Inflation consists of a sustained increase in the general price level, and it can have different causes.
Inflation can be Demand-pull when increasing demand from consumers leads to an increase in prices, or Cost-push when higher supply costs lead to higher prices.
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The most common cause of rising prices and therefore of inflation is related to when consumer demand for goods and services increases more than the aggregate supply, it is called “demand-pull inflation”. It is the rate of inflation caused by the Aggregate Demand curve.
It is commonly described as involving “too much money spent chasing too few goods”
The effects that an increase in demand can have on the overall economic equilibrium are clearly described by the law of supply and demand, that describes what happens when these two forces interact with one another. In fact, when demand increases, suppliers can either produce more or increase prices.
However, in reality for companies is not so easy to increase production, especially in certain industries and especially in the short term. This means that when demand rises if for various reasons they cannot increase production enough to satisfy demand, they will probably decide to raise prices in order to increase their profits.
If other suppliers do the same thing, the general price level grows and inflation is created.
Inflation usually takes place when the economy grows and confidence is higher, which means that people tend to increase consumer spending, and companies, on the other hand, increase their investments.
An example of this mechanism is the following: Suppose that in a specific market aggregate demand is increasing at a level of 5%, but at the same time, for different reasons, the productive capacity of that market is rising only at a level of 1%. At this point, firms have to increase production and they usually do this by hiring more workers, leading to a fall in the general level of unemployment and therefore to a general pressure on wages to move upward. The pressure on wages leads to wage-push inflation and to an increase in the disposable income of employees, that will start to buy more goods, therefore increasing consumer spending.
As you may have noticed in the previous example, the magnitude of the increase of the general price level depends heavily on how close suppliers are to full employment, and therefore to how steep the Aggregate Supply curve really is.
The closer suppliers are to the level of full employment, the higher the rise in inflation will be, because they will not be able to keep up with the increase in demand, and therefore prices will inevitably go up.
Causes of Demand-pull inflation
Various factors can cause or lead to Demand-pull inflation, like the depreciation of the exchange rate, which means that, in a floating exchange rate system, a currency loses value against other currencies.
In this situation, imports tend to be lower because goods and services that are sold in other currencies will be more expensive, while on the contrary domestic goods and services will be more appealing for foreigners, which means that exports are more likely to grow, leading to an increase in Aggregate Demand.
An increase in Aggregate Demand that can cause demand-pull inflation can also be originated by a sharp increase in consumption, or from a significant increase in Government Spending.
Moreover, other factors like expectations and excessive monetary growth can lead to demand-pull inflation. In the case of expectations, if in the general market there is the expectation that in the future inflation will rise, general prices will rise because firms and workers will try to “catch up” to inflation, while in the case of monetary growth when it increases too much and there is too much money in the system that are chasing too few goods, prices will increase.
How to prevent it?
In order to deal with demand-pull inflation, governments and monetary authorities can take different measures in order to slow it down.
When there is demand-pull inflation the main problem is that Aggregate Demand is rising too fast, therefore the measures that will be taken are intended to slow it down, in order to prevent the excessive increase in inflation that it could cause.
Governments and other monetary authorities can do it mainly by adopting a tight fiscal policy, like raising taxes and a tight monetary policy, like increasing interest rates or increasing the reserve requirements.
Cost-push inflation can be the result of an increase in the cost of production or a decrease in production. It happens because the increase in costs of firms is passed on to consumers.
With cost-push inflation, the aggregate supply curve shifts leftwards, thereby pushing prices up. It tends to arise more frequently due to supply shocks, for example, if the total supply of a specific product goes down but demand cannot be lowered easily as it happens often with certain factors of production, the price goes up because the quantity demanded is a lot higher than that supplied.
Higher costs of production will then be transferred to the final product which will be sold at a higher price, creating inflation.
Causes of Cost-push inflation
Cost-push inflation can be caused by many different factors, like, as seen in the previous example, by a supply shock, which is probably the most common cause of cost-push inflation. Supply shocks consist of big increases in prices of certain critical commodities, that therefore cannot be substituted easily with other similar commodities.
Moreover, higher taxes and higher wages can also be seen as causes of cost-push inflation. In fact, a higher level of taxation automatically increases the prices of goods, moreover, wages, which in many sectors account for the biggest portion of costs for the production of a good or service, are therefore influent in determining their final price.
This means that, if wages go up, due to the influence of labor unions or to other similar factors, production costs will go up as well, creating inflation.
How to prevent it?
As opposed to demand-pull inflation, with the cost-push inflation there are not many tools that governments and monetary authorities can use in order to cope with it. The only policies that they can adopt are supply-side policies, aimed at increasing aggregate supply, and based on the belief that higher rates of production will lead to higher rates of economic growth.
Unfortunately, most of these measures take a very long time to show a tangible effect and they are often difficult to implement.