Inflation matters. But, what are major causes of inflation to occur in any country?
There are four main factors that cause inflation:
- Excessive demand from customers.
- Higher costs for businesses.
- Increasing money supply.
- Higher expectations about the future.
Let’s take a look in details at these four causes of inflation in the economy.
1. Demand–pull inflation causes of inflation
Excessive demand from customers and consumers is also known as ‘demand-pull’ inflation.
Increased aggregate demand from customers can be caused by rise in consumption, higher government spending and more earnings from international trade caused by increased exports.
Consumer demand in the economy will be rising during an economic growth and will be at its peak during an economic boom. Individual customers and households will spend more money at a faster rate when their income levels are high. Businesses will be investing more capital in new projects by purchasing Fixed Assets such as land, buildings, machinery, etc. Government expenditure on public infrastructure will be increasing which will benefit businesses in basic materials, construction, energy and utilities sectors of the economy. There will be an increase in exports as well.
Domestic producers and retailers will realize that existing inventory of products can be sold to customers at higher prices. By raising prices, businesses will take advantage of high consumer demand to earn higher profit and higher profit margins.
If they did not raise prices, stocks would be sold out at lower prices, therefore profit and profit margins would not be maximized.
For very high demand-pull inflation to occur, there must be severe supply shortages leading to excessive demand.
2. Cost–push inflation causes of inflation
Higher costs for businesses are also known as ‘cost-push’ inflation.
Businesses will raise final selling prices when they face higher costs. They do it to maintain existing profit margins, so the firm can keep current profitability levels.
Higher Variable Costs (VC), or the costs of production, are caused mainly by two things. First, soaring prices of raw material caused by natural disasters such as hurricanes and earthquakes, oil spills, health epidemics such as SARS or COVID-19, limited supply due to bad weather or lower exchange rate pushing up prices of imported materials. Second, by strong push from workers who demand increased wages caused by trade union actions or job switching in the hopes for higher wages.
Higher Fixed Costs (FC), or expenses, are caused by mainly two things as well. First, skyrocketing rents caused by unreasonably high demands from landlords during shortages of new supplies in the housing market. Second, higher interest rates on bank loans and mortgages caused by hikes in interest rates introduced by the central bank to combat demand-pull inflation.
3. Money supply causes of inflation
Increasing money supply injected by the government into the economy through the repo mechanism will also cause inflation. It will happen when an increase in the money supply is not matching the real growth in output of the economy. The country’s central bank, for example European Central Bank, is responsible for that.
TIP: A repo mechanism results in injecting more money into the economy.
TIP: A reverse repo mechanism dries up the money supply.
It is because now the total amount of money that is circulating in the country is higher than the total number of products available on the market to be purchased. This will inevitably lead to inflation as individual customers and businesses now hold on to too much cash comparing with what they can buy for it.
That abundant amount of cash will be spent on consumption on limited goods and services, most likely leading to demand-pull inflation.
4. Higher expectations causes of inflation
Higher expectations from employees believing that inflation will occur sooner than later can actually be another cause of inflation itself. This is because workers and managers pressing for pay increases tend to build in anticipated amounts of inflation into their claims.
Employees will demand higher paychecks in response to both inflation in the previous year as well as expected inflation in the following year. If workers expect inflation to be 4% next year, and they want a 3% rise based on last year’s inflation rate, they will demand a 7% pay increase in total.
Workers will most likely expect pay rises in line with inflation rates (or higher) to maintain real living standards for their families.
To sum up, the four causes of inflation include excessive demand from customers, higher costs for businesses, increasing money supply and higher expectations about the future.
