Increase in Aggregate Demand
Increase in Aggregate Demand
In order to address this question it is first necessary to define both inflation and aggregate demand. Aggregate Demand is the total amount demanded by the whole economy, ie it is not related to one single market. Inflation is the persistent increase in the average level of consumer prices compared to the same time the previous year. This is a natural occurrence over time as wages rise and so the quantity demanded increases, which activates the incentive price function and causes prices to rise, thus causing inflation. There are numerous types of inflationary pressure but nearly all can be subdivided into demand-pull or cost-push inflation.
Demand-pull inflation is inflation caused by an extension in total demand, which is sufficiently big so that it exceeds total supply, this happens because of a huge increase in aggregate demand. As a result all factors that lead to large increases in aggregate demand can also cause demand-pull inflation. Thus, a main cause of demand-pull inflation could be a reduction in the levels of direct taxation. By reducing the level of direct taxation consumers have more real income and therefore greater disposable income to spend on goods and services, this leads to increased consumption and thus an extension in demand in all markets. Due to this extension in aggregate demand, firms will increase prices within each market leading to average price rises and inflation.
Another factor which would cause demand-pull inflation would be a boost in consumer confidence such as the one which occurs when an economy reaches the recovery stage after emerging from recession. Due to the boost in consumer confidence and increasing amount of money is spent on goods and services which in turn raises the demand and thus firms increases prices, leading to inflation. Several further factors which also cause demand-pull inflation are a decrease in indirect taxation, rapid consumer borrowing in times with low interest rates and depreciation in the exchange rate.
Cost-push inflation is inflation which occurs when firms increase prices in order to maintain a profit margin. They did this because of an increase in cost productuion. For example the price of cars will be increased by firms if there is an increase in demand for and therefore and increase in the price of steel. A main cause of cost-push inflation is increasing labour costs. Labour costs may be increased by the government introducing a higher minimum wage or by a union led workforce negotiating a higher wage. Due to this increase in overall costs profits are reduced and it is necessary for firms to increase their prices to increase the amount of profit they are making so it reaches the previous level. In this case average prices will rise compared to the previous year even though there has been no increase in aggregate demand, as cost-push inflation is not linked to demand.
A secondary cause of cost-push inflation is higher rates of indirect taxation which may be imposed by the government on certain products such as alcohol and tobacco or by increasing VAT. This is generally done in a free market economy to reduce the popularity of what are seen as negative goods which may harm people’s health. This happens because some firms feel that there is elastic demand for the products they supply and so pass on the increase in costs to their customers in the form of higher prices to maintain profitability. In this case aggregate demand has not grown but there has been an average price level increase.
There is no doubt that inflation can be caused by an increase in aggregate demand, in the form of demand pull inflation, however cost plus inflation also exists where inflation occurs without an increase in aggregate demand and thus this view is incorrect.