Inflation is the name given to an increase in price levels generally. It is also manifest in the decline in the purchasing power of money

Inflation does not mean that the price of every good and service increases, but that on average the prices are rising.

Inflation reduces the value of money

Governments aim to control inflation because it reduces the value of money and the spending power of households, governments and firms.

Demand-pull inflation is caused by higher levels of aggregate demand driving up the general price level of goods and services.

Demand-pull inflation is shown by a rightward shift of the aggregate demand curve from AD to AD1.

How does demand-pull inflation happen?
If aggregate demand grows at a 4% annual rate but productive capacity grows at a 2.5% annual rate, enterprises will see demand surpass supply. As a result, they raise their pricing.

Furthermore, as enterprises produce more, they hire more workers, resulting in an increase in employment and a decrease in unemployment. This increasing demand for labour pushes up salaries, resulting in wage-push inflation. Wage increases enhance workers' disposable income, which leads to an increase in consumer expenditure.



Demand-pull inflation is caused by higher levels of aggregate demand driving up the general price level of goods and services.

Increases in aggregate demand may result from:

a consumer boom
a rise in government spending
higher business confidence
an increase in investment
an increase in net exports.

Increase in money supply

Monetarists argue that the key cause of higher aggregate demand is increases in the money supply. They suggest that if the money supply grows more rapidly than output, the greater supply of money will drive up the price level.

Imported inflation

Imported inflation occurs due to higher import prices, forcing up costs of production and therefore causing domestic inflation.

A cut in interest rates

A cut in interest rates causes a rise in consumer spending and higher investment. This boost to demand causes a rise in aggregate demand and inflationary pressures.