Demand-Pull Inflation and the Cost-Push Inflation - Essay Example

? a) Inflation can be described as a sustained increase in the general price level. The rate of inflation measures the annual percentage increase in price and is usually measured by the Consumer Price Index (CPI). This is a weighted average of retail prices. To calculate it, goods and services are given different weights according to the percentage of income that households spend on them. There are several types of inflation, depending on its cause. However, the two most common are the demand pull inflation and the cost push inflation. Demand pull inflation is caused by a rise in aggregate demand which means persistent rightward shifts in the aggregate demand curve. The rise in aggregate demand may occur due to rises in consumer demand, in the level of government expenditure, in investment by firm, in foreign residents demand for the country’s exports or a combination of these four (Sloman 1997). Demand pull inflation is usually linked to a booming economy. When the economy is in recession, demand pull inflation tends be low. However, when the economy is near the peak of the business cycle, demand pull inflation is likely to be high. The graph above illustrates the rise in aggregate demand by a rightward shift in the aggregate demand curve, from AD1 to AD2. Prices rise from P1 to P2 and output rises from Q1 to Q2 resulting in inflation. On the other hand is the cost push inflation where high costs force firms to increase their prices (Gillespie 2001). Aggregate supply is the total amount of goods and services produced at a given price level in an economy. When there is a fall in the aggregate supply of goods and services caused by an increase in the cost of production, cost-push inflation occurs. Cost-push inflation essentially means that prices have rose by an increase in the costs of any of the four factors of production that is; labor, capital, land or entrepreneurship given that firms are already managing at maximum capacity. With increased costs and maximized productivity, firms cannot sustain profit margins by producing the same quantity of goods and services. Consequently, the increased costs are borne by consumers, causing an upward shift in the general price level. The graph above shows the amount of output that can be attained at the given price level. As production costs escalate, aggregate supply falls from AS1 to AS2 (given production is at maximum capacity), causing the prices to increase from P1 to P2 and total output to decrease from Q1 to Q2. Demand pull and cost push inflation can occur together, since price rises can be caused both by increases in aggregate demand and by independent causes pushing up costs. Similar is the case with the UK’s economy. The UK Consumer Prices Index (CPI) annual inflation rate went up to 4.5% in April, from 4% in March (BBC 2011). As always, there are elements of both types of inflation in the UK’s economy. With the ongoing recovery and a slight increase in demand, there is a small level of demand pull inflation. However, the majority of the effect is cost-push. The increase in VAT is one of the major reasons of inflation in this economy, as well as increases in non-discretionary items such as fuel, utilities, housing and food. These are all necessities whose price hikes act more like an additional tax. The figure below shows the change in the UK’s annual quarterly rate of inflation over the last 15 years. b) Keeping inflation down to a desirable moderate level is an important contributive factor to sustain economic growth. This is because it serves as an incentive for increasing output, investments and unemployment. A rapid rate of inflation disrupts regular economic life leading to a wider income gap, falling output and unemployment. However, the remedy for such inflation depends on the cause. Therefore, government must diagnose its causes before implementing policies. Government policies may pull the rate of inflation down through contractionary fiscal and monetary policies. Monetary policy covers government changes in either the supply of money or interest rates. These policies are usually imposed by the Central Bank of the country. In recent years, in several countries, changes in interest rates have been the main policy used to control inflation. An increase in the rate of interest, due to a decrease in money supply, will tend to reduce aggregate demand. This is because saving will be encouraged, borrowing discouraged and the spending power of households, who are borrowers, will be reduced. This downward pressure on spending is likely to reduce inflationary pressure. The figure below shows how interest rate rises from r1 to r2 when money supply falls from MS1 to MS2. This change makes money costly to use, thus demand falls or its increase slows down. However, this remedy has its drawbacks. Firstly, there is a time lag between changing interest rates and the change taking effect. Secondly, it may have an adverse effect on the country’s balance of payments. This is because a higher interest rate will attract hot money flowing into the country which will appreciate currency and cause export prices to rise and import prices to fall. Lastly, when the rate of interest is changed all households and firms are likely to be affected, some of which are expected to cope with such a change. For example, a rise in the rate of interest may hit the poor more than the rich as they are more likely to be net borrowers. Moreover, if the economy is entering a recession or recovering from one, lowering interest rates may make it worse as households and firms will switch to saving instead of spending (Bamford 2002). Similar is the case with UK’s economy since it is on the path of slow recovery from recession. UK interest rates have been observed to stay constant at the current level of 0.5% by as per the Monetary Policy. Economists had anticipated the decision, as recent data had highlighted concerns regarding UK's economic recovery. The decision comes regardless of the increase in the annual inflation rate from 4% to 4.5%. It is the 27th month that the bank has opted to leave the rates untouched. In the meantime, the European Central Bank's president, Jean-Claude Trichet, has indicated that interest rate could rise next month. Economists believe that policymakers are facing hardship in making a choice, that is, keep rates constant to facilitate the recovery, or raise them to combat inflation (BBC 2011). Works Cited Bamford, C. et al., 2002. Economics: AS and A Level. Cambridge University Press. Sloman, J., 1997. Economics, 3rd ed. Prentice Hall Europe. Gillespie, A., 2002. AS & A Level Economics. Oxford University Press. BBC News, 2011. UK inflation rate rises to 4.5% in April. [online] (17 May 2011) Available at: http://www.bbc.co.uk/news/business-13421614 [28 June 2011]. Read More