Causes of inflation and deflation

Demand-pull inflation

Aggregate demand grows faster than the economy's capacity to supply. Causes: rising consumer confidence, lower interest rates, tax cuts, higher government spending, booming exports or a weaker currency.

Diagram in words: draw price level on the vertical axis and real output on the horizontal. AD shifts right along an upward-sloping SRAS (or along the steep part of a Keynesian LRAS near full employment). The equilibrium moves up and to the right: higher price level and higher real output, until capacity is reached, after which only prices rise.

Cost-push inflation

Firms' costs rise, so they raise prices. Causes: higher oil, energy and commodity prices; wage rises greater than productivity growth; a depreciation that makes imported inputs dearer; higher indirect taxes.

Diagram in words: SRAS shifts left (upwards). The new equilibrium has a higher price level and lower real output, so inflation comes with weaker growth and possibly higher unemployment.

Growth of the money supply

If the money supply grows much faster than real output, there is 'too much money chasing too few goods'. Monetarists use the quantity theory, MV = PY: if velocity V and real output Y are fairly stable, a rise in money M leads to a proportional rise in prices P. Very rapid money creation to finance government spending has caused hyperinflations.

Causes of deflation

• Falling AD ('bad' deflation): a collapse in confidence, credit or exports shifts AD left, lowering prices, output and employment.
• Rising AS ('good' or benign deflation): new technology, higher productivity or cheaper commodities shift SRAS or LRAS right, lowering prices while output rises.
• A fall in the money supply: less money chasing the same goods.

Worked example

Oil prices double. Using AD/AS analysis, explain the likely effect on the price level and real output of an oil-importing economy.

1. Oil is a key input, so firms' costs of production rise.
2. SRAS shifts left from SRAS1 to SRAS2.
3. At the original price level there is excess demand, so the price level rises from P1 to P2.
4. Real output falls from Y1 to Y2 along the AD curve.

Answer: Cost-push inflation: higher price level, lower real output.

Check yourself

1. Which is most likely to cause demand-pull inflation?
   • A rise in the price of imported oil
   • Higher productivity
   • A large cut in income tax when the economy is near full capacity
   • A rise in the exchange rate
   Show answer

   A large cut in income tax when the economy is near full capacity. Higher disposable income raises consumption, shifting AD right when there is little spare capacity.

2. Wages rise by 6% while productivity rises by 1%. This is most likely to cause
   • cost-push inflation
   • demand-pull inflation
   • benign deflation
   • a rightward shift of LRAS
   Show answer

   cost-push inflation. Unit labour costs rise, so SRAS shifts left.

3. On an AD/AS diagram, cost-push inflation is shown by
   • a rightward shift of AD
   • a rightward shift of LRAS
   • a leftward shift of SRAS
   • a movement down the AD curve caused by lower costs
   Show answer

   a leftward shift of SRAS. Higher costs reduce the output firms will supply at each price level.

4. What happens to real output when there is cost-push inflation, other things equal?
   • It rises
   • It falls
   • It is unchanged
   • It rises then doubles
   Show answer

   It falls. SRAS shifts left along a downward-sloping AD, so output falls.

5. Using MV = PY, M = 500, V = 4 and Y = 1000. Find P.
   Show answer

   2. P = MV / Y = 2000 / 1000 = 2.

6. With V and Y constant, the money supply rises by 10%. According to the quantity theory, by what % does the price level rise?
   Show answer

   10 %. If V and Y are constant, P rises in proportion to M: 10%.

7. Which is an example of 'benign' deflation?
   • Prices fall because consumers stop spending in a crisis
   • Prices fall because banks stop lending
   • Prices fall because exports collapse
   • Prices fall because new technology greatly lowers production costs
   Show answer

   Prices fall because new technology greatly lowers production costs. Rising AS lowers prices while output rises, which is benign.

8. A large depreciation of a country's currency is most likely to cause inflation by
   • reducing exports
   • raising interest rates
   • raising the price of imported raw materials and finished goods
   • reducing the money supply
   Show answer

   raising the price of imported raw materials and finished goods. Imports cost more in domestic currency, raising costs (and AD rises as exports become cheaper).

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Sources

• Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics specification, Issue 2 (June 2018)
• Pearson Edexcel IAL Economics WEC12 Unit 2 mark scheme, January 2025

Last updated 8 November 2026. Spotted a mistake? Tell us.