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Theory 2 - Theories - Economic Indicators - External Environment - Business bank - Virtual Bank of Biz/ed

External environment - Economic indicators

Theory 2 - Inflation - what blows it up?

Causes of inflation

There are two main causes of inflation. The first is demand-pull inflation. This happens when the level of demand growth is more than the capacity of the economy to produce. This excess demand drags up prices, hence leading to it being called demand-pull inflation. The demand growth may have been caused by a number of factors including:

  • A cut in interest rates - this would give people more disposable income to spend and may encourage them to borrow more
  • Growth in house prices - this will make people feel wealthier and may encourage them to spend more, perhaps even extending their mortgage (called equity release).
  • Wage growth - significant growth in wages may encourage people to spend more, particularly on luxury goods (goods that are income elastic).
  • Tax cuts - if the government cut taxes, this will give people more disposable income and may therefore lead to a growth in demand.
  • Confidence/expectations - if people are confident about the future path of the economy they may be more willing to spend and this may also boost demand.

The second cause is cost-push inflation. This comes about when rising costs force companies to raise their prices, therefore causing inflation. The cost increases may arise from various sources:

  • Wage increases - wages are a major proportion of costs for many firms and so if wages are increasing, this may well cause cost-push inflation.
  • Government - if the government changes taxes, this may push up firms' costs. This is particularly true with excise duties on fuel and oil. Changes in interest rates can also affect firms' costs if they have borrowed significant amounts.
  • Abroad - exchange rate changes can affect firms' costs, particularly if they import many of their raw materials. An exchange rate depreciation will increase import prices and may therefore increase firms costs.

Measuring inflation

Inflation is measured by the Consumer Price Index (CPI). This was introduced as the official measure in December 2003 and replaced the Retail Price Index (RPI). The CPI is now used as it enables a more effective means of comparing inflation rates with our European trading partners. The index measures the average change in prices of a basket of goods and services. The basket has around 650 items in it, but a range of prices may be taken for each item to ensure that the prices are representative of all types of the item and also all areas of the economy. Over 130,000 prices are measured each month by a market research company on behalf of the Office for National Statistics (ONS) and ONS staff collect around a further 10,000 centrally. These price changes are all combined together and weighted to ensure that each price change reflects the importance to the average consumer. The average price change of all these measurements is the CPI figure for the month. The CPI differs from the RPI in that it does not include prices of household related items like mortgage interest payments, council tax, depreciation costs, buildings insurance and estate agents' and conveyancing fees. It does, however, include university accommodation costs and foreign students university tuition fees which the RPI did not include. The Office for National Statistics continues to publish data for both measures.