Inflation - AS Economics

Inflation is a sustained increase in the general price level.

Disinflation is a fall in the rate of increase in the general price level.

Deflation is a sustained decrease in the general price level.

Cost-push inflation occurs when costs of production increase across the economy, resulting in a decrease in short run aggregate supply, which pushes up the price level.  This can occur due to changes in unit labour costs (such as wages and productivity), prices of factors of production (influenced by exchange rates) and government taxes.  Workers will negotiate for higher wages to retain their real disposable income, further increasing production costs and leading to a wage-price spiral.

Demand pull inflation occurs when either consumption, government spending, investment or net exports increase. Supply struggles to meet demand, and older, less efficient factors of production are employed.  Workers are paid more overtime but can only produce so much more, leading to a rise in the price level.

Monetary inflation results from an increase in the money supply.  This is shown through the equation MV = PT.  If we assume V (velocity of circulation) and T (total output) remain constant, we see that an increase in M (money supply) leads to an increase in P (price level).

Alternatively, this can be shown on the loan market.  An increase in supply of money lowers the cost of borrowing (interest rates), which will increase consumption and investment in the economy.

Inflation makes borrowing more attractive to households and helps those owing money, as the real value of their debts decrease.  However the value of savings will erode, and those on fixed incomes will see a fall in real disposable income.  Households face shoe-leather costs as they move their money between financial institutions and invest in real assets that keep their value (such as gold).

Inflation also makes borrowing more attractive to firms, as real interest rates may become negative, effectively meaning that they are being paid to borrow money.  This can increase investment.  Firms may also be able to save money for investment without cutting nominal wages to workers, which would be unpopular.  Workers will be more likely to accept flat wages when inflation is at 3% than a 3% wage decrease when there is no inflation.  In addition, consumers will be more willing to accept price rises even if they are greater than the rate of inflation, resulting in higher profits.  Inflation may signal strong demand throughout the economy, boosting business confidence.  Importing firms find the products they sell are more competitive in the domestic market

However there…