Inflation: Causes & Effects

The syllabus splits inflation into two types according to its underlying cause.

Demand-pull inflation

Demand-pull inflation is caused by excessive aggregate demand in the economy, meaning too much total spending relative to what the economy can produce. Often summarised as "too much money chasing too few goods".

When aggregate demand (AD) rises faster than aggregate supply (AS), firms cannot ramp up output quickly enough to meet the extra spending. They respond by raising prices to ration their limited output to the most willing buyers.

Typical causes of rising AD:

• Cuts in interest rates that lower the cost of borrowing for households and firms.
• Tax cuts that leave households with more disposable income.
• Higher government spending on infrastructure, public services, or transfers.
• A consumer or housing boom in which households spend more out of confidence.
• Higher exports triggered by strong demand abroad.

On an AD-AS diagram, demand-pull inflation appears as the AD curve shifting right, raising both the price level and real GDP.

Cost-push inflation

Cost-push inflation is caused by rising costs of production (such as higher wages, raw-material prices, or import prices) that firms pass on to consumers as higher prices.

The mechanism: firms see their per-unit cost rise; to keep profit margins acceptable, they raise selling prices. Households and other firms then pay more for everything that uses those inputs.

Typical causes of rising costs:

• A rise in world oil or gas prices that flows through every transport- and energy-using industry.
• Wage rises that exceed productivity gains (sometimes called wage-push inflation).
• A fall in the exchange rate that raises the price of imported raw materials (imported inflation).
• A rise in indirect taxes (e.g. VAT, fuel duty) that producers add to retail prices.
• A supply shock: a war, disaster or pandemic that disrupts supply chains.

On an AD-AS diagram, cost-push inflation appears as the AS curve shifting left, raising the price level but reducing real GDP at the same time (called stagflation when severe).

Demand-pull vs cost-push at a glance