Understanding Inflation: Why Are Prices Rising?

Christopher White
Jun 2, 2022
7 min read

Updated: Sep 21, 2022

In economics, inflation is defined as a general rise in the prices of goods and services in an economy. When the general price level rises, each unit of currency purchases fewer goods and services; thus, inflation corresponds to a loss of money's purchasing power. Deflation, or a sustained decrease in the general price level of goods and services, is the inverse of inflation.

The inflation rate, which is the annualized percentage change in a general price index, is the most commonly used measure of inflation. Because not all prices rise at the same rate, the consumer price index (CPI) is frequently used for this purpose. In the United States, the employment cost index is also used to calculate

wages.

Figure 1: UK and US monthly inflation rates from January 1990 to March 2022. Source: Wikipedia, June 2, 2022

Forms of Inflation

This article will examine the different types of inflation in detail, which include:

Demand-Pull Inflation
Cost-Push Inflation
Open Inflation
Repressed Inflation
Hyperinflation
Money Supply
Monetary Policy

Demand-Pull Inflation

Demand-pull inflation is the price increase that occurs as a result of a supply shortage, which economists refer to as "too many dollars chasing too few goods."

The following are some key takeaways from Demand-pull inflation:

When demand exceeds supply, higher prices result. This is known as demand-pull inflation.
In general, a low unemployment rate is unquestionably beneficial, but it can lead to inflation because more people have more disposable income.
Increased government spending is also beneficial to the economy, but it can lead to scarcity of certain goods and inflation.

As detailed below, a few key factors can contribute to demand-pull inflation:

When the economy is growing: When consumers spend more and take on more debt. This causes a steady increase in demand, resulting in higher prices.
Increasing export demand: A sudden increase in exports forces currency undervaluation.
Government spending: Prices rise when the government spends more freely.
Inflation expectations: Companies may raise their prices in anticipation of future inflation.
Increased money in the system: When the money supply expands but there aren't enough goods to go around, prices rise.

Cost-Push Inflation

Cost-push inflation (also known as wage-push inflation) occurs when overall prices rise (inflation) as wages and raw materials prices rise. Higher production costs can reduce the economy's aggregate supply (the amount of total production). Because demand for goods has not changed, production price increases are passed on to consumers, resulting in cost-push inflation.

The following are some key takeaways from Cost-push inflation:

Cost-push inflation occurs when overall prices rise (inflation) as wages and raw materials prices rise.
Cost-push inflation occurs when higher production costs reduce the aggregate supply (the amount of total output) in the economy.
Because demand for goods has not changed, production price increases are passed on to consumers, resulting in cost-push inflation.

Recognizing cost-push Inflation. Inflation is a measure of the rate at which prices in an economy rise for a selected basket of goods and services. Inflation can erode a consumer's purchasing power if wages do not rise sufficiently to keep pace with rising prices. If a company's production costs rise, the company's executive management may try to pass those costs on to customers by raising product prices. Profits will decline if the company does not raise prices while production costs rise.

The most common cause of cost-push inflation is an increase in production costs, which may be expected or unexpected. For example, the cost of raw materials or inventory used in manufacturing may rise, resulting in higher costs.

For cost-push inflation to occur, demand for the affected product must remain constant during the period in which production costs change. To compensate for increased production costs, producers raise consumer prices to maintain profit levels while keeping up with expected demand.

Natural disasters, such as floods, earthquakes, fires, or tornadoes, are frequently unanticipated causes of cost-push inflation. Higher production costs are likely to follow if a large disaster causes unexpected damage to a production facility, resulting in a shutdown or partial disruption of the production chain. A company may be forced to raise prices in order to recoup some of the losses caused by a disaster. Although not all-natural disasters increase production costs and thus do not cause cost-push inflation.

Other events, such as a sudden change in government that affects the country's ability to maintain its previous output, may qualify if they result in higher production costs. Government-mandated increases in production costs, on the other hand, are more common in developing countries.

Open Inflation

Open inflation occurs when the prices of consumer goods consistently rise. Open inflation may not indicate a decline in the value of a currency, but rather a genuine increase in the value of consumer goods. An example of open inflation is when food and gas prices rise while home, car, and art prices remain flat or decline.

Every market participant can see the rise in the overall price level when there is open inflation. This term is usually used in conjunction with or to distinguish it from hidden inflation. Open inflation is the rule of inflation, at least in Germany, where the inflation rate is constantly measured.

Repressed Inflation

Direct economic controls (such as price controls, wage controls, and rationing) are used to prevent inflation without removing underlying inflationary pressures. Assume that an economy has an excess of demand. This usually results in a price increase. To prevent excess demand from raising prices, the government can use repressive measures such as price control, rationing, and so on.

Repressed Inflation vs. Open Inflation. An increase in demand and a supply shortage persists, which tends to lead to open inflation. Hyperinflation results from unchecked open inflation. On the other hand, repressed or suppressed inflation occurs when the government imposes physical and monetary controls to control open inflation.

Hyperinflation

The price level rises at a rapid pace during hyperinflation. In fact, prices are expected to rise every hour. Typically, this results in an economy's demonetization.

Government budget deficits financed by currency creation have caused almost all hyperinflations. War or its aftermath, sociopolitical upheavals, a collapse in aggregate supply or one in export prices, or other crises that make it difficult for the government to collect tax revenue are all associated with hyperinflation. A sharp drop in real tax revenue combined with a strong need to maintain government spending, as well as an inability or unwillingness to borrow, can lead to hyperinflation.

Money Supply

The money supply (or money stock) in macroeconomics refers to the total amount of currency held by the public at any given time. There are various ways to define "money," but the most commonly used metrics are currency in circulation (i.e. actual cash) and demand deposits (depositors' easily accessible assets on financial institutions' accounts). For its purposes, a country's central bank may utilize a definition of what constitutes legal cash.

Money supply data is collected and disseminated by a government agency or the country's central bank. Changes in the money supply are monitored by public and private sector analysts because they believe they affect the price levels of securities, inflation, exchange rates, and the business cycle.

The quantity theory of money has long been identified with the relationship between money and prices. At least for rapid increases in the amount of money in the economy, there is some empirical evidence of a direct relationship between the expansion of the money supply and long-term price inflation. For example, a country like Zimbabwe had unusually rapid growth in its money supply, which coincided with quick price increases (hyperinflation). This is one of the reasons for the use of monetary policy to manage inflation.

Monetary Policy

Monetary policy is the approach taken by a country's monetary authority to control either the interest rate paid on very short-term borrowing (banks borrowing from each other to meet their short-term needs) or the money supply, often in an attempt to reduce inflation or the interest rate, in order to maintain price stability and public confidence in the currency's value and stability.

Monetary policy is a change in the money supply, such as "printing" more money or reducing it by altering interest rates or removing excess reserves. Fiscal policy, on the other hand, focuses on taxation, government spending, and government borrowing as tools for a government to handle economic cycle events like recessions.

There are two types of monetary policy:

Expansionary policy occurs when a monetary authority uses its procedures to stimulate the economy. An expansionary policy maintains short-term interest rates at a lower than usual rate or increases the total supply of money in the economy more rapidly than usual. It is traditionally used to try to reduce unemployment during a recession by decreasing interest rates in the hope that less expensive credit will entice businesses into borrowing more money and thereby expanding. This would increase aggregate demand (the overall demand for all goods and services in an economy), which would increase short-term growth as measured by the increase of gross domestic product (GDP). Expansionary monetary policy, by increasing the amount of currency in circulation, usually diminishes the value of the currency relative to other currencies (the exchange rate), in which case foreign purchasers will be able to purchase more with their currency in the country with the devalued currency.
The contractionary policy maintains short-term interest rates greater than usual, slows the rate of growth of the money supply, or even decreases it to slow short-term economic growth and lessen inflation. A contractionary policy can result in increased unemployment and depressed borrowing and spending by consumers and businesses, which can eventually result in an economic recession if implemented too vigorously.

Conclusion

In general, Inflation is defined as a decline in a currency's purchasing power. In other words, as the general level of prices rises, each monetary unit can purchase fewer goods and services in aggregate. Inflation has a different impact on different sectors of the economy, with some suffering while others benefiting. For example, with inflation, those segments of society that own physical assets, such as property, stock, and so on, benefit from the price/value of their holdings rising, while those seeking to acquire them must pay more. Their ability to do so will be determined by how much of their income is fixed, and increases in payments to workers and pensioners, for example, frequently lag behind inflation.

Furthermore, some people's income is fixed. Individuals and institutions with cash assets will also see a decrease in the purchasing power of their cash. Inflationary pressures erode the real value of money (the functional currency) and other items with an underlying monetary nature.

References

Article by: Christopher White