Question: What Are the Causes of Inflation?
Answer: Inflation is the devastating condition when prices just keep going up, eating away at your standard of living. There are three main causes: demand-pull, cost-push, and monetary expansion.
Demand-pull inflation is the most common. It's simply when demand for a good or service increases so much that it outstrips supply. If sellers maintain the price, they will sell out. They soon realize now have the luxury of raising prices, creating inflation.
Many circumstances can lead to demand-pull inflation. A growing economy can create some inflation as people feel confident about the future and spend more. As long as inflation stays within limits, this could actually benefit economic growth. That's because it creates an expectation of inflation, which can contribute to further demand-pull inflation. As people expect further inflation, they make their purchases sooner to avoid further price increases. The Federal Reserve has set an inflation target to manage the public's expectation of inflation. The inflation target is currently set at 2%, as measured by the core inflation rate. This removes the effect of seasonal food and energy increases.
Discretionary fiscal policy contributes to demand-pull inflation. The government's ability to spend more or tax less increases demand in certain areas of the economy. Marketing and new technology can create demand-pull inflation for certain products or asset classes. For example, the Apple brand commands higher prices, a type of inflation, for its products. New technology, in the form of financial derivatives, created asset inflation in the housing market in 2005-2006. For more examples, see What Is Demand-Pull Inflation?. (Source: The St. Louis Federal Reserve, The Economic Lowdown; The Intelligent Economist, Demand-Pull Inflation)
A second cause of inflation is cost-push inflation. This isn't as common as demand-pull inflation, because it only occurs when there is a shortage of supply combined with enough demand to allow the producer to raise prices. Wage inflation can contribute to cost-push inflation. This is usually caused by strong labor unions. A company with the ability to create a monopoly can also create cost-push inflation. That's because controls the supply of a good or service. Monopolies were outlawed in 1890 by the Sherman Anti-Trust Act.
Natural disasters can temporarily create cost-push inflation by damaging production facilities, such as what happened to oil refineries after Hurricane Katrina. The depletion of natural resources will be a growing cause of cost-push inflation. For example, overfishing reduces the supply of seafood, driving up prices. Government regulation and taxation also reduce supplies. For example, subsidies of corn ethanol production reduced the amount of corn available to feed people and animals. This shortage created food price inflation in 2008.
Expansion of the Money Supply
A third cause of inflation is an over-expansion of the money supply. The money supply is not just cash, but also credit, loans and mortgages. When loans are cheap, then there will be too much money chasing too few goods, creating inflation. The prices of just about everything will increase, even though neither demand nor supply has changed.
Expansion of the money supply was another cause for inflation in housing prices in 2005-2006. Deregulation allowed banks to push mortgages onto everyone. When people could borrow for virtually nothing, and needed no money down, it made no sense to rent. With low interest rates, homeowners used their homes as ATM machines, spending their equity on TVs, cars...and more houses. However, inflation was restricted to housing prices. The price of everything else was subdued, since China kept its currency, the yuan, pegged below the dollar. This artificially made prices of their exports to the U.S. low.
When the money supply increases, it lowers the value of the dollar. When the dollar declines relative to the value of foreign currencies, the prices of imports rise, also creating cost-push inflation. That's why China pegs the yuan to always be lower than the dollar, which has been declining since 2002.
How does the money supply expand? Through expansionary fiscal policy or expansionary monetary policy
Expansionary fiscal policy is executed by the Federal government. It expands the money supply through either deficit spending or actually printing more cash or coins. Deficit spending pumps money into certain segments of the economy, creating demand-pull in that area, but delays the offsetting taxes in any other area until sometime in the future, adding it to the debt. Since investors know the Federal government will pay the debt, it has no ill effect until the debt-to-GDP ratio approaches 100%.
Expansionary monetary policy is executed by the Federal Reserve. It expands the money supply by creating additional credit with the use of its many tools. One tool is lowering the Federal Reserve requirement, which is the amount of reserve banks must keep on hand at the end of each day. The less they have to keep on reserve, the more they can lend. The Fed can also lower the Fed funds rate, which is the rate banks charge each other to borrow funds to maintain the Reserve requirement. This action also lowers all interest rates, allowing borrowers to take out a bigger loan for the same overall cost. Lowering the Fed funds rate has the same effect as lowering the reserve requirement, but is a lot easier, so it's done much more often. Article updated March 22, 2012