Causes of Inflation

What Causes Inflation (photo: National Business Capital)

Inflation refers to a rise in the prices of goods and services. The Consumer Price Index (CPI) is the most commonly used indicator to measure inflation, which calculates the percentage change in the price of a basket of goods and services consumed by households. The Reserve Bank of Australia utilizes the CPI as a measure of inflation in its inflation target, aiming to maintain annual consumer price inflation between 2 and 3 percent on average over time. Although other methods of measuring inflation are also examined, most measures of inflation exhibit comparable patterns over the long run.

This explanation aims to outline the primary causes of fluctuations in the inflation rate.

Causes of inflation

There are three primary categories of causes for inflation:

  1. Demand-pull
  2. Cost-push
  3. Inflation expectations

Demand-pull inflation is driven by factors related to demand within the economy, while cost-push inflation is brought about by the impact of increased input costs on the supply side of the economy. Inflation expectations can also lead to inflation, as the beliefs of households and businesses regarding future prices can influence actual prices. The Reserve Bank considers these various causes of inflation when assessing and predicting inflation.

- Demand-pull inflation

Demand-pull inflation occurs when the total demand for goods and services, known as 'aggregate demand,' surpasses the supply of goods and services that can be sustainably produced, also referred to as 'aggregate supply.' The resulting surplus demand creates upward pressure on prices for a wide variety of goods and services, ultimately leading to an increase in inflation. Essentially, demand-pull inflation 'pulls' inflation rates higher.

Aggregate demand can increase due to various reasons, such as heightened spending by consumers, businesses, or the government, or an increase in net exports. Consequently, the demand for goods and services will rise relative to their supply, allowing companies to increase their prices (and their profit margins, which is their markup on costs). Concurrently, businesses will try to employ more workers to meet this increased demand. With greater demand for labor, firms may need to offer higher wages to attract new talent and keep existing employees. Companies may also raise the prices of their goods and services to offset their increased labor costs.

As a result, more jobs and higher wages will increase household incomes, leading to a surge in consumer spending. This further amplifies aggregate demand and the ability of firms to raise their prices. When this occurs across a broad range of sectors and businesses, it results in inflation.

When aggregate demand decreases, the opposite effect occurs. Firms facing reduced demand will either halt hiring or lay off staff, resulting in a reduced workforce. This places upward pressure on the unemployment rate. With more job seekers and fewer vacancies, firms can offer lower wages, decreasing household incomes, consumer spending, and the prices of their goods and services. As a consequence, inflation declines.

The supply of goods and services that can be produced sustainably is also referred to as the economy's potential output or full capacity. At this level of output, factors of production such as labor and capital are being used as efficiently as possible without driving inflation upward. When aggregate demand exceeds the economy's potential output, this puts upward pressure on prices, and when aggregate demand is below potential output, it puts downward pressure on prices.

So, how can we determine the distance between the economy and its full capacity, and what impact does this have on inflation? While we can measure aggregate demand accurately on a quarterly basis using gross domestic product (GDP) data from the national accounts, potential output is not directly observable. We must infer it from other evidence about the behavior of the economy. For instance, just as there is a level of output where inflation is stable, there is also a level of the unemployment rate consistent with stable inflation. This is known as the Non-Accelerating Inflation Rate of Unemployment or NAIRU for short. When unemployment falls below the NAIRU, inflation will rise, and when it exceeds the NAIRU, inflation will decrease.

- Cost-push inflation

Cost-push inflation refers to a situation where the general price level of goods and services in the economy rises due to an increase in production costs. Such an increase in production costs could be caused by factors such as a rise in the cost of raw materials, wages, or taxes. This results in a decrease in the overall supply of goods and services in the economy (aggregate supply). When the aggregate demand for goods and services remains unchanged, the reduction in supply leads to a situation where there are more buyers than sellers, leading to an increase in prices. This increase in prices leads to an increase in inflation, which is known as cost-push inflation. 

Cost-push inflation occurs when there is a decrease in the total supply of goods and services that can be produced in the economy (aggregate supply), usually due to an increase in the cost of production. This increase in production costs could be caused by a rise in the price of domestic or imported inputs, such as raw materials or oil. As a result, firms must spend more to produce each unit of output and may produce less output, leading to an increase in the prices of their goods and services. This price increase can cause a chain reaction, leading to higher prices for other goods and services. For example, an increase in oil prices could initially cause higher petrol prices, but this could also lead to higher transport costs, leading to higher prices for groceries.

Furthermore, cost-push inflation can also occur when there are supply disruptions in specific industries due to natural disasters or unusual weather. For instance, major floods or cyclones can damage a large volume of agricultural produce, resulting in significant increases in the prices of processed food, restaurant meals, and takeaway food. These disruptions can lead to temporary periods of higher inflation.

Imported inflation and the exchange rate

Exchange rate fluctuations can impact inflation by affecting prices and demand. When the domestic currency depreciates, meaning it decreases in value relative to other currencies, it can lead to inflation in two ways. Firstly, the prices of imported goods and services rise compared to domestically produced ones, which results in higher prices for consumers and firms that rely on imports. This increase in prices directly contributes to cost-push inflation.

Secondly, the depreciation stimulates aggregate demand, as exports become cheaper for foreign buyers and demand for them increases. At the same time, domestic consumers and firms tend to shift their purchases from relatively more expensive imports to domestically produced goods and services, leading to an increase in demand for the latter. This increase in aggregate demand can lead to an increase in production and pressure on firms to raise their prices, indirectly contributing to inflation through the demand-pull channel.

Regarding imported inflation, the exchange rate's influence is greater on the prices of tradable goods and services that are exported and imported, while the prices of non-tradable goods and services depend more on domestic factors.

Inflation expectations

Inflation expectations refer to the beliefs that individuals and businesses hold about the future rate of price increases. These beliefs are important as they can influence present economic decisions that impact actual inflation outcomes. For instance, if businesses anticipate higher inflation in the future, they may increase their prices at a faster rate. Similarly, if individuals expect higher inflation, they may demand higher wages to offset the expected decline in their purchasing power. These behaviours, also known as "inflation psychology," can lead to a higher rate of inflation, making expectations about inflation self-fulfilling.

The extent to which inflation expectations are "anchored" has significant implications for future inflation outcomes since these expectations can affect actual price and wage setting. When households and businesses believe that inflation will eventually return to the central bank's inflation target, regardless of current inflation levels, their expectations are described as being "anchored" to the inflation target. When expectations are anchored, a temporary period of higher inflation will not cause households and businesses to alter their behaviour, and inflation is likely to return to its target eventually. However, if inflation expectations become "unanchored," a persistent period of higher inflation can occur as households and businesses anticipate higher inflation in the future and adjust their behaviour accordingly. Therefore, it is easier for central banks to manage inflation when inflation expectations are anchored.  

Illustrative Example of Anchored and
Unanchored Inflation Expectations


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