Economists say that there are 3 major causes of inflation. They are:
- Cost-Push Inflation
- Demand-Pull Inflation
- An increase in the Money Supply
What is Cost-Push inflation?
As the cost of raw materials or wages increases it causes producers to be forced to increase the cost of their products in order to be able to cover their costs of production and a reasonable profit. This results in a “snowball effect” as these new products raise the prices of other products.
But that leads us to the “chicken or the egg” question. What caused the cost of raw materials or wages to rise in the first place? It is possible for foodstuffs to be in short supply due to weather considerations thus causing a shortage and temporarily driving up prices. Other possible causes include natural disasters like a hurricane, flood, or earthquake damaging or destroying production facilities thus reducing supply and in view of constant demand thus causing a rise in prices.
The interesting thing about all of these factors that can start the process of cost-push inflation is that they are all temporary. Floodwaters will recede, factories will be rebuilt, weather conditions will improve, and crops will regrow, etc.
On the other hand, there is a different class of causes that are not so temporary, and they result from government actions. Wars can cause shortages of labor and raw materials. Other government policies such as minimum wage laws can drive up wages, environmental regulations can raise compliance costs, and trade regulations can limit markets. Thus, governments can cause systemic problems that can wreak havoc over decades or longer.
What is Demand-Pull Inflation?
We have all heard that prices are a result of the balance between supply and demand. If demand falls, sellers must lower their prices in order to induce customers to buy their products. According to Keynesian Economic theory the opposite is also true and is the cause of Demand-Pull Inflation. In other words, when people suddenly all decide they want to buy something at once it will drive up the price of an item and cause inflation.
Once again, the major problem with this theory is that it is only temporary and not a cause of systemic inflation. As demand rises, the producer ramps up production in order to capitalize on the increase in demand and although this may take time, it will happen, causing prices to begin to fall again. Also, competitors will enter the market with cheaper competing products, and this will also drive prices down. The only way to ensure ever-higher prices is through a government-imposed monopoly, where supply can be permanently restricted.
The real underlying cause of all systemic (i.e. long-term) inflation is an increase in the money supply. When gold was the primary currency, the money supply was relatively fixed with only a few examples of massive discoveries causing a sudden increase in supply. However, a major discovery of readily available gold could cause a temporary inflationary boom because as the new gold entered the economy, people spent it, increasing demand (similar to what happens in demand-pull inflation).
How an Increase in Money Supply Causes Inflation
When boiled down to the lowest common denominator, long-term systemic inflation is caused by an increase in the money supply. A simple example is that of an island with ten people on it and each person has $1. and one item for sale. Simple mathematics tells you the average price for each item would be $1.
Now suppose you wanted to make everyone richer, so you gave each one another dollar. There are still only 10 items for sale but now there is $20 to spend so the average price would now be $2. This means the price doubled, so no one is any richer because they can still only buy one item with their $2.
In this case, no one was better off because the increased money supply was distributed evenly. But in real life that is not how it works. In real life, the government gets all the new money and spends it at its original (higher) value. As it filters through the economy, people begin to realize that it is worth less and prices are driven up. Thus, hurting the people whose income is still fixed at the old lower rate the most.
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michael sherrard says
Tim. Great article. I am not an economist, but have read Milton Friedman. I understand from your article that with $4T in assets, the Fed can go in either way. To stop inflation, they can decrease the money supply by selling assets. To stop deflation, they can but increase the money supply by buying assets. Essentially, they are stabilizing the money supply. But what about money velocity? Is there a problem with the Fed holding massive assets?
Tim McMahon says
Good question! Velocity of money is primarily a result of market perception. Which is why the FED can sometimes “Jawbone” the inflation rate up or down by simply convincing the market that it has things under control (whether it actually does or not). But if it can get the media to cooperate it can herd the sheeple in the direction it wants. But other than that the only control it has on the velocity of money is interest rates which can help prod the sheep in the “right” direction.