwards from SRAS1 to SRAS2

. Firms will pass on these higher costs via higher prices, hence increasing, cost push inflation

Question 12

Explain ‘Wages Increase’

Cause of Cost Pull Inflation

Answer 12

. Wages are a significant cost of production for businesses

. A rise in wage costs can occurs if there is higher minimum wages, growing trade union occurs, low unemployment or anticipated inflation

. This results in an inward shift of SRAS to the left from SRAS1 to SRAS 2

. Firms will pass on these higher costs via higher prices increasing cost push inflation

Question 13

Explain growth of money supply

(Cause of inflation)

Answer 13

. If banks increase their lending to customers and firms, the money supply will grow

. This means that the marginal propensity to consume will increase shifting AD from AD1 to AD2 and the price level rises from P1 to P2

. This results in demand - pull inflation