by Chris Pearce

Created on: July 10, 2011   Last Updated: May 09, 2012

Inflation is the name given to a sustained rise in the overall level of prices for the goods and services we buy. It is usually measured by an indicator such as a consumer price index. In broad terms, inflation is brought about in the short and medium term by pressures on the demand for and supply of goods and services. Inflation over the longer term depends more on the increase in the money supply, as determined by interest rate policy.

Demand pull inflation

When an increase occurs in the quantity of goods and services purchased by individuals, businesses and governments, demand pull inflation can result. If this new level of aggregate demand exceeds the supply of goods and services that producers are willing and able to provide, prices will be bid up by those wanting the available goods and services. Producers will often be able to satisfy this increase in demand by recruiting extra employees and perhaps investing in new machinery and other assets or improving efficiency. If producers are unable to make these changes, a period of inflation might result. This usually occurs when resources are already fully employed or close to it.

Demand pull inflation can be caused by a number of factors that generally occur when the economy is at or near full capacity. For example, a rise in consumer confidence can mean that plans to purchase certain goods and services may be brought forward. Also, a favorable housing market will boost dwelling sales, leading to greater demand for household goods, which could lead to higher prices and inflation. A further cause of demand pull inflation can be a reduction in taxes, resulting in more money in consumers’ pockets and thus higher demand for goods and services.

Depreciation in the value of the currency is another factor that can lead to inflation. Here, import prices rise and export prices fall, leading to increased demand for the products of export industries and import substitution industries, placing pressure on prices. Demand pull inflation can also occur if general interest rates are set too low and financial institutions increase their borrowings, boosting the level of funds they have available to lend to consumers and businesses.

Cost push inflation

When the supply of goods and services is curtailed, this can mean households, business and government have to compete for the smaller stock, pushing prices up, often resulting in cost push inflation. A reduction in supply can be due to higher input prices or the effects

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