Inflation, in simple terms, is the increase in the general price level of goods and services in an economy over a period of time. This means that for each unit of currency, you can purchase fewer goods and services. A widely recognized measure of inflation is the Consumer Price Index (CPI), which tracks the percentage change in the price of a basket of common household goods and services (see Explainer: Inflation and its Measurement for more details). Central banks, like the Reserve Bank of Australia, often use the CPI to gauge inflation and set targets, aiming to maintain annual consumer price inflation within a specific range, such as 2 to 3 percent in Australia’s case (see Explainer: Australia’s Inflation Target). While CPI is prominent, other inflation measures exist and are monitored, with most exhibiting similar trends over the long run.
This article delves into the primary reasons behind fluctuations in the inflation rate, providing a comprehensive understanding of this crucial economic phenomenon.
The Core Causes of Inflation
The fundamental causes of inflation can be broadly categorized into three main types:
- Demand-Pull Inflation
- Cost-Push Inflation
- Inflation Expectations
As the names suggest, demand-pull inflation originates from the demand side of the economy, while cost-push inflation stems from the supply side, specifically from increased production costs. Furthermore, inflation expectations, reflecting what people and businesses anticipate about future prices, can significantly influence actual inflation. These distinct causes are carefully considered by central banks when analyzing and forecasting inflation trends.1
Three Primary Drivers of Inflation: Demand-Pull, Cost-Push, and Inflation Expectations.
Demand-Pull Inflation: When Too Much Demand Chases Too Few Goods
Demand-pull inflation happens when there’s an increase in the total demand for goods and services in an economy, known as ‘aggregate demand’, that outstrips the economy’s capacity to produce them, or ‘aggregate supply’ at a sustainable level. This excess demand creates upward pressure on prices across a wide spectrum of goods and services, ultimately leading to a rise in the inflation rate. Essentially, heightened demand ‘pulls’ inflation upwards.
Impact of Increased Aggregate Demand on Price Levels and Output.
Aggregate demand can surge due to various factors, such as increased spending by consumers, businesses, or governments, or a rise in net exports. This increased demand relative to supply empowers businesses to raise prices and increase their profit margins. Simultaneously, companies will seek to hire more workers to meet this elevated demand. In a competitive labor market, firms might need to offer higher wages to attract and retain employees. These increased labor costs can then be passed on to consumers through higher prices for goods and services.2 The cycle continues as more jobs and higher wages boost household incomes, leading to further consumer spending, which again elevates aggregate demand and provides businesses with more leeway to increase prices. When this pattern unfolds across numerous businesses and sectors, it results in a broad increase in inflation.
The Cycle of Demand-Pull Inflation: From Increased Demand to Higher Prices.
Conversely, a decrease in aggregate demand has the opposite effect. Businesses facing reduced demand will slow down hiring or even lay off staff, pushing the unemployment rate upwards. With more people seeking jobs, firms can offer lower wages, putting downward pressure on household incomes, consumer spending, and ultimately, prices. Consequently, inflation will decrease.
The sustainable level 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 (including machinery and equipment) are utilized as efficiently as possible without fueling inflation. When aggregate demand surpasses potential output, inflationary pressures emerge. Conversely, when aggregate demand falls below potential output, it exerts downward pressure on prices.
Measuring the gap between actual output and potential output (or full capacity) is crucial for understanding inflation dynamics. While aggregate demand can be tracked relatively accurately using GDP data from national accounts (see Explainer: Economic Growth), potential output is not directly observable. Economists infer it from various economic indicators, such as the unemployment rate consistent with stable inflation, known as the Non-Accelerating Inflation Rate of Unemployment (NAIRU) (see Explainer: The Non-Accelerating Inflation Rate of Unemployment (NAIRU)). When unemployment falls below the NAIRU, inflation tends to rise, and when it exceeds the NAIRU, inflation tends to decrease.
Output Gap and Inflation: The Relationship Between Economic Capacity and Price Stability.
Cost-Push Inflation: When Rising Costs Drive Up Prices
Cost-push inflation arises when there is a decrease in the total supply of goods and services that the economy can produce, known as ‘aggregate supply’. This reduction in aggregate supply is often triggered by an increase in the costs of production. If aggregate supply decreases while aggregate demand remains constant, upward pressure is exerted on prices, leading to cost-push inflation. In this scenario, inflation is ‘pushed’ higher by rising costs.
Impact of Decreased Aggregate Supply on Price Levels and Output.
An increase in the price of inputs, whether domestic or imported, such as oil or raw materials, directly increases production costs. Faced with higher costs per unit of output, firms tend to reduce production levels and raise the prices of their goods and services to maintain profitability. This can have cascading effects throughout the economy, pushing up prices across various sectors. For example, a surge in oil prices, a key input for many industries, will initially lead to higher gasoline prices. However, elevated gasoline prices also increase transportation costs, which, in turn, can raise the prices of goods like groceries and other consumer products.
Cost-push inflation can also be caused by supply disruptions in specific industries, for instance, due to extreme weather events or natural disasters. Events like major cyclones and floods can severely damage agricultural production, causing significant price increases for processed foods, takeaway meals, and restaurant dining, leading to temporary periods of higher inflation.
Imported Inflation and Exchange Rates
Exchange rate fluctuations also play a role in price levels and inflation. A depreciation of the domestic currency (a decrease in its value) tends to increase inflation through two primary channels. Firstly, it makes goods and services produced overseas more expensive relative to domestic products. Consumers end up paying more for imported goods, and businesses that rely on imported materials face higher input costs. These price increases for imported goods and services directly contribute to inflation via the cost-push mechanism.
Secondly, currency depreciation can stimulate aggregate demand. This occurs because exports become cheaper for foreign buyers, leading to increased demand for exports and higher overall aggregate demand. Simultaneously, domestic consumers and businesses may reduce their consumption of now-expensive imports and shift their spending towards domestically produced goods and services, further boosting aggregate demand. This increase in aggregate demand puts pressure on domestic production capacity, allowing domestic firms to raise prices. These price increases contribute indirectly to inflation through the demand-pull channel.
In terms of imported inflation, exchange rates have a more pronounced impact on the prices of tradable goods and services (those that are exported and imported), while the prices of non-tradable goods and services are more influenced by domestic economic conditions.
Inflation Expectations: Shaping Future Price Behavior
Inflation expectations represent the beliefs that households and businesses hold about future price increases. These expectations are significant because they can influence current economic decisions, which, in turn, can affect actual inflation outcomes. For example, if businesses anticipate higher inflation in the future and act on this belief, they might increase their prices at a faster rate preemptively. Similarly, if workers expect higher future inflation, they may demand higher wages to compensate for the anticipated erosion of their purchasing power. This behavior, often referred to as ‘inflation psychology’, can contribute to a higher actual inflation rate, making inflation expectations self-fulfilling.
Given the influence of inflation expectations on price and wage setting, the degree to which these expectations are ‘anchored’ is crucial for future inflation outcomes. Expectations are considered ‘anchored’ when households 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, a temporary period of higher inflation, perhaps due to a cost-push shock, is less likely to cause significant behavioral changes, and inflation is more likely to revert to its target. However, if inflation psychology shifts and expectations become ‘unanchored’, moving away from the central bank’s target, a period of higher inflation can become persistent. In this scenario, households and firms expect continued high inflation and adjust their behavior accordingly, perpetuating the inflationary trend. Therefore, managing inflation is considerably easier for a central bank when inflation expectations are well-anchored.
Illustrative Example of Anchored and Unanchored Inflation Expectations
‘Anchored’ inflation expectations
Anchored Inflation Expectations: Stability Despite Short-Term Fluctuations.
In a scenario with anchored expectations, long-term inflation expectations remain relatively stable even when actual inflation rises temporarily. Households and businesses perceive the inflation surge as transient and do not significantly alter their economic behavior, anticipating that inflation will eventually return to the central bank’s target.
‘Unanchored’ inflation expectations
Unanchored Inflation Expectations: Persistent Increase Following Inflationary Shocks.
Conversely, with unanchored expectations, long-term inflation expectations shift upwards in response to a period of higher inflation. Households and businesses anticipate that higher inflation will persist and adjust their behavior accordingly, ultimately contributing to a sustained higher rate of actual inflation.
While inflation expectations are a vital determinant of actual inflation, they are not directly observable. Policymakers, like central banks, rely on indirect measures of expected inflation derived from surveys (asking people directly about their inflation outlook) or financial assets like government bonds (where asset prices reflect assumptions about future inflation, see Explainer: Bonds and the Yield Curve).
Box: Supply Shocks and Stagflation – The Worst of Both Worlds
If a supply shock is substantial or prolonged, it can trigger cost-push inflation and significantly reduce both current and potential output levels in an economy. This can lead to the challenging combination of economic ‘stagnation’ (output decline) occurring simultaneously with rising prices. This situation, characterized by stagnant growth (with high or rising unemployment) and high inflation, is known as stagflation. Stagflation can become deeply entrenched, particularly when inflation expectations are not well-anchored.
The 1970s serve as a stark example of stagflation, marked by two major oil price shocks. In October 1973, OPEC members, along with Egypt and Syria, imposed an oil embargo on industrial nations supporting Israel during the Yom Kippur War. This embargo resulted in a quadrupling of oil prices and energy rationing, triggering a global recession where unemployment and inflation surged in tandem. Compounding the issue, central banks at the time did not have explicit inflation targets, contributing to a prolonged period of high inflation in many economies.
1 Reserve Bank of Australia. (n.d.). Causes of Inflation. Retrieved from [original article URL]
2 Ibid.
