What causes inflation?
Inflation occurs when the general price level in an economy rises over time. It can result from several different forces, each affecting prices in distinct ways. One of the most common causes is demand-pull inflation, which happens when aggregate demand grows faster than the economy’s ability to produce goods and services. When demand exceeds supply, firms raise prices, leading to upward pressure on the price level. This often occurs during periods of strong economic growth or large increases in government spending.
Another major cause is cost-push inflation. This occurs when production costs rise for firms, forcing them to increase prices to maintain profitability. Common triggers include higher wages, increased raw material prices, or supply chain disruptions. For example, a sharp rise in global oil prices can make transportation and manufacturing more expensive, pushing prices upward across the economy.
A third cause is built-in inflation, which is linked to expectations. If workers expect prices to rise, they demand higher wages. Firms then raise prices to cover these wage increases, creating a wage–price spiral. Expectations therefore play a powerful role in determining whether inflation stays stable or becomes persistent.
Inflation can also stem from monetary factors. When the money supply grows faster than real output, too much money chases too few goods, driving prices upward. Central banks manage interest rates and the money supply to maintain stability, but mistakes or shocks can still lead to inflationary pressure.
In reality, inflation often results from a combination of these forces, making it essential for policymakers to understand its underlying causes before responding.
FAQs
What is the difference between demand-pull and cost-push inflation?
Demand-pull inflation occurs when spending in the economy grows faster than supply, causing firms to raise prices. Cost-push inflation arises when production costs increase, forcing firms to charge more even if demand has not changed. Both forms raise prices, but they originate from different parts of the economy. Policymakers must identify the source to choose the appropriate response. Misdiagnosis can worsen economic conditions.
How do expectations cause inflation?
Expectations shape behaviour in wage-setting and price-setting. If workers expect future price increases, they demand higher wages to maintain purchasing power. Firms then raise prices to cover these wage costs, reinforcing inflation. When expectations become unanchored, inflation can rise even without strong demand or supply shocks. Central bank credibility is crucial for keeping expectations stable.
Can increasing the money supply cause inflation?
Yes. If the money supply grows faster than the economy’s ability to produce goods and services, inflation often results. More money in circulation increases spending, pushing prices upward. However, if the economy has unused capacity, moderate increases in the money supply may not cause inflation. The impact depends on economic conditions and how quickly money circulates.
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