Tra My Nguyen (Magda)

IB1
HOMEWORK - Inflation Essay
[30.04.2010]

Word Count:

a. Explain the possible causes of a rise in the rate of inflation in an

economy. (10p)
b. Evaluate the possible impact on economic performance that may
result from a government decision to bring inflation under control.
(15p)

a. Explain possible causes of a rise in the rate of inflation in an

economy: (1073)

Firstly, what does the concept “inflation” mean? “Inflation” is defined as a persistent
increase in the average price level in the economy, usually measured through the
calculation of a consumer price index (CPI), which is measuring the price of the large
amounts of different types of goods and services demanded. Inflation is assessed by
comparing the prices of similar goods at two different periods of time, assuming the
quality to remain the same.

When the prices of goods and services go up, it means that the purchasing power will
be reduced. With the same amount of money, people will not be able to buy as much as
they could in the previous period of time (e.g: previous year). There are many different
types of inflation, such as: single-digit inflation, double-digit inflation, galloping
inflation, hyper inflation, etc. One of the very significant examples of this is the hyper
inflation in 1913 in Germany. Before the World War I, we could change 1 USD into 4
Marks, but after 10 years, 1 USD was equal to 4 billion Marks. So in suggests that
inflation growing depends not only on the length of period of time considered, but also on
the country condition at that period of time (e.g: war).

So what are the causes of inflation? There have been agreed 3 main causes that lead
to inflation: demand-pull inflation, cost-push inflation and inflation due to excess
monetary growth.

Demand-pull inflation
The demand-pull inflation occurs as a result of increasing aggregate demand in the
economy. It can be simply shown as in the Figure 1 below:

Inflation Essay
30.04.2010
 Tra My Nguyen (Magda)
Average price level IB1
SRAS

P2

P1

AD1 AD2

0 Real output
O1 O2
{Figure 1}
In this figure, when the demand increases, AD1 shifts to the right to AD2, also
causing the real output to increase from O1 to O2, which results in the increase in average
price level, from P1 to P2. And there occurs the inflation, since the prive level has been
pulled up by the demand. So it is called demand-pull inflation.There are also two more
cases where the demand-pull inflation is likely to occur, shown in Figure 2 and Figure 3.
That is when the economy is approaching full employment (figure 2) or when the
economy is at its level of full employment (figure 3).
Average price level

LRAS
{Figure 2}

P2

P1
AD2

AD1

0 Real output
O1 O2

Inflation Essay
30.04.2010
 Tra My Nguyen (Magda)
IB1
As the demand increases, the AD1 curve will be shifted to the right to AD2,
passing through the small amount of spare capacity, causing the prive level to increase
from P1 to P2 along with the increase in real output from O1 to O2. And therefore, the
demand-pull inflation takes place.

When the AD curve has passed through the whole spare capacity, it reaches the
level of full employment, which is shown below:

{Figure 3}
Average price level
LRAS

P2

P1
AD2

AD1

0 O Real output

Here, since the AD curve has reached the level of full employment, it is unable to
expand the output as the demand increases, however the price still keeps increasing when
people are buying more. And there occurs the demand-pull inflation.

Cost-push inflation
The second of the three main causes is the cost-push inflation, that is the result of
an increase in the costs of production.

{Figure 4}

Inflation Essay
30.04.2010
 Tra My Nguyen (Magda)
IB1

Average price level

SRAS2
SRAS1

P2

P1

AD

0 Real output
O2 O1

As the costs of production increase, the economy tends to produce less, shifting
the SRAS curve to the left from SRAS1 to SRAS2. This results in the movement along the
AD curve, increasing the average price level from P1 to P2, and therefore decreasing the
level of the real output from O1 to O2, leading to the cost-push inflation.

As stated, cost-push inflation exists because of the increase in the cost of

production. There are several well-known causes of increase in the costs of production,
such as:
- Wage-push inflation: There’s an increase in prices because of the
increase in the costs of labour.
- Cost-push pressures: The prices are increased because of the change in
costs of domestic raw materials.
- Import-push inflation: Caused by increases in the costs of imports
capital, components, raw materials, or a fall in the value of a country’s
currency.

Inflation due to excess monetary growth

Monetarists argue that excessive increases in the money supply by government
are the cause of inflation, because when there is more money in the economy, there tends
to be more spending, thus resulting in higher aggregate demand, which then leads to
increase in price level. This is shown in the Figure 5, through the neo-classical
perspective, because the monetarism is defined to be a “branch” of neo-classical
economics.

Inflation Essay
30.04.2010
 Tra My Nguyen (Magda)
IB1
{Figure 5}

Average price level

LRAS

P2

P1
AD2

AD1
0 O Real output

According to the monetarists, increases in the money supply result in higher

aggregate damand, that is why the AD curve shifted from AD1 to AD2. As the economy
stays at the full employment level of output in the long run (LRAS), increases in demand
can not influence the level of output because the economy is not able to expand the
output beyond the level O, still the prices are rised from P1 to P2, resulting in the inflation
– inflation due to excess monetary growth.

Beside these three main and the most well-known causes leading to inflation,
there are some other causes which are less important but still have an impact.

- Inflation due to economy’s structure: That is, the successful firms tend to
raise wages for employees, therefore, not to lose employees, those firms
which are not very successful also have to raise their employee’s wages.
However, the not-successful firms, in order not to make losses, they have
to raise the prices. Therefore, inflation occurs.
- Inflation due to change in demand:
- Inflation due to exports: That is, exports result in the increase in demand
within the country, which is likely to excess the relevant supply, or
because the exports result in the lack of domestic supply, makes the
demand higher. Therefore, as there is unbalance between demand and
supply, inflation occurs.

Inflation Essay
30.04.2010
 Tra My Nguyen (Magda)
IB1
- Inflation due to imports: That is, when the costs of imports increase, then
the price of selling the good imported go up. When the costs of imports
excess the average price level, inflation occurs.

In sum, the inflation has, generally speaking, nagative effects on the economy and
particularly the consumers as they have to pay more to purchase for goods and services.
However, the inflation has a good influence on imports of the country beucase when a
country has a higher rate of inflation, that will make exports less competitive, but will
attract import-partners. Or good influence can also be concluded from the fact that
inflation helps to balance the incomes between different levels of society.

a. Evaluate the possible impact on economic performance that

may result from a government decision to bring inflation under
control.

There are many possible impacts on economic performance that may result from a
government decision to bring inflation under control, or simply, this maybe referred to as
the government’s effects.

Inflation Essay
30.04.2010