Assess the view that inflation is always caused by an Increase in Aggregate Demand

Essay by BenHounslea1High School, 10th gradeA, October 2014

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'Assess the view that inflation is always caused by an 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...