Inflation
In one line. Inflation is a sustained rise in the general price level. Demand-pull inflation comes from aggregate demand rising near full employment, raising prices with output; cost-push inflation comes from rising costs that shift short run aggregate supply left, raising prices while output falls. The consequences fall unevenly across agents, and deflation is the mirror case.
Exam relevance: a core A Level Economics topic, on ETG analysis of the last ten years. Taught the way an economics tutor who wrote the answer keys teaches it.
01What inflation is
Inflation is a sustained rise in the general price level of an economy over time, and the high marks come from identifying its cause as either demand-pull or cost-push.
Inflation is a sustained increase in the general price level of an economy over a period of time. The word sustained is important: a one-off rise in a single price is not inflation.
This page is about the causes and effects of inflation. How inflation is measured, through the consumer price index and the inflation rate, is covered in the macro-indicators notes; here the focus is on why the general price level rises and what follows. There are two engines of inflation, demand-pull and cost-push, and they are almost always paired in the examination, each with its own AD/AS diagram.
02Demand-pull inflation
Demand-pull inflation is a sustained rise in the general price level caused by aggregate demand rising faster than the economy's productive capacity, when the economy is at or near full employment.
The pressure can come through any AD component: rising consumption from higher incomes or confidence, higher investment, higher government spending, or higher net exports from a depreciation. The crucial condition is that the economy is at or near full employment. As the diagram shows, when AD shifts right against the steep part of the AS curve, the price level rises sharply with only a small rise in output. Without that near-full-capacity condition, the same rightward shift would simply raise output and would be growth, not inflation.
03Cost-push inflation
Cost-push inflation is a sustained rise in the general price level caused by rising costs of production that shift short run aggregate supply up and to the left, so prices rise while output falls.
The sources are higher wage costs, higher imported input costs such as oil and raw materials, especially after a depreciation, and higher indirect or carbon taxes. The signature that distinguishes cost-push from demand-pull is that the price level rises and output falls together, the stagflation result. For a small, import-dependent open economy the dominant channel is imported cost-push inflation, which is why exchange-rate rather than interest-rate policy is the natural corrective.
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04Telling the two apart
The two types share the same symptom, a rising price level, but differ in what happens to output, which is how you identify the cause and draw the correct diagram.
- Demand-pull: AD shifts right near full employment. The price level rises and output rises a little. The cause is on the demand side.
- Cost-push: SRAS shifts up and to the left. The price level rises and output falls. The cause is on the supply side.
Read the output direction. If the price level rises with output, it is demand-pull. If the price level rises while output falls, it is cost-push. Drawing the wrong curve, or anchoring the AD shift away from full employment, is the most common error on this topic.
05Consequences of inflation
Inflation has costs that fall unevenly across different agents, which is why a strong answer names who is hurt rather than asserting that inflation is simply bad.
High or unanticipated inflation erodes the real purchasing power of money and savings, so it redistributes from savers and creditors to borrowers and hurts those on fixed incomes hardest. It raises the cost of living, which can lower material and non-material living standards. It creates uncertainty that discourages investment, and for an open economy it can erode export price competitiveness. The point that lifts an answer is naming the specific agents affected and tracing the chain from inflation to the cost of living to the standard of living, rather than listing costs in the abstract.
06A brief note on deflation
Deflation is the mirror image of inflation, a sustained fall in the general price level, and it is not always the harmless opposite of inflation.
Deflation is a sustained fall in the general price level, a negative inflation rate, and it is distinct from disinflation, which is a falling but still positive rate where prices are still rising, just more slowly. There are two kinds with opposite implications: malign deflation from falling aggregate demand, which can trigger a deflationary spiral as households defer spending; and benign deflation from rising aggregate supply, for example cheaper imported oil, which lowers prices while raising output. As with inflation, the cause matters more than the label.
Do not confuse deflation with disinflation. Deflation is prices falling, a negative rate. Disinflation is the inflation rate falling while staying positive, so prices are still rising. Mixing them up is a frequent slip.
07Test yourself
- Using an AD/AS diagram, explain how a rise in consumer spending near full employment causes demand-pull inflation.
- Explain why cost-push inflation raises the price level while lowering output, and name one source of it.
- Explain which groups gain and which lose from unanticipated inflation, and why.
08Questions students ask
Demand-pull inflation is caused by aggregate demand rising faster than the economy's productive capacity, shown as a rightward AD shift that raises the price level when the economy is at or near full employment. Cost-push inflation is caused by rising costs of production that shift short run aggregate supply up and to the left, raising the price level while output falls. The stagflation signature, prices up and output down, is what distinguishes cost-push from demand-pull.
It is caused by an increase in any component of aggregate demand, rising consumption from higher incomes or confidence, higher investment, higher government spending, or higher net exports from a depreciation, when the economy is at or near full employment. The near-full-employment condition is the discriminator: without it a rightward AD shift simply raises output and is growth, not inflation.
Inflation is a sustained rise in the general price level; deflation is a sustained fall in the general price level, a negative inflation rate. Deflation is distinct from disinflation, which is a falling but still positive inflation rate, so prices are still rising, just more slowly. Deflation can be malign, from falling demand, or benign, from rising supply, and the cause matters more than the label.