on The basic causes of inflation were covered at AS level.

This note considers the demand and supply-side courses in more detail including the impact of changes in the exchange rate and the prices of goods and services in the international economy. Cost Push Inflation Cost-push inflation occurs when businesses respond to rising production costs, by raising pricesin order to maintain their profit margins. There are many reasons why costs might rise: Rising imported raw materials costs perhaps caused by inflation in countries that are heavilydependent on exports of these commodities or alternatively by a fall in the value of the pound inthe foreign exchange markets which increases the UK price of imported inputs. A good exampleof cost push inflation was the decision by British Gas and other energy suppliers to raisesubstantially the prices for gas and electricity that it charges to domestic and industrialconsumers at various points during 2005 and 2006. Rising labour costs - caused by wage increases which exceed any improvement in productivity.This cause is important in those industries which are labour-intensive. Firms may decide not to pass these higher costs onto their customers (they may be able to achieve some cost savings inother areas of the business) but in the long run, wage inflation tends to move closely with priceinflation because there are limits to the extent to which any business can absorb higher wageexpenses. Higher indirect taxes imposed by the government for example a rise in the rate of exciseduty on alcohol and cigarettes, an increase in fuel duties or perhaps a rise in the standard rate of Value Added Tax or an extension to the range of products to which VAT is applied. These taxesare levied on producers (suppliers) who, depending on the price elasticity of demand and supplyfor their products, can opt to pass on the burden of the tax onto consumers. For example, if thegovernment was to choose to levy a new tax on aviation fuel, then this would contribute to a risein cost-push inflation.Cost-push inflation can be illustrated by an inward shift of the short run aggregate supply curve.This is shown in the diagram below. Ceteris paribus, a fall in SRAS causes a contraction of realnational output together with a rise in the general level of prices.

D emand Pull Inflation Demand-pull inflation is likely when there is full employment of resources and when SRAS isinelastic. In these circumstances an increase in AD will lead to an increase in prices. AD mightrise for a number of reasons some of which occur together at the same moment of theeconomic cycle y A depreciation of the exchange rate , which has the effect of increasing the price of imports and reduces the foreign price of UK exports. If consumers buy fewer imports,while foreigners buy more exports, AD will rise. If the economy is already at fullemployment, prices are pulled upwards.

y A reduction in direct or indirect taxation . If direct taxes are reduced consumers havemore real disposable income causing demand to rise. A reduction in indirect taxes willmean that a given amount of income will now buy a greater real volume of goods andservices. Both factors can take aggregate demand and real GDP higher and beyond potential GDP. y T he rapid growth of the money supply perhaps as a consequence of increased bank and building society borrowing if interest rates are low. Monetarist economists believethat the root causes of inflation are monetary in particular when the monetaryauthorities permit an excessive growth of the supply of money in circulation beyond thatneeded to finance the volume of transactions produced in the economy. y Rising consumer confidence and an increase in the rate of growth of house prices both of which would lead to an increase in total household demand for goods andservices y F aster economic growth in other countries providing a boost to UK exports overseas