Demand pull inflation
When there is an increase in aggregate monetary demands it results in demand pull inflation. This can be caused by an increase in one or more of the components of aggregate demand (AD) and where aggregate supply (AS) is slow to adjust.
The causes are demand shocks, like:
- Earning rising above productivity.
- Reduction in interest rates and cheaper credits.
- Excessive rate of public sector borrowing.
- Creating equity withdrawal and a positive wealth effect.
- Changes in savings ratio.
Savings ratio: It represents the percentage of disposable national income rather than the spent income. The sudden changes in savings ratio are honest indicators of future changes in spending and AD, and can be one of the reasons for inflation or deflation. A rise in savings ratios represents a decline in customer confidence whereas a fall in savings ratio represents a rise in confidence and spending which can in turn trigger the increase in price rates.
Cost pull inflation
When an economy experiences a negative cost shock a cost push inflation occurs. The causes of it are:
- Oil price shocks caused by wars.
- Increase in farm price rates following a series of poor harvest.
- Rise in wage costs, rapidly.
- A fall in exchange rate which increases the price of all imports.
- Imported cost push inflation.
Exchange rates and cost push inflation
The fall in exchange rates will indicate that you require to purchase more of a given quantity of imports. That is in other words the price rate of imports will rise. For example, a motor vehicle imported from Germany for €50,000 would cost £25,000 at an exchange rate of £1 – €2. If Sterling falls in value, to £1 = €1.90, then the Sterling price would rise to £26,316.
The effect of the fall in the exchange rate is to raise the CPI. Imported raw materials are also more expensive so costs of production will rise for those firms that source their inputs from abroad. Hence, while a low exchange rate may be beneficial for exports, it has as a potentially inflationary effect on costs and prices.