Causes and Effects of Inflation

This document discusses the causes and effects of inflation in an economy. It explains demand-pull inflation and cost-push inflation, and explores the factors that contribute to each type of inflation.

Running head: ASSIGNMENT 1
ASSIGNMENT B
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ASSIGNMENT 2
Question3
a.
i. Demand-pull Inflation
In an economy, demand-pull inflation results from an increase in aggregate demand more
than the aggregate supply (Totonchi, 2011). This inflation occurs as the economy grows and
unemployment decreases. As too much money chases only few available goods and services in
the economy, a point is reached where no more production can be done to counter demand and as
a result the aggregate demand curve shifts from AD1 to AD2 and this leads to a price increase
from P1 to P2 as shown in the diagram below.
ii. Cost-push inflation
A decrease in an economy’s aggregate supply of goods and services leads to cost-push
inflation (Öner, 2012). This is due to production costs’ increase after maximum productivity has
been reached. Producers find it unprofitable to offer more goods and services at this point and
hence cut their supply and pass the higher production costs to final consumers. The aggregate

ASSIGNMENT 3
supply curve shifts to the left from AS1 to AS2 hence raising price from P1 to P2 as shown in the
diagram below.
b.
Causes of demand-pull inflation
Future expectation of price increase: This leads to an increase in aggregate demand as the
aggregate supply decreases and hence prices increase.
An increase in consumer income level: A rise in consumer income level increases their
disposable income and hence they demand more goods and services. This increases aggregate
demand more than aggregate supply making prices to rise.
Causes of cost-push inflation

ASSIGNMENT 4
Wage increment: An increment in salaries for employees increases production costs
which are passed to final consumers in form of increased prices for goods and this leads to cost
push inflation.
An increment of profit margins by companies: Companies may raise their profit margins
especially due to market power. The increased profits are met by increasing prices for goods and
services and this leads to cost-push inflation.
Question5
a.
When firm managers improve their marketing and selling skills, more customers are
convinced about the company’s products and end up purchasing them. This increases the
aggregate demand as the companies’ sales and profitability increase. As a result, the aggregate
demand curve shifts towards the right direction from AD1 to AD2. This leads to an increase in
economic activity as the quantity demanded increases from Q0 to Q1 while the overall economy
prices increase from P0 to P1 as shown in the diagram below.

ASSIGNMENT 5
b.
An increase in personal income tax decreases the consumer income level. As a result,
consumers decrease their consumption. This reduces the aggregate demand and the aggregate
demand curve shifts towards the left direction from AD0 to AD1. This slows the economic
activity as the quantity demanded decreases from Q0 to Q1. Suppliers are forced to decrease their
prices from P0 to P1 as shown below.
c.
An increase in exports increases the quantity supplied by businesses. The aggregate
supply increases and this shifts the aggregate supply curve towards the right direction from AS0
to AS1. This boosts the economic activity as the total output increases from Q0 to Q1. The prices
decrease from P0 to P1 as shown below.

ASSIGNMENT 6
d.
When the capital stock in an economy is significantly destroyed due war the aggregate
supply in the economy decreases. This shifts the aggregate supply curve towards the left
direction from AS0 to AS1. The economic activity deteriorates as the total output decreases from
Q0 to Q1. The prices in the economy increase from P0 to P1 as shown below.

ASSIGNMENT 7
Question6
a.
Advantages of Consumer Price Index in Prices Measurement
CPI assists the government in adjusting its budget for social security and other programs
for which it funds. CPI gives the level of consumer income and hence assists the government in
determining the extent of giving assistance to its people.
CPI gives an indication of the nation’s inflation level. CPI higher annual percentage
indicates higher inflation while CPI lower annual percentage indicates lower inflation level and
hence government can take measures for controlling inflation as indicated by the CPI.
Disadvantages of CPI in Prices Measurement
CPI may actually overstate a nation’s inflation level. This is because CPI doesn’t
consider technology advancement level over a given period of time and hence may give
inaccurate inflation rate.
CPI price measurement ignores the quality of goods and services under consideration. A
change in a product quality included in a basket of commodities under consideration may occur.
This change is not accounted for by the CPI and hence false goods information about prices may
be given due to unmatched quality of products.
b.
Some people gain from inflation especially the borrowers. This is because they repay
their borrowed funds at the previous lower interest rates as compared to current inflation rates.

ASSIGNMENT 8
Some people especially the fixed income earners and money lenders lose from inflation.
Money lenders receive their money lend to borrowers at lower previous interest rates which are
not adjusted to match the current inflation rates. Fixed income earners just continue to earn their
normal pay irrespective of the current inflation level.
Question7
a. No. When government securities are sold to banks, the money available in banks for
lending decreases. This reduces money supply in the economy.
b. Yes. When interest rates fall more people and businesses borrow money from banks and
money lenders as the cost of borrowing decreases. This increases money supply in the
economy.
c. Yes. When government borrows money from banks to increase its expenditure it
expounds its projects which aim at fostering economic growth. The increase in
government expenditure increases the supply of money in the economy.
d. Yes. When the central bank purchases government securities from the banking sector,
more money is availed in banks for lending. More money is therefore lent to borrowers
and this increases money supply in the economy.
e. No. An agreement by the Treasurer and the Central Bank Governor to cut the target
inflation rate means that the nation’s interest rates have to be increased. This will
discourage borrowing as borrowing costs increase and as a result, the supply of money in
the economy is reduced.
Question8
a. “Imports of goods”: When DVD recorders are imported from Japan then this is classified
under the imports of goods.

ASSIGNMENT 9
b. “Capital transfers to the nation from overseas”: The purchase of nation’s insurance cover
by residents from overseas is categorized as the capital transfer into the nation from
overseas nation.
c. “Capital transfers sent overseas from the nation”: An extension of aid to overseas
developing country is categorized capital which is transferred to overseas country from
the nation.
d. “Investment in the nation from overseas”: A US car company factory set up is classified
as an overseas investment in the nation.
e. “Short-term financial outflows”: When the residents of the nation go for a holiday outside
the nation this is categorized as financial outflows from the nation on short-term basis.
f. “Other income inflows”: When residents earn interest on assets situated overseas, then
this is categorized as other income inflows.
g. “Drawing on reserves”: When the central bank of the nation runs down foreign exchange
stock, then this is categorized as drawing on reserves.
h. “Short-term financial inflows”: Migrants transferring property into the nation are
classified under this category as their movement is just for short-term period.
i. “Adding to reserves”: Overseas residents’ deposits add reserves to the nation’s banks.
j. “Exports of goods”: When the nation sells palm oil in the UK, then it is said to have
exported it.

ASSIGNMENT 10
References
Öner, C. (2012). Inflation: Prices on the rise. International Monetary Fund.
Totonchi, J. (2011). Macroeconomic theories of inflation. In International Conference on
Economics and Finance Research (págs. 459-462). Singapore: IACSIT Press.