Causes of Inflation: 2 Real Reasons for Rising Prices

Helicopter creating inflation
••• One cause of inflation is too many dollars. Illustration: sorbetto/Getty Images

There are two main causes of inflation. They are demand-pull, which includes over-expansion of the money supply, and cost-push.

Demand-Pull Inflation

Demand-pull inflation is the most common. It's when demand for a good or service increases so much that it outstrips supply. If sellers maintain the price, they will sell out. They soon realize they now have the luxury of raising prices, creating inflation.

Five circumstances lead to demand-pull inflation. A growing economy creates inflation as people are confident and spend more. That further benefits economic growth by creating an expectation of inflation. That motivates them to buy more now to avoid further price increases. The Federal Reserve sets an inflation target to manage the public's expectation of inflation. It's at 2 percent as measured by the core inflation rate. The core rate removes the effect of seasonal food and energy increases.

Discretionary fiscal policy contributes to demand-pull inflation. The government's ability to spend more or tax less increases demand in some areas of the economy. Marketing and new technology create demand-pull inflation for particular products or asset classes. For more, see Types of Inflation.

For example, Apple's branding commands higher prices for its products. New technology also occurred in the form of financial derivatives.

It created asset inflation in the housing market in 2005. For more examples, see What Is Demand-Pull Inflation? (Source: "The Economic Lowdown," The St. Louis Federal Reserve. "Demand-Pull Inflation," The Intelligent Economist.)

Over-expansion of the money supply can also create demand-pull inflation.

 The money supply is not just cash, but also credit, loans and mortgages. When the money supply expands, it lowers the value of the dollar. When the dollar declines relative to the value of foreign currencies, the prices of imports rise. That also creates cost-push inflation. 

How does the money supply increase? Through expansionary fiscal policy or expansionary monetary policy.

The Federal government executes expansionary fiscal policy. It expands the money supply through either deficit spending or printing more cash. Deficit spending pumps money into certain segments of the economy. It creates demand-pull inflation in that area. It delays the offsetting taxes, thus adding it to the debt. It has no ill effect until the ratio of debt to gross domestic product approaches 90 percent.

The Federal Reserve controls expansionary monetary policy. It expands the money supply by creating more credit with the use of its many tools. One tool is lowering the reserve requirement. It's the amount of funds banks must keep on hand at the end of each day. The less they have to keep on reserve, the more they can lend.

Another tool is lowering the fed funds rate. That's the rate banks charge each other to borrow funds to maintain the Reserve requirement.

This action also lowers all interest rates. That allows borrowers to take out a bigger loan for the same cost. Lowering the fed funds rate has the same effect, but is a lot easier. Therefore, it's done much more often. When loans are cheap, then there will be too much money chasing too few goods, creating inflation. The prices of everything increases, even though neither demand nor supply has changed.

Cost-Push Inflation

The second cause is cost-push inflation. It only occurs when there is a supply shortage combined with enough demand to allow the producer to raise prices. There are five contributors to inflation on the supply side. Wage inflation increases salaries. It rarely occurs without active labor unions. A company with the ability to create a monopoly also creates cost-push inflation.

That's because it controls the supply of a good or service. The Sherman Anti-Trust Act outlawed monopolies in 1890.

Natural disasters create temporary cost-push inflation by damaging production facilities. That's what happened to oil refineries after Hurricane Katrina. The depletion of natural resources is a growing cause of cost-push inflation. For example, overfishing reduces the supply of seafood, driving up prices.

Government regulation and taxation also reduce supplies. In 2008, subsidies to produce corn ethanol reduced the amount of corn available for food. This shortage created food price inflation.

When a country lowers its currency's exchange rates that creates cost-push inflation in imports. That makes the foreign goods more expensive to the locally produced goods. (Source: "Cost-Push Inflation," The Intelligent Economist. "Cost-Push Inflation," Biz/Ed.)