Types and Causes of Inflation

Demand Pull Inflation

Demand Pull inflation is caused by increasing levels of Aggregate Demand caused by changes in the components of AD.

From the new classical view, assuming the economy is operating at its full potential, as AD increases beyond the full potential, from Yfe to Y1 the economy experiences an increase in the average price level (Pl. -> Pl1) and also experiences an increase in its Real GDP (Yfe -> Y1)

From the Keynesian Perspective, an increase in AD1 to AD2 causes an increase in the real GDP from Y1 to Y2 and experiencing an increase in the average price level from Pl. to Pl1 only as the economy approaches it's potential. Before this, due to spare capacity, an increase in AD will not lead to an increase in the average price level

Demand pull inflation therefore is associated with inflationary gaps in the economy as a result of increasing average price level, with increasing Real GDP.

The Role of the Money Supply

The growth of the money supply refers to an increase in the total amount of money circulating in an economy. While moderate growth in the money supply can support economic expansion, excessive increases can lead to inflation. When more money is available without a corresponding rise in the production of goods and services, demand outpaces supply, causing prices to rise.

Monetary policies, such as low interest rates and quantitative easing, can contribute to rapid money supply growth and subsiquent increase in the levels of Aggregate Demand. If not managed carefully, this can result in demand-pull inflation, where too much money chases too few goods. Hyperinflation, as seen in historical cases like Zimbabwe and Weimar Germany, demonstrates the dangers of unchecked money supply growth. Therefore, central banks play a crucial role in regulating money supply expansion to balance economic growth with price stability. (This is looked at in more detail in the consequences section)

Cost Push Inflation

Cost push inflation is caused by an increase in the cost of production for firms. As a result of the increase in the cost of production for firms, the SRAS curve shifts to the left. The increased cost of production, causes an increase in the average price level in the economy (Pl1-> Pl2), however it also increase a decrease in the real GDP of an economy (Yp -> Y1). As such, cost push inflation is characterised by an increase in the average price level and a decrease in the real GDP. We call this situation "Stagflation" as opposed to a recessionary gap (due to recessionary gaps being the result of decreasing AD).

Changes in Cost of Production can include:

Taxes
Increase cost of FOP/Resource prices
Changes in Exchange Rates
Supply Side Shocks - such as oil price shocks such as those in 1970s and supply chain constraints post Covid lockdowns in 2021.

It should be noted that we can only show Cost Push Inflation on the New Classical/Monetarist View. This is because the Keynesian model is focused on the stressing the importance of focusing on Aggregate Demand.

Cost Push Inflation and Stagflation in 1970s

After WW2, the predominant schools of thought that many countries adopted was that of Keynesian. Through government intervention, governments tried to balance the macroeconomic objectives of Low and Stable Inflation and Low Unemployment. (The relationship between these will be looked at later on). As we have seen so far from the Keynesian perspective, when we reach our full potential (low unemployment) we will begin to experience higher average price levels and when real GDP falls below the potential, we see lower average price levels, but rising unemployment. Therefore, governments around the world focused on managing this relationship through policies to try to balance these objectives. (Fiscal and Monetary Policies)

However, during the 1970s, many countries began to experience (periods of slow or stagnant growth & high inflation). One of the main driving factors behind this was the increase in oil prices globally as well as an oil embargo and rising food shortages, causing a supply shock for many countries reliant on importing oil. This resulted in high levels of inflation and unemployment (stagflation) which the current Keynesian policies were unable to deal with. As such, the Monetarist ideas of Milton Friedman and other free-market economists began to gain traction in both the UK & US with President Ragen and Prime Minister Thatcher. In particular, was the idea that the government's role is to focus on the Money Supply in the economy in order to manage the rate of inflation and allow for economic growth.

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