💰 More money to spend
Households may pay less tax, so they have more disposable income. The government may spend more on roads, schools or hospitals. Both push up demand.
Inflation » Causes of Inflation
What you'll learn this session
Study time: 30 minutes
Cambridge spec: 4.7.3
- What demand-pull inflation is and what causes it
- What cost-push inflation is and what causes it
- How to tell the two apart in a short piece of information
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Unlock This CourseWhy do prices keep rising?
You already know that inflation is a sustained rise in the general price level. This lesson asks a different question: why does it happen? There are two main causes. Either buyers push prices up, or firms' costs push prices up. Cambridge asks you to know both.
Key terms:
- Demand-pull inflation: inflation caused by total demand in the economy rising faster than the economy's output.
- Cost-push inflation: inflation caused by rising costs of production, which firms pass on to customers as higher prices.
Demand-pull inflation
Think of an auction. If more people want to buy than there are items to sell, the bidding pushes the price up. The same happens across a whole economy. If households, firms, the government and foreign buyers want to buy more than the economy can produce, firms find they can raise prices and still sell everything. Prices are pulled upwards by demand.
The important words are "faster than output". Demand can rise without causing inflation if firms can produce more to meet it. Prices rise when output cannot keep up, for example when factories and workers are already busy.
What makes total demand rise? Here are the usual causes:
🏦 Cheaper borrowing
When the interest rate falls, loans become cheaper. Households borrow to buy more and firms borrow to invest more.
🙂 Higher confidence
If people feel secure about their jobs and the future, they spend more and save less.
🌍 More export demand
If foreign buyers want more of a country's goods, total demand rises because exports are part of it.
Worked example
The country of Rundala has factories running at full capacity. The government cuts income tax and the central bank lowers the interest rate. Households spend 9% more, but firms can only produce 2% more goods. Total demand has risen faster than output, so firms raise their prices. This is demand-pull inflation.
Cost-push inflation
Now imagine a bakery. Demand for bread has not changed, but the price of flour has gone up. The baker's costs are higher, so to protect profit the baker raises the price of bread. Prices are pushed upwards by costs. When this happens to many firms at the same time, the general price level rises.
Notice that there does not have to be more demand. The usual causes are:
👷 Rising wages
Wages are a big cost for most firms. If wages rise faster than productivity, each unit of output costs more to make.
🏭 Rising raw material prices
Oil, metals, cotton or wheat may become more expensive. Every firm that uses them has higher costs.
📦 Dearer imports
If a country's currency falls in value against other currencies, imported goods and materials cost more in the home currency. Firms that rely on imports face higher costs.
💲 Higher indirect taxes
An indirect tax, such as a tax on fuel, adds to a firm's costs. The firm may pass it on in a higher price.
Worked example
In Kaveria, the world price of oil rises sharply. Transport firms, factories and farms all use fuel, so their costs rise. Demand has not changed. Firms raise their prices to cover the extra cost, and the general price level goes up. This is cost-push inflation.
How to tell them apart
In the exam you will be given a short piece of information and asked which type of inflation it shows. Look for the clues.
| Clue in the information | Type |
|---|---|
| Consumers or firms are spending more, interest rates fall, taxes are cut, government spending rises, exports are booming | Demand-pull |
| Wages rise, raw materials or energy cost more, the currency has fallen in value so imports cost more, a new indirect tax is introduced | Cost-push |
Ask yourself one question: did the pressure start with buyers wanting more, or with firms paying more? Buyers wanting more means demand-pull. Firms paying more means cost-push.
Sometimes the two combine. Higher wages raise firms' costs (cost-push), but they also give workers more to spend (demand-pull). In your answer, say which one the information points to most clearly.
Common mistakes
- Writing "prices rise because demand rises" without saying that demand rises faster than output. That phrase is what makes it inflation.
- Saying a rise in the price of one good is cost-push inflation. Inflation is a rise in the general price level, so many prices must rise.
- Treating a wage rise at firms as a rise in demand. For the firm it is a cost, so the usual answer is cost-push.
- Forgetting to link the cause to the price rise. Always finish with "so firms raise prices".
Exam-style question
Read the information, then answer the questions.
Ostrava is a middle-income country. Last year the government cut taxes and the central bank cut the interest rate. Shoppers spent much more. At the same time the price of imported steel rose because the country's currency fell in value, and a new tax was placed on diesel fuel. Prices in Ostrava rose by 7%.
(a) Define cost-push inflation. [2 marks]
(b) Identify two causes of demand-pull inflation from the information. [2 marks]
(c) Explain how a rise in the price of imported steel could lead to cost-push inflation. [4 marks]
Model answer
(a) Cost-push inflation is inflation (a sustained rise in the general price level) (1) caused by rising costs of production, which firms pass on to customers in higher prices (1).
(b) Any two from: the government cut taxes (1); the central bank cut the interest rate (1); shoppers spent much more (1).
(c) Steel is a raw material for firms such as builders and car makers (1). If its price rises, their costs of production rise (1). To protect their profit, they may raise the prices of their goods (1). If many firms do this, the general price level rises, which is cost-push inflation (1).
Exam tip
In part (b), copy the cause from the information in a few words. For "identify" you only need to name it, so do not write long explanations that earn no extra marks.