Causes of Inflation
Demand-Pull and Cost-Push
WRITTEN BY PAUL BOYCE | Updated 1 February 2022
Main Causes of Inflation
There are three main causes of inflation in economics. They are cost-push, demand-pull, and built-in inflation. Firstly, cost-push inflation refers to the supply side of goods. This includes anything that affects the price of producing a good. For example, raw materials, labour inputs, or any other cost factors such as taxes and costs of doing business.
By contrast, demand-pull inflation looks at the demand side. That includes anything that affects the price after it reaches market. For example, growing consumer confidence, a credit boom, or a fiscal stimulus.
There is also built-in inflation. This is where inflation becomes persistent due to expectations from consumers and businesses. For example, employees demand higher wages to keep up with inflation, but this puts extract cost pressures on businesses. In turn, those same businesses increase prices, thereby creating an inflationary cycle.
- One of the causes of inflation, cost-push, is usually driven driven by supply pressures which push up the cost of raw materials. For example, supply chain issues that occured due to COVID-19 meant that businesses were short on raw materials, thereby driving prices up.
- Another cause of inflation, demand-pull, is where there is a sudden increase in demand that is in excess of supply. For example, supply issues for microchips have caused signifcant issues for goods such as motor vehicles. In turn, it has created cost pressures which increase the price to businesses.
- The is also built-in inflation, which is where businesses and consumers already price in inflation to their budgets.
Cost-push inflation occurs when the price of inputs increases, thereby forcing businesses to pass on the cost to the consumer. This may occur due to several factors. For instance, the price of supplies may start to increase, or labour may become more expensive due to a tightening labour market.
Cost-Push Inflation is the least common cause of inflation, which is usually driven by demand-pull inflation.
Causes of Cost-Push Inflation
1. Exchange Rate
When the exchange rate weakens, it takes more currency to buy the same number of goods. So if the US dollar weakens against the Chinese Yuan, the price of goods from China becomes more expensive. This is because it takes more US dollars to buy the same number of Chinese Yuan.
As imported goods become more expensive, it has two effects. First of all, it creates inflation in consumer goods. For instance, a fridge coming from China will cost more if the exchange rate is weakens. Again, this is because it takes more US dollars to buy the same number of Chinese Yuan.
We then have an effect on business to business trade. For a business that relies on another country for its supplies, a weakening exchange rate will put great pressure on costs. In other words, the cost of inputs starts to increase.
Rising costs of imports then put pressure on manufactured goods. In turn, this not only has an impact on final consumer goods but also on exports abroad. However, a falling exchange rate should compensate for rising costs, exports to other countries should remain stable for manufactured goods that rely on imported inputs.
2. Higher Prices of Inputs
Inflation can cause the price of raw materials to go up. One notable example is the price of oil and gas. As these are used in almost all manufacturing, any increase in price can directly impact on a firm’s cost.
One reason for a price increase may be due to poor exploration results, or a reduction in supply to the market. Oil-rich countries work together through OPEC to limit supply and artificially increase prices.
Input costs may increase for several reasons. For example, there might be a tightening of the labor market which means suppliers need to offer higher salaries. Alternatively, there may be a weakening of the local currency, making imported supplies more expensive. Or, it may just be a case of other increases in costs such as rent or electricity.
3. Wage Inflation
Wage inflation generally occurs as a result of a tightening labour market. This is where firms are looking to expand and hire, but find it difficult to recruit the necessary talent. As a result, they start increasing the offered salary to attract staff. In turn, this means that the firms costs of production increase, which are passed on through higher prices to consumers.
We may also see firms increasing wages to keep talent. For instance, in a market where there is a shortage of supply, it is important for businesses to keep hold of their employees. As it becomes harder to recruit, it becomes increasingly important to reduce employee turnover. This may benefit them in the form of reduced levels of turnover, but also potential productivity gains.
4. Natural Disaster
Inflation that results from a natural disaster is generally a one-off shock that increases prices in the short-term, with prices falling back down in the long-term. This is due to the fact that these natural disasters affect the supply of goods.
For instance, when a hurricane, tsunami, or other natural disaster hits, it disrupts the supply chain. Goods cannot get to where they need and businesses may not be able to get their supplies. Goods are unable to reach stores, leaving residents without sufficient food, water, or other supplies. This means there is limited supply and in some cases, prices rise in order to ration what is left.
Some prices may rise during natural disasters, but we would consider this as price gouging, which is illegal in many countries. So many goods end up undersupplied as prices are unable to rise.
The inflationary effect of natural disasters can depend on how much damage it does and to what facilities. For example, the 2011 Japanese Tsunami caused great damage to several local car manufacturers. In total, it cost the 7 biggest manufacturers a combined $5.6 billion. This not only had an impact on the final price of Japanese cars but also on how the industry does business.
Businesses may look to increase prices to respond to higher government taxes. In countries such as the UK, the final price includes a value-added tax. It is then up to the retailer to submit the value-added tax receipts to the government. So any tax increases are usually passed on to the consumer.
We then have other forms of tax. For instance, business rates, corporation taxes, and other indirect taxes on supplied goods. Some businesses may choose to absorb the costs, whilst others may pass them on to the consumer. In reality, it depends on how elastic demand is. In other words, how responsive the consumers are to price. For goods that are highly responsive to changes in price, the firm may absorb the taxes. However, for goods that are not so responsive to price changes, the firms may pass those costs on to the consumer.
6. Declining Productivity
Declining productivity is another cause of inflation, which can arise from diseconomies of scale. For instance, as a company grows bigger, it may start to become more inefficient. This may occur for a number of reasons such as employing more staff than necessary, or wasteful management procedures.
Companies may face declining productivity as they grow bigger, or there may be other factors at play. Perhaps employees become increasingly disgruntled with management, or equipment starts to wear out and become less efficient.
As productivity declines, it means it takes more workers and resources to make the same number of goods. In turn, the cost to produce a good increase which the company may pass on to the final consumer, thereby leading to inflation.
When a market is controlled by one company, it is known as a monopoly. This means that the firm can set prices without any competition. Consumers are unable to go elsewhere as there are no direct substitute goods. In turn, they can raise prices with limited loss of custom.
This may be based on whether the good the monopoly supplies is elastic or inelastic. In other words, the customer can just go without buying the product, or, is it a necessity that the customer needs, meaning it is highly inelastic. If the good is elastic and consumers can go elsewhere or without, then the monopoly may be unable to increase prices. However, if the good is inelastic, consumers are less responsive to changes in price, so the monopoly is able to increase prices.
Demand-pull inflation is where prices increase as a result of higher demand. It assumes that supply remains stable, so an excess of demand is making prices rise higher.
For example, a bakery store makes 100 loaves of bread every day and sells 100 of them for $1. However, over time, the baker starts experiencing customers come in and ask for bread after they are sold out. In turn, the baker starts increasing the prices to reduce excess demand, knowing the bread is popular.
Put simply, demand-pull inflation occurs when there is greater demand than supply. As a result, prices rise and inflation sets in as firms increase prices until they can meet the new supply. The greater level of revenues may then be expended to increase production. Whether this is more staff, more machinery, or investment in real estate.
Demand-pull inflation is the most common form of inflation and is generally what we see driving prices higher today.
Causes of Demand-Pull Inflation
1. Growing Economy and Consumer Confidence
When the economy is growing, it is generating jobs and the long-term future of both employees and employers looks good. What we see as a result is greater consumer spending. This is because consumers generally feel more secure and confident in periods of economic boom when jobs are plentiful.
We can contrast this to periods of economic decline, where people are fearful of their future employment. If consumers are fearful they may not have a job next month, they are incentivized to reduce spending and save for the tough times ahead.
2. Consumer Expectations
Another cause of inflation is consumer expectations. As inflation sets in and becomes a frequent occurrence in life, consumers start to expect it and plan accordingly.
For instance, an increase in inflation of 10 percent would be extraordinary in most developed nations as consumers become accustomed to rates of around 2 percent.
A one-off increase of 10 percent will have little effect in the short-term. However, the effects start to multiply once the inflation sticks at that rate. If it remains consistently at 10 percent, it starts to become self-fulfilling, adding more fuel to the fire.
Put another way, once consumers expect inflation of 10 percent, they tend to move purchasing decisions forward. In turn, this stimulates demand and hence further inflation as companies look to capture this excess demand in their profits.
3. Credit Boom
During a credit boom, consumers are demanding more and more debt. This may be driven by several factors. Perhaps growing consumer confidence, a loss in purchasing power, or relaxation on restrictions by financial institutions. In reality, it’s likely to be a mix of such factors.
When consumers are demanding more debt, it increases the broad money supply. Essentially, a greater number of ‘IOU’s’ are circulating, which we see and understand as money. In turn, this stimulates demand and the associated inflationary pressures.
With consumers borrowing more, it means that they can afford more goods. In turn, businesses start raising prices to capture the excess demand. Businesses will then start increasing supply to obtain more profits through higher levels of demand.
4. Money Supply Expansion
Money supply expansion is one of the most important causes of inflation. It is generated solely through the central banking system.
The central bank creates money from thin air by adding money onto its balance sheet and purchasing assets from financial institutions. In turn, the money is transferred over to banks, pension funds, and other institutions. They then use this money to purchase other financial instruments and to lend out to the wider economy.
With the central bank pumping new money into the wider economy, it translates into greater levels of inflation. Businesses have greater access to credit as it means banks have more to lend out and consumers may start to see increases in wages.
5. Fiscal Stimulus
Governments use fiscal policy for a number of reasons, although mainly political.
Lowering taxes and increasing government spending both have the potential to increase the rate of inflation. This is otherwise known as expansionary fiscal policy. If government spending increases, but tax receipts don’t, then we have what is known as a budget deficit. The same applies when taxes fall, but government spending doesn’t.
A tax stimulus, in other words, a tax cut, puts more money back into the hands of the average consumer. This means higher disposable incomes. When consumers have higher disposable incomes, they also tend to spend more, leading to greater demand for goods and services.
Now, this can boost the economy, but by creating greater levels of demand, it also puts upwards pressure on prices. The same could be said for government spending, particularly when it comes in hand with a budget deficit. This is because government spending filters into thousands of different industries; depending on where governments decide to spend.
The important aspect of government spending is that it must borrow the money if it is not bringing it in through taxes. When it does that, it is essentially injecting ‘IOU’s’, or debt, into the economy. This acts as money and with more money circulating inflation results.
6. Velocity of Money
When considering inflation, it is important to also bear in mind velocity. That is to say how many times a single dollar, pound, or euro, is exchanged in a certain time frame.
For example, there are two individuals in an economy. Mr. A and Mr. B. Mr. A pays $100 to Mr. B to cut his hedge. Mr. B then pays $100 to Mr. A for 10 oranges. Mr. A then uses that $100 to buy 20 bananas from Mr. B. Then finally Mr. B uses that $100 to buy 10 loaves of bread from Mr. A.
In total, $400 has circulated in the economy for only $100 worth of currency. It has stimulated the production of many goods and services. More so than if Mr. A just kept his money. In conclusion, velocity is important because the faster money goes round the economy, the more it stimulates economic activity.
Inflation and deflation expectations can in turn impact on the velocity of money. Inflation pressures can increase the velocity, whilst deflationary expectations can lower it. Which is why many Central Banks aim for a steady but relatively low rate of inflation.
Another cause of inflation includes built-in inflation. This is where consumers, businesses, and the rest of the ecoonmy expect price rises and therefore plan accordingly. For example, consumers may move purchasing decisions forward in the expectation they will be significantly more expensive next year.
Businesses also come under pressure from employees to increase wages. Yet at the same time, other businesses in the economy are facing similar pressures. So for businesses that rely on supplies from another business, they too may be facing inflationary pressures. In turn, suppliers are forced into increasing prices, as well as those tertiary businesses that sell to the final customer.
Built-in inflation usually arises as a result of cost-push or demand-pull inflation. However, that inflation become entrenched in the minds of businesses and consumers. This is because inflation is expected. Businesses start increasing prices before they face cost pressures, and consumers buy goods and services before they become more expensive.