Causes of Inflation

Causes of Inflation in the Economy

To understand the causes of inflation in the economy, we need to understand the meaning of inflation and its importance for our economy. Tracking the price of a single good over time might be easy, but it doesn't give too many insights into what's going on and how individuals are affected. Instead, inflation captures the increase in the prices of goods and services that most people, including you, consume daily.

Causes of inflation can be categorized into the following groups:

• Demand-Pull Inflation: It happens when people and firms in the economy try to buy more goods and services than the economy can produce. Hence, raising the price level.
• Cost-Push Inflation: This type of inflation is driven by a rise in input prices that firms use to produce goods such as energy or wages.
• Wage-Price Spiral: This occurs when an increase in the price level causes workers to ask for higher wages, adding to the cost of producers, which then increases inflation further and makes it hard to stop.
• Excessive Monetary Growth: When there is more money in the economy, the price level will go up to reflect the decreased value of money.

Causes of Demand Pull Inflation

The main causes of demand pull inflation are:

• growing economy
• increased export demand
• increased government purchases
• other factors

Demand-pull inflation kicks in when consumer demand for goods and services exceeds the available supply, which increases the cost of living overall.

Figure 1. Demand-pull inflation,StudySmarter Originals

Figure 1 shows an increase in the overall price level due to the rise in aggregate demand from AD₁ to AD₂. On the vertical axis, you have the price level; on the horizontal axis, you have the output produced. Notice that as aggregate demand increases, the short-run aggregate supply (SRAS) supply does not move. Therefore, the new equilibrium occurs at a higher price level jumping from P₁ to P₂, as the economy cannot produce enough to catch up with the demand.

Several factors contribute to demand-pull inflation, which are as follows:

• An expanding economy: When the economy is growing, individuals and firms expect that the economy will also be good in the future, and they will consume and invest more in the economy. This then raises aggregate demand in the economy, causing prices to increase.
• An increase in demand for exports: An increase in exports means a higher demand for goods and services produced in the United States. As demand increases, the price level will also increase.
• An increase in government purchases: When the government spends money, it increases aggregate demand in the economy. In turn, the price will rise.
• Money Supply: The amount of money that circulates in the economy directly relates to the inflation level. Whenever there is a significant increase in the money supply, borrowing becomes cheaper, which fuels the demand in the economy. As a result, the price level increases.

Causes of Cost-Push Inflation

The cost-push inflation explanation says that inflation is caused by the increase in production costs. Whenever one of the production factors is experiencing an increase in the price, there will be higher prices in the economy.

The most prevalent reason for cost-push inflation is a rise in the cost of manufacturing, which may be anticipated or unanticipated depending on the circumstances.

For instance, there is a possibility that the cost of the raw materials or inventory utilized in manufacturing would rise, resulting in increased expenses. Energy prices and wages are common reasons for manufacturing costs to go up.

Natural disasters, including floods, earthquakes, fires, and tornadoes, are also a source of cost-push inflation. Natural disasters can drive prices upward. In the event of a major catastrophe that causes unforeseen damage to a production facility and results in a shutdown or partial interruption of the supply chain, production costs for the firms that rely on this supply will increase as a consequence of the event.

Inflation Control Measures

In most cases, governments try to maintain inflation levels within a desirable range that fosters economic expansion while minimizing the degree to which a currency's buying power is adversely affected.

There are a lot of different approaches that may be taken to rein in inflation. Although none are 100% foolproof, some are more successful, and some have caused more minor collateral damage than others.

The government can decide to impose price control on specific products or industries to control inflation. It works by having the government put an upper limit on the price of certain goods, typically inputs that are used in production.

Contractionary monetary policy is one of the most common measures to combat inflation in today's economy. By raising interest rates, the objective of a policy referred to as "contractionary" is to lower the amount of money that is circulating within an economy. This serves to cool down the economy by making borrowing more costly, which in turn affects expenditure by both consumers and businesses.

The Federal Reserve, which serves as the United States's central bank, employs various strategies to combat inflation.

The Fed bears a significant portion of the responsibility for containing inflation in the United States and has to balance the goals of stable prices and low unemployment.

The Fed controls the money supply with three primary tools:

1. The reserve requirement ratio refers to the total amount of deposits banks have to keep in their reserve. When there is an increase in the reserve requirement ratio, there is less money available in the economy; hence, inflation drops.
2. The Federal Funds Rate refers to the interest rate commercial banks pay to the Fed for borrowing money from it. When this interest rate increases, borrowing becomes more costly, and the inflation level drops.
3. Open market operations refer to the buying of securities from the market by the Fed. In combating inflation, the Fed sells securities back to the market, which essentially takes money out of the market and helps lower the money supply and inflation.

Inflation vs. Deflation

To understand the difference between inflation and deflation, let's start by considering deflation.

The main difference between inflation and deflation is that inflation is an increase in the price level of goods and services in the economy. In contrast, deflation refers to the decrease in the general price level in the economy.