Inflation is the rate at which the general price level of goods and services is rising within an economy. Thus, it means your purchasing power has reduced from before, this means the same amount of money a year ago, buys you less goods and services now. In other words, you can say your real income has gone down.
Real income, is your income adjusted for inflation. For example, if your employer gives you an increase in your salary by 2%, but inflation is at 3%. Nominally, your income has gone up. BUT, your real income has gone down as ‘rate of inflation is > rate of increase in salary’. On the other hand, if inflation is at 4% and your employer gives you an increase in your salary by 5%, both your nominal and real income have gone up.
Anyways, back to the real topic… Inflation.
There are two types of inflation:
DEMAND PULL INFLATION
Demand pull inflation occurs in an economy when aggregate demand is rising faster than aggregate supply. Because the demand for a good is above equilibrium, firms will respond by increasing their prices. Demand push inflation usually happens at times of economic prosperity. During an economic boom, unemployment is at a low, consumers are working and therefore have more disposable income in their pockets, which they go out and spend because they have an increase in consumer confidence. Out of nowhere, because everyone is spending more money, firms can’t increase production in the short run to supply more, they simply just increase the price of the good.
An example of demand push inflation is a restaurant gets a great review from a food critic. This in turn means that because the restaurant serve great tasting food, and the economy is in a boom, consumers can afford more normal/luxury goods, the demand for their food goes up. Due to this, the restaurant can see more people want their food than they are supplying and increase the price to give the good (their food) to the people who want it the most, creating a new equilibrium in the process.
COST PUSH INFLATION
Cost push inflation occurs in an economy when the cost of production increases. This includes the actual production of the good and the cost of raw materials themselves. Because the reason for cost push inflation isn’t in the hands of the consumer as we saw with demand push inflation. Cost push inflation leads to a lower standard of living as people are unable to afford goods. There are many reasons as to why we see cost push inflation:
- The price of raw materials has gone up – For example, if you are a toy manufacturer, if the price of plastic goes up, either you buy less raw material, or you buy the same and absorb the loss in a bit of your profits, or you increase the price to maintain your profits, which is what you’ll most likely do. As the main objective of any firm is to make profit.
- If wage rates go up – Human capital is one of the biggest factors of production. Therefore, if wages go up, the firms’ cost also goes up. This could eventually lead to demand push inflation, as workers would have more disposable income in their pocket. Their demand for goods goes up, causing even more inflation.
- Another large cost of production is taxes – For example, in the UK, a firm has to pay corporation tax and Value Added Tax (VAT). Firms may decide to pass on these extra costs to the consumer, as you can see below in the picture, Apple states that they have included £83.17 in the price of the iPad due to VAT.