Causes of Inflation in Macroeconomics

In this video, we delve into the macroeconomic concept of inflation, which is defined as a sustained rise in prices. We identify two primary causes of inflation: demand-pull causes and supply-push causes.

Demand-Pull Causes

Demand-pull inflation occurs when there is an increase in aggregate demand (AD). The aggregate demand formula is AD = C + I + G + X - M, where:

• C stands for consumption,
• I for investment,
• G for government spending,
• X for exports, and
• M for imports.

Increases in consumption, investment, or government spending directly increase aggregate demand, causing the demand curve to shift to the right. This shift leads to an increase in the price level from P1 to P2, thus resulting in inflation. Additionally, a fall in imports or a rise in exports increases the aggregate demand, further amplifying inflation.

An important note is that if there is an increase in demand without a corresponding increase in supply, inflation occurs. An increase in supply could potentially counteract inflation, but without it, only the price levels rise.

Supply-Push Causes

Supply-push inflation is triggered by various factors affecting supply:

• Inelastic Goods: If firms sell inelastic goods (goods for which demand does not significantly change with a change in price), businesses can repeatedly raise prices without losing much demand. This sustained price increase leads to inflation.

• Increase in the Cost of Production: Factors such as an increase in indirect taxes raise production costs. Higher costs can lead to decreased profit margins for businesses, some of which may exit the market, reducing the aggregate supply. This reduction in supply causes the supply curve to shift up, resulting in higher prices and, thus, inflation.

• Wage Increases: Although technically a factor that influences demand, wage increases allow people to buy more, thereby increasing aggregate demand. This increase in demand leads to higher prices, contributing to inflation.

An additional note is that an error was acknowledged regarding the impact of import prices on inflation. An increase in import prices would actually decrease the attractiveness of imports, leading to a decrease in imports and inadvertently causing a demand-pull inflation.

Overall, inflation is a complex phenomenon influenced by both demand and supply factors within the economy.