Economics Online Tutor
Causes of Inflation |
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| Inflation can be caused by forces that work on aggregate demand, called demand-pull inflation; or by forces that work on aggregate supply, called cost-push inflation. Demand-Pull Inflation The aggregate demand / aggregate supply model shows that the price level increases whenever aggregate demand increases (the AD curve shifts rightward). This can be a permanent situation due to continual increases in the money supply and government spending. Wars generally create demand-pull inflation because of government borrowing to finance war efforts. Cost-Push Inflation The aggregate demand / aggregate supply model shows that the price level increases whenever aggregate supply decreases (the AS curve shifts leftward). This is not a permanent situation, because the general trend is for aggregate supply to shift rightward. Occasionally it can shift leftward due to a supply shock: a sudden decrease in aggregate supply. Examples are weather related reductions in the production of basic foods, large cutbacks in oil production, and a large increase in the minimum wage. A supply shock results in both higher prices and lower output. In this case, both high inflation and high unemployment can occur at the same time. This is called stagflation, and occurred in many industrialized nations during the 1970s. |
The Money Supply and Inflation Perhaps you have heard people say that inflation is always caused by an over-supply of money, created by government action. Perhaps you already believe that to be true. Many people do. In that case, the above explanations for the causes of inflation can be interpreted in terms of the underlying supply of money. Consider the following situation: Suppose that the world supply of oil was suddenly reduced drastically, as it was in the 1970s. This would be a classic case of supply shock. The aggregate supply curve shifts leftward, resulting in both higher inflation and higher unemployment. Now also suppose that the government decides to intervene with stimulus monetary and/or fiscal policies in order to reduce unemployment. In this case, the government believes that the best short run policy would be to stimulate output and employment. Expansionary government policy to deal with the situation will shift the aggregate demand curve to the right. This will create more output and lower unemployment, but will also magnify the inflation problem. So, how does the situation coincide with the belief that inflation is always caused by an increase in the underlying money supply? After all, the initial inflationary pressures had nothing to do with the money supply, but the government response did. Some people will look at the government's reaction first, and say that the money supply caused this inflation. Most economists would not agree with that assessment. |