Download Cost-push inflation

WHAT CAUSES INFLATION?
LESSON DETAILS
Grades: 9-12
Author: Tim Florian
Posted: January 12, 2006
Updated: May 14, 2008
This lesson explores different types of inflation and terms associated with this economic concept.
You may have heard relatives talk about the good old days when a dollar would buy something.
What happened to that dollar? Why won’t it buy as much as it did last month or last year? What
happened is inflation. In this lesson you will examine the various causes and theories of inflation
as well as how it affects different groups in the economy such as savers, lender, and people
living on fixed incomes.
STUDENTS WILL
 Identify the main theories of inflation
 Understand main terms associated with inflation
 Compare different theories of inflation
INTRODUCTION
This lesson will explore types of inflation and terms associated with this economic concept. You
may have heard relatives talk about the good old days when a dollar would buy something. What
happened to that dollar? Why won't it buy as much as it did last month or last year? What
happened is inflation. In this lesson we will examine the various causes and theories of inflation
as well as who is responsible for tracking it.
PROCESS
Provide the students with copies of Study Guide #1 and Study Guide #2.
EXTENSION ACTIVITY
Assign the students to write an essay comparing and contrasting the causes of inflation. In their
essays, the students should use the information they used to complete the process section.
Answers will vary:
Students should provide an analysis of the various types of inflation and theories behind them.
http://www.econedlink.org/lessons/index.php?lid=615&type=educator
Name: ______________________________________ Date: ________________
Inflation
Inflation is a rise in the general price level and is reported in rates of change. Essentially what this means
is that the value of your money is going down and it takes more money to buy things. Therefore a 4%
inflation rate means that the price level for that given year has risen 4% from a certain measuring year
(currently 1982 is used). The inflation rate is determined by finding the difference between price levels for
the current year and previous given year. The answer is then divided by the given year and then
multiplied by 100. To measure the price level, economists select a variety of goods and construct a price
index such as the consumer price index (CPI). By using the CPI, which measures the price changes, the
inflation rate can be calculated. This is done by dividing the CPI by the beginning price level and then
multiplying the result by 100.
Causes of Inflation
There are several reasons as to why an economy can experience inflation. One explanation is
the demand-pull theory, which states that all sectors in the economy try to buy more than the economy
can produce. Shortages are then created and merchants lose business. To compensate, some
merchants raise their prices. Others don't offer discounts or sales. In the end, the price level rises.
A second explanation involves the deficit of the federal government. If the Federal Reserve System
expands the money supply to keep the interest rate down, the federal deficit can contribute to inflation. If
the debt is not monetized, some borrowers will be crowded out if interest rates rise. This results in the
federal deficit having more of an impact on output and employment than on the price level.
A third reason involves the cost-push theory which states that labor groups cause inflation. If a strong
union wins a large wage contract, it forces producers to raise their prices in order to compensate for the
increase in salaries they have to pay. The fourth explanation is the wage-price spiral which states that no
single group is to blame for inflation. Higher prices force workers to ask for higher wages. If they get their
way, then producers try to recover with higher prices. Basically, if either side tries to increase its position
with a larger price hike, the rate of inflation continues to rise.
Finally, another reason for inflation is excessive monetary growth. When any extra money is created, it
will increase some group's buying power. When this money is spent, it will cause a demand-pull effect
that drives up prices. For inflation to continue, the money supply must grow faster than the real GDP.
Effects of Inflation
The most immediate effects of inflation are the decreased purchasing power of the dollar and its
depreciation. Depreciation is especially hard on retired people with fixed incomes because their money
buys a little less each month. Those not on fixed incomes are more able to cope because they can simply
increase their fees. A second destablizling effect is that inflation can cause consumers and investors to
changer their speeding habits. When inflation occurs, people tend to spend less meaning that factories
have to lay off workers because of a decline in orders. A third destabilizing effect of inflation is that some
people choose to speculate heavily in an attempt to take advantage of the higher price level. Because
some of the purchases are high-risk investments, spending is diverted from the normal channels and
some structural unemployment may take place. Finally, inflation alters the distribution of income. Lenders
are generally hurt more than borrowers during long inflationary periods which means that loans made
earlier are repaid later in inflated dollars.
Study Guide Part 1:
Complete the questions below using the information from this reading:
1. What is inflation?
2. To measure the price level, economists select a variety of goods and construct a
price index such as the ___________ _________ ________ (CPI).
3. Describe two reasons for the causes of inflation.
4. What types of people are most negatively affected by inflation and the depreciation of
the dollar?
5. _________ are generally hurt more than _________ during long inflationary periods
which mean that loans made earlier are repaid later in inflated dollars.
In your own words, based on the lecture from yesterday, explain the quantity theory of
money.
Part #2:
Theory 1 - Demand-pull inflation - is inflation demanding?
Demand-pull inflation happens when the level of aggregate demand grows faster than the underlying
level of supply. This may be easier to imagine, if you think of supply as the level of capacity. If our
capacity to produce is growing at 3%, and the level of demand grows at the same rate or slower then
we don't have a problem. We can produce all we need. However, if our capacity grows at 3%, but
demand grows faster, then we have a problem. In effect we have 'too much money chasing too few
goods', and we can't manage to produce all we need. Something has to give, and it is prices that are
forced up, therefore causing inflation. We can see all this in the diagram below. As the aggregate
demand curve shifts to the right, the price level rises - inflation.
There are a variety of possible reasons for the increased aggregate demand, and to look at these in
more detail we need to look at the components of aggregate demand. Aggregate demand is made up
of all spending in the economy. It is:
AD = C + I + G + (X-M)
where C is consumer expenditure, I is investment, G is government expenditure, X is exports and M is
imports
An increase in aggregate demand could therefore be because consumers are spending more, perhaps
because interest rates have fallen, taxes have been cut or simply because there is a greater level of
consumer confidence. It could be because firms are investing more in the expectation of future
economic growth. It could be that the government is boosting spending on defence, health, education
and so on. Or it could be because there is a boom in UK exports to overseas. Whatever it is, it will be
inflationary if demand grows faster than supply.
It would be nice to stop at that point and claim we have understood demand-pull inflation, but it's not
that simple. As you'll have spotted by now, economists are not specialists in simple solutions! There
are differences between economists about the causes of demand changes, and as if that weren't
enough, there are also differences on the effects these changes have.
The effect of a shift in aggregate demand depends on the shape of the aggregate supply curve, and
this is where economists particularly differ. There are two particular views; Keynesian and Classical.
Few economists would fall totally into one camp or the other, but the main differences are given
below.
Classical economists
Classical economists have a fundamental belief in free markets - a 'laissez-faire' economy. They
believe that left to itself, the economy will find its own full-employment equilibrium. In other words,
there is no point in the government trying to manipulate the economy to get full-employment, it will
make its own way there in the long run. The key to this is in the way they assume the labour market
works. If the economy is below full-employment, then the following will happen:
Unemployment (a surplus of labour)
wages fall
more labour is employed
full-employment is
restored.
This process happens automatically thanks to the market mechanism, so there is no need for the
government to intervene in the long run. This means that the long run aggregate supply curve will be
vertical.
Any attempt by the government to boost aggregate demand in the long run using reflationary policies
will simply be inflationary as it will shift the AD curve straight up a vertical AS curve.
In the short run they acknowledge that the AS curve will be upward sloping because of diminishing
returns, but any reflationary policy will still be stoking up inflation for the future.
In this diagram we can see that the reflationary policy did shift aggregate demand to the right, which
increased real output in the short run, but in the long run the increase in prices wiped this out and
there was no overall increase in the real level of output.
Keynesian economists
Keynesian economists, not surprisingly, subscribe to the views of John Maynard Keynes, a famous
economist of the twentieth century. They have a different view of the workings of the labour market,
and would argue that it doesn't work perfectly. They believe that wages are 'sticky downwards'. This
means that any unemployment may not lead to wages falling. This in turn means that the unemployed
do not get re-employed. Getting rid of unemployment therefore means the government intervening to
boost demand enough to get those people employed again.
They argue that the long run and short run AS curves will be the same and that to reduce
unemployment, the government must use reflationary policies to boost the level of demand.
The difference between Classical and Keynesian policy can be summed up therefore in their approach.
The Classical economists argue for 'laissez-faire' or non-intervention, whereas Keynesians argue for
active intervention.
Talk to a Classical economist, and they will advise
'Don't just do something, sit there!'
while a Keynesian will advise
'Don't just sit there, do something!'
In your own words explain the demand-pull theory of inflation.
Part #2:
Theory 2 - Cost-push inflation - is inflation pushy?
Cost-push inflation happens when costs increase independently of aggregate demand. It is important
to look at why costs have increased, as quite often costs are increasing simply due to the economy
booming. When costs increase for this reason it is generally just a symptom of demand-pull inflation
and not cost-push inflation. For example, if wages are increasing because of a rapid expansion in
demand, then they are simply reacting to market pressures. This is demand-pull inflation causing cost
increases.
However, if wages rise because of greater trade union power pushing through larger wage claims this is cost-push inflation. Cost-push inflation is shown on the diagram below. The aggregate supply
curve shifts left because of the cost increase, therefore pushing prices up.
So why might costs get pushed up, causing inflation? There are a number of possible sources of rising
costs.
Wages
If trade unions gain more power, they may be able to push wages up independently of consumer
demand. Firms then face higher costs and are forced to increase their prices to pay the higher claims
and maintain their profitability.
Profits
If firms gain more power and are able to push up prices independently of demand to make more
profit, then this is considered to be cost-push inflation. This is most likely when markets become more
concentrated and move towards monopoly or perhaps oligopoly.
Imported inflation
We now work in a very global economy and many firms import a significant proportion of their raw
materials or semi-finished products. If the cost of these increases for reasons out of our control, then
once again firms will be forced to increase prices to pay the higher raw material costs. This could
happen for several reasons:

Exchange rate changes - if there is a depreciation in the exchange rate, then our exports will
become cheaper abroad, but our imports will appear to be more expensive. Firms will be paying
more for their overseas raw materials.

Commodity price changes - if there are price increases on world commodity markets, firms will
be faced with higher costs if they use these as raw materials. Important markets would include
the oil market and metals markets.

External shocks - this could be either for natural reasons or because a particular group or
country has gained more economic power. An example of the first was the Kobe earthquake in
Japan, which disrupted world production of semi-conductors for a while. An example of the second
was when OPEC forced up the price of oil four-fold in the early 1970s.
Exhaustion of natural resources
As resources run out, their price will inevitably gradually rise. This will increase firms' costs and may
push up prices until they find an alternative source of raw materials (if they can). This has happened
with fish stocks. Over-fishing has put many types of fish and fish-based products under extreme
pressure, forcing their price up. In many countries equivalent problems have been caused by erosion
of land when forests have been cleared. The land quickly becomes useless for agriculture.
Taxes
Changes in indirect taxes (taxes on expenditure) increase the cost of living and push up the prices of
products in the shops. An example would be when the level of VAT was increased from 8% to 15% in
the 1979 Budget. Many saw this as a one off change in prices rather than triggering inflation in its true
sense, i.e. a general increase in the price level. The RPIY measure of inflation takes out the effect of
indirect tax changes to get a clearer picture of the true level of inflation.
In your own words explain the cost-push theory of inflation.
ASSESSMENT ACTIVITY
1. According to the Quantity Theory:
(a) Inflation occurs because there is not enough money in the economy.
(b) Inflation occurs because demand exceeds supply for goods and services.
(c) Inflation occurs because there is too much money in the economy.
2. The cost-push theory of inflation states that:
(a) Inflation occurs because there is not enough money in the economy.
(b) Inflation occurs because of the cost of producing goods and services go up and are
then passed along to the consumer.
(c) Inflation occurs because there is too much money in the economy.
3. Which of the following best describes the demand-pull theory of inflation?
(a) Inflation occurs because demand exceeds supply for goods and services.
(b) Inflation occurs because of the cost of producing goods and services go up and are
then passed along to the consumer.
(c) Inflation occurs because there is too much money in the economy.
4. Purchasing power describes what happens to our ability to buy goods and services when
prices...
(a) fall due to inflation.
(b) rise due to inflation.
(c) rise due to deflation.
Study Guide 1 Answer Key
Complete the questions below using the information from the reading:
1. What is inflation?
Inflation is a rise in the general price level and is reported in rates of change.
2. To measure the price level, economists select a variety of goods and construct a
price index such as the Consumer Price Index (CPI).
3. Describe two reasons for the causes of inflation.
1. One explanation is the demand-pull theory, which states that all sectors in the
economy try to buy more than the economy can produce. Shortages are then created
and merchants lose business. To compensate, some merchants raise their prices.
Others don't offer discounts or sales. In the end, the price level rises.
2. A second explanation involves the deficit of the federal government. If the Federal
Reserve System expands the money supply to keep the interest rate down, the federal
deficit can contribute to inflation. If the debt is not monetized, some borrowers will be
crowded out if interest rates rise. This results in the federal deficit having more of an
impact on output and employment than on the price level.
3. A third reason involves the cost-push theory which states that labor groups cause
inflation. If a strong union wins a large wage contract, it forces producers to raise their
prices in order to compensate for the increase in salaries they have to pay. The fourth
explanation is the wage-price spiral, which states that no single group is to blame for
inflation. Higher prices force workers to ask for higher wages. If they get their way, then
producers try to recover with higher prices. Basically, if either side tries to increase its
position with a larger price hike, the rate of inflation continues to rise.
4. Finally, another reason for inflation is excessive monetary growth. When any extra
money is created, it will increase some group's buying power. When this money is
spent, it will cause a demand-pull effect that drives up prices. For inflation to continue,
the money supply must grow faster than the real GDP.
4. What types of people are most negatively affected by inflation and the depreciation of
the dollar?
People with fixed incomes. Retired people often live off of a fixed income so they are
negatively affected by inflation.
5. Lenders are generally hurt more than Borrowers during long inflationary periods,
which mean that loans made earlier are repaid later in inflated dollars.
Part #1:
In your own words explain the quantity theory of money.
The classical economists view of inflation revolved around this theory, and this theory
was in turn derived from the Fisher Equation of Exchange. This equation says that:
MV = PT
Where:
M is the amount of money in circulation
V is the velocity of circulation of that money
P is the average price level
T is the number of transactions taking place
The equation is in fact an identity/truism. It says that the amount of the money stock
times the rate at which it is used for transactions will be equal to the number of those
transactions times the price of each transaction. It will always be true, as it simply says
that National Income will be equal to National Expenditure and basic macroeconomics
tells us that this is true anyways. So nothing stunning there! However, what makes it
important is what classical economists predicted from it.
Classical economists suggested that V would be relatively stable and T would always
tend to fill employment. Therefore they came to the conclusion that:
In other words increases in the money supply would lead to inflation. The message was
simple; control the money supply to control inflation.
Part #2:
In your own words explain the cost-push theory of inflation.
Cost-push inflation happens when costs increase independently of aggregate demand.
It is important to look at why costs have increased, as quite often costs are increasing
simply due to the economy booming. When costs increase for this reason it is generally
just a symptom of demand-pull inflation and not cost-push inflation. For example, if
wages are increasing because of a rapid expansion in demand, then they are simply
reacting to market pressures. This is demand-pull inflation causing cost increases.
Part #3:
In your own words explain the demand-pull theory of inflation.
Demand-pull inflation happens where there is ‘too much money chasing too few goods.’
Excessive growth in demand literally pulls prices up. With the information you have
gained, give a real life example for two of the three types of inflation.
Answers will vary, but should include examples from real lives such as; if a work force
gets and increase in pay the company will increase the cost of their goods. This is cost
push inflation.
If a government is printing too much money and everyone has as much as they want
then that is demand-pull inflation. When the Fed makes changes in the money supply
through monetary policy it can increase or decrease the rate of inflation.
ASSESSMENT ACTIVITY
1. According to the Quantity Theory:
(a) Inflation occurs because there is not enough money in the economy.
(b) Inflation occurs because demand exceeds supply for goods and services.
(c) Inflation occurs because there is too much money in the economy. [CORRECT]
2. The cost-push theory of inflation states that:
(a) Inflation occurs because there is not enough money in the economy.
(b) Inflation occurs because of the cost of producing goods and services go up and are
then passed along to the consumer. [CORRECT]
(c) Inflation occurs because there is too much money in the economy.
3. Which of the following best describes the demand-pull theory of inflation?
(a) Inflation occurs because demand exceeds supply for goods and
services. [CORRECT]
(b) Inflation occurs becasue of the cost of producing goods and services go up and are
then passed along to the consumer.
(c) Inflation occurs because there is too much money in the economy.
4. Purchasing power describes what happens to our ability to buy goods and services when
prices...
(a) fall due to inflation.
(b) rise due to inflation. [CORRECT]
(c) rise due to deflation.