Causes of inflation: Theories and explanations

Causes of inflation: Theories and explanations

Inflation is a sustained increase in the general price level of goods and services within an economy over a period of time. Subsequently, an inflation rate corresponds to the measurement of inflation or more specifically, the percentage change in a particular general price index such as the consumer price index or the producer price indexes.

Note that the sustained increase in general price levels mirrors a decline in the purchasing power per unit of money. Hence, inflation also represents the devaluation of a particular currency or any medium of exchange.

Why does inflation happen: The major types and causes of inflation

No single model can explain extensively and effectively why the prices of goods and services increase. However, scholars and economists have provided a few hypotheses that correspond to the types, as well as the factors or causes of inflation. These hypotheses pertain to either a monetary explanation based on the monetarist school of economics or the special-factors explanations based on Keynesian economics.

1. Monetary Inflation: An Increase in the Money Supply

The monetary explanation of inflation argues that inflation occurs due to excessive growth in the money supply. This explanation is also similar to the law of supply and demand. Remember that the prices of goods and services are determined by their supply and demand. If there is too much supply of a particular product, its price goes down. Similarly, too much supply of money makes its value go down.

Nonetheless, price levels across goods and services increase because the quantity of money increases faster than its demand. This abundance of money supply means that there is more money chasing the same number of goods and services to buy. In other words, inflation results either from rapid growth in the money supply or a persistently falling real demand for money.

There are different reasons why money supply can grow excessively. For example, during economic recessions, the government needs to stimulate the economy by creating more jobs and thus, increasing economic productivity. But employment requires payment. The workaround is to increase the money supply by printing and increasing the number of bank notes in circulation, increasing sovereign debts, or letting banks make bigger loans on the same security.

Economic stimulation through deliberate government-led inflation was observed during The Great Depression and 2008 Financial Crisis. Essentially, governments that followed this strategy increased their money supply to create more jobs at the cost of inflation. However, there are instances when a government merely overprints money for malicious purposes—such as in the case of hyperinflation in Zimbabwe.

2. Cost-push Inflation: An Increase in the Costs of Production

Specific economic conditions occurring before or during the inflation fall under the special-factors explanations of the causes of inflation. One of these special factors is due to an increase in the costs of production that results in cost-push inflation.

Cost-push inflation is a type of inflation that occurs whenever business organizations increase the price of their goods and services to offset the increasing costs of their production. Necessarily, as production becomes costly, businesses are compelled to pass this burden to the consumers by increasing their prices to maintain their profit margins.

Increases in the costs of production primarily stem from the difficulties in securing and maintaining specific factors and means of production. For example, surges in the prices of inputs or raw materials from suppliers would certainly affect the total cost of production. As a more specific example, supply-shifters such as alternatives, competition, natural disasters, human-made crises, and government interventions can lead to a decline in the supply of inputs, thus increasing their prices in the market.

Other more specific examples of factors affecting the costs of production include higher taxes and trade tariffs, an increase in the prices of auxiliary goods or services such as oil and gas or electricity and utilities, growing rent, increase in wages and salaries, and foreign exchange rates, among others.

3. Demand-pull Inflation: An Increase in Aggregate Demand

Demand-pull inflation is also part of the special-factors explanations. This type of inflation occurs when there is an overall increase in demand for goods and services. To be specific, if demand is growing faster than supply, prices will increase. The law of supply and demand explains that high demand and limited supply will drive prices higher. Furthermore, it also explains that high demand means that people are willing to pay more for specific goods and services.

Take note that based on Keynesian economics, excessive growth in the money supply is also one of the causes of the demand-pull inflation alongside the inability of supplies to keep up with demand. Excessive money supply can stimulate excessive demand. In other words, a disproportionate growth in the money supply means that there is too much money chasing too few goods and services.

It is also worth mentioning that favorable economic conditions can promote the aggregate income of a population. When this happens, more people will have more purchasing power. However, if supply fails to keep up with the income-driven demand, demand-pull inflation will occur. This is the reason why certain goods and services are more expensive in high-income societies than in low-income societies.

Other causes of high demand center on the different examples of demand shifters and other factors affecting demand such as tastes or preferences, number of consumers, future expectations including speculations, government interventions such as tax breaks, and lowered banking interest rates, among others.

4. Build-In Inflation: Vicious Cycle of Involving Wage and Price

In his book “Macroeconomics: Theory and Policy,” American economist and Keynesian theorist Robert J. Gordon introduced the concept of “triangle model” to explain the primary root causes of inflation based on the interrelationships between cost-push inflation, demand-pull inflation, and the so-called built-in inflation.

Accordingly, built-in inflation or hangover inflation is a type of inflation caused by previous events that persistently affect current economic conditions. To be specific, built-in inflation originates from the continuous influence of cost-push inflation and demand-pull inflation.

The relationship between wages and prices or the price/wage spiral in a capitalist economic system provides a prime example of built-in inflation. To illustrate further, whenever members of the workforce demand for higher wages, employers respond favorably but they transfer this additional labor cost to the consumers by raising the prices of their goods and services to maintain their profit margins

An increase in prices would compel members of the workforce to demand again for higher wages. In most instances, employers would respond again favorably at the expense of the consumers. This relationship between wages and prices result in a vicious cycle in which inflation from the past merely encourages inflation to persists in the future.