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(originally published to Helium writing site, now gone)

Inflation is the name given to a sustained rise in the overall level of prices for the goods and services we buy. It is usually measured by an indicator such as a consumer price index. In broad terms, inflation is brought about in the short and medium term by pressures on the demand for and supply of goods and services. Inflation over the longer term depends more on the increase in the money supply, as determined by interest rate policy.

Demand pull inflation

When an increase occurs in the quantity of goods and services purchased by individuals, businesses and governments, demand pull inflation can result. If this new level of aggregate demand exceeds the supply of goods and services that producers are willing and able to provide, prices will be bid up by those wanting the available goods and services. Producers will often be able to satisfy this increase in demand by recruiting extra employees and perhaps investing in new machinery and other assets or improving efficiency. If producers are unable to make these changes, a period of inflation might result. This usually occurs when resources are already fully employed or close to it.

Demand pull inflation can be caused by a number of factors that generally occur when the economy is at or near full capacity. For example, a rise in consumer confidence can mean that plans to purchase certain goods and services may be brought forward. Also, a favorable housing market will boost dwelling sales, leading to greater demand for household goods, which could lead to higher prices and inflation. A further cause of demand pull inflation can be a reduction in taxes, resulting in more money in consumers’ pockets and thus higher demand for goods and services.

Depreciation in the value of the currency is another factor that can lead to inflation. Here, import prices rise and export prices fall, leading to increased demand for the products of export industries and import substitution industries, placing pressure on prices. Demand pull inflation can also occur if benchmark interest rates are set too low and financial institutions increase their borrowings, boosting the level of funds they have available to lend to consumers and businesses.

Cost push inflation

When the supply of goods and services is curtailed, this can mean households, business and government have to compete for the smaller stock, pushing prices up, often resulting in what is called cost push inflation. A reduction in supply can be due to higher input prices or the effects of natural disasters. A rise in the price of oil, for example, will increase costs across all industries, forcing companies to raise their prices. Higher labor costs will have the same effect, pushing up prices, as will an increase in indirect tax such as an excise duty on certain products.

Built-in inflation can be caused by expectations that inflation will continue into the future, due to past demand pull and cost push inflation. This is where both labor and capital are continually seeking catch ups in wages and prices because of previous price and wage increases respectively.

An increase in the money supply

If the supply of money, including through bank lending as well as deposits and currency, rises faster than the rate of real economic growth, this can result in inflation. Economists disagree on the importance of this link as a cause of inflation. There are two main schools of thought. Keynesian economists feel that an increase in the money supply is just one factor that can cause inflation, while the main influence is demand and cost pressures. Monetarists regard changes in the money supply as by far the most important cause of inflation.

Most governments aim to control the supply of money through a central bank by raising or lowering key interest rates, depending on economic circumstances. If rates are set too low for the current economic conditions, this can result in an increase in lending by financial institutions above the desired level. This leads to greater amounts of money in the community and a rise in aggregate demand, which can lead to inflation if the economy is already close to full capacity. Responsible interest rate policy should result in moderate and desired levels of inflation only.

Where the money supply rises at a much faster rate than the increase in production, this can result in hyperinflation. Here, consumer demand will far exceed the supply of goods and services produced, so businesses will raise their prices. At the same time, labor will seek pay increases to compensate for the higher prices. This can lead to a wage-price spiral, which can quickly get out of control and which can be made worse by government policy favoring an increase in bank lending or simply printing more money.

Perhaps the best known examples of hyperinflation have been in Germany and Zimbabwe. Hyperinflation in Germany in the 1920s was largely caused by successive devaluations of the mark due to a huge war reparations bill. In Zimbabwe, current hyperinflation stems from the government continuing to spend and print more money while the economy was falling apart.

The causes of inflation can be many. The major ones are pressures on supply and demand and increases in the money supply. The main way governments aim to control inflation these days, and keep it within an acceptable band, is through official interest rate policy, thereby influencing the amount of money in an economy.