Price Stability

Inflation is a sustained rise in the general price level. AD/AS analysis identifies two main causes.

Demand-pull inflation is caused by an increase in aggregate demand when the economy is at or near full capacity. AD = C + I + G + (X − M), so a rise in any component — for example a credit boom raising consumption, a tax cut, very low interest rates, or surging exports — shifts the AD curve to the right. If the economy is near full capacity (on the steep section of AS, close to LRAS), firms cannot easily produce more output, so the extra demand pulls up the price level. The cause is therefore excess demand.

Cost-push inflation is caused by a rise in the costs of production, which shifts the short-run aggregate supply (SRAS) curve to the left. Triggers include higher wages, higher raw material or energy prices (e.g. an oil shock), higher indirect taxes, or a fall in the exchange rate that raises imported input costs. As SRAS shifts left, the equilibrium moves to a higher price level and, importantly, a lower level of real output — so cost-push inflation tends to be accompanied by falling output and rising unemployment ('stagflation').

The key difference is the source: demand-pull comes from the demand side (AD shifting right against limited capacity), whereas cost-push comes from the supply side (SRAS shifting left because costs have risen). This distinction matters for policy: demand-pull inflation can be reduced by lowering AD, whereas using the same policy against cost-push inflation would worsen unemployment without removing the cost cause, so supply-side measures are needed instead.

Inflation rate. The CPI rose from 100 to 108, so inflation = (108 − 100)/100 × 100 = 8%.

Effect on workers' real wages. Money wages rose by only 5%, but inflation was 8%. So real wages ≈ 5% − 8% = about −3%: workers' real wages fell by around 3%, meaning they can buy less than before despite a higher money wage. Their living standards have therefore declined.

Type of inflation. Because the inflation was "largely caused by a doubling of imported energy prices", this is cost-push inflation: higher energy costs raise firms' costs of production, shifting SRAS to the left and pushing up the price level (often with lower output).

Implication. This is a difficult situation: the cost-push inflation has reduced real incomes, and if the government tried to cut inflation by reducing AD, it would risk higher unemployment without removing the energy-cost cause. Supply-side responses (e.g. improving energy efficiency or finding alternative supplies) would be more appropriate.

A high rate of inflation — a rapid, sustained rise in the general price level — has wide-ranging consequences, most of them harmful, though the severity depends on circumstances.

Harmful consequences. High inflation erodes the value of money and savings, hurting savers and those on fixed incomes (e.g. pensioners), while benefiting borrowers whose debts shrink in real terms — a redistribution of income that can worsen inequality. It damages international competitiveness: if a country's inflation is higher than its rivals', its exports become relatively dearer and imports cheaper, worsening the current account. High and volatile inflation creates uncertainty, which discourages investment and long-term planning, harming growth; it also generates menu costs (constantly changing prices) and shoe-leather costs (managing cash). It can trigger a wage-price spiral, as workers demand higher wages to keep up, feeding further inflation.

Mitigating considerations. The consequences depend heavily on the rate and predictability of inflation. If inflation is anticipated, people and firms can adjust (index wages and contracts), reducing the harm. Low, stable inflation is far less damaging than high or hyperinflation, and is preferable to deflation, which can cause delayed spending, rising real debt and a prolonged slump. The effects also differ between groups: borrowers and those with index-linked incomes are less affected than savers and fixed-income groups.

Judgement. A high rate of inflation is clearly damaging — it erodes savings, redistributes income unfairly, harms competitiveness and discourages investment, and at the extreme (hyperinflation) can destabilise an entire economy. The severity is worst when inflation is high, volatile and unanticipated. However, the analysis also shows that low, stable inflation is mild and even beneficial compared with deflation, so the real problem is high and unstable inflation rather than inflation as such. The most defensible conclusion is that high inflation is one of the most serious macroeconomic problems and justifies the priority central banks give to price stability, but a small, stable positive rate is not harmful and is the appropriate target.

Many governments and central banks treat low, stable inflation as their main objective. Whether it should be the main one must be weighed against other macroeconomic goals — growth, employment and the current account.

The case for prioritising inflation control. Price stability provides the certainty needed for firms to invest and for households to plan, supporting long-run growth. It protects the value of savings and fixed incomes, prevents the redistribution and inequality caused by high inflation, and preserves international competitiveness (avoiding a worsening current account). Because high or volatile inflation is so damaging — and at the extreme can collapse an economy — controlling it can be seen as a precondition for achieving the other objectives. This is why many central banks are given an explicit inflation target.

The case against making it the main objective. Focusing on inflation can conflict with other goals. Using contractionary policy to cut inflation reduces AD, which can raise cyclical unemployment and slow growth — a clear short-run trade-off. If inflation is cost-push, tightening demand is especially damaging, worsening unemployment without removing the cost cause. In a deep recession, prioritising inflation over jobs and output would be inappropriate; reducing unemployment or restoring growth may matter more to welfare. Some inflation is also harmless, so an obsessive focus on it could be misplaced.

Judgement. Controlling inflation is a central objective and, because high inflation undermines the other goals, keeping it low and stable is usually a sensible primary anchor for policy — which is why inflation targeting is so widespread. However, it should not always be the single overriding objective regardless of circumstances: in a recession, unemployment and growth may deserve priority, and against cost-push inflation, supply-side measures matter more than squeezing demand. The most defensible conclusion is that controlling inflation should be a key objective and the usual priority in normal times, but governments must balance it against employment, growth and the current account depending on the state of the economy — so it should be the main objective only conditionally, not unconditionally.