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Causes of inflation – Demand pull inflation Inflation is caused by:- Cost push inflation Demand pull inflation Inflation expectations 1. Demand Pull Inflation Demand-pull inflation is likely when there is full employment of resources and when SRAS is inelastic. If this occurs then an increase in AD will lead to an increase in prices. AD might rise for a number of reasons – some of which occur together at the same moment of the economic cycle 2. A depreciation of the exchange rate This has the effect of increasing the price of imports and reduces the foreign price of UK exports. If consumers buy fewer imports, while foreigners buy more exports, AD will rise. If the economy is already at full employment, prices are pulled upwards. 3. A reduction in direct or indirect taxation. If direct taxes are reduced consumers have more real disposable income causing demand to rise. A reduction in indirect taxes will mean that a given amount of income will now buy a greater real volume of goods and services. Both factors can take aggregate demand and real GDP higher and beyond potential GDP. 4. The rapid growth of the money supply If interest rates are low more money is borrowed leading to more consumption and an increase in AD 5. Rising consumer confidence Leads to an increase in total household demand for goods and services 6. Faster economic growth in other countries Provides a boost to UK exports overseas. Inflationary gaps As AD increase AS becomes less elastic forcing up prices If AD goes beyond potential GDP ie the pressure for AD is beyond the LRAS curve then an inflationary gap appears which forces factor prices higher. The effect of this is to cause an inward shift of SRAS taking real national output back towards a macroeconomic equilibrium at Yfc but with the general price level higher than it was before. |