Economy Basic Concepts Part 6 – Inflation

Graph showing Increase in AD


AD can increase for the following reasons:

  1. Increased wages. Higher real wages increase disposable income and encourage consumer spending.
  2. Increased government spending (G).
  3. Fall in value of sterling which makes exports cheaper and increases the number of exports(X).
  4. Increased consumer confidence, which encourages spending (C).
  5. Lower income tax which increases the disposable income of consumers and increases consumer spending (C).
  6. Rising house prices, which create a positive wealth effect and encourages homeowners to spend more

Long-term economic growth

This requires an increase in the long run aggregate supply (productive capacity) as well as AD.

Diagram showing long-run economic growth


LRAS or potential growth can increase for the following reasons:

  1. Increased capital. e.g. investment in new factories or investment in infrastructure, such as roads and telephones.
  2. Increase in working population, e.g. through immigration, higher birth rate.
  3. Increase in Labour productivity, through better education and training or improved technology
  4. Discovering new raw materials.
  5. Technological improvements to improve the productivity of capital and labour e.g. Microcomputers and the internet have both contributed to increased economic growth.

Improvement in well being

  1. From the perspective of mainstream economics, the answer seems clear-cut: The consumption of material goods and services satisfies people’s preferences and contributes to their happiness.
  2. And higher levels of consumption should—all else equal—contribute positively to social welfare.
  3. The “all else equal” caveat is quite important here. While non-economists sometimes assume that mainstream economics is concerned narrowly with the monetary value of market goods and services.
  4. In fact, economics textbooks very much stress the contributions that public goods and environmental quality make to human well-being.

Conservation of environment

  1. The notion that stabilizing climate might require reductions in the levels of material production and consumption is one facet of the rapidly evolving “degrowth” movement.
  2. This perspective notes (rightly) that greenhouse gas emissions tend to increase with the level of economic activity because higher income and consumption levels translate into increased demand for carbon-intensive goods.
  3. An analogous argument, however, is offered by analysts who favour free-market energy policies over the interventionist policies needed to put the economy on course towards the achievement of a sustainable energy system.
  4. The argument is that the production of goods and services requires energy and that cutting energy use—or shifting toward higher-cost forms of energy—necessarily threatens to reduce the level and growth of economic output.
  5. As one example of this line of reasoning, the U.S. Energy Information Administration (USEIA) predicted that implementing the Kyoto Protocol would reduce U.S. economic output by up to 4.3 per cent in the year 2010.
  6. A more representative assessment is provided by the Stern Review on climate change, which found that stabilizing atmospheric carbon dioxide concentrations
  7. At 500–550 parts per million—a level sufficient to limit the future increase in mean global temperature to roughly 2 degrees Celsius—would impose costs equivalent to a permanent 1 per cent reduction in the level of present and future economic output.
  8. One key point is that achieving Stern’s stabilization target would require a gradual but also nearly complete transition away from today’s high-carbon energy economy to a mainly post-carbon energy system over the course of the next four decades.
  9. On the other hand, Stern’s analysis implies that climate change policies would have almost no impact on the rate of economic growth.
  10. Because climate change policies would be phased in gradually over time, an economy that might have grown at a rate of 3.00 per cent per year would instead grow at a lower rate of 2.95 percent per year.
  11. If one assumed that climate policies had costs in the middle of the range described by the Intergovernmental Panel on Climate Change in its systematic literature review.

Indicators of Sustainable development

  1. Green GDP – it is the GDP adjusted for the cost of environmental degradation, it is obtained by deducting the value of environmental degradation from the GDP.
  2. Genuine Saving – it is obtained by (Gross saving – Depreciation in the manmade capital – depreciation in natural capital)

Threats to sustainable development

  1. Depletion of resources (Renewable and Non-renewable)
  2. Environment Degradation


  1. A sustainable future will emerge if we build institutions that, on a practical level, sustain the natural environment and the social and technological conditions that will empower future generations to define and pursue their own conception of the good life.
  2. As the Nobel Prize-winning economist, Amartya Sen wrote in his book Development as Freedom,[45] the path to enhanced human flourishing will be built by expanding the scope of choices and opportunities.



  1. Persistence increase in the price level or increase in average prices of goods and services in an economy over a long period of time.
  2. It is a situation in which too much money is chasing too few goods.
  3. It reduces the value (real purchasing power)
  4. Inflation is caused by a combination of four factors. Those factors are:
  5. The supply of money goes up.
  6. The supply of goods goes down.
  7. Demand for money goes down.
  8. Demand for goods goes up.

Let’s discuss types of inflation

  1. Cost pull inflation
  2. Demand-pull inflation


Demand-pull inflation


  1. Caused due to increase in aggregated demand in the economy, Sustained increase in the prices of goods and services resulting from a high demand.
  2. Stimulated by easy credit and hire purchase offers accompanied by insufficient supplies. In general, more inflation is caused by demand-pull factors than by cost-push factors. Also called demand inflation, it is the opposite of cost-push inflation.

 Reasons for demand-pull inflation

  1. Increase in money supply leads to an increase in currency, bank deposit etc.
  2. Another reason is deficit financing which leads to the printing of money
  3. Increase in foreign exchange reserve – Whenever the dollar is exchanged via foreign tourist for investing or purchasing of goods and services.
  4. Increase in black money
  5. Decrease in income
  6. The decrease in direct taxes and increase in disposable income
  7. Increase in population
  8. Increase in Government (public) expenditure
  9. Increase in budgetary deficit
  10. Increase in export
  11. Increase in import
  12. Depreciation of money


Cost-push inflation


  1. Cost-push inflation occurs when we experience rising prices due to higher costs of production and higher costs of raw materials.
  2. Cost-push inflation is determined by supply-side factors (cost-push inflation is different to demand-pull inflation which occurs due to aggregate demand growing faster than aggregate supply).
  3. Cost-push inflation can lead to lower economic growth and often causes a fall in living standards, though it often proves to be temporary.

Causes of cost-push inflation

  1. Increase in cost of production
  2. Prices of inputs
  3. Reduction in output
  4. Increase in indirect taxes
  5. Defective supply
  6. Increases in prices of imported commodity
  7. Depreciation
  8. Increase in the price of crude oil

Inflation in Summary

  1. Cost-push inflation and demand-pull inflation can be explained using our four inflation factors.
  2. Cost-push inflation is inflation caused by rising prices of inputs that cause factor 2 (The supply of goods goes down) inflation.
  3. Demand-pull inflation is factor 4 inflation (The demand for goods goes up) which can have many causes.

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