Economics IB - Inflation Essay

Tra My Nguyen (Magda)IB1

HOMEWORK - Inflation Essay [30.04.2010]

Word Count:

a. Explain possible causes of a rise in the rate of inflation in an economy: (1073)

Firstly, what does the concept “inflation” mean? “Inflation” is defined as a persistent increase in the average price level in the economy, usually measured through the calculation of a consumer price index (CPI), which is measuring the price of the large amounts of different types of goods and services demanded. Inflation is assessed by comparing the prices of similar goods at two different periods of time, assuming the quality to remain the same.

When the prices of goods and services go up, it means that the purchasing power will be reduced. With the same amount of money, people will not be able to buy as much as they could in the previous period of time (e.g: previous year). There are many different types of inflation, such as: single-digit inflation, double-digit inflation, galloping inflation, hyper inflation, etc. One of the very significant examples of this is the hyper inflation in 1913 in Germany. Before the World War I, we could change 1 USD into 4 Marks, but after 10 years, 1 USD was equal to 4 billion Marks. So in suggests that inflation growing depends not only on the length of period of time considered, but also on the country condition at that period of time (e.g: war).

So what are the causes of inflation? There have been agreed 3 main causes that lead to inflation: demand-pull inflation, cost-push inflation and inflation due to excess monetary growth.

Demand-pull inflationThe demand-pull inflation occurs as a result of increasing aggregate demand in the

economy. It can be simply shown as in the Figure 1 below:

Inflation Essay30.04.2010

a. Explain the possible causes of a rise in the rate of inflation in an economy. (10p)

b. Evaluate the possible impact on economic performance that may result from a government decision to bring inflation under control. (15p)


{Figure 1}In this figure, when the demand increases, AD1 shifts to the right to AD2, also

causing the real output to increase from O1 to O2, which results in the increase in average price level, from P1 to P2. And there occurs the inflation, since the prive level has been pulled up by the demand. So it is called demand-pull inflation.There are also two more cases where the demand-pull inflation is likely to occur, shown in Figure 2 and Figure 3. That is when the economy is approaching full employment (figure 2) or when the economy is at its level of full employment (figure 3).


Real output0

SRAS

AD2AD1

O1 O2

LRAS

AD2

AD1

O2O1

P1

P2

0 Real output

{Figure 2}

Average price level

P2

P1

Average price level


As the demand increases, the AD1 curve will be shifted to the right to AD2, passing through the small amount of spare capacity, causing the prive level to increase from P1 to P2 along with the increase in real output from O1 to O2. And therefore, the demand-pull inflation takes place.

When the AD curve has passed through the whole spare capacity, it reaches the level of full employment, which is shown below:

{Figure 3}

Here, since the AD curve has reached the level of full employment, it is unable to expand the output as the demand increases, however the price still keeps increasing when people are buying more. And there occurs the demand-pull inflation.

Cost-push inflationThe second of the three main causes is the cost-push inflation, that is the result of

an increase in the costs of production.

{Figure 4}


LRAS

AD1

AD2

Average price level

Real outputO

P1

P2

0


As the costs of production increase, the economy tends to produce less, shifting the SRAS curve to the left from SRAS1 to SRAS2. This results in the movement along the AD curve, increasing the average price level from P1 to P2, and therefore decreasing the level of the real output from O1 to O2, leading to the cost-push inflation.

As stated, cost-push inflation exists because of the increase in the cost of production. There are several well-known causes of increase in the costs of production, such as:

- Wage-push inflation: There’s an increase in prices because of the increase in the costs of labour.

- Cost-push pressures: The prices are increased because of the change in costs of domestic raw materials.

- Import-push inflation: Caused by increases in the costs of imports capital, components, raw materials, or a fall in the value of a country’s currency.

Inflation due to excess monetary growthMonetarists argue that excessive increases in the money supply by government

are the cause of inflation, because when there is more money in the economy, there tends to be more spending, thus resulting in higher aggregate demand, which then leads to increase in price level. This is shown in the Figure 5, through the neo-classical perspective, because the monetarism is defined to be a “branch” of neo-classical economics.


P2

P1

O2 O1

Real output

Average price levelSRAS2

SRAS1

AD

0


{Figure 5}

According to the monetarists, increases in the money supply result in higher aggregate damand, that is why the AD curve shifted from AD1 to AD2. As the economy stays at the full employment level of output in the long run (LRAS), increases in demand can not influence the level of output because the economy is not able to expand the output beyond the level O, still the prices are rised from P1 to P2, resulting in the inflation – inflation due to excess monetary growth.

Beside these three main and the most well-known causes leading to inflation, there are some other causes which are less important but still have an impact.

- Inflation due to economy’s structure: That is, the successful firms tend to raise wages for employees, therefore, not to lose employees, those firms which are not very successful also have to raise their employee’s wages. However, the not-successful firms, in order not to make losses, they have to raise the prices. Therefore, inflation occurs.

- Inflation due to change in demand: - Inflation due to exports: That is, exports result in the increase in demand

within the country, which is likely to excess the relevant supply, or because the exports result in the lack of domestic supply, makes the demand higher. Therefore, as there is unbalance between demand and supply, inflation occurs.


AD2

AD1

LRAS

P2

P1

O Real output

Average price level

0


- Inflation due to imports: That is, when the costs of imports increase, then the price of selling the good imported go up. When the costs of imports excess the average price level, inflation occurs.

In sum, the inflation has, generally speaking, nagative effects on the economy and particularly the consumers as they have to pay more to purchase for goods and services. However, the inflation has a good influence on imports of the country beucase when a country has a higher rate of inflation, that will make exports less competitive, but will attract import-partners. Or good influence can also be concluded from the fact that inflation helps to balance the incomes between different levels of society.

a. Evaluate the possible impact on economic performance that may result from a government decision to bring inflation under control.

There are many possible impacts on economic performance that may result from a government decision to bring inflation under control, or simply, this maybe referred to as the government’s effects.


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Economics IB - Inflation Essay