Inflation, in simple terms, is the rate at which the general level of prices for goods and services is rising, and consequently, the purchasing power of currency is falling. A common measure of inflation is the Consumer Price Index (CPI), which tracks changes in the price of a basket of goods and services that households typically consume. Many central banks, like the Reserve Bank of Australia, use the CPI to guide their monetary policy, aiming to keep inflation within a target range (for example, 2–3 per cent annually in Australia). While CPI is widely used, other inflation measures exist and generally show similar trends over time.
This article delves into the primary reasons behind changes in inflation rates, offering a comprehensive understanding of this crucial economic phenomenon.
The Core Causes of Inflation
The causes of inflation can be broadly categorized into three main types:
- Demand-Pull Inflation
- Cost-Push Inflation
- Inflation Expectations
Demand-pull inflation arises from increased demand in the economy, while cost-push inflation is driven by rising production costs. Furthermore, inflation expectations—what people and businesses anticipate about future price levels—can significantly influence actual inflation. Central banks carefully analyze these factors when forecasting and managing inflation. [^1]
Three main causes of inflation: demand-pull, cost-push and inflation expectations
Demand-Pull Inflation: Too Much Money Chasing Too Few Goods
Demand-pull inflation occurs when there’s an increase in aggregate demand—the total demand for goods and services in an economy—that outpaces the economy’s ability to produce those goods and services, known as aggregate supply. This excess demand creates upward pressure on prices across the board, leading to inflation. Essentially, when demand “pulls” prices up, it’s demand-pull inflation.
Graph showing aggregate demand increase leading to price and output increases
Aggregate demand can surge due to several factors, including increased spending by consumers, businesses, or governments, or a rise in net exports (exports minus imports). When demand outstrips supply, businesses find they can raise prices and increase their profit margins. To meet this heightened demand, companies often hire more workers, leading to increased competition for labor and potentially higher wages to attract and retain employees. These rising labor costs can then be passed on to consumers in the form of higher prices. [^2] This cycle of increased incomes, spending, and prices fuels demand-pull inflation.
Flow chart explaining aggregate demand increase impact on firms and prices
Conversely, a decrease in aggregate demand has the opposite effect. Businesses facing reduced demand may slow hiring or even lay off workers, increasing unemployment. A larger pool of job seekers allows firms to offer lower wages, which in turn reduces household incomes and consumer spending, ultimately putting downward pressure on prices and decreasing inflation.
The sustainable supply of goods and services an economy can produce is also referred to as its potential output or full capacity. At this level, resources like labor and capital are utilized efficiently without causing inflationary pressures. When aggregate demand exceeds potential output, prices tend to rise. Conversely, when demand falls below potential output, prices tend to fall.
Economists try to gauge how close an economy is to its potential output by looking at the output gap. While aggregate demand is measurable through GDP data, potential output is harder to observe directly. One indicator is the unemployment rate. The Non-Accelerating Inflation Rate of Unemployment (NAIRU) is the level of unemployment below which inflation tends to increase. If unemployment falls below NAIRU, it suggests the economy is operating above its potential, and inflation is likely to rise. If unemployment is above NAIRU, inflation tends to decrease.
Spare capacity and inflation example with output gap and NAIRU
Cost-Push Inflation: When Production Costs Rise
Cost-push inflation happens when there’s a decrease in the aggregate supply of goods and services throughout the economy. This reduction in supply is often triggered by an increase in the costs of production. If aggregate supply shrinks while aggregate demand remains the same, the imbalance pushes prices upwards, resulting in cost-push inflation. In this scenario, inflation is “pushed” higher by rising costs.
Graph showing aggregate supply decrease leading to price increase and output decrease
Increases in the prices of inputs, whether domestic or imported (like oil or raw materials), drive up production costs. Faced with higher per-unit costs, businesses tend to reduce their output and increase the prices of their products and services. This can have ripple effects across the economy. For instance, a jump in oil prices directly increases gasoline prices, but also makes transportation more expensive, leading to higher prices for goods like groceries due to increased shipping costs.
Supply disruptions, such as those caused by extreme weather events or natural disasters, can also lead to cost-push inflation in specific sectors. For example, major storms or floods can devastate agricultural production, causing significant price increases for food items, contributing to temporary spikes in overall inflation.
Imported Inflation and Exchange Rates
Exchange rate fluctuations can also significantly impact domestic prices and inflation. A depreciation of a country’s currency—a decrease in its value relative to other currencies—can fuel inflation in two primary ways.
Firstly, depreciation makes imported goods and services more expensive relative to domestically produced ones. Consumers pay more for the same imported products, and businesses that rely on imported materials face higher input costs. These higher import prices directly contribute to inflation through the cost-push mechanism.
Secondly, currency depreciation can stimulate aggregate demand. Exports become cheaper for foreign buyers, increasing demand for them and boosting overall aggregate demand. Simultaneously, domestic consumers and businesses reduce their consumption of now-pricier imports, shifting their spending towards domestic goods and services, further increasing aggregate demand. This rise in aggregate demand puts pressure on domestic production capacity, allowing domestic firms to raise prices. These price increases indirectly contribute to inflation through the demand-pull channel.
The exchange rate’s impact on inflation is particularly pronounced for tradable goods and services (those that are exported and imported). Prices of non-tradable goods and services are influenced more by domestic economic conditions.
Inflation Expectations: The Self-Fulfilling Prophecy
Inflation expectations are what households and businesses believe will happen to prices in the future. These expectations are crucial because they can influence current economic decisions and ultimately affect actual inflation. For instance, if businesses anticipate higher inflation, they might increase their prices more aggressively. Similarly, workers expecting higher inflation may demand larger wage increases to maintain their purchasing power. This “inflation psychology” can become a self-fulfilling prophecy, contributing to higher actual inflation.
The degree to which inflation expectations are “anchored” is vital for managing inflation. Anchored expectations mean that people and firms believe that inflation will return to the central bank’s target in the future, regardless of current inflation levels. When expectations are anchored, temporary periods of higher inflation, like those caused by cost-push events, are less likely to become persistent because people don’t drastically alter their behavior. However, if inflation expectations become “unanchored” and move away from the central bank’s target, higher inflation can become entrenched as people and businesses expect it to continue and adjust their actions accordingly. This makes it significantly harder for central banks to control inflation.
Illustrative Examples of Anchored and Unanchored Inflation Expectations
‘Anchored’ inflation expectations
Graph illustrating anchored inflation expectations remaining stable despite temporary inflation increase
In a scenario with anchored expectations, long-term inflation expectations remain stable even during periods of higher inflation. Households and firms view the inflation spike as temporary and don’t significantly change their behavior, expecting inflation to return to the central bank’s target.
‘Unanchored’ inflation expectations
Graph illustrating unanchored inflation expectations rising in response to persistent inflation increase
With unanchored expectations, long-term inflation expectations rise in response to sustained higher inflation. Households and firms expect inflation to persist, adjust their behavior accordingly, and contribute to a higher actual rate of inflation.
While inflation expectations are a powerful force, they are not directly measurable. Policymakers rely on surveys that directly ask people about their inflation outlook and on financial instruments like government bonds, where prices reflect assumptions about future inflation.
Box: Supply Shocks and Stagflation
A severe or prolonged supply shock can not only cause cost-push inflation but also significantly reduce both current and potential economic output. This can lead to stagflation—a challenging economic situation characterized by stagnant economic growth (or decline), high unemployment, and high inflation simultaneously. Stagflation is particularly difficult to manage and can become entrenched if inflation expectations are not well-anchored.
The 1970s provide a stark example of stagflation, driven by two major oil price shocks. In 1973, OPEC, along with Egypt and Syria, imposed an oil embargo on industrial nations supporting Israel, causing oil prices to quadruple and leading to energy shortages. This resulted in a global recession with surging unemployment and inflation. Compounding the problem, central banks at the time were not focused on inflation targeting, contributing to a prolonged period of high inflation in many economies.
[^1]: Reserve Bank of Australia analysis.
[^2]: Economics Explainer: Demand and Supply.
