What is inflation, how does it work and what impacts can it have?

Inflation is a rise in the general price level of goods. There are two main types of inflation: cost-push inflation and demand-pull inflation. Inflation is measured using the CPI – the Consumer Price Index, which is calculated by the ONS or Office for National Statistics. The CPI uses a weighted basket of consumer goods and tracks changes in their prices to measure the overall price level in an economy at a given time.

Types of Inflation

Cost-Push Inflation

The UK is currently experiencing cost push inflation in many goods and services. This is caused by a shortage of resources, which is a result of many aspects. Cost-push inflation is seen with a decrease in the SRAS/LRAS, which moves the equilibrium higher and pushes up the price level.

One reason for the current cost-push inflation is a decreased national output from countries we buy from. As a net importer, we rely on other countries for a large amount of our national supply of goods, and so when these countries export less we can produce less. For example, countries we import from which are currently facing such problems include:

  • China, as a result of shipping delays and factory shutdowns because of Covid, have decreased their RNO, causing a shortage for us. 
  • Russia as a result of sanctions because of their war with Ukraine, and the subsequent economic war between Russia and almost everyone else

Demand-Pull Inflation

Demand pull inflation is less common in the UK currently, one example is housing, the largest cause of the increase in housing prices is demand steadily increasing with the population of the UK. When aggregate demand increases due to one of the components of AD (with the exception of Imports) increasing, if the economy is near or at full capacity then producers can no longer increase output. This means that instead the price is bid up, increasing the equilibrium price level.

After lockdown, the price of housing with gardens spiked, causing a demand-pull inflation in suburban housing. This is because people began to appreciate the benefits of having open space to breathe fresh air, when the option of going to parks was removed. However, demand for inner-city housing decreased. Although prices in the inner-city still rose, the rate of inflation had fallen – this is known as disinflation, which we will explore in more depth in a future article.

Why is inflation considered bad?

As mentioned previously, the government and Bank of England target for inflation is 2% +/- 1%. This is because some inflation is beneficial – if the economy encountered deflation, then we could enter a deflationary spiral (we will explore why deflation and the problems of a deflationary spiral in a future article). However, when inflation exceeds this target, it can cause a multitude of problems. Firstly, it can cause real incomes to fall. Even if nominal wages are rising, if items are becoming more expensive, and at a rate greater than the income rise (i.e. inflation > income increase), then you are actually left poorer – you can buy fewer goods and therefore have a lower standard of living.

Furthermore, real GDP can fall, as although the economy’s nominal GDP may rise, this is most likely due to the prices of goods and therefore value of the goods produced rising. However, the volume of finished goods and services produced might have actually fallen, suggesting economic decline, as we use real GDP which is nominal GDP adjusted for inflation. Two consecutive quarters of negative economic growth in terms of real GDP means that we are in a recession, which can cause a chain reaction of negative events. If we enter a recession, animal spirits are low which can drive financial markets into a slope. Investment falls greatly and people save their money, lowering consumption. Both of these factors decrease AD, causing further economic decline. In our next article, we will look at methods of fighting inflation, who is in charge of this and how effective it can be.


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