Causes of Inflation

There are two main causes of inflation. The first occurs when demand-pull conditions drive widespread price increases.  The second cause of inflation results from cost-push factors. Some people think an expansion of the money supply is a third cause of inflation. But it is actually a type of demand-pull inflation.

Demand-Pull Inflation

Demand-pull inflation is the most common cause of rising prices.

It occurs when demand for a good or service increases so much that it outstrips supply. If sellers don't raise the price, they will sell out. They soon realize they now have the luxury of hiking up prices. If enough do this, they create inflation.

There are five circumstances that create demand-pull inflation. The first is a growing economy. As people get better jobs and become more confident, they spend more.

As prices rise, they start to expect inflation. That expectation motivates consumers to spend more now to avoid future price increases. That further boosts growth. For this reason, a little inflation is good. As a result, the Federal Reserve sets an inflation target to manage the public's expectation of inflation. It's at 2 percent as measured by the core inflation rate. The core rate removes the effect of seasonal food and energy cost increases.

The third circumstance is discretionary fiscal policy.

The government's ability to spend more or tax less increases demand in some areas of the economy.

Marketing and new technology create demand-pull inflation for specific products or asset classes. The asset inflation that results can drive widespread price increases. Asset and wage inflation are types of inflation.

 For example, Apple's branding commands higher prices for its products. New technology also occurred in the form of financial derivatives. It created a boom and bust cycle in the housing market in 2005.  

Over-expansion of the money supply can also create demand-pull inflation. The money supply is not just cash, but also credit, loans, and mortgages. When the money supply expands, it lowers the value of the dollar. When the dollar declines relative to the value of foreign currencies, the prices of imports rise. In the long run, it can also trigger cost-push inflation. Companies that import materials may need to raise their prices to cover the increased cost of their supplies.

How does the money supply increase? Through expansionary fiscal policy or expansionary monetary policy. The federal government executes expansionary fiscal policy. It expands the money supply through either deficit spending or printing more cash. Deficit spending pumps money into certain segments of the economy. It creates demand-pull inflation in that area. It delays the offsetting taxes and adds it to the debt. It has no ill effect until the ratio of debt to gross domestic product approaches 90 percent.

The Federal Reserve controls expansionary monetary policy.

It expands the money supply by creating more credit with the use of its many tools. One tool is lowering the reserve requirement. It's the amount of funds banks must keep on hand at the end of each day. The less they have to keep on reserve, the more they can lend.

Another tool is lowering the fed funds rate. That's the rate banks charge each other to borrow funds to maintain the Reserve requirement. This action also lowers all interest rates. That allows borrowers to take out a bigger loan for the same cost. Lowering the fed funds rate has the same effect. But it is a lot easier. As a result, it's done much more often. When loans become cheap, too much money chases too few goods and creates inflation. The prices of everything increase, even though neither demand nor supply has changed.

Cost-Push Inflation

The second cause is cost-push inflation.

It only occurs when there is a supply shortage combined with enough demand to allow the producer to raise prices. There are five contributors to inflation on the supply side. The first is wage inflation that increases salaries. It rarely occurs without active labor unions. 

A company with the ability to create a monopoly is a second contributor to cost-push inflation. That's because it controls the supply of a good or service. The Sherman Anti-Trust Act outlawed monopolies in 1890.

Natural disasters create temporary cost-push inflation by damaging production facilities. That's what happened to oil refineries after Hurricane Katrina. The depletion of natural resources is a growing cause of cost-push inflation. For example, overfishing reduces the supply of seafood and drives up prices.

Government regulation and taxation also reduce supplies. In 2008, subsidies to produce corn ethanol reduced the amount of corn available for food. This shortage created food price inflation.

When a country lowers its currency's exchange rates, it creates cost-push inflationin imports. That makes foreign goods more expensive compared to locally produced goods.