Inflation is a steady increase in the prices of goods and services in a country, usually measured in terms of a specific annual percentage. This decreases the purchasing power of currency by reducing the amount of goods or services a person can get for the same amount of money. It has many different possible causes, but they are generally divided into Keynesian and monetarist theories. The main Keynesian theories, known as the triangle model, are demand-pull, cost-push, and built-in inflation, and the main monetarist theory is the quantity model. There are also many things that can cause short-term increases in prices, including natural disasters and wars.
In the case of demand-pull, inflation is caused by aggregate demand being more than the available supply. Aggregate demand is made up of consumer spending, investments, government spending, and whatever is left after subtracting imports from exports. Factors that commonly lead to demand-pull inflation include a sudden increase in the amount of money in an economy and decreases in taxes on goods, which leaves consumers with more disposable income. Since people have more money to spend, manufacturers raise the general prices of goods and services.
Another common cause of demand-pull situations is an increase in consumer spending because of increased optimism caused by a boom in the economy. When people are more confident about their financial future, they tend to spend more, contributing to a rise in prices. A dip in currency exchange rates can lead to an increase in the value of imported goods, while causing a reduction in the value of exports. When this happens, prices in the local market will go up as importers and manufacturers transfer the cost to local consumers, causing the price of goods to increase.
Cost-push inflation occurs when manufacturers and businesses raise prices as a result of shortages, or as a measure to balance other increases in production costs. An example of this is rising labor costs. When workers demand wage increases, companies usually pass on these costs to their customers. An increase in the taxes imposed on goods may lead to a cost-push situation as well, since suppliers transfer the costs to consumers. This also often happens when one or several companies has a monopoly in the market, and decides to raise their prices above demand to increase their profit.
Built-in inflation happens as a result of previous increases in prices caused by demand-push or cost-pull. In this type of situation, people expect prices to continue to rise, so they push for higher wages. This raises costs for manufacturers, which then raise the cost of goods to compensate, causing a cycle of inflation.
Quantity theory states that inflation is caused just by having too much money in an economy. This includes cash as well as financial instruments like investments and mortgages. It is part of monetarist economics, in which some inflation is to be expected and is seen as a normal thing, but any excess has to be controlled by manipulating the money supply.
Other causes of inflation include wars, natural disasters, and decreases in natural commodities. Wars often result in this situation as governments must recoup the money spent on them, and repay the funds borrowed from central banks. Wars also affect international trading labor costs, and product demand, resulting in a rise in prices. Natural disasters may have a similar effect by disrupting the usual cycle of the production process. This creates a temporary scarcity as people scramble to purchase the limited supply of goods, causing the prices to skyrocket. Decreases in natural commodities, like helium or oil, can act in the same way.
Means of Control
Governments take different approaches to controlling inflation, depending on what they believe is causing it and their stance on government involvement in the economy. In the case of a demand-pull or cost-push situation, a government taking a classical economics approach would do nothing, since this approach is based on the idea that the market will naturally work itself out and get back to normal without government influence. A government taking a Keynesian approach would become involved in the economy by breaking up monopolies, regulating commodity prices, or controlling wage levels. A monetarist government, or one that believes in the quantity theory, would make changes in policy to control the amount of money in an economy.