Everything is becoming expensive in the United States, but not only. Most countries report an increase in the price of their goods and services. Some blame Covid for breaking the supply chain of goods worldwide, and others blame the low interest rate and the abundance of money. Some also blame the war between Russia and Ukraine. Which one is it? What causes inflation? Why has a significant increase in the price level, and what can the government do about it? Is inflation here to stay?
Well, at some point, inflation should stop. To understand why it will stop and what the causes of inflation are, keep reading and learn about different control measures!
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.
Inflation refers to an increase in the general price level of goods and services. We measure inflation by using a price index, which is a statistical series that tracks price changes over time. The price index is based on a market basket, a representative sample of goods and services that consumers or firms buy.
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.
How is inflation measured?
A wide range of goods and services can go into the market basket of a price index:
- Food grains, metals, and fuel
- Utility services such as electricity or transportation
- Entertainment, health care, and labor services.
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When the price index is rising, it means that things are becoming more expensive. Consumers and firms must pay more to receive their usual goods and services.
This means that the currency's value is decreasing, and you can buy fewer products with the same amount of money as prices rise.
For example, $100 could get you 20 apples last year, but you can only buy 15 apples this year because of the increase in price. This means that your purchasing power is decreasing.
Do you want to learn about the topic of inflation itself? Here is our explanation: Inflation.
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.
Imagine that there are only 100 iPhones Apple has in their stock that they could sell. Suddenly, the demand for Apple's iPhone increased, as everyone seemed to be wanting to buy the iPhone. However, Apple can't produce more iPhones in such a short time, and that pushes up the prices of the iPhone. The price increases to the level where demand and supply are equal again -- when only 100 buyers are willing to pay for an iPhone.
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.
Suppose a firm's production costs go up. In that case, the company's executive management may attempt to transfer the higher costs onto customers by increasing the prices of the goods and services they sell. Suppose that the corporation does not raise prices while manufacturing costs continue to rise. In that case, the company's earnings will continue to decline, which is not something that shareholders like to see.
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.
Arguably, most countries are currently experiencing cost-push inflation. You might have seen in the news that most countries register higher inflation numbers. After the war between Russia and Ukraine broke out, the price of energy and food increased, as Russia is a major supplier of oil and natural gas, and both countries are big exporters of food and fertilizers.1 This then cost the manufacturing cost to go up, increasing inflation worldwide.
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:
- 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.
- 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.
- 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.
Deflation is the opposite of inflation. It occurs when the demand and there are excess supply of goods and services in the economy. The general price level of goods and services decreases.
For instance, if a specific automobile model suddenly becomes very popular, other manufacturers will start producing vehicles that are quite similar to the one that is selling so well. Soon, automakers will have more of that vehicle model than they can sell, so they will need to lower their prices to sell more automobiles.
When a company is burdened with too much inventory, they are forced to find ways to decrease expenses, often resulting in employees losing their jobs. Unemployed people will have lower demand for consumer products, so prices of these products will decrease, which then causes the trend to continue. When this is happening throughout the economy, general prices will decrease because of the lower aggregate demand.
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.
Causes of Inflation - Key takeaways
- Inflation refers to an increase in the general price level of goods and services.
- Many factors could contribute to an increase in inflation. The main explanations include demand-pull inflation, cost-push inflation, wage-price spiral, and excessive monetary growth.
- The demand-pull inflation explanation: inflation occurs when individuals and firms in the economy try to buy more goods and services than the economy can produce, hence, raising the price level.
- The cost-push inflation explanation: inflation is caused by a rise in the cost of manufacturing, which may be anticipated or unanticipated depending on the circumstances.
- Contractionary monetary policy is one of the most common measures to combat inflation in today's economy.
References
- The Guardian. "Ukraine war ‘will mean high food and energy prices for three years’." Apr 26, 2022. https://www.theguardian.com/business/2022/apr/26/ukraine-war-food-energy-prices-world-bank
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