Causes of Inflation
Two Causes of Inflation and the Circumstances That Create Them
There are two main causes of inflation: Demand-pull and Cost-push. Both are responsible for a general rise in prices in an economy. But they work differently. Demand-pull conditions occur when demand from consumers pulls prices up. Cost-push occurs when supply cost force prices higher.
You may find some sources that cite a third cause of inflation, expansion of the money supply. But the Federal Reserve explains that it's a type of demand-pull inflation, not a separate cause of its own.
Demand-pull inflation is the most common cause of rising prices. It occurs when consumer demand for goods and services increases so much that it outstrips supply. Producers can't make enough to meet demand. They may not have time to build the manufacturing needed to boost supply. They may not have enough skilled workers to make it. Or the raw materials might be scarce.
If sellers don't raise the price, they will sell out. They soon realize they now have the luxury of hiking up prices. If enough do this, they create inflation.
There are five circumstances that create demand-pull inflation. The first is a growing economy. As people get better jobs and become more confident, they spend more.
As prices rise, people start to expect inflation. That expectation motivates consumers to spend more now to avoid future price increases. That further boosts growth. For this reason, a little inflation is good. Most central banks recognize this. They set an inflation target to manage the public's expectation of inflation. The U.S. central bank, the Federal Reserve, has set a target of 2% as measured by the core inflation rate. The core rate removes the effect of seasonal food and energy cost increases.
The third circumstance is discretionary fiscal policy. That's when the government either spends more or taxes less. Putting extra money in people's pockets increases demand and spurs inflation.
Marketing and new technology create demand-pull inflation for specific products or asset classes. The asset inflation that results can drive widespread price increases. Asset and wage inflation are types of inflation. For example, Apple uses branding to create demand for its products. That allows it to command higher prices than the competition. New technology also occurred in the form of financial derivatives. These new products created a boom and bust cycle in the housing market in 2005.
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 increases prices in the general economy.
How exactly 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. Deficit spending pumps money into certain segments of the economy. It creates demand-pull inflation in that area. It delays the offsetting taxes and adds it to the debt. It has no ill effect until the ratio of debt to gross domestic product approaches 90%.
Occasionally, the government can create inflation simply by printing more cash. Venezuela did this between 2013 and 2019. It created hyperinflation, and the money became worthless. People began using eggs as currency.
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 it is a lot easier. As a result, it's done much more often. When loans become cheap, too much money chases too few goods and creates inflation. The prices of everything increase, even though neither demand nor supply has changed.
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. The first is wage inflation that increases salaries. It rarely occurs without active labor unions.
A company with the ability to create a monopoly is a second contributor to cost-push inflation. It controls the entire 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 has reduced the supply of seafood and drives up prices.
Government regulation and taxation also reduce supplies. In 2018, U.S. tariffs reduced supplies of imported steel. That created shortages in manufactured parts, with some producers raising prices. In 2008, subsidies to produce corn ethanol reduced the amount of corn available for food. This shortage created food price inflation.
The Bottom Line
There are two major types of inflation: demand-pull and cost-push. Demand-pull inflation occurs when consumers have greater disposable income. Having more money to spend allows people to want more products and services. Expansionary fiscal and monetary policies, consumer expectation of future price increases, and marketing or branding can increase demand.
Cost-pull inflation happens when supply decreases, creating a shortage. Producers raise prices to meet the increasing demand for their goods or services. Increase in wages, monopoly pricing, natural disasters, government regulations, and currency exchange rates often decrease supply vis-à-vis demand.