Causes of inflation
Why do prices rise? Economists point to too much spending, rising costs, expectations, and in the long run, money growth.
Demand-pull inflation
Demand-pull inflation occurs when aggregate demand grows faster than the economy's capacity to produce: 'too much money chasing too few goods'. Strong consumer spending, government stimulus, booming exports, or easy credit can all pull prices up, especially when the economy is near full employment.
Cost-push inflation
Cost-push inflation occurs when production costs rise, shifting aggregate supply left. Oil price shocks, rising wages not matched by productivity, supply chain disruptions, and a weaker currency raising import prices are examples. The 1970s oil shocks raised both inflation and unemployment, a combination called stagflation.
The wage-price spiral
If workers expect higher prices, they demand higher wages; firms then raise prices to cover costs, which leads to further wage demands. This feedback can sustain inflation even after the original cause fades, which is why central banks care about expectations.
Inflation expectations
Expectations shape inflation. If people believe inflation will stay near 2%, they set wages and prices accordingly, helping it stay there. If expectations become unanchored and drift upward, bringing inflation back down usually requires tighter policy and can cost jobs. Central bank credibility helps keep expectations anchored.
The quantity theory of money
The quantity equation is \(MV = PY\): money supply times velocity (how often money changes hands) equals the price level times real output. If velocity and output are fairly stable, faster money growth leads to higher inflation. Milton Friedman summarised this as 'inflation is always and everywhere a monetary phenomenon' in the long run.
Hyperinflation
Hyperinflation is extremely rapid inflation, often defined as over 50% per month. It usually occurs when governments print money to pay their bills. Examples include Germany in 1923, Zimbabwe in 2007-2008, and Venezuela in the late 2010s. Money becomes nearly worthless, and people switch to foreign currencies or barter.
Inflation after the pandemic
From 2021, inflation rose sharply in many countries, with US CPI inflation peaking at about 9% in June 2022, the highest in about 40 years. Causes included strong demand from stimulus and reopening, supply chain disruptions, and energy and food price spikes linked to the war in Ukraine. Central banks raised interest rates rapidly in response.
Worked example
Suppose money supply grows 8% a year, velocity is constant, and real output grows 3%. From MV = PY in growth rates, money growth + velocity growth = inflation + output growth, so 8% + 0 = inflation + 3%, giving inflation of about 5%.
Key takeaways
Demand-pull inflation comes from spending outrunning capacity; cost-push from rising production costs, which can cause stagflation. Wage-price spirals and expectations can sustain inflation. The quantity theory MV = PY links money growth to inflation in the long run. Hyperinflation stems from printing money to finance government. Post-pandemic inflation had both demand and supply causes.
Flashcard
Spending outpaces capacity
Check your understanding
A sudden rise in world oil prices that raises costs across the economy causes: