Rationalize inflation through theory review

By | July 12, 2013

There are generally two major causes for inflation that are commonly referred to as demand-pull and cost push which would be further analyzed in the following part.

 

1.1.1            Demand side inflation

 demand

Figure 1 Demand side inflation

Source: Baumol, W. & Blinder, A. 2011. Economics: Principles and Policy. Natrop Boulevard: South Western Cengage Learning, p. 673

 

 

 

Demand pull inflation occurs when aggregate spending exceeds the economy’s normal full-employment output capacity. It generally occurs at the peak of a business cycle and is characterized by real GDP exceeding potential GDP because labor is short companies bid up the price and inflation occurs (Delaney, Whittington & Delaney 2012, p.132).

 

As demonstrated in the figure above, suppose at the very beginning, the interaction between the demand results in the long run equilibrium at point A. When the aggregate demand curve shifts rightward from D0 to D1, at this happens, the economy moves to point B and so the price level will also increase relatively.

 

1.1.2            Supply side inflation

 supply

Figure 2 Supply side inflation

Source: Baumol, W. & Blinder, A. 2011. Economics: Principles and Policy. Natrop Boulevard: South Western Cengage Learning, p. 673

 

When an inflation is caused by supply side shocks, it is called a supply shock inflation, a supply side inflation or most commonly known as a cost push inflation. Such an inflation is defined as any rise in the price level originating from increases in cost that are not caused by excess demands in the market for factors of production. Examples are a rise in wage rates caused by the exercise of union power in the absence of any excess demand for labor (Lipsey & Harbur 2004, p.430). As the figure above indicates, price level is determined by the interaction of supply curve and demand curve, when the supply reduces sharply from S0 to S1, suppose the demand does not change a little, then the equilibrium point would move from A to B resulting in an increase of price level. And when the prices of a large proportion of goods encounter similar situations, the inflation rate would increase relatively.

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