What Causes Inflation in Economics?

Technically speaking there are many causes of inflation in the short-run, and I will examine the most significant of them in this article, but whatever the particular cause in any given situation its effect will be initiated by one, or both, of two forces:

1. Demand-Pull Forces - whereby consumers directly and excessively bid up the prices of goods because the supply of those goods is insufficient to match demand for them.
2. Cost-Push Forces - whereby the prices of key inputs necessary for the production of goods & services are rising, and firms have to pass on some of those costs to consumers.

I have already written about these two forces in separate articles and will not repeat myself here, so click through the links above for more specific details if that is what you are looking for. I should also note that, once started, the role of inflationary expectations will also be a causal factor in perpetuating the existence of inflation.

In this article I want to address not just the dry technical causes of inflation, but more interestingly the institutions in our societies which are usually to blame for mismanaging our economies such that inflation results. I'm referring, of course, to the government and the monetary authorities in a country.

What Causes Inflation to Rise?

As you may have gathered from my opening paragraph, there is a distinction between the short-run and the long-run when examining the causes of inflation. The long run is simpler in some ways because it always comes down to an expansion of the money supply.

As the famous quote goes:

What is less commonly known is that Friedman was specifically referring here to persistent long-run inflation, he was fully aware that many other factors can cause inflation in the short-run. For details of the correct framework in which to think about long-run persistent inflation, have a look at my article about:

• The Quantity Theory of Money

In the short-run, inflation is usually caused by the boom-bust cycle in the economy. Austrian economists put the blame for that cycle on the inefficient management of interest rates by the monetary authority i.e., the Federal Reserve in the US, because it leads to too much lending and debt financed spending during the boom periods.

Malinvestment due to artificially low interest rates then lead, inevitably, to price rises as output growth fails to keep pace with growth in spending. An economic crash then occurs, with falling output and rising unemployment until the cycle repeats.

The artificially low interest rates, that frequently occur under the Fed, allow the government to fund many of its programs by increased borrowing. This creates even more stress on the economic growth rate via the crowding-out effect, because government programs are inevitably inefficient. The more that growth is impeded, the less that supply can keep up with growing demand, and the more that inflationary pressures will build up.

Other than the Austrian business cycle explanation of inflation, there are times when significant supply shocks can cause inflation, and typically it can be much higher than usual. This has happened twice in recent decades, the first being in the 1970s when the OPEC oil price rises caused the costs of production to rise significantly, and the second being the 2021 government mandated lockdowns in response to the Covid-19 pandemic.

What Caused Inflation in the 1970s?

The causes of inflation in the 1970s are recounted in my article about Stagflation, and I'd encourage you to read up on that interesting and illuminating period in modern economic history.

To summarize, there had been excessive government spending throughout the 1960s that created an unsustainable level of aggregate demand, and then the OPEC oil embargo caused a significant contraction in aggregate supply. 

What caused inflation to rise in 2022?

The root causes of inflation in the 2020s date back to the 2008 financial crisis and the way in which it was handled via quantitative easing (QE). For full details on that refer to my article at:

• Does Quantitative Easing Cause Inflation?

The key point is that there was an enormous amount of money that was printed and pumped into the banking sector in order to avoid a collapse of the global financial system. That extra money did not enter the real economy i.e., for goods and services, until recently and did not influence the CPI measure of inflation for that reason. Instead it pumped up stock prices and real estate.

Unfortunately, QE didn't fix anything, it merely delayed the inevitable. The breaking point came with the Covid-19 pandemic and the way in which that was handled. Massive fiscal stimulus combined with loose monetary policy and the lockdowns meant that aggregate demand surged even as workers were kept at home and unable to maintain aggregate supply. Similarly, global supply-chains were destroyed as overseas firms were unable to supply products or raw materials in the quantities needed.

Neither the government nor the Federal Reserve were able to predict the inevitable consequences of excess demand relative to supply, and by the time inflation was represented in rising CPI numbers, Fed Chairman Powell labelled it 'transitory' and declared that "we're not even thinking about thinking about raising rates".

Government and Fed attitudes soon changed once inflation began to assert itself, with interest rates soaring in a belated attempt to ease the rate of rising prices.

The Russian invasion of Ukraine in February 2022 also impacted on inflation, with further printing of money by the Western economies in order to help support Ukrainian resistance. Oil prices and other important input costs have soared because sanctions against Russia have cut off many supplies of these cheap imports.

However, we should not allow our political elites to use the problems in Ukraine as an excuse for inflation, because it clearly stems from incompetent handling of the economy that dates back many years prior to 2022.

What Causes Inflation during War?

Special mention has to go to the incidence of inflation during periods of war. War is an extremely expensive business, and in the most serious of wars, where significant numbers of workers are conscripted into the army and where significant productive resources are diverted away from creating consumer goods in favor of military goods, serious shortages of many consumer goods can develop.

Shortages of key supplies can even lead to rations being imposed.

The consequences of this are, of course, rampant price rises as consumers compete to buy up whatever goods are available. At the same time, an illegal informal sector will develop with goods being bought and sold on the black market.

While this does cause inflation, and severe supply shortages that can persist for some time even after the war has ended, the good news is that the production of consumer goods and services can rapidly expand once the fighting is over. Historically this expansion of aggregate supply has played a big part in reducing inflation in postwar years, especially after World War II.

Sources:

• Reserve Bank of Australia - The Causes of Inflation (PDF)

Related Pages:

• Adaptive Expectations
  
• Capacity Constraints
• Positive Output Gap
• What is Reflation?
• What is Inflation, and Why is it Bad?

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