Theory 1 - Theories - Causes - Inflation - Monetary Policy - Economics bank - Virtual Bank of Biz/ed

Monetary Policy - Inflation - Causes

Theory 1 - Demand-pull inflation - is inflation demanding?

Demand-pull inflation happens when the level of aggregate demand grows faster than the underlying level of supply. This may be easier to imagine, if you think of supply as the level of capacity. If our capacity to produce is growing at 3%, and the level of demand grows at the same rate or slower then we don't have a problem. We can produce all we need. However, if our capacity grows at 3%, but demand grows faster, then we have a problem. In effect we have 'too much money chasing too few goods', and we can't manage to produce all we need. Something has to give, and it is prices that are forced up, therefore causing inflation. We can see all this in the diagram below. As the aggregate demand curve shifts to the right, the price level rises - inflation.

As aggregate demand shifts to the right, the price level rises

There are a variety of possible reasons for the increased aggregate demand, and to look at these in more detail we need to look at the components of aggregate demand. Aggregate demand is made up of all spending in the economy. It is:

AD = C + I + G + (X-M)
where C is consumer expenditure, I is investment, G is government expenditure, X is exports and M is imports

An increase in aggregate demand could therefore be because consumers are spending more, perhaps because interest rates have fallen, taxes have been cut or simply because there is a greater level of consumer confidence. It could be because firms are investing more in the expectation of future economic growth. It could be that the government is boosting spending on defence, health, education and so on. Or it could be because there is a boom in UK exports to overseas. Whatever it is, it will be inflationary if demand grows faster than supply.

It would be nice to stop at that point and claim we have understood demand-pull inflation, but it's not that simple. As you'll have spotted by now, economists are not specialists in simple solutions! There are differences between economists about the causes of demand changes, and as if that weren't enough, there are also differences on the effects these changes have.

The effect of a shift in aggregate demand depends on the shape of the aggregate supply curve, and this is where economists particularly differ. There are two particular views; Keynesian and Classical. Few economists would fall totally into one camp or the other, but the main differences are given below.

Classical economists

Classical economists have a fundamental belief in free markets - a 'laissez-faire' economy. They believe that left to itself, the economy will find its own full-employment equilibrium. In other words, there is no point in the government trying to manipulate the economy to get full-employment, it will make its own way there in the long run. The key to this is in the way they assume the labour market works. If the economy is below full-employment, then the following will happen:

Unemployment (a surplus of labour) leads to... wages fall leads to... more labour is employed leads to... full-employment is restored.

This process happens automatically thanks to the market mechanism, so there is no need for the government to intervene in the long run. This means that the long run aggregate supply curve will be vertical.

The AD curve shifts straight up a vertical AS curve

Any attempt by the government to boost aggregate demand in the long run using reflationary policies will simply be inflationary as it will shift the AD curve straight up a vertical AS curve.

In the short run they acknowledge that the AS curve will be upward sloping because of diminishing returns, but any reflationary policy will still be stoking up inflation for the future.

In the long run there is no overall increase in the real level of output

In this diagram we can see that the reflationary policy did shift aggregate demand to the right, which increased real output in the short run, but in the long run the increase in prices wiped this out and there was no overall increase in the real level of output.

Keynesian economists

Keynesian economists, not surprisingly, subscribe to the views of John Maynard Keynes, a famous economist of the twentieth century. They have a different view of the workings of the labour market, and would argue that it doesn't work perfectly. They believe that wages are 'sticky downwards'. This means that any unemployment may not lead to wages falling. This in turn means that the unemployed do not get re-employed. Getting rid of unemployment therefore means the government intervening to boost demand enough to get those people employed again.

The government intervenes to boost demand enough to get people employed again.

They argue that the long run and short run AS curves will be the same and that to reduce unemployment, the government must use reflationary policies to boost the level of demand.

The difference between Classical and Keynesian policy can be summed up therefore in their approach. The Classical economists argue for 'laissez-faire' or non-intervention, whereas Keynesians argue for active intervention.

Talk to a Classical economist, and they will advise

'Don't just do something, sit there!'

while a Keynesian will advise

'Don't just sit there, do something!'