What Causes Inflation?: Common Questions About Inflation

What are the main causes of inflation? Or you may be wondering more broadly, how is inflation caused? These days, it seems like everyone is asking these kinds of questions as inflation continues to increase. Many people understand that inflation means that prices are rising. But why are they rising? In this article, we will explore common questions about inflation.

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What Are the Main Causes of Inflation?

Inflation simply means that the average price level in the economy has increased. Goods and services cost more than they used to. Why does this happen? What are the main causes of inflation? Most economists point to 6-8 factors that can help you answer the question, “How is inflation caused?” at your next dinner party.

Cuts in Interest Rates

If consumers and businesses can borrow money at very low rates and receive low rates on saving balances, they will be more likely to spend money instead of saving it. This will naturally push up prices on many goods as it increases demand. Specifically, low mortgage rates increase demand for homes and the input costs to homes. The increases in input costs are a direct driver of inflation. Economists also describe a “wealth effect” that occurs when people’s homes increase in value. They feel rich, and they increase their demand for goods and services, which is a pro inflationary phenomenon.

Increased Money Supply

If the amount of goods available in the economy does not change, but the amount of money goes up, inflation is likely to follow. It is a very simple concept. If a baker sells bread for $2 today, but tomorrow he realizes everyone in the town has twice as much cash as they did yesterday, he can double the price of his bread and experience no decline in demand. This is inflation.

Higher Wages

If employees, on average, begin making substantially higher wages, this can lead to inflation. Why? Employees are also consumers. With more money in their pockets, consumers become willing and able to pay more for a variety of goods and services, and prices will rise to meet this increased demand. On the other hand, of course, paying higher wages is also a cost for businesses. As wages rise, businesses may increase prices to maintain profit margins. Higher wages can lead to inflation from both a demand and supply side.

Relevant Import Prices / Currency Devaluation

Imagine that parts for engines are overwhelmingly sourced abroad. Because of a labor strike or natural disaster, the cost of these parts increases dramatically. Or imagine that the U.S. dollar falls in value relative to the currency of the countries supplying the parts. In both cases, it now costs a lot more to make a car, boat, plane, or machine in the U.S. because more must be spent on these engine parts. This will often lead to higher prices for machines that rely on these more expensive parts.

Raw Material Prices

In the above paragraphs we talk about wages and import prices. These are both examples of input costs. Another key input cost is raw materials. If, for example, weather reduces the supply of crops and costs skyrocket, many food manufacturers will raise prices because the ingredients for their products now cost more.

Declining Productivity

If businesses experience declining productivity, perhaps because experienced workers are getting older and retiring, this can lead to higher cost of goods sold. To maintain profit margins, firms could raise prices, leading to inflation.

Higher Taxes

Higher taxes on inputs or profits can also lead to inflation, as firms seek to counteract this new cost with higher prices.

Inflation Expectations

Another major driver of inflation is a funny one: the expectation of inflation. If businesses expect inflation, they may increase prices in advance, which then becomes a self-fulfilling prophecy. Or, if consumers expect inflation, they may dramatically increase their demand for products now, before they become more expensive. But again, this allows firms to charge higher prices!

People often ask what caused inflation in the 1970s? Increases in oil prices are often blamed, and certainly that played a part. But most economists now believe that monetary policies were the major cause. The U.S. introduced too much money into the economy and the Federal Reserve kept interest rates unnecessarily low in an ill-advised attempt to spur economic growth.

Common Questions About Inflation

Even if one understands the main causes of inflation, there are often several derivative questions people have about how inflation works. Let’s explore some of these.

Does Raising the Minimum Wage Cause Inflation?

Does raising the minimum wage cause inflation? Above, we mention that increases in wages can cause both demand-pull and cost-push inflation. So, it would seem like the answer to, “Does minimum wage cause inflation?” would be yes. However, the more accurate answer is not really.

Individuals earning a minimum wage tend to make up a very small portion of the overall cost of goods or services. This is the theory behind why an increase in the minimum wage would not cause much inflation. Empirical studies have also shown that an increase in the minimum wage doesn’t really lead to inflation. One study found that a 10% increase in the minimum wage led to only a 0.36% increase in prices.

Does Printing Money Cause Inflation?

Does printing money cause inflation? There is a nuance that must be considered to answer this question with complete accuracy. The basic answer though, is yes – printing money causes inflation. However, economists believe in times of depression or severe recession, printing money and getting it in the hands of consumers to drive economic activity is an optimal response, and can be done without leading to inflation (at least without leading to inflation that is anywhere close to as troublesome an issue as a sustained recession).

Do Low Interest Rates Cause Inflation?

Do low interest rates cause inflation? Again, the basic answer is that yes, they often can, as described above. However, as with printing money, in times of economic recession, interest rates can be kept low to spur economic growth, which is a net positive for a nation’s overall economic health.

Does Inflation Cause Unemployment?

Does inflation cause unemployment? It certainly can, for three reasons. First, uncertainty around unemployment can lead firms to avoid making investments, leading to a lower need for talent. Firms aren’t sure what inputs will cost, or what consumers will be willing to pay. So, they delay investing.

Second, inflation can lead to a “boom and bust” cycle. Economic growth heats up, wages and prices rise, and workers are hired as profits soar. But eventually, consumer demand flattens out, and monetary authorities increase interest rates to ensure inflation doesn’t get out of control. This causes a reversal of fortunes quickly, and firms are now forced to reduce employment to combat lower demand.

Finally, if a firm exports its goods, but experiences inflationary pressure, it may increase prices. But now, its goods are less competitive, and foreign demand declines. This can lead to unemployment in the export sector.

The Difference Between Cost-Push Inflation and Demand-Pull Inflation

Many of the above factors and drivers of inflation can be placed into one of two major categories: demand-pull and cost-push.
What causes demand-pull inflation? It’s an umbrella term that captures many of the drivers we’ve already discussed. Demand-pull inflation refers to demand growing faster than aggregate supply. In other words, consumers increasingly want to buy goods and services but the availability of those goods and services is not keeping pace with this demand. This tends to happen for the following reasons:

  • An increased money supply
  • Unnaturally low interest rates
  • Higher wages

All the above lead to a situation where consumers have money, and they want to spend it. In addition, higher wages can also be a driver of both demand-pull and cost-push inflation.

The more noteworthy category of inflation is cost-push inflation. Here, prices rise not because of demand issues, but because of input costs. Things begin to cost more, and businesses increase prices accordingly to maintain margins. The following can be categorized as cost-push inflation drivers:

  • Higher wages (as it now costs more for a business to produce a good or service)
  • Higher raw material costs, import prices, or taxes
  • Declining productivity

Inflation expectations are also a critical inflation driver that could fall into either the demand-pull or cost-push category. But really, this driver stands alone. Whether you are a business trying to plan production or a consumer trying to budget out a major purchase, if you believe prices are going to rise in the future, this will often cause you to take actions that lead to near term price increases, creating a self-fulfilling prophecy.

How Does Inflation Affect Businesses?

“What are the main causes of inflation?” is a question we’ve now explored in detail. How is inflation caused? You should have a much better sense now. But why does inflation matter to businesses? Let’s explore further.

If wages and input costs all rose 5%, and everyone agreed they were going to rise 5%, with all else being equal, a business could raise prices by 5%. If in general, competitors pulled from the same labor pool and supplier base, and consumers understood the dynamics at play, prices could rise at 5-7% per year without a major impact on businesses. But that perfect world does not exist, and the major way that inflation impacts businesses is through uncertainty. Businesses hate uncertainty, because it makes planning hard, and it makes investing in major projects even harder.

Imagine that you are a business owner and that you think inflation is coming. You estimate it means your product can be sold for a 5-10% higher price in five years. You are considering a $10M investment in a new plant to increase production. What if input costs rise by 5% per year and wages rise by 7% per year, but the prices for your products in the market only rise by 3% per year due to competition?

Let’s do some simple math. Assume you pay workers $20 per hour and you charge $1,000 per unit today. In five years, you are paying $28 per hour and charging $1,159 per unit. This means you are paying workers 40% more but charging only 16% more. If it takes 30 hours of labor to produce your product, profit per unit declines by >20% (from $400 in profit to $317, ignoring all other input costs).

Inflation causes a lot of uncertainty, which causes business leaders to avoid making the investments needed to create economic growth and spur continued employment.

Conclusion

What are the main causes of inflation? Monetary policy, raw material prices, tax policy, and even expectations of inflation all play a major role. “How is inflation caused?” can at times be a complex question to answer. But one thing is certain. Except in times of severe recession and depression, signs of inflation are worrisome. The uncertainty caused by inflation can prevent businesses and the broader economy from functioning properly.

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