Inflation means the overall price level in an economy is rising, so each dollar buys less than before. Two major causes are demand-pull inflation and cost-push inflation. Demand-pull inflation happens when buyers want more goods and services than producers can supply.
Cost-push inflation happens when production costs rise and businesses raise prices to protect profits.
Key Facts
- Inflation rate = (New price index - Old price index) / Old price index x 100
- Demand-pull inflation: high demand + limited supply = upward pressure on prices
- Cost-push inflation: higher input costs = higher prices for final goods and services
- Real income = nominal income adjusted for inflation
- If wages rise 3% and prices rise 6%, purchasing power falls by about 3%
- Inflation can be caused by strong spending, supply shocks, rising wages, higher energy costs, or expansion of the money supply
Vocabulary
- Inflation
- Inflation is a sustained increase in the overall price level of goods and services in an economy.
- Demand-Pull Inflation
- Demand-pull inflation occurs when total spending rises faster than the economy can produce goods and services.
- Cost-Push Inflation
- Cost-push inflation occurs when rising production costs lead businesses to raise prices.
- Purchasing Power
- Purchasing power is the amount of goods and services that money can buy.
- Supply Shock
- A supply shock is a sudden event that reduces supply or raises production costs, such as an oil price spike or crop failure.
Common Mistakes to Avoid
- Confusing any single price increase with inflation. Inflation refers to a broad rise in prices across the economy, not just one expensive item.
- Thinking demand-pull inflation is caused by businesses raising prices for no reason. It usually begins when consumers, firms, or governments spend more than producers can easily supply.
- Ignoring input costs in cost-push inflation. Higher wages, fuel, materials, or shipping costs can push prices up even when customer demand is not increasing.
- Assuming higher wages always make people richer. If prices rise faster than wages, real income and purchasing power decrease.
Practice Questions
- 1 A price index rises from 125 to 135 in one year. Calculate the inflation rate.
- 2 A worker earns $20 per hour and receives a 4% raise, but prices rise by 7%. What is the new hourly wage, and did the worker's purchasing power rise or fall?
- 3 A drought reduces wheat production, causing bread prices to rise even though people are buying about the same amount of bread. Explain whether this is demand-pull or cost-push inflation and why.